Banking "mysticism" and the hot potato

Paul Krugman seems to have gotten into an argument with the MMT guys about commercial banks creating money. I'm just giving my own views on this question. I'm basically following Leland Yeager [update: and David Laidler]. Strangely, while I agree with the MMT guys on many points (banks do create money out of thin air) I end up (I think) in much the same place as Paul.

Start out with an economy with no commercial banks. Just a central bank issuing currency. Suppose the central bank wants to increase the stock of money. It does not have to persuade people to want to hold more money. Money is weird like that. People accept money in exchange for the goods they sell, not because they (necessarily) want to hold more money, but because they plan to exchange that money for something else.

Money is a consumer (and producer) durable, but it's very different from other consumer durables.

The stock of money is supply-determined in a way that the stock of refrigerators is not. A manufacturer of refrigerators needs to persuade people to hold more refrigerators if it wants to increase the stock of refrigerators in public hands. A manufacturer of money doesn't. That's because money is the medium of exchange. If every household only wanted to own one refrigerator, and already owned one, any extra refrigerators would be left lying on the sidewalk. That could never happen with money, if it was still being used as money. People would pick it up and spend it.

An excess supply of money is like a hot potato. Nobody wants to hold it. But everybody is perfectly willing to accept it, because he knows he can pass it on to someone else, who in turn accepts it because he knows he can pass on to another. I might buy a refrigerator even if I knew I could never sell it again. I would never buy money if I thought I could never sell it again.

The hot potato process is a disequilibrium process. The average person expects to receive $100, and plans to spend $110, to get rid of a $10 hot potato. But he is surprised to discover that he received $110 instead of the $100 he expected, because everybody else is doing the same thing. So he tries again, and keeps on trying until eventually expectations adjust, prices adjust, and incomes adjust, and the extra money is willingly held, in the sense that the average person plans to spend an amount equal to what he expects to receive. Supply of money, eventually, creates its own demand.

Now lets bring in commercial banks.

Commercial banks cannot create GICs out of thin air. Individually and collectively, if commercial banks want to increase the stock of GICs in public hands, they must persuade people to hold more GICs. GICs are like refrigerators.

Commercial banks can create money out of thin air. The commercial bank just buys something. It doesn't matter what it buys. It could be a new computer, or an IOU from someone who wants a loan. The bank pays for it by writing a cheque, drawn on itself. When that cheque is deposited, either at the original bank, or at another, the stock of money in public hands has increased. It does not matter whether the seller of the computer, or seller of the IOU, wants to hold more money in his chequing account. Most likely, he wanted the money because he planned to spend it. That's why people accept money in exchange for goods and services and IOUs. They accept it, only because they believe that someone else will in turn accept it from them.

If that was all there was to it, there would be no difference between commercial banks and central banks. Both can create money out of thin air (or paper, or ink marks, or electrons) just by buying something. They can increase the stock of money in public hands without having to increase the stock of money demanded. But there is one important difference between commercial banks and central banks.

Commercial banks promise to redeem their money at a fixed exchange rate (at par) for central bank money. Central banks do not (banking crises aside) promise to redeem their money for commercial bank money. Redeemability is asymmetric. Just like if the Bank of Canada fixed the exchange rate of the Canadian dollar to the US dollar, but the Fed made no commitment the other way. And because each individual commercial bank promises to redeem its money in central bank money, the central bank is at the centre of a fixed exchange rate system in the same way that the US Fed was at the centre of the other central banks under Bretton Woods.

The bank that makes no promises is free to do what it wants. The banks that promise to redeem their money for another bank's money aren't free to do what they want.

An individual commercial bank can create money out of thin air simply by buying something. But the money it creates may not be its own. Its money may subsequently be redeemed for the money of another bank, or the central bank. The individual commercial bank that wants a permanent increase in its stock of money may need to persuade people not to redeem its money. Whether or not it needs to do anything to persuade them all depends on how the other banks, especially the central bank, react.

I can imagine a world in which an individual commercial bank can permanently create money. All it needs is that the central bank, which is free to do what it wants, allows the supply of its own money to increase in proportion to the supply of commercial bank money. This is what would happen if the central bank targeted a rate of interest, for example. One commercial bank creates money, and all the other commercial banks, and the central bank, respond to the hot potato process by increasing their own money supplies in response to the rising demand for loans and deposits and currency.

But it doesn't have to happen that way. It didn't ought to happen that way. The central bank is free to do what it wants, and it didn't ought to let individual commercial banks set monetary policy in this way. Just because the Bank of Montreal wants to expand its balance sheet by 10% doesn't mean that all banks and the Bank of Canada should expand their balance sheets by the same 10%. Instead, the Bank of Canada should be doing something sensible, like targeting inflation (or NGDP). If the Bank of Montreal wants to permanently increase the size of its balance sheet, and if the Bank of Canada doesn't want to increase the size of its balance sheet, the Bank of Montreal will need to persuade people not to redeem its monetary liabilities for the monetary liabilities of the Bank of Canada and all the other commercial banks. It will need to pay higher interest on deposits, cut fees, open more branches, or whatever, to try to change the public's desired composition of the total stock of money.

The Bank of Canada doesn't need to do that. Because it makes no promises to redeem its money. If the Bank of Canada wants to increase the supply of Bank of Canada money, it just does it. It doesn't need to persuade people to want to hold more.

Comments

[bill woolsey]

Good proces explanation.

Too many economists mess this up by focusing solely on the equilibrium condition.

[Nick Rowe]

Bill: exactly! Thanks.

[K]

Ok but Krugman said that commercial bank money is limited by reserves and the central bank's limit on the quantity of currency. He also said that an individual bank must get deposits from somewhere. This is truly just nonsense. Of course there's some kind of macro equilibrium money supply which the CB can determine given the dynamics of the economy. But it's definitely a result of a complex system, and not some kind of exogenous constraint. The most sane thing to say is that if the CB holds rates constant, and the natural rate rises, then people will borrow and invest/consume more and the quantity of deposits will rise as a result of borrowing. *That* is the NK model. Then you can layer the CB response on top of that. But to claim that the money supply is exogenous in our economy is pretty absurd.

[Anon1]

K:

Over the long-run the money supply is exogenously set by the central bank as it follows something like a Taylor Rule. In the short-run, with an interest rate target, it is endogenously determined. The confusion of endogeneity vs. exogeneity of the money supply often comes down to confusing the horizon one is analyzing.

[vjk]

K:

This is truly just nonsense

This is not nonsense.

The bank lending ability is limited primarily by its capital, not its reserve balance account, true.

However, if the bank needs to settle with another bank, it does need some M0 on its reserve account, even in Canada where the reserve requirement is zero, or the UK. The retail deposit base is the cheapest source of funding to procure settlement money for banks. Those banks that 'think' otherwise usually die. Witness the fate of Chicago Continental in the US or Northern Rock in the UK that chose to rely on wholesale market for interbank cash rather than on traditional retail deposits.

The lender of the last resort notwithstanding who will lend up to a point and then 'resolve' the bank.

[Nathan Tankus]

"strangely, while I agree with the MMT guys on many points (banks do create money out of thin air) I end up (I think) in much the same place as Paul."

It should be mentioned that Krugman got into an argument with Steve Keen, not an MMT person. This post looks somewhat confused to my eyes.

"If the Bank of Montreal wants to permanently increase the size of its balance sheet, and if the Bank of Canada doesn't want to increase the size of its balance sheet, the Bank of Montreal will need to persuade people not to redeem its monetary liabilities for the monetary liabilities of the Bank of Canada and all the other commercial banks. It will need to pay higher interest on deposits, cut fees, open more branches, or whatever, to try to change the public's desired composition of the total stock of money."

how so? I'm assuming that you're talking about a deposit drain from lending. If increased lending growth is higher for the Bank of Montreal and this results in a deposit drain, the Bank of Montreal will increase it's demand for reserves. This will be supplied by other banks on the interbank loan market. If withdrawals of cash cause the commercial banks as a whole to be short of reserves, not providing sufficient reserves will cause a liquidity crisis. Not supplying sufficient reserves to the banking system goes against the reason for a Central Bank's existence!

http://www.bankofcanada.ca/wp-content/uploads/2010/05/wp97-8.pdf

[vjk]

Nick:

The bank pays for it by writing a cheque, drawn on itself

If the above implies that the bank can loan to itself thus manufacturing credit money, that is not true at all. It cannot, and if it did it would be fraudulent. The bank can only lend to another entity, not to itself.

In order to buy stuff, the bank will exchange its assets, possibly the bank's deposit at another bank for the stuff in question.

[vjk]

Closing italics :)

[JW Mason]

Krugman's post was silly.

The money supply is not "exogenously set" by the central bank. It is influenced by the central bank, and the degree of that influence depends how close substitutes private liabilities are for c.b. liabilities. Krugman implicitly assumes that demand for c.b. liabilities is perfectly inelastic -- i.e. a fixed proportion of assets will be held as outside money. It would be a better approximation today to say that the demand for c.b. liabilities is perfectly elastic. -- that any change in the price of c.b. liabilities will lead to an arbitrarily large shift between them and other assets. In other words, the condition that Krugman calls "the liquidity trap" is just the normal operation of modern financial systems, and has been for probably 15 or 20 years now.

Your post is not silly, but I still don't agree with it.

(1) When you say "But it doesn't have to happen that way. It didn't ought to happen that way," is that, as it seems to be, a tacit admission that it actually does happen that way? Because, it does. As a practical matter, the stock of c.b. liabilities is not a constraint on deposit creation by private banks.

(2) You keep talking about asymmetric redeemability. I don't think there is any such animal. In any real-world situation, it is exactly as easy to convert cash to to a checking account, as it is to convert a checking account to cash. And people do not hold commercial bank liabilities because they can be converted to money. They hold commerical bank liabiliteis because they can be converted to goods and services, i.e. because they *are* money.

(3) "Start out with an economy with no commercial banks. Just a central bank issuing currency." It would be interesting, one of these days, if you were to start out from the opposite premise. Imagine a world with no central bank (or commodity money), just private bank liabilities used to settle transactions.

[Luis Enrique]

MMTers often point out that banks can lend first and finance later (this is the point made in that BIS paper everybody likes to quote, and that chap Holmes that Keen quotes in his response to Krugman). This might matter, if you thought that banks have to have loanable funds up front before they lend, and hence giving them more reserves could loosen a constraint and boost lending. But otherwise it's unimportant. In the money multiplier story taught to undergrad, nothing hangs on which order things happen in, that I can see.

Some MMTers also say that banks create deposits when they lend - they can just out of thin air create $1000 in the deposit account of somebody who borrows a $1000. This is also true but unimportant. That's just an entry in an accounts ledger. As soon as the borrower actually uses the money, the bank has to be able to finance it. Banks cannot finance their lending via these notional deposits created in the act of lending. We know banks need people to deposit funds with them, because they go to great expense to attract savers.

There's a post by asymptosis on angry bear (sorry no links, in a hurry) where he/she uses an example to argue it doesn't matter whether people save or not, the money is all there in the banking system somewhere to finance lending. I think that's wrong. Borrowers still require savers. Somebody somewhere has to keep a positive balance in their bank to finance somebody else having a negative balance. If everybody (individuals, firms) did decide to spend their income as soon as they got it, and keep their bank balances at zero, there wouldn't be anybody to fund lending (except the central bank?).

