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Banks are not reserve constrained

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In a fiat money system, there is not a very good correlation between base money and M1 and credit because reserves don’t create loans. In practice, the lending operations of commercial banks have no interaction with reserve operations. Lenders simply take applications from customers who seek loans and assess creditworthiness and lend accordingly.

In approving a loan, banks instantly create a deposit, a zero net financial asset transaction – and this happens entirely independently of the reserve requirement. In Australia, Canada, Sweden and New Zealand there are no bank reserve requirements.

-Chart of the Day: Excess Reserves

Our friend Yves is away, so I wanted to step in for a moment with some thoughts about the banking sector, bank capital, leverage and fractional reserve banking.

Capital and Leverage

Banking is problematic because it creates an inherent financial instability due to a potential mismatch between a financial institutions’ liabilities and its assets. Many financial institutions have fewer liquid assets than short-term liabilities and demand deposits. Moreover, if a financial institution gets into trouble from reckless lending or investing, it could sell its assets in order to cover its liabilities; but this would result in fire-sale prices. So even if the bank had enough assets to cover its liabilities, a run on the institution could render it insolvent, cascading its problem down the line to its own lenders.

Leading up to the credit crisis, the Federal Reserve under Alan Greenspan relaxed the investment banking net capital rule, effectively allowing them to increase their leverage tremendously. This was an extreme act of reckless anti-regulation by the Greenspan Fed which had disastrous results when the investment banks’ investments went pear-shaped in 2007 and 2008, resulting in a run in the wholesale lending market. Yet, the relaxed anti-regulatory stance remains in effect today. That means another major asset downturn would create the preconditions for similar runs and insolvencies. Anyone who wants greater economic stability understands this is a problem. Some people like Simon Johnson have argued we need much more capital for these banks, as much as 30%.

But capital is not reserves. Capital is capital. Reserves are another matter.

Fractional Reserve Banking

Some people still believe in the money multiplier taught in old economic textbooks that fractional reserve banking has banks taking deposits, multiplying them as much as possible, subject to the reserve ratio, and making a much larger amount loans. That is not how it works. In practice, banks don’t wait for the reserves to be available to issue loans. They make loans first and then borrow the reserves in the interbank market. The loans come first, not the reserves.

Banks are never constrained by reserves or reserve ratios. Banks are capital constrained. In our fiat money system, the central bank uses reserves in the system to help the it hit a target interest rate. So, the central bank provides the system with enough reserves to meet any reserve ratio at its target rate. The reserves are about helping set interest rates, not about pyramiding money on a reserve base.

Understanding this should also help you understand why QE has been a boon for financial speculation but a bust in the real economy:

Now, the money multiplier – which is the mathematical ratio of base money to larger monetary aggregates like m2 m3 or MZM – exists. It’s just that the Fed doesn’t control it. They can print all the money they want, but if creditors and debtors aren’t solvent there isn’t going to be any additional lending. They are pushing on a string

-Does the Money Multiplier Exist?

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward

91 comments

  1. craazyman

    Seriously Ed, I just wanted to say how much I appreciate your commentary.

    It has been a doorway through which I’ve pushed myself to get up to speed on this stuff. It all seems clear in hindsight, but foresight takes some effort, especially for somebody as lazy as I am about details.

    But your explanations and tutorials make that effort relatively painless and very interesting.

  2. sgt_doom

    I second that, this was an outstanding blog post.

    And Simon Johnson is a complete and total fraud, who espouses that “free market” claptrap, and is an ardent supporter of the Rockefeller family mythology (not surprising, as they pay him a handsome stipend throught the fraudster Peterson Institute!), and is all over the landscape, some days he’s claimed to be against the credit default swap construct, other days he’s its ardent fan!

    And he still supports the IMF, the stooge!

    But has MIT ever had anyone but a fraudster on the economics faculty?

  3. MyLessThanPrimeBeef

    Banking is problematic because it creates an inherent financial instability due to a potential mismatch between a financial institutions’ liabilities and its assets.

    ——-

    Assets = Liablities + Equity

    One way to eliminate a mismatch is to make Equity = 0. That way, there is no mismatch as Assets = Liabilities.

    1. craazyman

      In the long run all assets = all liabilities.

      It’s a law of the universe.

      The problem is the short run. LOL.

    2. VM

      There never was any real equity. The misalignment of pay for short term performance and long term prudence ensured that equity was always traded for an illusion of short term gains.

    3. Ignim Brites

      I just don’t get why banks should be have any liabilities. If we do away with reserve requirements, then banks would have zero need to fund themselves. As institutions authorized to create money, that is all the should do.

      1. mdm

        banks will always have liabilities because they are deposit taking institutions.