What I need to give more thought to is the idea that lending adds to aggregate demand because it creates new money to be spent. Krugman doesn't like that idea, saying that the spending of the borrower is offset by the saving of somebody else. That sounds suspiciously like "the money has to come from somewhere" argument against fiscal stimulus. If you think of credit expansion as either increasing the money multiplier or endogenously drawing forth an increase in base money, or both, they it increases the money supply and don't people believe increases in the money supply increase AD? But the idea the new borrowing adds one to one to AD doesn't sound right either- what then would be the difference between the money supply and AD? they'd just be different ways of saying the same thing.

This idea of Keen's that credit expansion adds to AD except when it "leaks" into higher asset prices looks like pure horseshit to me.

[JW Mason]

The bank lending ability is limited primarily by its capital, not its reserve balance account, true.

This is already a big advance over Krugman.

However, if the bank needs to settle with another bank, it does need some M0 on its reserve account

Yes, but it matters how inelastic this demand is. Some of the demand for cars falls on Ford Fiestas. But that does not mean that Ford, as the monopoly supplier of Fiestas, can set the price of generic "cars".

[wh10]

“They can increase the stock of money in public hands without having to increase the stock of money demanded.”

Nick, I am confused by the way you are wording this, and I am not sure I agree. The banks don’t have to increase the stock of money demanded because they are responding to an increased demand for money. Someone wanted a loan (i.e. they wanted more money), so they bank supplies it at a price. But the way you write it makes it seem like banks can just push more money on people without persuading them (see your second paragraph); that’s missing the whole point that the bank is responding to increased demand for money. Is this different from what you’re saying?

[vjk]

K:

I do agree that these words of Krugman's are questionable:

First of all, any individual bank does, in fact, have to lend out the money it receives in deposits.

But, the MMT point of view that the bank just extends a loan and "worries about reserves later" is quite naive and simplistic too. In the sense of being able to settle interbank obligations, the reserve account position is a real issue although not a one-to-one metric of the bank's lending capacity. That issue resolution is the fed fund desk manager's full time job at bigger banks or a treasurer's at smaller banks who try to predict fed fund inflows/outflows proactively in order to ensure their bank survival.

[vjk]

Anoter italics problem.

[JW Mason]

not a one-to-one metric of the bank's lending capacity.

Right, the relationship is complicated. But to do economics, we need to represent it in a simple way. So the question is, which first-order approximation is better: Krugman's, that there is a one to one relationship between reserves and bank loans? Or the Post Keynesian, that bank loans are not constrained by reserves?

Personally, I think Krugman's approximation was ok in the postwar decades when he was first studying economics, but the PK approximation has been clearly better since sometime in the 1980s, or 1990s at the latest.

(Note that talking of "banks" is already missing a big part of the story. What we've seen in recent decades is that if the supply of reserves does constrain bank lending, then we will just get more credit creation by non-bank financial institutions.)

[wh10]

Luis Enrique- you're missing the point that when the bank needs reserves to settle withdrawals of some sort (like when a borrower uses their loan), they can get their reserves from the interbank market. And the CB supplies the right amount of reserves to keep the interest rate in the interbank market at their target. So the bank always knows the cost of reserves is X% in the interbank market- and that will serve as the "base" loan rate. But it's not about quantity of reserves, it's about the price administered by the CB. Now, you are right, new deposits are also a source of reserves for banks. If banks can acquire new deposits in a way that is lowering their cost of liabilities more so than if they were just borrowing reserves in the interbank market, then they can perhaps make loans at a lower rate. But this doesn't change the intuition being offered by Post-Keynesians, Keen, MMTers, about how bank lending works. It's about price, not quantity of money deposited or supplied by the CB etc.

[JW Mason]

Borrowers still require savers.

Not true. Keen has a confusing and idiosyncratic way of expressing himself, but he is absolutely right to insist he is following Schumpteter and Wicksell as well as Keynes in saying that credit creation by banks does not require an affirmative decision by any economic agent to increase saving.

What's remarkable to me about Krugman is that not only is he unfamiliar with the heterodox literature (forgivable) but he doesn't seem to know anything about Wicksell, who is supposed to be one of the founders of the profession and who was theorizing a system of pure credit money over a century ago.

The banking system makes a loan of $1,000 to A. This increases both banking system assets and liabilities by $1,000. Fro the point of view of the non-bank economy, money stock has increased by $1,000. A spends the new money on goods and services, transferring the liabilities to other actors who increase their spending in turn, until prices and/or income have risen in the aggregate by just enough to increase desired money holdings by $1,000. Nobody at any time wished to save more. Again, this is what both Wicksell and Schumpeter believed was the normal process of money creation in the banking system. (Altho unlike Keynes, they believed that it was mainly or entirely the price level, rather than aggregate income, that would adjust.) The central bank money story is a later addition that corresponds to a new set of regulations imposed in the first half of the 20th century on top of this credit money system -- reserve requirements etc. Historically, the evolution is the opposite of the one Nick describes.

[Ritwik]

Ahh, that beautiful reserve constrained vs. capital constrained debate again.

Nick, I think it is time to introduce 'desired reserves' in the Macro lexicon, just like 'desired savings'.

Also, a simple reductio ad absurdum of a bank that met capital requirements and still had excess reserves can be useful, no? I don't know where to get this data.

Loanable funds is fundamentally a two-period (at least) model of expectations. I have never quite understood how/why MMT tries to disprove it by using a cash flow statement, which only captures what happened, not what was desired, and is an after-the-fact one period model.

[vjk]

“They can increase the stock of money in public hands without having to increase the stock of money demanded.”

Yes, I agree with wh10, that the above is incorrect. Unless someone comes into a bank and asks for a loan, there is nothing the bank can do to extend a credit without a willing counter-party. No loan -> no credit -> no money creation.

[Lord]

You left out one of the most common ways for banks to create money, lower lending standards. They do create money out of thin air. They are not alone in this but do operate with much higher leverage and a lender of last resort which non banks lack.

[wh10]

VJK- maybe it is an oversimplification, but I think JW Mason rightly identifies it as a econ 101 simplification that doesn't change too much and is intended to drive the point that "loans create deposits" and banks can always require reserves, if needed, at some price. That said, from a high-level, simplified, literal perspective, because of the lagged reserve accounting system, it kind of looks like banks "worry about reserves later." But if you read the actual literature, it won't be that simplified. These are obvious complex, contemporaneous matters. Even in the informal setting, MMTers will say that banks are always 'worrying' about the cost of acquiring reserves, so it's clear they don't mean "worry about reserves later" in all senses of the words. In any case, I don't think MMT banking experts like Scott Fullwiler would disagree with what you are getting at.

[Ritwik]

Also, I think it is possible to defend loanable funds from the 'loans create deposits' challenge by invoking J W Mason's great 'what adjusts' argument. In 'loans create deposits', a cash flow entry is being invoked holding income constant. This obviously does not scale in the aggregate because in the aggregate, income adjusts. That's what a demand-driven business cycle is all about anyway.

[vjk]

which first-order approximation is better: Krugman's, that there is a one to one relationship between reserves and bank loans ? Or the Post Keynesian, that bank loans are not constrained by reserves?

Well, JW, in my opinion neither is good enough due to both being too extreme and simplistic. One has to be able to model price of liquidity management in banks' lending activity. That price, for the bank, may vary from zero to infinity under various market circumstance during relatively short periods of time. And calculating that price is extremely tricky taking into account that fed fund/M0 borrowing is uncollaterized and largely depends on the borrower credibility and/or CB whims which in many cases are unquantifiable. The cost of funding is not just the current price of interbank money set up by the CB.

[vjk]

Lord:

"Thin air" emphasis is rather odd and misleading too.

The bank, by extending a loan, risks its capital. If the loan defaults, the bank capital decreases by the amount of the loss, simplifying somewhat in the spirit of Econ 101 and assuming the loan is uncollarized and the TBTF put is not in place

[wh10]

vjk- right, but like I said, the process is more accurately understood from a cost of funding perspective, not a quantity constraint. that's the point of the oversimplification, and it's an econ 101 oversimplification that still drives that main point home.

[wh10]

Ritwik- I don't understand the points you are trying to make.

"Also, a simple reductio ad absurdum of a bank that met capital requirements and still had excess reserves can be useful, no? I don't know where to get this data."

Banks in the US right now have TONS of excess reserves, due to QE and IOR, and are meeting capital requirements. What's your point?

As far as "desired reserves," banks desire reserves to the extent that they need them to settle payments or meet reserve requirements. They often hold a small buffer of excess reserves to avoid penalties. Banks have no use for reserves beyond this, so they loan them out in the interbank market to earn something off of them. Or in the US today, they just hold them due to IOR, which becomes the interbank rate.

[Kms]

My god, I understood that! Bless you, Nick Rowe, a thousand times bless you.

This argument has had me confused from jump street, but I'm not an economist... I just watch them on tv (and the Internet).

[Ritwik]

Oops, sorry, 'loans create deposits' is also a two period thing, and income adjusts there as well.

I think I will have to go back to 'desired reserves'.

[Ritwik]

wh10

My argument is simple, if lending was never reserve constrained, then you should never see excess reserves.

"Banks have no use for reserves beyond this, so they loan them out in the interbank market to earn something off of them. Or in the US today, they just hold them due to IOR, which becomes the interbank rate."

So, you're saying, there are negligible lending opportunities in the US beyond a risk adjusted rate of 0.25%? The world does not change radically if IoR is 0.25% instead of 0%.

[wh10]

Ritwik - before IOR in the US, you didn't see excess reserves, beyond the small buffer I mentioned, precisely because of the points I was making. See http://research.stlouisfed.org/fred2/series/EXCRESNS

But that buffer is not properly thought of as 'constraining' lending, because again, this is a story about cost of funding, not quantity constraints.

There aren't literally negligible lending opportunities in the US now, but credit appetite and willingness to supply the loans has certainly diminished given the state of the economy and the debt binge we're recovering from. The reason there are so many excess reserves is because the Fed swapped bonds for reserves like crazy via the QE program. Normally this would make the FFR plummet to 0%, but the Fed is paying IOR to support it at a positive level.

[JW Mason]

if lending was never reserve constrained, then you should never see excess reserves.

This is backward. It is reserve-constrained lending that is incompatible with excess reserves.

Anyway, in the real world, we never see excess reserves unless the central bank pays interest on them.

(Normally we get reserve-requirement carrying lending up to the limit of reserves. The we get lending that does not carry reserve requirements, at an additional funding cost of epsilon. The cost to a abnk of converting some demand deposits to time deposits is trivially low. As is the cost of substitution from bank to nonbank lenders, once the fixed costs of entry have been paid.)

[K]

I just can't get past how embarrassing the Krugman post is. He really did say that individual banks need to get deposits to lend them out! And I agree with you, Anon1, that the misunderstanding can be interpreted as confusing an exogenous constraint with an equilibrium condition. And he actually said that he thinks the currency supply is controlled by a CB *limit*. I'm dumbfounded.