        >As institutions authorized to create money, that is all the should do.

        The the creator of money is in effect issuing a liability upon itself. So long as banks remain deposit taking institutions and the ability to create loans, then they will always have liabilities.

        1. Ignim Brites

          Yes. If they take deposits they will of course have liabilities. But why take deposits? With the power to create money, they do not need them to make loans. Simply put, the federal government should outlaw banks from assuming any liabilities. That will end the systemic risk posed by banks.

          1. mdm

            >But why take deposits? With the power to create money, they do not need them to make loans. Simply put, the federal government should outlaw banks from assuming any liabilities. That will end the systemic risk posed by banks.

            As I understand it the reason banks accept deposits is as follows:

            1. Where would ‘deposits’ go? Some institution has to accept them otherwise they are worthless. If an entity doesn’t accept its liabilities then it is reducing the acceptability of its liabilities. The same principle applies to why the government demands its liabilities in payment of taxes.

            2. Accepting deposits improves bank profitability. Banks make a profit based upon the spread between interest repayments on loans and the cost of acquiring funds. By receiving deposits the bank is potentially increasing that spread. Furthermore if it finds itself with excess reserves, then it can lend these in the overnight market.

            3. The systemic risk is also present on the bank’s accept side. Loans can go bad, and when they do the corresponding reduction on the asset side is matched by a reduction in equity. You’re not going to reduce systemic risk if you simply ignore the most sensitive part of a bank’s balance sheet to risk.

            On reflection I may have misunderstood what you’re saying. Are you saying that there should be a separation between lending institutions and deposit taking institutions?

    4. Just a thought...

      That’s not the mismatch discussed. The mismatches banks must deal with are the varying impacts of changes in market conditions (most commonly interest rates) on their balance sheets. No equity means the first loss position at all banks, not just the too big to fail, falls on you the tax payer or you the depositor. Remember, bank losses occur on the asset side of the balance sheet otherwise they’d be called gains.

  4. Valissa

    Very educational post, Ed, thanks! I have trying to grok this money-as-debt thing and related systemic issues for while now… so this post very helpful. The more I learn about fiat money the more I am reminded of the Disney classic “The Sorceror’s Apprentice.”

    1. novitius incantatoris


      fiat money the more I am reminded of the Disney

      Ed has uncovered the Curtango Hole of the Bankster’s Operating system, the Mother of All Back-doors.

      MOABd

  5. Finnucane

    I believe that the thesis that banks are not reserve constrained is part of, or consistent with, the Chartalist/MMT school of economic thinking. As with other theses of that school, this one is of sufficient clarity and self-evidence that it makes me think EITHER: (1) I’m overlooking something that people with degrees in economics or finance find humiliatingly obvious; OR, (2) something is very, very wrong with our world. If it is self-evident that current fed policy is only pushing a string, and CAN only push a string, then doesn’t it follow directly that current fed policy can only be a windfall for the same interests that ruined our economy already? Or perhaps MMTers should go back to their playpens and stay out of legitimate economics, and mere civilians like me should keep our mouths shut?

    Is economics a way of understanding the world the way it really exists, or is it something else? Something not just tendentious, but something sinister?

    1. Oggy

      What aspect of MMT supports the Fed policy of quantitative easing? MMT supports the use of fiscal policy, not quantitative easing, which MMT sees as just swapping one asset class, bonds, for another, money, with no net economic benefit.

      1. Finnucane

        What aspect of MMT supports the Fed policy of quantitative easing?

        None, as far as I can tell. That was the point. Perhaps I’m bad at making points. Perhaps my pseudo-Irish mellifluence gets the better of me.

        I’ll spell it out in as Protestant-straight, Anglo-Saxon terms as I can muster:

        (1) MMT is, at least as far as the “banks are not reserve constrained” thesis goes, obviously, almost self-evidently, correct;

        (2) QE is predicated on a very different, perhaps diametrically opposed, understanding of the effect and meaning of bank reserves;

        (3) QE is effectively the law of the land, specifically of the most powerful, richest land in human history;

        ERGO,

        (4) either (a) I (and much cleverer people than I) are actually complete dunces, our understanding of what is “self-evident” is nonsense, and the people running our nation know better; OR, (b) there is something very crummy going on here, such that a very obviously wrong thesis is our new constitution, while a quite obviously correct thesis is exiled to University of Missouri KC and the like. Do you really sense that I’m advocating option 4(a)?

        Here’s my corner-of-the-bar, (pseudo) Irish pub punchline: MMT isn’t at the fringes because it is hard to understand, counterintuitive, or even revolutionary. MMT is at the fringes because it is a sort of approach, with attendant discipline, that more or less falls under the rubric of “economics,” but it doesn’t do what economics is supposed to do, viz. explain for the peasant masses why they (the peasants) live up to their knees in poop, while their rentier overlords read their hours from gilt breviaries, charge forth in tournament on priceless snow-white steeds, and flog their footmen for fun in their spare time without threat of arrest. As such, MMT is a failed discipline, even though, or even BECAUSE, it is correct, to the extent that it really isn’t the purpose of the discipline of economics to be correct.

        And dude, I don’t get where you got “you think MMT supports QE”.

        1. skippy

          Thank you, thank you, thank you.

          Skippy…rose colored romantic cognitive mental contacts, inserted from birth and reinforced via MSM et al….confluence of events my marsupial back side!

        2. attempter

          Part of the reason MMT is at the fringes is because of the attitude of its propagators.

          MMT, although objectively a rational and moderate idea, is radical and extremist from the point of view of this insane status quo. So to be effective with its real target audience, actual citizen activists, it would have to comport itself with revolutionary elan.

          But its theorists tend to want to present it in a picayune, reformist, appeasement-minded way. They think their target audience is establishment politicians, think tanks, and the mainstream media, who will in fact never do anything but laugh at it when they don’t ignore it completely. I suspect many an MMTer is a Jacob Hacker in waiting.

          Meanwhile, they seem eager to shout down anyone who wants to apply the idea in radical ways. Thus the frequent lectures about how MMT has “no moral implications”, doesn’t imply anything about the legitimacy of property, etc.

          We discussed this here a few days ago regarding the meager “jobs program” suggestions MMTers are prone to come up with, which don’t even reach the level of the New Deal, let alone the more aggressive measures we’d need today.

          1. Skippy

            Alternatively…a well worn path dimly lit, now softly illuminated with planets rotation and its relationship with the sun or a path that was always there, but, never tread upon. Any way the_past is the past_the PreZBloviator…said so…cuz before we even see the next crest…those that matter most…are…far beyond it.

            Skippy…you have to be down the road, too lay ambushes. This last one was a near ambush, look up the correct military response.

    2. mdm

      >I believe that the thesis that banks are not reserve constrained is part of, or consistent with, the Chartalist/MMT school of economic thinking.

      You will also find it in Post Keynesian theory (in any event, there’s a thin line between an MMTer and a Post Keynesian).

      >As with other theses of that school, this one is of sufficient clarity and self-evidence that it makes me think EITHER: (1) I’m overlooking something that people with degrees in economics or finance find humiliatingly obvious; OR, (2) something is very, very wrong with our world.

      As a student I make an effort to bring up as many different points of contention as possible. I’ve raised the issue of banking and loan creation with a few of my professors:

      A few of them never thought about it that way, some of them agreed, and others seem puzzled by what I was saying. As an aside my current finance textbook states that banks lend other peoples money when making a loan, yet on their online website under quiz solutions they have a footnote which states: “If a bank’s deposits are not sufficient to fund all its profitable loans, the bank will usually raise additional funds by borrowing from the financial markets rather than declining requests for loans”.

      There’s something similar on the chapter related to the central bank. It goes on and on about how the central bank controls the supply of reserves, governments cause (financial) crowding out and loanable funds, but then on the last few lines in the chapter it says something like: ‘in practice [the central bank] supplies the necessary amount of reserves in achieve its target rate’. So what was the point of the entire chapter? Apart from that the actual explanation of how the central banking system works in my country is wrong (at least when compared with what my central bank says it does in its papers).

      1. mdm

        Schumpeter has a great quote on this in his history of economic analysis. In the actual passage Schumpeter is comparing different views on loan creation and how the two views (banks lend deposits and loans create deposits) have gone back and forth in terms of their dominance in economics. He concludes that:

        “it is much more realistic to say that the banks ‘create credit’ that is, that they create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them”. He argues that the analytic distinction is important because “…depositors should not be invested with the insignia of a role which they do not play [capital formation]. The theory to which economists clung so tenaciously makes them out to be savers when they neither save nor intend to do so; it attributes to them an influence on the ‘supply of credit’ which they do not have”. (1994, p. 1112).

        1. financial matters

          Nice point. When people put their money in the bank they don’t think they are supplying the bank capital as would be the case if they bought stock in the bank. But they earn varying levels of interest and it could be considered an investment but one which they assume they will get back. This is really only true to the extent that varying forms of deposit insurance are in place and aptly funded.

          1. Just a thought...

            Depositors are not “supplying the bank capital”. Operationally impossible argument. Both deposits and capital are on the same side of the balance sheet.

            Though contrary to Harrison’s assertions, capital could be used as reserves.