But come to think of it, it really explains a lot about his discomfort with the NK model that he himself has used as recently as his 2010 paper with Eggertsson. He always wants to come back to ISLM, and the reason, it now appears is that he truly believes the LM curve to be an essential part of the macro dynamic. The NK model doesn't have a quantity of money, not because the money supply doesn't exist, but because it is extraneous to the problem, a mere vestigial appendage. As JW Mason points out, perhaps some, like Krugman, whose understanding was developed in an earlier reserve banking era can't shake their essentially monetarist intuitions.

[JW Mason]

Krugman's reserve-constrained lending model (which Nick endorses) makes a simple prediction: there is a stable money multiplier. If we don't see that -- and we don't -- his model needs to be replaced.

neither is good enough due to both being too extreme and simplistic.

Sorry, this won't do. Economics -- communication in general -- is impossible without simplification The only question is which simplification to choose. Map is not territory, etc.

Krugman has a model in which, normally, the binding constraint on the volume of credit, and the level of real activity in the economy, is the stock of outside money set by the central bank. (Nick R. has this model too.) If there is not a *stable* relationship between the supply of outside money and the supply of bank money, this model needs to be replaced. You can say, well, yes there's a relationship but it's constantly bouncing around. but in that case, it's not changes in the stock of money that's driving fluctuations in real activity. It's whatever's causing the relationship to bounce around. If you you know what that is, put it in your model. If you don't know, then you need to treat bank lending as exogenous.

Any valid theory can be represented in a simple model. If you can't summarize your theory, you don't have a theory. The statement, "the volume of lending is driven by a vast complex of variables whose interactions are too complex to be summarized" is operationally equivalent to, "I don't know what drives lending."

[K]

JW Mason: "the volume of lending is driven by a vast complex of variables whose interactions are too complex to be summarized..."

Hilarious! And bang on.

[Ritwik]

JW Mason,

How is that backward? If 'finding reserves' after the fact of 'making a loan' is not a challenge (lending is not reserve constrained), then a bank will never hold excess reserves. Hence, if lending were never reserve constrained, then you would never see excess reserves.

wh10

I agree with your point of why you see excess reserves in the system due to QE and the constancy of the FFR - Buiter has made a similar point when he argued that having an IoR/FFR (he views the two as same conceptually) is incompatible with quantity reserve requirements (you can't control the price and the quantity of anything at the same time). I will go further to argue that this also explains the near zero reserves in other 'liquidity demand' recessions - had the Fed done QE then, my hypothesis is, you would have seen excess reserves shoot up even at an IoR of 0%.

Notice how you say 'credit appetite' and 'willingness to supply the loans' in the same sentence - this is exactly my view of the world. In all states of the world, investment is both demand constrained and supply constrained. 'Loans create deposits' captures the demand bit and the interaction between borrowers and financial intermediaries. Loanable funds captures the interaction between savers and financial intermediaries. You can only bring the two together by trying to model default risk and liquidity demand (and not the commercial banking system per se, which anyway is not the most important financial intermediary anymore).

[wh10]

"loans create deposits" isn't intended to describe the entire process, obviously. And obviously there will be other premia attached to loans beyond the cost of acquiring reserves (default, term, etc). I am well aware I said those words, but they don't change anything regarding my point. I don't know what your model of loanable funds is, but if it tells you Person A needs to save and deposit in a bank for the bank to lend to Person B, then it's wrong empirically and theoretically. It is missing the Fed and its role in making sure reserves are always available at whatever its target is. Banks always have that.

[JW Mason]

If 'finding reserves' after the fact of 'making a loan' is not a challenge (lending is not reserve constrained), then a bank will never hold excess reserves. Hence, if lending were never reserve constrained, then you would never see excess reserves.

To say "lending is reserve constrained" is to say "the volume of lending is determined by the stock of reserves." In a world where this was true, any change in the quantity of reserves would be reflected in a proportionate change in the volume of lending. In other words, to say that lending is reserve-constrained, is to say that banks are lending as much as they can given the supply of reserves. So there should never be excess reserves.

By contrast, to say that lending is NOT reserve-constrained, is to say that volume of loans and the volume of reserves vary independently. An increase in lending simply involves the financial system substituting away from liabilities that carry reserve requirements. If the liabilities involved are close substitutes -- as they are -- then this process will be effectively costless. In this case, we would expect to see a large fall in lending and/or large increase in reserves associated with the appearance of excess reserves.

[vjk]

Ritwik:

not the commercial banking system per se, which anyway is not the most important financial intermediary anymore

The commercial bank is the only institution that can manufacture credit money. Other intermediaries operate with loanable funds that are pre-created by banks and vitally depend on the former in their operations and the very existence. Other intermediaries do not create new deposits but merely provide ways to swap existing ones (ownership transfer). Thus, in the light of the above your quoted statement is incorrect.

[Luis Enrique]

apols if this is a duplicate, earlier comment got eaten

wh10 - sure, the savings can arrive via the wholesale (interbank) or retail markets, it doesn't matter.

JWMason,

as I said, when a bank creates both an asset and a liability by lending £1000, that doesn't create any funds to finance loans - that requires a saver. In your story, when A spend the money the money has to come from somewhere. If banks really could create money out of thin air, they'd be printing it like the central bank, and would have no need to pay savers interest on their deposits to attract them. When you write that borrowing does not require an affirmative decision to save by somebody else, I half agree. When A spends the money buying roller skates, the money ends up in the skate vendors deposit account. If the vendor then spends it, the vendor's bank can't use it to fund loans. If the vendor keeps it on deposit for a while, they are 'saving' it and it can be used to fund loans.

[Ritwik]

JW Mason

I think this is one of those A->B vs not A -> not B type divergences. To say lending is reserve constrained is not to say that an increase in the quantity of reserves would lead to increased lending. It is to say that a decrease in the quantity of reserves would lead to decreased lending. The two are not symmetric.

By corollary, if lending were exogenously determined and not reserve constrained, then a 'reverse-QE' type action by the Fed now would lead to a decrease in excess reserves. The 'desired reserves' hypothesis would say that lending would fall.

We are unlikely to see this scenario (reverse QE, decrease in gross quantity of reserves) play out anytime soon, and I anyway believe this is only one half of the story. But I do believe that the mechanical accounting process of making a loan does not negate this half of the story.

In my ideal theory, the 'desired reserves' would be subsumed by 'liquidity demand' and reserves would not be treated differently from other short term interest bearing government liabilities. Currency and reserves would be modelled separately, with the current redeemability being an artifact of history and not a model necessity. The transactions demand of money would be preceded by (and indeed arise from) default risk. Money would be both endogenous and exogenous, investment would be both demand and supply constrained and 'liquidity demand' and 'default risk' of the financial sector (not just commercial banks) would explain disequilibria and recessions. This is close to the Goodhart/ Buiter way of thinking.

[chrismealy]

"It would be interesting, one of these days, if you were to start out from the opposite premise. Imagine a world with no central bank (or commodity money), just private bank liabilities used to settle transactions."

That's where Keen starts from (and why he gets grief from his MMT friends).

[Ritwik]

Nick,

What if the Bank of Canada wants to decrease the supply of Bank of Canada money. Does it still not need to convince anyone to hold less?

[Ritwik]

Sorry, chuck the previous comment. It does not make sense.

[Dan Kervick]

Nick,

Suppose you expect to receive $100,000 of monetary income in the forthcoming year. You have a detailed plan for spending and saving that income. In accordance with that plan, you expect that exactly one year from today, you will have spent $90,000 and saved $10,000. Your planned saving/income ratio is therefore 1/10 and your planned spending /saving ratio is 9/1.

Call this the “expected outcome” (EO) - the outcome in which your income and spending/saving ratio are exactly as described above.

Now, your income in the coming year might be different than what you expect. It might be higher. And you might save either a higher or lower percentage of your income as a result. There are many ways in which these outcomes might diverge from expectations. But let’s just consider a few such as the following in which you still spend exactly the expected amount of $90,000:

(O1) You receive $110,000 in income. Your saving to income ratio is 2/11 and your spending to saving ratio is 9/2.

(O2) You receive $120,000 in income. Your saving to income ratio is 3/12 and your spending to saving ratio is 9/3.

(O3) You receive $130,000 in income. Your saving to income ratio is 4/13 and your spending to saving ratio is 9/3.

(O4) You receive $140,000 in income. Your saving to income ratio is 5/14 and your spending to saving ratio is 9/4.

Etc …

Now my claim would be that a rational person obviously ranks each of these alternative outcomes as preferable to the expected outcome EO. And yet in each case, the alternative saving to income ratio is higher than the saving to income ratio in EO. In each of the alternatives, you end up holding both a higher percentage of your income, and a higher quantity of money overall.

Now, perhaps I do not understand what the hot potato thesis is. But as I understand it, your claim is that the behaviorally fundamental variable in all this is the expected quantity of income saved. That’s your target. So as your income rises in an unanticipated way, your marginal propensity to spend out of income rises with it.

But to me, that seems backward. Your target quantity of saving is simply an epiphenomenon of your anticipated income and desired spending, and has no independent preferential significance for you. There is no reason at all to think that income earners would regard unanticipated income as a hot potato because it forces their expected quantity of saving higher if not spent. The expected quantity of saving isn’t a target that rational agents desire to maintain; it is a by-product of a constraint that they are very happy to see change if the constrain is lessened.

I believe it would be equally a mistake to believe that the behaviorally fundamental variable in all this is the ratio of spending to saving, or equivalently, the ratio of saving to income. If those ratios were your target, then for every one of the alternative outcomes O listed above, there would be a preferable outcome O’ that we can list this way:

(O1’) You receive $110,000 in income. But your saving to income ratio remains 1/10 and your spending to saving ratio remains 9/1.

(O2’) You receive $120,000 in income. But your saving to income ratio remains 1/10 and your spending to saving ratio remains 9/1.

(O3’) You receive $130,000 in income. But your saving to income ratio remains 1/10 and your spending to saving ratio remains 9/1.

(O4’) You receive $140,000 in income. But your saving to income ratio remains 1/10 and your spending to saving ratio remains 9/1.

Etc …

Some might argue that O1’ is preferable to O1, and also to any other alternative in which the income is $110,000 and the saving rate goes us. They might make the same point about O2’ and O2, etc. But this does not seem to accord with empirical evidence as I understand it, which generally finds that as income goes up, the marginal propensity to consume goes down.

[Dan Kervick]

... So since there is no hot potato effect, there is no mechanism preventing the aggregate motives of the public from being the mere sum of the aggregate motives of individuals. There is no ceiling on the willingness of the public to hold more money. As long as someone is giving them money as opposed to asking them for something in exchange for it - either goods or services or promises of more money in return - they will be happy to accept more money.

But this is one place where the asymmetry between commercial banks and central banks plays a role. Commercial banks do give monetary instruments away - they always exchange it. They have to because the money they create and "give" to their loan customers is a real liability for them, a debt for something that they don't control. The central bank's "liabilities" corresponding to issued currency are not genuine debts.

And the other difference between the two is that the central bank, even if it wants to give money away, is more limited by law as to whom it can give it to and for what purposes. It doesn't matter whether they can sock as much money into commercial bank reserve accounts or securities accounts as they want. That activity has little influence on what commercial banks will do.