      2. Finnucane

        … but then on the last few lines in the chapter it says something like: ‘in practice [the central bank] supplies the necessary amount of reserves in achieve its target rate’. So what was the point of the entire chapter?

        That is funny; I giggled. Econ can be fun. Also pretty bizarre: in what scientific discipline, howsoever ‘soft’ it may be, is a false doctrine set out with such care and in such detail in a textbook, only to be self-refuted at the end?

        Imagine if the last line of Ptolemy’s Almagest read: “Psyche, I take it back; the sun is at the center.”

  6. AlleyGator

    Really cool post! I’ve never read about this side of the business before, but it really puts into perspective all the fuss about LIBOR rates skyrocketing about 3 years ago.

  7. Anjon Roy

    Thanks Ed,

    I asked Marshal a similiar question:

    I understand that QE is a bust for the real economy (because it doesn’t actually push money into the real economy, but it does decrease private interest income through the asset swap and push up primary commodity prices making energy/food more expensive), but can you explain exactly HOW it increases speculation? Is it just psychology? I mean, if the money is just sitting in reserves, and therefore doesn’t get into the “real” economy, how exactly does it chase financial asset prices?

    Thanks!

  8. Matt

    You can’t stop explaining this until people understand it the Banks that lend and increase the Money supply, and that the days of the FRB regulating through required reserve margins and the Federal Fund Rate are history.

    Deposits 8.0 Trillion
    Required Reserves 74.8 Billion

    http://www.federalreserve.gov/releases/h3/current/h3.htm
    http://www.federalreserve.gov/releases/h8/current/default.htm

    The first corollary is that the the US QE is just the FRB holding the MBS and long Treasuries while the banks would rather just get 0.25 percent from deposits at the FRB.

  9. financial matters

    Nice blog post, thanks.

    My understanding is that by stopping QE and selling off its assets of mbs and treasuries the fed and treasury will be draining excess reserves which will slow speculation and set the groundwork for higher interest rates… the problem is they say they are doing this because the economy is strong enough to handle it when the truth seems to be the opposite. the economy can’t take any more of it… they are finally forced to have the rubber meet the road which should lead to lower home and equity prices… these are overdue corrections but should be balanced by an increase in the social safety net and a confrontation of the fraud that got us here in the first place

    1. Matt

      The banks can make excess reserves any time they want and put the bucks in a special investment vehicle. The FRB is the puppet, not the puppet master. The banks have purposely chosen to trade their MBS and long treasuries to the FRB in exchange for the “excess” deposits at the FRB.
      Banks should no longer trust each other to lend overnight funds, and they would certainly have the FRB have long maturities than for them to carry them.

    2. Frankfurt

      Incorrect. No QE means lower interest rates as US debtholders get more desperate. You people don’t get it at all.

      Eventually rates will hit 0% as the debtholders become ungodly desperate. It that doesn’t work, than they will destroy the US economy by ramming up short term rates to essentially “bailout” themselves(and the US essentially) why the yield curve epically inverts. All economic activity would stop and most likely all law and order. I would consider myself a US “debtholder”.

      People simply don’t get it. They don’t understand what QE is REALLY for. Confidence. Nothing more or less. Get the oversaved to spend on investment and allow the overleveraged economy to save and pay down debt through the enhanced job creation. The problem is, it doesn’t work as a lone prescription. Eventually, people will just start ignoring it.

      Kalecki pretty much told the story of this 90 years ago.

  10. Jim

    Edward:

    Has our fiat money contributed in any way to the corruption of our current political/economic regime?

    Has our fiat money in any way been used(by those who are responsible for this politcal/financial/economic/cultural crisis) to lubricate the status quo(i.e. save their butts) and thus helped to relieve these same powers of acknowledging their responsibility for this crisis?

    Has our fiat money in any way contributed to the disdain which our banking commuinty exhibits toward the average citizen.

    Has our fiat money in any way strengthened our increasingly ineqalitarian structure of power?

    1. financial matters

      from the above link

      “”Yves Mersch, governor of the Banque centrale du Luxembourg and member of the European Central Bank council today warned Europe’s banks they would not be rescued a second time.

      Markets are watching Mersch’s speech closely this afternoon to gauge how a leading candidate touted to replace Jean-Claude Trichet as the European Central Bank’s president views financial institutions.

      He said the maxim some banks were ‘too big to fail’ is “not compatible with the principles of a market economy”, and moral hazard from bail-outs means “the State and its taxpayers are held to ransom.”"

      —–

      Is this why the more bailout friendly Mario Draghi is now a contender to be the next head of the eurozone central bank.

      http://www.google.com/hostednews/afp/article/ALeqM5jskSu10yLAIhVXxG_FkwsGizlT4A?docId=CNG.42018502043ba9252f3fa2fe6c31dce7.1061

      “”German Chancellor Angela Merkel is playing her cards close to her chest on her pick for the next head of the European Central Bank, though frontrunner Mario Draghi is emerging as an acceptable choice for Berlin, analysts said.

      Merkel has kept mum on the issue, although sources close to German Finance Minister Wolfgang Schaeuble have not concealed that he would prefer Draghi, the head of the Italian central bank, to be the next head of the eurozone central bank.

      A former Goldman Sachs banker, Draghi would succeed Frenchman Jean-Claude Trichet whose appointment ends at the end of October, but this has never been said officially. France last week threw its support behind Draghi.”"

      1. Susan Truxes

        So is the entire world insolvent? Even the clues from China are disconcerting. What is the solution to global insolvency?

        1. financial matters

          Enabling people like Yves Mersch who at least are willing to recognize the problems would seem like a good start…

          “”He said a “strict silo-like regulation of the formal banking world” missed the danger that “hazardous businesses do not disappear, instead they simply migrate into the unregulated arena”.”"

  11. joecostello

    All banks start with some sort of “capital”. Then they begin making loans, reserve requirements come out of the new loans, that is how leverage is constrained. Meaning if you make a new loan, you can only then lend 90% new out, and then 90% on that loan etc, you’re constraining leverage. 10% reserves means on any one loan you can only leverage up roughly 10 times.

    You’re not lending based on reserves, you’re lending based on “capital” which is accounted as new loans, but the amount of reserves allows some stability in the case of turmoil, thus you could hold up better in lean times, and it disallows you to simply leverage into infinity.

    In “capital requirements” as seems to have been done in the last couple decades, you start relying more on stock prices and other things that can be “artificially” pumped, you’r contributing to a self-promoting bubble, more leverage that when it pops, you’re going to have greater destruction.

    1. mdm

      >Then they begin making loans, reserve requirements come out of the new loans, that is how leverage is constrained. Meaning if you make a new loan, you can only then lend 90% new out, and then 90% on that loan etc, you’re constraining leverage. 10% reserves means on any one loan you can only leverage up roughly 10 time

      firstly, that is not how banks create loans. The bank doesn’t lend out anything. It creates a credit (issues a liability upon itself) that is denominated into state money. Whether or not the bank has the actual reserves is irrelevant. What matters is access to credit worthy customers, sufficient capital (short term constraint) and the price that the bank can obtain reserves.

      Secondly, reserve requirements do not constrain leverage. They simply limit the banks total profitability – in other words, they are an opportunity cost. In reality reserve requirements work nothing like you suggested, they work on a lagged basis: an amount of reserves is required to be held in period based upon an amount of specific liabilities in period t – 1 (previous period).

      Reserve requirements assist in allowing the central bank to maintain its target rate.

      There is therefore no leverage limit which is imposed upon a bank due to its reserve requirements.

      1. joecostello

        so if i use a “credit” card do I not have to pay it back, as its not a loan its “credit”.

        “Whether or not the bank has the actual reserves is irrelevant.”

        The bank creates reserves when it creates the loan, not preceding it. Its all accounting, the value of which isnt decided until the loan is paid back. When they create a hundred loan, they mark it as an asset, but can then only lend on that loan, in a 10% reserve system, $90 on the next loan, then $81 on the next, thats fractional reserve.

        How they all account everything these days, I suppose is anyone’s guess.

        How the banks then all interact with the Fed is another story.

        1. mdm

          Joecostello,

          >so if I use a “credit” card do I not have to pay it back, as its not a loan its “credit”.

          I don’t know how you arrived at that conclusion. I’m simply stating that what a bank is doing is creating a credit (in the economic sense of the word) that is denominated into state money. In other words, the bank is issuing a liability upon itself.

          >The bank creates reserves when it creates the loan, not preceding it. Its all accounting, the value of which isnt decided until the loan is paid back.

          This is wrong. Only changes in the central bank’s balance sheet can change the total number of reserves. This is because reserves appear on the liability side of the central bank’s balance sheet, indicating that they are the issuer. The banking system cannot create or destroy reserves, only shift them around within the banking system.

          >When they create a hundred loan, they mark it as an asset, but can then only lend on that loan, in a 10% reserve system, $90 on the next loan, then $81 on the next, thats fractional reserve.

          When a bank creates a loan, they are creating a credit that is denominated into state money. The credit is a financial asset with a matching liability. SO what the bank is doing is creating an asset (the loan) and a liability (the deposit). It is opposite for the customer, whom the loan is the liability and the deposit is the asset. The bank’s reserve position hardly figures in the loan decision process, this is because the bank can always obtain the necessary reserves from the overnight market. If the bank can issue a loan with interest repayments which are a sufficient mark-up over its costs, then it will make the loan.