[JW Mason]

The commercial bank is the only institution that can manufacture credit money. Other intermediaries operate with loanable funds that are pre-created by banks

Wrong. Non commercial banks create credit money all the time. Credit cards are issued by institutions other than commercial banks. Money market mutual funds function as means of payment. Etc.

as I said, when a bank creates both an asset and a liability by lending £1000, that doesn't create any funds to finance loans - that requires a saver.

You did say, but it isn't true. In the process I described, money was created and no one made any decision to save. Again, this is not new. Schumpeter describes exactly this process in Business Cycles (and other places.) Wicksell describes it. Keynes describes it.

In your story, when A spend the money the money has to come from somewhere.

Nope. When A "spends the money", they transfer their liability on the banking system to person B. have you ever written or received a check? Have you ever used a credit card? These are bank liabilities that are transferred from payor to payee. The bank liability itself is the money, there is no other money coming form somewhere else.

If banks really could create money out of thin air, they'd be printing it like the central bank, and would have no need to pay savers interest on their deposits to attract them.

The statement that that banks may face funding costs associated with expanding their balance sheets is not the same as the statement that they need outside money provided by the central bank. In any case, demand deposits typically do not pay interest. The banking system creates deposits at the same time it creates loans. the private sector holds those deposits willingly because the process of credit creation increases nominal income by enough to increase transaction-balance demand by the amount of the newly created deposits.

Martin Wolf: "money is just the liability counterpart to private credit decisions." That would be Martin Wolf, the FT columnist. Maybe he knows a little about the financial system.

[Determinant]

Canada is a complicated example, but it's worthwhile to understand the plumbing. The plumbing determines the rules of the game and that is intentional.

In Canada we should not talk about "reserves" but about capital. In order to make loans and participate in the banking process (actually make payments) you have to have sufficient capital to participate in the Large Value Transfer System. LTVS has two channels for payment, Tranche I and Trance II. Tranche I is secured by the clearer's Bank of Canada deposit account, so it is "reserves" in a classic sense. You cannot clear a transaction in Tranche I greater than your deposited amount, if you want to do so you have to deposit more funds.

Tranche II is "defaulter pays" (from the BoC account).

Tranche II is a secured pool of funds provided by clearing participants. It is expected that the pool will cover any default and if it doesn't (lottery odds) the Bank of Canada will cover the residual.

Banks are expected to arbitrage the cost of clearing in Tranche I and Tranche II, normally Trance II handles 90% of all transactions.

You can't participate in Trance II if you can't participate in Trance I, though if you are eliminated from Tranche II you an still clear in Trance I, by design.

So to participate in LVTS you need enough money (capital and deposits) to have a Bank of Canada deposit balance and if you have that, you can also use Tranche II by providing liquid money-market capital.

Monetary policy in Canada consists mostly of setting account requirements for clear and the "spread" between the overnight deposit and loan rates on Bank of Canada accounts. Buy design, interbank loans for Tranche II are less than the BoC spread, otherwise an immediate arbitrage opportunity is created to force the rate back down.

Retail cheques are cleared in another system called ACSS that has interest rates 1.5% above the LVTS rates. It's LVTS that determines monetary policy.

[Ron Ronson]

"Money is a consumer (and producer) durable, but it's very different from other consumer durables"

I'm not sure I agree. The demand for money derives from specific attributes it possesses. For example: Marketability (it can be exchanged for just about anything) , expected future value, ease of storage etc. Other goods have some of these attributes and may be used as partial substitutes for money. With commodity money the supply is derived by the market as for any other good. With non-commodity money the supply is regulated and controlled by the monetary authorities.

If the monetary authorities do a poor job of managing supply then at one extreme (where supply increases too quickly) people will not hold money because they expect it to be worth less in the future than it is now. In this situation people may well choose a refrigerator (that they do not need to store food in) over money if they expect that the value of the refrigerator will hold up better. At the other extreme people may choose to hold onto money as an alternative to spending it on other things. If the monetary authorities do not adjust the supply to meet this increased demand then the value of money will increase. If prices happen to be sticky then we get a slowdown in economic activity. People may well resort to barter or alternative monies if official money is doing a bad job of optimizing market transactions .

In a modern economy the banking system is one way that the authorities regulate the money supply. When banks "create money out of thin air" then they can only do so safely if they have access to funds that will be acceptable to people who end up selling goods to the takers of the new loans. It will typically be the monetary authorities who control the size of and access to these funds and who ultimately use this to control the size of the money supply.

[Ritwik]

JW Mason/ wh10

Not sure if you're still interested in this, but I just wanted to understand what are the implications of 'lending is exogenous to the monetary base'.

Let's say reserve requirement is 20%. Let's say at the beginning of time, there are no excess reserves : the balance sheet of the banking system (B) has $20 reserves, $20 govt bonds, $60 private loans as assets (with various corresponding deposits as liabilities) and the central bank (CB) has $80 govt. bonds as assets and $20 reserves as liabilities (with $60 net worth). Assume no currency.

Assume I am the only active private sector non-bank player in the economy. Everybody else is sleeping. Now, I go to a bank, ask for a loan of 10, it makes me the loan, creates equivalent deposits. It gets its reserves shortfall from some other bank, which gets it from some other bank, etc. but B as a whole is still short of reserves (because it had zero excess reserves at t=0). So B goes to CB and asks for $2 reserves. CB buys $2 govt bonds from B and adds $2 reserves to its account. B's balance sheet increase by $10, CB's balance sheet (and monetary base) increases by $2. Mishkin/Mankiw see this as a money multiplier of 5 - we laugh at their ignorance for mistaking cause and effect. All is well with the world.

Tomorrow, I go to the bank to 'pay back' my loan. B's balance sheet reduces by $10, it now has $2 in excess reserves. B asks CB to exchange its $2 in excess reserves with govt. bonds. CB, run by a perversely 'inflationary' monetarist, doesn't want to reduce the monetary base/ balance sheet. It declines. $2 shows up as excess reserves, even though these reserves pay zilch.

1) Is this a fair description of what you would expect to happen?

2) If yes, why is 2008 the first time that excess reserves showed up (beyond the various frictions that wh10 describes)? Are you saying that it has never happened in modern American history that the private sector has wanted to reduce debt and the central bank has not wanted to let the monetary base fall?

3) Tomorrow, if the Fed were to bring the IoR to 0% and also refuse to sell back the government debt that it has, what do you expect would happen to excess reserves?

[Peter N]

The various Federal Reserve banks have veritable warehouses full of papers on how bank lending works. I'm amazed that any professional economist could not know this stuff.

http://www.bostonfed.org/economic/conf/conf39/conf39c.pdf

Banks make loans by creating offsetting asset and liability entries. If they don't want to hold the asset, they can securitize and sell it. This removes both entries from the balance sheet leaving only whatever profit was made from the transactions (and maybe some servicing revenue). Note that what was loaned was money, and the security is (broad) money (assuming it goes through the blessing process to become a AAA CDO). Money has been magically doubled.

There are effectively no constraining reserve requirements. The Fed supplies reserves as needed. Bank lending is constrained by:

Capital ratios and VAR calculations
Demand for loans at rates profitable to lend.
credit standards which swing between lax and paranoid depending on where we are in the business cycle.
other Basel requirements (this stuff is above my pay grade, and I'd make a hash of it.)

Last I looked, There were something like $1 trillion of excess reserves. This is a result of QE and has no effect on bank lending, since lending is still constrained by the factors above, but nobody is constrained by a surplus of reserves.

However, banks are always looking for leverage, since profit is a function of leverage. The more you can lend, the more you can make.

So they have tricks among them:

valuation of tier 3 capital (it's worth what I say it is). There are limits on the percentage of capital that can be tier 3
off balance sheet entities http://voices.washingtonpost.com/economy-watch/2010/04/lehman_brothers_the_evil_repo.html
securitization of loans
repos which use the much higher velocity of money in the repo market as a multiplier http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1440752
exploiting idiots like AIG (a Goldman specialty) http://en.wikipedia.org/wiki/Joseph_Cassano

Lehman had 40:1 leverage. And eventually they were constrained out of business, but it took years and they took a few people with them. Some of the European banks have 50:1 leverage.

As for whether debt adds demand, have a look at this chart.

http://research.stlouisfed.org/fredgraph.png?g=67L

When you teach fractional reserve banking, what on earth do you teach?

[vjk]

JW:

Wrong. Non commercial banks create credit money all the time.
What specific non-depository institutions do you have in mind that "create credit money all the time" ?

Credit cards are issued by institutions other than commercial banks.
That is incorrect because those institutions are still banks, albeit specialized banks. None of the major non-commercial bank card issuers operate outside banking system. They run specialized banking subsidiaries such as GE Money Bank, Discover Bank, etc., so-called "monoline" credit card banks that are an integral part of credit money production settling their mutual obligations over Fedwire, in the US case, just as an ordinary commercial bank would.

Money market mutual funds function as means of payment. Etc.
That is also incorrect because, operationally, no new credit money production occurs but merely a change in ownership of already manufactured deposits takes place via a concrete money market instrument transfer to the new owner.

[wh10]

Nice Peter N.

Ritwik- here’s the thing. If the CB is not paying IOR, it is going to make sure there are not any excess reserves. Why? Because the excess reserves are going to push the interbank lending rate to 0% as banks try to trade them away. The Central Bank targets an interest rate and it has to manage reserves appropriately to achieve that target rate. So what you describe in the last paragraph isn’t going to happen. Now, if the CB is paying IOR, then it can just set the IOR at the target rate and it doesn’t matter if there are excess reserves. So as for 2), I don’t think the Fed in the past has paid IOR. Therefore, to keep a positive federal funds rate, in the past it had to make sure to mop up those excess reserves. For a short period of time, the Fed tried targeting monetary aggregates, but that failed and they ultimately ended up setting rates in an indirect way anyways. From Fullwiler: “As a result, even when the Fed’s stated strategy during 1979-1982 was to target a reserve aggregate such as non-borrowed reserves, in order to keep volatility in the federal funds rate from becoming excessive—which was highly likely given that reserve balances earned no interest while there were also significant “frown costs” historically associated with borrowing from the Fed—the actual tactic employed ensured that the federal funds rate remained within an acceptable range, as confirmed in Meulendyke (1988). Thus, Moore (1988) labeled this tactic “dirty interest-rate targeting,” the Fed’s public statements notwithstanding.”

3) Tomorrow, if the Fed were to bring the IoR to 0% and also refuse to sell back the government debt that it has, what do you expect would happen to excess reserves?

If the IoR were 0%, then the FFR would drop to 0. Excess reserves would... still be excess reserves. They can't go anywhere, unless people want to start withdrawing cash, or they could start to become required reserves if banks start lending a lot more.

[JW Mason]

Peter N's comment seems exactly right to me.

Ritwick: The problem is that you're assuming what you need to prove, that resere requirements bind.

The problem is here:

Now, I go to a bank, ask for a loan of 10, it makes me the loan, creates equivalent deposits. It gets its reserves shortfall from some other bank

In that second sentence, if it is at all costly to find additional reserves, the bank can easily avoid the necessity by converting $10 of demand deposits to $10 of time deposits or other non-reserve requirement bearing liability.