          The reserve requirements which you are talking about don’t operate that way. In America (one of the few OECD countries which still uses RR) the bank is required to hold a number of reserves in a given period equal to the amount of (specific) liabilities it held in an earlier period. RR does not operate in the instantaneous process you suggest.

          >How they all account everything these days, I suppose is anyone’s guess.

          How the banks then all interact with the Fed is another story.

          It isn’t anyone’s guess; people have actually gone out and done the research. MMTers and Post Keynesians have written a substantial number of papers on how the accounting and interactions within the banking system and between the banking system and central bank operate. There are even some central bank papers and BIS papers which detail the processes, and which are consistent with MMT and PK descriptions

  12. frances snoot

    “But from July 1 the set of narrow collateral will be expanded to include U.S. and Canadian government bonds, which were previously only eligible as wider collateral. Those issuers join Britain, Germany, France and the Netherlands, whose papers will continue to be accepted as narrow collateral.

    Debt issued by a group of countries whose markets are deemed less liquid will, from July 1, only be accepted as wider collateral — requiring banks that present such securities to pay a premium.

    The group comprises Austria, Belgium, Cyprus, Denmark, Finland, Ireland, Italy, Luxembourg, Norway, Portugal, Slovenia, Spain and Sweden.”

    http://uk.reuters.com/article/2011/02/11/uk-britain-boe-collateral-idUKTRE71A3T520110211

    1. Susan Truxes

      Sounds like central bankspeak for “tax base.” The little countries don’t have the tax base to be first line collateral.

  13. skippy

    Nice Mr Harrison.

    Funny thou, in history’s looking glass, the need to constantly fiddle with currency’s evolution…cough…fungible/liquidity syntax…all in the name of efficacy…snicker. Gone from scarcity based to electrons, why[?], I don’t buy the classical arguments (too much academic control). Humanity’s potential, on the only planet they have…belittled…for the convenience of only a few.

    Skippy…when will people start looking under the pretense afforded century’s of rubbish dressed up as progress, for our good, humanity’s future. What has be wrought has little to do with good intentions or society needs (planetary externalization inclusive), but a few’s fear of loss and its materialization.

  14. Paul Tioxon

    I see MMT as model of a closed, mechanical system. As I see the model of the economy within the larger social order, the banking system can not be understood theoretically without the something that the medium of exchange is referencing. As information about the economic activity, it seems that the aggregate of money represents the cost of everything in the economy. Since capitalism pays a price for all of its inputs and sells at a profit, where does the money come from, that profit has extracted from the cost of everything, held as accumulate capital?

    Banks, lend money, in excess of reserves. It seems the function of the lending theoretically replaces the profit extracted from the system with new money. This money is then used to form a new profit making enterprise, that purchases at a price, its costs and again, expanding the system, sells at a profit which is again extracting money from the system. A virtuous cycle of economic expansion ensues, where profit takes money from the system where it purchased everything and sells for more than the cost of the inputs and banks replace money extracted as profit, back into the system replacing the money taken as profit.

    This seems to me the unit of analysis to answer the questions of money and profit, being conserved more or less by the relationship of banking, the medium of exchange formally organized and economic productivity, the production of wealth created when you can sell something for more than it costs you to make it. As profits increase, money supply must follow to replace extracted profits.

    With this model, the relationship of money to itself, trading as various financial assets breaks away from the virtuous cycle, because the profits being extracted from financial trading does not take money from the system of production but from the system of finance. The cycle that ensues with trading is not wealth production but medium of exchange production, which when introduced into the productive economy causes distortions and breaks down the conservation of profits and money lending.

    1. Toby

      Very good.

      And meanwhile, because scarcity is built in, or necessary for profit making, there is an ongoing bias towards corruption from all participants. It is a zero-sum dynamic masked by growth. While there is growth this system ‘works.’ When there is no growth, it collapses. Exactly as a ponzi or pyramid scheme.

      The process is nothing more than the ever increasing transformation of ‘idle’ resources into Goods and Services. Because it must grow to be ‘healthy’ more and more of the non-economic realm must be brought into the machine and churned into economic activity. Haven’t got any friends? Hire one to take to parties with you. No time to bring up your own children? Hire nannies. No time to cook? Buy pre-cooked meals. Now while none of these things is necessarily good or bad in itself, cumulatively the assumption that economic activity must grow not only depletes resources and trashes the environment, it slowly but surely renders everything we do impersonal, competitive and greedy. It atomizes society. And it ossifies too, as interests fearfully defend their ‘hard earned’ lucre.