Are you saying that it has never happened in modern American history that the private sector has wanted to reduce debt and the central bank has not wanted to let the monetary base fall?

Yes, actually, altho it's not really related to the main point here. Because in modern times, except perhaps briefly during the Volcker period (when they definitely did want to keep the monetary base down) the Fed targets interest rates, not the money supply. Normally the Fed lets the monetary base adjust as necessary to hit its interest rate target.

[JW Mason]

(Or, what wh10 said.)

[wh10]

Good point about non-reserve requirement bearing liabilities. Details like that reveal that reserve requirements bear even less weight.

[Ritwik]

wh10

Transcribed to my scenario (where the private sector wants to 'destroy' money but the Fed is in an expansionary mood), the Fulwiller comment would basically imply that monetarism fails because the Fed fails to be sufficiently monetarist - it gives in to the private sector's demand for destroying money because of its Wicksellian obsession with the fed funds rate. I'd say that this description *could* describe the failure of the Fed's response to the early 90s S&L crisis driven recession.

As a further thought experiment, what would happen if the IoR was -0.25%? -0.5%? Do you hypothesize that banks would reduce the interest on demand deposits correspondingly and people would just withdraw cash and sit on it? Or would the 'representative loan officer' call up the local small business and say, you know what, take that loan you always wanted for 4% instead of 5%? And even if people were to withdraw cash, they wouldn't sit on it if inflation expectations were positive, so you'd get a surge in consumer spending (with a matching reduction in inventories, most likely). In either case, the 'monetarist' view of the world holds. This is the sense I get from reading Buiter/ Svensson - with negative IoRs, you don't need QE and Nick's hot potato effect comes into play.

Conceivably, even with 0 or positive IoRs, there is some level of reserves beyond which the hot potato effect holds.

I'm just trying to see what the hot potato case could be - I believe it is at a maximum one half of the story.

[nemi]

The FED is conducting monetary policy through the money supply in about the same way as the Swedish central bank is conducting monetary policy through the enter button.

Of course, the Swedish central bank do not care whether they use the enter button, the left mouse button or have to write “confirm” to set the interest rate to r. Neither do the FED care whether they have to use x or y dollar to set the interest rate to r. However, a lot of people seem to put some significance on the fact that the FED is using the money supply instead of the enter button.

[wh10]

Ritwik, I think Post-Keynesians would think monetarism fails just because it's always about price and not quantity. In any case, there was some interesting debate a couple years back between Fullwiler and Sumner regarding what would happen if IOR was negative. I'll have to find the links.

[wh10]

Here, with a link to a previous post where I believe Sumner engaged directly in the comments. http://neweconomicperspectives.org/2009/07/why-negative-nominal-interest-rates.html

Fullwiler summarizes what he thought happened here

“I took this one on myself on the KC blog a few times in July. Got a bit of a response from Sumner and some on his blog, but we were mostly talking past each other, claiming the other had misinterpreted, etc., so I let it go.

Basically, both the excess reserve tax (which is the negative nominal interest rate on excess reserves) and the currency tax of Mankiw are based on Yeager’s “money does not burn holes in pockets.” In seeing Sumner’s responses to me, he doesn’t think the money multiplier is the mechanism for the negative interest rate on ER, but rather that if you can push everyone holding short-term investments into deposits, then they will spend. The basic idea would be to have a negative rate on ER and a higher rate on RR, so that banks would be encouraged to convert ER to RR, not necessarily via lending, though, but instead by raising the relative return on deposits to other short-term investments. What you’d really get is a bunch of portfolio shifting, but no more spending, probably less at least from wealth holders since their returns fell (though some would argue the lower interest rate would bring about more borrowing, the net effect of borrowers and savers is less clear, as we know). For instance, in the US, banks would reclassify existing sweep accounts (about $800 billion right now) as deposits to raise RR relative to ER, but this would have no effect on depositors at all, who already think they are holding deposits.

An important point to bring out is that these folks (including some at the Riksbank) believe that setting the remuneration rate on reserve balances equal to the target rate is a tightening of policy, since it is believed that banks no longer have an incentive to “work off” ER either via lending (money multiplier) or the process I described above. So, the Fed’s move in the fall to pay interest on reserve balances was actually a tightening in their view that is more than partly to blame for the recession. They actually believe that in the US, banks desire to hold $700 billion in ER right now. Some at the Fed appear to believe this, too. Simply astounding!”

http://bilbo.economicoutlook.net/blog/?p=4763

[Ritwik]

JW Mason

I'm not trying to prove that reserve requirements bind - I think that that's an ill-posed statement - as I went on to say that the central bank does accommodate this demand for additional reserves without much ado. I get your point about demand deposits vs. time deposits (Though I don't understand why this institutional structure must be assumed to be given - I can very easily imagine regulation that bans this) but I think it is irrelevant to the concept of credit creation being independent of the monetary base.

My point was that if credit creation is independent of the monetary base, you should have seen excess reserves in some or the other earlier recession as well, but like you said, the Fed has never really tried to hit a monetary aggregate target for expansionary purposes, so my point is moot.

This was, until this recession, where even though the Fed does not have a monetary aggregate target, one could describe QE as trying to hit that level of monetary base beyond which credit creation will increase.

The way I understand things is - your view implies that there is no such maximum level of monetary base, while the monetarist view implies that if the Fed were to reverse QE right now, credit creation should fall. A marginal increase in monetary base leading to a marginal increase in excess reserves while lending remains constant proves or disproves neither view.

I tend to disagree with the monetarist account but not because of 'bank lending is not reserve constrained'. Rather, because

1. Banks are not the only or the primary lenders.
2. In part because of 1, 'desired reserves' is not the only component of liquidity demand.
3. There is no default risk in either account.

[JW Mason]

nemi hits an important point. There have been times and places historically where there were genuine commodity money systems, where it made sense to think of the quantity of money in circulation as an important economic variable. Over the course of the 19th century, this gave way almost completely (at least in the advanced countries) to systems of bank-created credit money.

Then, mostly in the early 20th century, countries adopted new regulations to control the pace of credit creation by banks. Among these new regulations were reserves. Reserve requirements created a new quantity to be controlled by the central bank, and thus created a superficial formal similarity between the credit money system ad the older commodity money systems. But the quantity of reserves was never really an economic variable in its own right, it was just a tool that central banks used to control interest rates. That central banks happened to control interest rates using a knob labeled "quantity of reserves" gave a new lease of life to old quantity theories, in the form of monetarism. But it really was just the label on the knob. Leijonhufvud has a nice essay on this.

[JW Mason]

(And really, I should say one of the knobs. The reserve requirement system only worked in the context of lots of other regulations -- interest rate ceilings, strict limits on the activities of different types of institutions, etc. -- that limited the ability & incentive of banks to innovate around the requirements.)

[Dan Kervick]

Ritwik,

It seems to me that in your thought experiment about a negative rate of interest on reserves, you are confusing the rate of interest on reserves with something like the Fed's discount rate. If the Fed imposed a negative rate of IOR, that would amount to a tax on reserves. Every day, the bank's reserve balances would shrink as that tax is deducted.

What should then happen is that the Fed Funds rate would also go higher The banks would be losing reserve balances, and so their demand for the reserves needed to make their routine interbank payments would go up, driving up the Fed Funds rate with the demand. Of course, ultimately the results would be catastrophic if the Fed kept sucking reserves out of the system. The payments system would freeze up and bank lending would grind to a halt. It certainly wouldn't make banks more willing to lend at lower rates, because they would have no means of accommodating the higher volume of payments that increased loans would require.

Positive interest on reserves effectively decreases the cost of acquiring additional reserves, since it means that the Fed is providing banks with additional reserves each day for free. It's like a discount off the discount rate and the Fed Funds rate, and is a zero bound tool. The discount rate puts a ceiling on the Fed Funds rate. Since the Fed can't make the these rates go below zero, the only think it can do instead is provide reserves for free, so that the resultant real cost of acquiring reserves is negative.

[JW Mason]

Ritwik-

To me, the statement that banks are not the only or primary lenders is precisely one of the main reasons that bank lending is not reserve-constrained. Just consider the first "banks" to refer to entities that are regulated as banks, and the second "bank" to refer to institutions that function as banks.

I don't think you're right about QE. The goal of QEI was to remove bad assets from the banking system. Expansion of base money was an unintended side effect. They initially financed asset purchases by reducing Treasury holdings and only started selling reserves when they were in danger of running out of Treasuries. As for QEII, I would think the monetarist view would be that since it is just trading one non-money asset for another, it should have no effect on private credit creation. Nick has probably written something about this but I am not going to look it up right now.

All right, I'm off to the bar.

[Determinant]

Excellent point about commodity money systems, JW Mason. Bretton Woods was an attempt to revive this in that the US dollar was pegged to gold, and everyone else pegged to the US dollar but it led to well-known market instabilities and economic constraints that were considered politically unacceptable.

But even in the heyday of Bretton Woods few central banks actually cared about gold, they preferred to own US Bonds instead (to get interest) and Canada refused to participate in Bretton Woods entirely from 1950 - 1962. Gold was a nice conceit, but it wasn't at the heart of the matter. It was the icing on the cake.

[Nick Rowe]

Wow! I head off to put new tires on a couple of cars, and do a brake job, and 56 comments!

Let me just respond to some points:

Nathan: "Not supplying sufficient reserves to the banking system goes against the reason for a Central Bank's existence!"

What does "sufficient" mean? What quantity, at what rate of interest, under what conditions? The very reason for a modern central bank's existence is to choose the supply function (note I said supply *function*, not quantity) of reserves in a way to get the best monetary policy.

vjk: "In order to buy stuff, the bank will exchange its assets, possibly the bank's deposit at another bank for the stuff in question."

The bank buys something by giving the seller an IOU signed by the bank (a cheque).

JW: "The money supply is not "exogenously set" by the central bank."

The whole argument about whether the stock of money (people should stop saying "supply" when they mean "actual stock") is exogenous or endogenous is very confused. The weather is exogenous in most macro models but endogenous in all meteorological models. Plus, the exogenous/endogenous distinction is totally different from the supply-determined/demand-determined distinction.

"(1) When you say "But it doesn't have to happen that way. It didn't ought to happen that way," is that, as it seems to be, a tacit admission that it actually does happen that way? Because, it does."

No it doesn't. The Canadian inflation rate is chosen by the Bank of Canada, not the Bank of Montreal.

"And people do not hold commercial bank liabilities because they can be converted to money. They hold commerical bank liabiliteis because they can be converted to goods and services, i.e. because they *are* money."

People don't accept cheques from bust commercial banks. They run to redeem commercial bank money into central bank money.

wh10: "The banks don’t have to increase the stock of money demanded because they are responding to an increased demand for money. Someone wanted a loan (i.e. they wanted more money), so they bank supplies it at a price."

If I want to borrow $100,000 to buy a house, that is not a demand to *hold* an additional $100,000 in my wallet or bank account. When I (and nearly all economists) talk about the "demand for money" we mean the desired stock of money we choose to keep in our wallets and chequeing accounts. It's the desired average inventory of money.

Ritwik: "Nick, I think it is time to introduce 'desired reserves' in the Macro lexicon, just like 'desired savings'."

The concept of "desired reserves" is already very well established in the macro lexicon. It's the desired reserve ratio (and *not* the *required* reserve ratio) that belongs in the traditional banking multiplier story.

wh10: "Banks in the US right now have TONS of excess reserves,..."

No they don't. People should stop (implicitly) defining "excess reserves" as "actual reserves minus *required* reserves". Excess reserves should instead be defined as "actual reserves minus *desired* reserves", because that's what matters. Required reserves only matter insofar as they influence desired reserves.

JW: "Krugman's reserve-constrained lending model (which Nick endorses) makes a simple prediction: there is a stable money multiplier."

Nope.

General point on "reserves": There is a demand for central bank money. Some of that demand comes from the public, and some of it comes from the commercial banks.

Ritwik: "What if the Bank of Canada wants to decrease the supply of Bank of Canada money. Does it still not need to convince anyone to hold less?"

That comment did make sense, and was a good question. My answer is "no".

Dan: "Your target quantity of saving is simply an epiphenomenon of your anticipated income and desired spending, and has no independent preferential significance for you. There is no reason at all to think that income earners would regard unanticipated income as a hot potato because it forces their expected quantity of saving higher if not spent. The expected quantity of saving isn’t a target that rational agents desire to maintain; it is a by-product of a constraint that they are very happy to see change if the constrain is lessened."

We aren't talking about "saving", as that concept is conventionally defined in economics. We are talking about the desired stock of the medium of exchange that people choose to hold. That's what 'demand for money" means. The quantity of money demanded is not a constant. It depends on things like; the price level, income, interest rates, etc.

"There is no ceiling on the willingness of the public to hold more money. As long as someone is giving them money as opposed to asking them for something in exchange for it - either goods or services or promises of more money in return - they will be happy to accept more money."

They will be happy to *accept* more money, but that doesn't mean they want to *hold* more money.

JW: "Martin Wolf: "money is just the liability counterpart to private credit decisions." That would be Martin Wolf, the FT columnist. Maybe he knows a little about the financial system."

Many finance people don't have a clue about money. Money is *not* just the liability counterpart to private credit decisions. Money is the medium of exchange.

Peter N: "The Fed supplies reserves as needed."

No it doesn't. It chooses a supply *function* of reserves in order to attain its monetary policy objectives, like hitting the 2% inflation target (for the Bank of Canada).

[wh10]

I'm curious to here Nick Rowe's responses to the comments more towards the beginning of the thread. Namely this idea of "forcing money" vs "responding to demand" and also Tankus's point RE: risking instability of the system.

[Nick Rowe]

Typepad just put my comment in spam!! The cheek of it! I had to fish it out!

wh10: I'm running a bit behind, and don't know if I'll ever catch up. But I think I did respond on those questions.

[Ritwik]

JW Mason (@7:50 pm)

I should have specified that by QE, I meant the way Buiter uses the term. You can find him being his usual lucid and prescient self here.

http://blogs.ft.com/maverecon/2009/01/quantitative-and-qualitative-easing-again/#axzz1qjKEbNbo

http://blogs.ft.com/maverecon/2008/12/quantitative-easing-and-qualitative-easing-a-terminological-and-taxonomic-proposal/#axzz1qjKEbNbo

QE1 was therefore, qualitative easing + quantitative easing and QE2 (or Operation Twist) was not QE at all, in his terminology. Qualitative easing is aimed at capital, quantitative easing is aimed at funding. Buiter regards both as important, and is more concerned about qualitatitve easing than about quantitative easing. But I digress.

Dan,

When the banking system has excess reserves, taxing and dwindling those reserves does not create the need for reserves for routine interbank payments. The fed funds rate could be anywhere above that rate (including positive) but interbank lending is unimportant (from the perspective of private credit creation) in the situation of excess reserves, except to study funky anomalies, like why the interbank rate frequently breaches the floor set by the IoR.

wh10

Thanks, I will read Scott Fulwiller's post, but that excerpt critiques a particular view of Sumner (which the literature would probably call the 'money view' of monetary policy) that I have no wish to defend. The relation of monetary base and private credit creation is firmly in the 'lending view' of Bernanke/Gertler. For a discussion, read Kashyap/Stein here : http://www.bostonfed.org/economic/conf/conf39/conf39c.pdf (Warning - this paper is firmly rooted in the exogneous money view, so it does not handle the loans create deposits critique. It is a good description of what seems to be the dominant strand of central bank thought these days, though. )

JW Mason (@7:37)

Thanks for that Leijonhufvud essay! Though, I have to ask, did you actually read it in full? Sample these :

" Wicksell presented the pure credit system model as "a precise antithesis to the equally
imaginary case of a pure cash system, in which credit plays no part whatever" (1936, p. 70, italics
added). The strategy for developing applied monetary theory, he suggested, was to regard actual
monetary systems
... as combinations of these two extreme types. If we can obtain a clear picture of the causes
responsible for the value of money in both of these
imaginary cases, we shall, I think, have found the right key to a solution of the complications which
monetary phenomena exhibit in practice. (ibid.).
This is a stroke of genius -- more original, in my opinion, than the cumulative process by
itself. But it is by the same token deeply problematic, for Wicksell has very little to tell us about
how to go about the task of fashioning a viable synthesis from his two antithetical models. "

"This lack of an outline of the suggested synthesis has been unfortunate in that the
Ricardian thesis and Tookean antithesis have been carried down to the present day as mutually
exclusive theories with Monetarists denying the relevance of credit and Credit theorists still
lacking a theory of the price level4. Thus Milton Friedman turned the evolutionary argument
against Credit theories: monetary theory should focus on the banking system's liabilities and not on
their assets which evolution had reduced to a minor component of total credit."

"One notes, however, that the "horizontalist" position -- i.e., the
proposition that the observed money stock is determined by demand -- has the same
consequence here as in Tooke, namely, the price level is not explained by supply and demand.
Theories with the anti-quantity theory lineage of Radcliffe-Kaldor-Moore tend, rather, to have
prices determined by a mark-up on wages, and money wages in turn determined by the power
of trade unions."

"When the market and natural rates get back into line and the credit expansion stops, the
demand for "cash money" at the elevated price level will exceed the supply. This real balance effect may be weak in Wicksell's theory and easily overridden by credit movements, but it is
nonetheless present. So, a mean-reversion tendency will be built into the system. This is an
extremely important property, even if the tendency is relatively weak. The objections to the pure
credit model now have answers"

"In Keynes's theory, the idea that liquidity preference could prevent the long rate of interest from
declining to a level where investment would absorb full employment saving was central to his
explanation of persistent unemployment13. Early Keynesian theory retained this focus on failures of
the intertemporal price mechanism to coordinate saving and investment. But later Keynesian
unemployment theory shifted the focus back to the "classical" preoccupation with rigid or "sticky"
wages." (Ergo, Operation Twist, etc.)

I think that we are agreed that banks are not important (credit is). I would also say that reserves are not important( but funding liquidity is - which is why I am not ready to trash loanable funds yet).

[Ritwik]

Incidentally, the whole money vs. liquidity and financial frictions bit is also why I am trying to grapple with Steve Williamson's latest paper. Though, I believe, at the heart of his model is a tautology. But I can't see it yet.

[Mike Sproul]

Nick:

The fed only issues a dollar if people are willing to hand it a dollar's worth of stuff (e.g., bonds) in return. People will only hand over that stuff if they want the dollar more than the stuff. As long as the Fed is only paying the going market price for that stuff, the quantity of dollars is demand-determined.

Only when the Fed starts overpaying for stuff will people start wanting unlimited amounts of the fed's dollars. The Fed, seeing this unlimited demand, might ration its issue of dollars. Now the quantity of dollars looks "supply-determined", but the real issue is that the fed is selling its dollars too cheap.

[Dan Kervick]

@Nick

They will be happy to *accept* more money, but that doesn't mean they want to *hold* more money.

Well if they accept it during some period of time they either have to hold it throughout that period of time or spend it on something during that period time (including perhaps some other other kind of asset.) What makes them suddenly more eager to spend it now than they were before? I can't make any sense of the notion that additional income becomes a hot potato. Nobody forces anybody else to acquire additional monetary income. People acquire that income because they want it for some reason, and more monetary income always dominates over less monetary income, no matter what percentage of the additional income is spent and what percentage is held. One spends income during some period if the expected value of the expenditure is greater than the expected value of non-expenditure, and holds it otherwise. But the expected value of holding the margin is never negative, and so it is never a hot potato.

When the banking system has excess reserves, taxing and dwindling those reserves does not create the need for reserves for routine interbank payments. The fed funds rate could be anywhere above that rate (including positive) but interbank lending is unimportant (from the perspective of private credit creation) in the situation of excess reserves, except to study funky anomalies, like why the interbank rate frequently breaches the floor set by the IoR.

Reserves are only in excess relative to some required reserve ratio. That's just a regulatory determination that does not entail anything about motives. If the reserve ratio is 10%, and a bank's current reserves are at 11%, but the bank calculates it needs to raise reserves to 12% to comfortably accommodate its anticipated volume of payments, then in what economically meaningful sense is the bank carrying "excess reserves"?

[Nathan Tankus]

Nick:"What does "sufficient" mean? What quantity, at what rate of interest, under what conditions? The very reason for a modern central bank's existence is to choose the supply function (note I said supply *function*, not quantity) of reserves in a way to get the best monetary policy."

true, the central bank supplies reserves to the banking system on demand, but may change the conditions under which it supplies or the "cost" (ie the interest rate) of those reserves. But you seem to imply some withholding reserves when you said "But it doesn't have to happen that way". If the central bank increases the cost with which it supplies reserves to the banking system, it is effectively raising interest rates. this only constrains lending in so far as banks deem less borrowers credit worthy at higher interest rates and borrowers lower their demand for loans at higher interest rates.

[vjk]

Nick:

The bank buys something by giving the seller an IOU signed by the bank (a cheque).

Let's assume Canadian bank A bought a new security system for $1M from seller S. It paid with a check that S deposited at bank B.

How bank A is going to settle with bank B ? It does not have $1M on its account at the BoC, so it has to sell some assets in order to be able to settle with B. So, A sells some government securities to someone, most likely an institutional investor I holding its money at bank C.

As a result of depositing A's check at B by S and A selling government securities to I , $1M of interbank money will flow from C to A to B. I's deposit at C will vanish and reappear at B as owned by S.

No new money creation took place, just an existing deposit at C moved to B, i.e. existing credit money ownership was transferred from I to S.

[wh10]

" Excess reserves should instead be defined as "actual reserves minus *desired* reserves", because that's what matters. Required reserves only matter insofar as they influence desired reserves."

Nick, I defined desired reserves as roughly that amount needed to settle payments and meet reserve requirements, plus a small buffer to "play it safe." Do you not agree? Why else would banks want reserves?

[Peter N]

Why do you think desired reserves creates a multiplier? It seems clear enough that in capital constrained banks, it doesn't, and these days almost all banks are capital constrained.

"The bank that makes no promises is free to do what it wants. The banks that promise to redeem their money for another bank's money aren't free to do what they want.