  15. K Ackermann

    Nice post.

    Our friend George Washington had a nice post on this subject here about a year ago, too.

    Poof! Let’s make money.

  16. Edward Harrison Post author

    Sorry I haven’t been in the comments yet. I was tied up yesterday and then out to dinner with my sister, something I have to do more often. But let me say thank you to everyone for your thank yous. It’s greatly appreciated.

    I may go to individual comment posts and answer them real quick in a few, but here’s my overarching comment for now:

    I wrote a post on how QE really works here:
    http://www.creditwritedowns.com/2011/03/how-quantitative-easing-really-works.html

    Here’s the mechanism through which it works:

    “The Fed telegraphs how short-term rates will or will not be affected by the real economy and expectations shift accordingly. Therefore, to the degree the Fed is successful in getting long-term interest rates to move, it is because it has adjusted those expectations. That’s how it works.

    The reason this is true is market arbitrage. Any market participant could go out into the market and purchases zero coupon treasury strips as an arbitrage against long-term Treasury yield mispricing if long-term rates did not reflect the path of future expected short rates. Let me repeat that: if long-term rates don’t reflect the expected path of short-term rates, you have a sure fire arbitrage opportunity. If the Fed is destined to keep rates at zero percent for the next five years and I am sure of it, but the yield on five-year Treasuries doesn’t reflect this, all I have to do to make money is buy the five-year and sell Treasury strips and leverage that trade up in the Repo market. Isn’t that what some investment banks are doing right now – ploughing their POMO acquired money into a leveraged bet on Treasuries? That is exactly what happened after the first jobless recovery in 1992-1994 before Greenspan caused a huge bear market in Treasuries by raising rates.”

    The whole song and dance about interest rates going through the moon hasn’t happened yet and I suspect won’t happen anytime soon.

    Here’s the feed through to asset (and commodity) prices:

    “the real economy effects of QE are to slightly lower aggregate demand. This is offset by changing interest rate expectations, which alter private portfolio preferences, and lower risk premia, leading to credit growth, leverage and speculation, forces which should pump up the real economy. The Fed had intended to lower interest rates via the lowered risk premia. To date, the Fed has lowered risk premia. But this has also provided the tinder for speculation and leverage. Moreover, the Fed has also raised inflation expectations to boot, causing interest rates to rise and working at cross-purposes with the lowered risk premia. Thus, QE2 has only been successful insofar as it has increased business credit and raised asset prices.”

    Notice that inflation expectations are now falling though.

    QE is very overrated as a policy tool. But when rates are zero percent and more fiscal is not going to happen, there are not a lot of options. I think QE is bad policy. So do many others. That is why QE2 will end and QE3 will not happen unless and until we see serious economic problems.

  17. Philip Pilkington

    Super bonus question:

    If the Republicans have their way and the debt ceiling is not raised (http://bit.ly/mtjDfl) will the Big Guv’ment continue to issue reserves?

    Still can’t figure this one out. Some people argue that the law is a bit fuzzy here and the government could continue to spend but could not issue bonds — considering that bonds are only real issued to soak up reserves and ensure that interest-rates don’t fall this could be a very good thing. Why? Because — as Ed’s chart shows — reserve accumulation has already driven down interest rates and if the government continued to spend without issuing bonds the goombas over at the Fed would finally get the whole ‘the government is not spending constrained’ thing through their thick skulls (oh, and we could rub it in Krugman’s face… now THAT would be sweet).

    I asked Wray about this and got a very cryptic answer. I think what he was saying was that the Treasury should just change its operating procedure and cut checks anyway — but I assume that this would rise or fall on the legality question.

    He also said that the realistic outcome would probably be that the Treasury would issue a few checks for the most necessary spending — then they would push most of the spending forward (“we’ll pay for that in two weeks”) and put major pressure on Obama and his coward-brigade to get down on their knees and lick some Republican cowboy-boot.

    Anyway… discuss… is there a lawyer in the room that could check this out?

  18. Jim Haygood

    Good comment, Ed. But I’m curious why you don’t mention the role of overnight sweeps, which Greenspan recklessly approved in 1994, setting off the great 1995-2000 tech bubble.

    Thanks to overnight sweeps of reserved demand deposits into reserve-free savings (a subterfuge probably inspired by the tale of Cinderella — banksters aren’t very imaginative), required reserves are now negligible.

    That is, even if reserves WERE a theoretical constraint, they wouldn’t matter now because banks can simply sweep them away with the wave of a wand over a comely glass slipper.

    1. Philip Pilkington

      “But I’m curious why you don’t mention the role of overnight sweeps, which Greenspan recklessly approved in 1994, setting off the great 1995-2000 tech bubble.”