An individual commercial bank can create money out of thin air simply by buying something. But the money it creates may not be its own. Its money may subsequently be redeemed for the money of another bank, or the central bank. The individual commercial bank that wants a permanent increase in its stock of money may need to persuade people not to redeem its money. Whether or not it needs to do anything to persuade them all depends on how the other banks, especially the central bank, react."

This isn't right. If a bank makes a loan and securitizes it with a AAA baptism (by selling a mortgage to a GSE, for instance), that bank is free to do what it wants with its profit. The borrower has already made free use of the mortgage money, and the owner of the CMO has free use of it as collateral, which for AAA rated securities is money (or was until the great revulsion).

A commercial bank that meets its capital requirements normally doesn't need to persuade anybody in order to lend. Maybe it should have to, but few buyers of CDs worry about their counterparty risk. So with access both to securitization and non demand deposit liabilities, a bank really only has to worry about capital constraints (and off balance sheet entities can be used to evade even capital constraints - e.g. Lehman, and lets not forget repos).

"It's the desired reserve ratio (and *not* the *required* reserve ratio) that belongs in the traditional banking multiplier story." Which story is ancient history. It's positively last millenium! (actually it died sometime in the early 1990s after a period of illness).

[Ritwik]

Peter N

So, funding considerations don't hold when there are credit derivatives. Fine. And what happens when the credit derivative markets and mechanisms collapse - as they have now. Are we back in Nick's world?

[Peter N]

In 2002 the FDIC Improvement Act minimum capital ratio was 10% for a bank to be considered well capitalized.

At that time this was the RISK WEIGHTED capital ratio profile for bank assets:

10-11% 40%
11-12% 26%
12-13% 18%
13-14% 4%
14-15% 2.5%

Banks hold as much in asset risk as they feel they safely can based on their capital. Then they look for ways to make more that involve offloadimg risk.

[Ritwik]

Peter N

You are confusing things. You first claimed that funding (or reserve) considerations don't matter because the bank can securitize and sell the loan (and hence keep its balance sheet constant, or increase it purely by the amount of net profit it made on the transaction). Now you're talking about capital adequacy ratios.

My point simply is that when securitization does not work, a new loan increases the bank balance sheet and presumably, funding considerations of the kind that Nick is talking about kick in again. This has nothing to do with the quality of that loan/ the quality of the bank's other assets and the capital adequacy ratios. It's simply, might funding considerations (over and above, or at least independent of capital requirements) start to matter when the access to securitization goes away (which in effect is what has happened).

Then we're back to the earlier discussions with wh10, JW Mason, etc. where no one assumed securitization. The deeper point is, that conceptually, saying that bank money creation is independent of reserve/funding considerations is an argument that does not (or should not) depend on transient institutional context, like credit derivatives.

[Ritwik]

The more I read Fulwiller, the more it seems that he is answering the question of 'Has the Fed ever been monetarist' with a 'No', rather than answering 'Can a Fed ever be Monetarist' with a 'No'. Witness 'dirty interest rate targeting', as a good example.

Here is the San Fran Fed's take on '79 to '82 - this basically claims that people expected the Fed Funds rate to fluctuate, and indeed it did fluctuate (and was allowed to fluctuate). In '82 the Fed moved back to targeting the interest rate because 1) It had already achieved its target of breaking expected inflation (Monetarism was successful) 2) The standard transmission mechanisms were weakening because of financial market deregulation (but going forward it was likely to be less successful).

http://www.frbsf.org/education/activities/drecon/2003/0301.html

[Nick Rowe]

Mike: "The fed only issues a dollar if people are willing to hand it a dollar's worth of stuff (e.g., bonds) in return. People will only hand over that stuff if they want the dollar more than the stuff. As long as the Fed is only paying the going market price for that stuff, the quantity of dollars is demand-determined."

Nope. When I sell my car for $2,000 that does not mean I prefer *holding* an extra $2,000 in my bank account to owning my car. It (usually) means I want to buy a new car (or something else. I prefer the new car to the old car.

Dan: think of the stock of inventory. The used car dealer has a desired average stock of inventory. The actual stock of inventory fluctuates up and down as he buys cars and sells cars. Sometimes his inventory is bigger than desired, and sometimes it's smaller than desired. The whole point of an inventory is that it acts as a buffer stock, so that flows in and flows out don't have to be perfectly synchronised. If someone offers him a car at a good price he buys it, and his inventory is *temporarily* bigger than he desires, so he takes steps to reduce his inventory again, by offering slightly better deals on sales and/or slightly worse deals on purchases.

Nathan: "true, the central bank supplies reserves to the banking system on demand, but may change the conditions under which it supplies or the "cost" (ie the interest rate) of those reserves."

Agreed. Too many (heterodox) people assert that the supply of reserves is perfectly elastic at a given fixed rate of interest. It isn't. It depends on the monetary policy objectives of the central bank. In Canada, over a longer horizon, the supply of reserves is perfectly elastic at 2% *inflation*. It is perfectly *in*elastic with respect to the rate of interest (except at very short horizons).

vjk: what you describe is something that *might* happen. Your bank A has simply changed the composition of its assets, and not created money. But that doesn't have to happen. What actually happens depends, for example, on whether A had excess desired reserves.

wh10: "Nick, I defined desired reserves as roughly that amount needed to settle payments and meet reserve requirements, plus a small buffer to "play it safe." Do you not agree? Why else would banks want reserves?"

Banks hold buffer stocks of reserves for exactly the same reasons that you and I hold buffer stocks of money. Central bank money is to commercial banks what commercial bank money is to you and me.

Peter N. "Why do you think desired reserves creates a multiplier? It seems clear enough that in capital constrained banks, it doesn't, and these days almost all banks are capital constrained."

Speak for your own (US?) banks ;-) My banks aren't capital-constrained. In any case, a bank that is capital-constrained can normally get more capital, if it's profitable to do so.

Banks desire reserves and banks desire capital. If we are interested in monetary policy (I am) then we focus on reserves because the supply of reserves is controlled by the Bank of Canada while the supply of capital is not. And the Bank of Canada chooses to make the supply of reserves perfectly *in*elastic with respect to the rate of interest (except in the very short run) and perfectly elastic with respect to the rate of inflation (in the medium term).

An excess supply of reserves creates a hot potato multiplier for banks in exactly the same way that an excess supply of money creates a hot potato multiplier in the economy as a whole.

[Peter N]

Points, OK.

1)Financial institutions have always and probably will always find ways to create money - tokens of value of sufficient lifetime and wide acceptance that they can transfer them to someone else's books in return for better quality money. Minsky would have called this either speculative or Ponzi money depending on the likelihood of someone being left holding the bag.

2) Securitization hasn't stopped, and the banks are on to newer and better scams. If you liked subprime CMOs, you'll love securitized student loans. They're the next coming disaster, and it's going to be bad. Students with $50,000 of debt aren't going to be forming households and buying homes any time soon. Not only do we create another bubble, but we remove enormous quantities of future demand. Young people start businesses and form households. Saddling a few million of the most promising ones with debt is a very bad idea. And making it nonrecourse debt is an even worse one. Talk about lender moral hazard! (a slight digression, but it makes me crazy how people are ignoring this).

3) I'm not sure exactly what sort of considerations Nick is talking about without a great deal more specificity. For instance, there are at least 3 different money multipliers, and then there are velocities. What is multiplied by what by what exact mechanism? Otherwise it's just hand-waving. Reserve multipliers are dead. I just posted figures showing banks built assets at risk right up to the FDIC limit of 10% in 2002. It's unlikely to have improved since then. Base money multipliers are looking sickly as a control mechanism, though you can always calculate one as a description.

4) Funding considerations always matter, but is debatable how much control the Fed has over them, what the mechanisms are and what the delays and side effects are.

5) Banks have other ways to hide and transfer risk (sometimes even successfully).

6) Money can be created in the Repo market by exploiting its increased velocity. High tech check kiting.

7) Value at risk depends on evaluation of risk. This in turn depends on ratings agencies and monoline insurers. Their track record has been less than stellar. And, in case of emergency, you can lobby for a change in accounting standards or waiver or delay.

8) the money supply as measured by the Divisia aggregates was growing at a considerably higher rate that the Fed's cumulative aggregates through 2007, and we only have data for M1 and M2. There's every reason to think the broader measures increased even more.

Some more articles from the Fed and others. I'm mostly just the messenger:

http://www.federalreserve.gov/pubs/feds/2010/201041/201041pap.pdf
http://www.relooney.info/0_New_8881.pdf
http://newyorkfed.org/research/epr/02v08n1/0205vand.pdf
http://www.bostonfed.org/economic/conf/conf39/conf39c.pdf

[Peter N]

Lord you weird Canadians. Reserve requirements! Solvent banks! How quaint. We in the modern US of A have left all that stuff behind and are enjoying the freedom of a new age of irresponsibility.

More seriously, it's clear your Canadian Banks don't work like the US ones do with regards to their respective central banks. Thus we were somewhat talking past each other. Unfortunately, when the US catches cold, Canada gets pneumonia, so the Fed matters even in the great north.

Also, unfortunately, the European banks are every bit as bad as the US ones and mostly worse. Otherwise the ECB wouldn't have just spent over a trillion Euros bailing them out, with more to come. If Europe targets NGDP, Chuck Norris won't help. They'll need Chuck Bernanke, which is why, I believe, he's keeping his powder dry. He may have to bail out the ECB while China and Japan have their own financial crises. In Japan, the consumption tax is their political equivalent of the Bush tax cuts, while China is discovering that if you build it, they won't always come, particularly if it doesn't work and they can't afford it.

[Bill Woolsey]

Wow. A lot of comments.

The demand for money is the amount of money people want to hold at a point in time.

The demand for money is not the same thing as how much money people want to borrow, either over some period of time or their desired indebtedness at a point in time.

The supply of money is how much money exists. It isn't how much money is being lent.

Getting deep into the weeds to talk about how much money is available for poeple to borrow, how much they do borrow, and so on, is beside the point.

An investment bank can sell 10 year bonds for a corporation, which uses the money to build a factory. There is a credit transaction here. Those buying the bonds are the lenders. The corporation issuing the bonds is the borrower. Money is borrowed and lent. Presumably, those buying the bonds give up balances in their checking accounts which are transferred to the corporation and then on to those constructing the Factory.

That is a credit transaction that has no impact on the quantity of money or the demand to hold money.

In equilibirum, banking transactions are fundamentally the same.

In disequilibirum, they can be different.

[Nick Rowe]

Bill: I agree. Those things needed saying (in this thread, and elsewhere).

One picky exception: "The supply of money is how much money exists. It isn't how much money is being lent."

Should be: 'The [stock] of money is how much money exists [and it will equal the supply of money]. It isn't how much money is being lent.'

[Nick Rowe]

Peter: Canada abolished reserve requirements years ago (not sure if you were saying that or the opposite). China still has them, and changes them from time to time as an instrument of monetary policy.

[Peter N]

Finally, the E word. I've been waiting for this. Deus ex machina.

"In equilibirum, banking transactions are fundamentally the same."

And how do you expect to show this?

My rational expectation is that if you think you can prove that there's a single equilibrium or it's stable, you're fooling yourself.

"The search for stability at great levels of generality is probably a hopeless one. That does not justify economists dealing only with equilibrium models and assuming the problem away. It is central to the theory of value."

Franklin Fisher in

The Stability of General Equilibrium--What Do We know and Why is it Important?

http://economics.mit.edu/files/6988

This paper is also quite enlightening:

Aggregation in Production Functions: What Applied Economists Should Know

http://economics.mit.edu/files/2631

[vjk]

Nick:

what you describe is something that *might* happen. Your bank A has simply changed the composition of its assets, and not created money.

What I described is something that is *most likely* to happen. I agree that if the bank spends excess reserves, a new deposit will be created. However, the bank's purchases are funded by its revenue stream, as any company's, not by diminishing its capital. So, the *most likely* scenario with extra reserves would be spending a part of the bank's revenue stream thus destroying a deposit elsewhere and creating a new deposit of more or less equal value. So, without a new loan creation, the amount of credit money in the system would remain more or less the same.

Another argument contra your hypothetical is that a new deposit creation at the expense of the bank's capital shrinkage is not only unlikely but statistically insignificant in overall credit money production process.

[Tschaff]

Very hard argument to follow Nick. So far everyone, even Krugman agrees that loans create deposits. The disagreement is over if the monetary base constrains bank lending. Krugman and the neo-classicals say yes, many central bankers, bankers, and empirical researchers say no. Krugman, regrettably, leaves out modern central bank policy from his story, a divorce that will leave him with false conclusions.

Reading Scott Fullwiler's Modern Central Bank Operations— The General Principles would be a huge benefit to him.

[Tschaff]

I should add that CBs (universally?) target rates, which has influence on the demand for reserves from banks.

[DeusDJ]

Absolutely amazed that people like Luis Enrique still exist..."you need an existing stock of savings to lend"...really pal? I shouldn't say I am shocked because Paul Krugman of all people made this very mistake...

[DeusDJ]

Luis Enrique: "We know banks need people to deposit funds with them, because they go to great expense to attract savers."

Yes, because demand deposits are *CHEAPER* than going to the FFM. My god, don't you know that they're still trying to make a higher profit? You said in the previous paragraph that the original money multiplier story doesn't mean much, but in the very next paragraph you rely on it to say that banks *need* to maintain a reserve ratio. WTF?

[Dan Kervick]

@Nick

Dan: think of the stock of inventory. The used car dealer has a desired average stock of inventory. The actual stock of inventory fluctuates up and down as he buys cars and sells cars. Sometimes his inventory is bigger than desired, and sometimes it's smaller than desired. The whole point of an inventory is that it acts as a buffer stock, so that flows in and flows out don't have to be perfectly synchronised. If someone offers him a car at a good price he buys it, and his inventory is *temporarily* bigger than he desires, so he takes steps to reduce his inventory again, by offering slightly better deals on sales and/or slightly worse deals on purchases.

But Nick, increasing and holding one's inventory of cars has a cost. It costs money to acquire the cars and its costs money to store them. Because of those costs, there will be a point in which the possessor of an automobile inventory will not want additional cars even if those cars are given to him, because the marginal cost of acquiring that car exceeds the marginal value of possessing the car.

But there is no parallel in the case of dollars. What you seem to be claiming is that there is some sort of saturation point of dollars - either for individual business and household units or for the economy as a whole - where the quantity of dollars in dollar inventories becomes so high that the holders of those dollars actively seek to unload them. But there is no such phenomenon.

Suppose you go into your bank tomorrow, and they tell you, "The central bank decided to credit your account overnight with $1000 additional dollars. Don't know why, but it's yours."

And suppose every single day you walk into your bank they tell you exactly the same thing, day after day after, $1000 each day.

Is there ever any day in which it is rational for you to say, "Enough! What am I going to do with all of these dollars?!" Of course not.

And note that the situation is unchanged even if the injections of dollars in your account and other accounts cause dramatic inflation. No matter how high the rate of increase in the price level, it is always better to have more dollars than less dollars.

[dwb]

I find MMT puzzling and annoying, there seems to be no explanation for how Bernanke's jaw is able to move the markets (expecations), no role for expectations, no private sector demand for loans, no endogenous growth or productivity, and no nominal (or real) interest rates or inflation (among other strange issues). It seems to be a tautology wrapped in an accounting identity (what the heck is "hidden fiscal policy"??).

As noted above, bank lending is constrained by capital (including risk-based capital, as noted above), not necessarily reserves (ok i know people use these synonymously but they are not). Banks have other liabilities other than deposits, but in any case, banks do not *have* to make loans, they will only do so if there is a positive return on capital (their lending will be governed by a capital plan which will also include dividends and stock buybacks).

The fundamental issue seemingly ignored by the MMTers is that the demand for loans is determined by growth and inflation expectations (people do not borrow money for the sake of it, they do so to build stuff, and the return on building stuff is determined by growth and inflation expectations over the term of the useful life of the thing they are building, in the process of building stuff they employ people and pay them, which expands the economy).

which gets me back to the original point: reserves are not constraining banks at the moment (capital is, for various reasons). But more fundamentally, the central banks ability to target (long or short) rates, set inflation (or nominal gdp) targets, and so on to effect monetary policy. all these tools seem to be dismissed by mmters ... but i have no idea why.

[Dan Kervick]

The fundamental issue seemingly ignored by the MMTers is that the demand for loans is determined by growth and inflation expectations (people do not borrow money for the sake of it, they do so to build stuff, and the return on building stuff is determined by growth and inflation expectations over the term of the useful life of the thing they are building, in the process of building stuff they employ people and pay them, which expands the economy).

I really have no idea what you are talking about here dwb. MMT emphasizes that the demand for loans for the purposes of consumption and production is in fact what is responsible for driving the creation of new money in the economy, and disputes the claim that the central bank can force money into the real economy by creating additional reserves. The only thing the CB can do is influence the price of loans.

[Tschaff]

I am a student of MMT, so take everything I say as maybe correct with regards to the MMT literature...

"I find MMT puzzling and annoying, there seems to be no explanation for how Bernanke's jaw is able to move the markets (expecations)"
There are at least two explanations you can find in MMT. First, the fed just has to announce an interest rate target, and market participants will take it to that price knowing that it is foolish to bet against someone with an unlimited checkbook. It doesn't mean fools don't exist, if they do the NY Fed can give them a schooling. See http://www.nakedcapitalism.com/2010/03/auerbackparenteau-operation-twist-part-deux.html for more on this point. The ECB a few times that I'm aware of stepped in to buy Greek debt to calm speculative attacks on Greek debt, not the same as announcing an interest rate target, which for political/legal reasons they don't do, but nevertheless an example of how the CB changes market expectations. The second way is people try to guess the likely outcomes of what the Fed is doing and adjust their portfolio accordingly. Think QE will be inflationary? Buy up commodities and other inflation hedges, so you're wrong that expectations don't matter.

"no private sector demand for loans"
Where do you get this from? You couldn't be more wrong, private loan demand is endogenous in MMT's (and other post Keynesians) book.

"no endogenous growth or productivity"
Again, fear not, there is both of these in MMT.

"and no nominal (or real) interest rates"
Ok.. have you read ANY MMT literature?

"or inflation (among other strange issues)."
:-( ok... someone needs to go to Mosler's mandatory reading section before posting about what they haven't read, therefore doesn't exist.

[dwb]

Some MMTers seem to think QE is nothing more that "asset swaps" and call expectations "magic" and seem to deny that the Fed has power to create inflation through targeting, and send me papers suggesting much so i honestly dont know what to make of that. on the other hand, once you incorporate all the stuff i mentioned, how its any different that new Keynsianism. Yes, I've tried to read MMT stuff, get part way through, and I find it mind numbing, like trying to make sense of Dianetics with its own ill-defined lingo. Show me a mathematical model that demonstrates this is nothing more than an tautology.

also, respectfully, I think this whole debate about the hot potato theory is interesting but ultimately fruitless. Its like trying to figure out the heat of the room by adding up all the individual atoms in the room. pointless. Its a nice story to tell undergrads in money in banking but banks are enormously complicated. It conflates capital and reserves, assumes the deposits and loans have the same maturity, ignores what people DO with the loans (to build stuff) and ignores some other serious issues (like maturity mismatch issues, capital, securitization, savings, and so on).

and, moreover, one risks falling prey to the fallacy of composition. in macro econ, the sum of the parts is often very different than the whole.

[wh10]

"Banks hold buffer stocks of reserves for exactly the same reasons that you and I hold buffer stocks of money. Central bank money is to commercial banks what commercial bank money is to you and me."

Come on, Nick. That's such a vague and unsupported assertion, and it doesn't seem at all true. I at least offered you specifics on what a bank's desire for reserves is a function of. Explain what you think banks do with reserves and why they want reserves.

[Tschaff]

@DWB

"Some MMTers seem to think QE is nothing more that 'asset swaps''

Save yourself a tremendous amount of time and learn MMT from the developers, not autodidacts like myself. :-) QE is an asset swap. There is a lot more you can say about it as well.

"and call expectations "magic'"

You need to understand the context that they call in magic in. Usually it is in reference to the CB being able to create inflation via altering people's expectations of inflation via open market operations. People wrongly believe that a bigger monetary base = inflation, you know more of something dilutes its value. Krugman calls it a credible threat to act irresponsibly. See: http://www.winterspeak.com/2010/12/why-inflations-expectation-model-is.html The trouble is how can the CB actually create the inflation, since they don't actually add demand for real goods and services, how does the CB buying a security inflationary? See: http://neweconomicperspectives.org/2009/11/what-if-government-just-prints-money.html In short, it's possible for the CB to credibly create inflation a few ways and not how we commonly think they do. The CB can take huge huge capital losses in hopes people will spend more, they could buy loads of foreign currency importing inflation, they could do away with capital requirements (or enforcing them) in hopes banks go on a lending binge maybe helped by focusing loans on unproductive things, maybe raise interest rates so the interest paid to the non-govt sector on the national debt increases demand (though this one has so many wheels turning at once it's a little ambiguous to the inflationary results of an interest rate hike). Most of these things it is illegal for the CB to do for obvious reasons, but since we like thought experiments there ya go. MMTers prefer to use fiscal policy to target inflation, it's a much sharper and direct tool.

"how its any different that new Keynsianism."
For starters it includes banks in their models.

"Yes, I've tried to read MMT stuff, get part way through, and I find it mind numbing, like trying to make sense of Dianetics with its own ill-defined lingo"
They may not be the best writers, but nobody is perfect. Moser's seven deadly innocent frauds and soft currency economics is an easy read for everyone. There are videos if you're too lazy to read here: http://www.netrootsmass.net/fiscal-sustainability-teach-in-and-counter-conference/

It's a deep rabbit hole DWB.

[Tschaff]

@Nick Rowe-Save yourself a headache, accept that central banks target interest rates, and they achieve this by having a perfectly elastic supply of reserves at their target rate every day. Quantity of reserves will change up or down depending on lending behavior of banks which is influenced by the price of reserves. Build the rest of your thinking around that information or you'll end up driving yourself (and all those who try to follow you) mad.