      Don’t getcha… if loans cause the money-supply to expand — and not vice versa — then how could easing reserve requirements have set of a stock market bubble?

  19. F. Beard

    So how are banks different from counterfeiters other than that they lend out their “money” rather than spend it?

    Where does the purchasing power for their “loans” come from?

    Hmmm?

  20. Philip Pilkington

    “Where does the purchasing power for their “loans” come from?”

    It comes from here, of course:

    http://www.youtube.com/watch?v=NuiynIn-g9s

    Seriously though, central banks create purchasing power. That’s their job. Asking where it ‘comes from’ is like asking why the king gets to be king — he just does… that’s why.

    The difference between counterfeiters and the central bank is that counterfeiting is illegal — and if it went on for too long would cause inflation. The government and the central bank have certain responsibilities — like ensuring that inflation doesn’t get too severe. It’s a case of power being wielded, but with it a great share of responsibility.

    1. F. Beard

      Seriously though, central banks create purchasing power. Philip Pilkington

      Only partially true in the sense that new money spent on investment can increase productivity and thus the purchasing power of every money holder. However, the purchasing power for that new money (or “credit”) is certainly “borrowed” from all money holders until the new investment comes on line. And since that purchasing power is “borrowed” without permission or adequate compensation (interest) then it is, in effect. stolen purchasing power.

      And then there are loans for pure consumption which only indirectly at best increase productivity but certainly increase prices.

      Legal or not. banks are counterfeiters.

      1. Philip Pilkington

        “Legal or not. banks are counterfeiters.”

        Strictly speaking that statement makes no sense. You can’t be a ‘legal’ counterfeiter any more than you can be a ‘legal’ murderer.

        “Only partially true in the sense that new money spent on investment can increase productivity and thus the purchasing power of every money holder.”

        Increasing investment does not increase purchasing power — not directly, anyway. If I build a factory and hire loads of new workers who then get wages and spend their money on consumer goods, well, the money has to come from somewhere… and ultimately it comes from the central bank.

        1. F. Beard

          Strictly speaking that statement makes no sense. You can’t be a ‘legal’ counterfeiter any more than you can be a ‘legal’ murderer. Philip Pilkington

          What those folks did in Nazi Germany was legal but they were nevertheless executed for murder.

        2. F. Beard

          If I build a factory and hire loads of new workers who then get wages and spend their money on consumer goods, well, the money has to come from somewhere… Philip Pilkington

          But it need not and should not come from a government enforced counterfeiting cartel. You could pay those workers with common stock or product coupons or you could borrow at honest interest rates.

          and ultimately it comes from the central bank. Philip Pilkington

          Private monies could come from anywhere. As for government money, only the government should issue it.

          1. Philip Pilkington

            “You could pay those workers with common stock or product coupons or you could borrow at honest interest rates.”

            Coulda, woulda, shoulda.

            We COULD do loads of things. We COULD pay workers in moon dust. But we don’t.

            “Private monies could come from anywhere. As for government money, only the government should issue it.”

            Eh… duh?

  21. Cedric Regula

    I think it’s very debatable if all MMTers really understand MMT, but since it takes most of them 5000 words to say hello, it’s a debate I don’t have the time or patience for.

    One of their many problems is their bizarre desire to co-opt what has been known for a very long time by so called conventional economists and even Fed monetarists and present it as some sort of striking new discovery by the masterminds of MMT.

    Like “Loans precede reserves”. This probably gets a “wow” from all the 19 year olds in Kansas, Missouri and Texas econ classes, but here is some history about Marriner Eccles, a banker hired by FDR to restructure how the Fed operates.

    “Utah Banker Marriner S. Eccles Helped Design FDR’s New Deal”
    http://historytogo.utah.gov/utah_chapters/from_war_to_war/marrinerseccleshelpeddesignfdrsnewdeal.html

    Eccles was the one that coined the term “pushing on a string.” A little later Keynes formulated the “liquidity trap” description of the same phenom. So there is an understanding that sometimes there is no loan demand, or willingness for banks to make loans.

    The Fed, and even many economists, have noticed that banks do interbank lending. The Fed even formalizes how they think they can fit in. They say the make the “discount window interest rate”, where banks can borrow direct from the Fed, higher than the Fed target rate they set with FOMC actions. This encourages the banking system to equalize individual excess liquidity amongst themselves, and the Fed is the provider of liquidity as a last resort.

    Then the underdiscussed part, IMO, is that the interbank lending and Fed lending needs to be secured with collateral. When the quality or market price of the collateral comes into question, we get a “wholesale” credit crisis. Also, if you can borrow overnight, every night, liquidity acts the same as a long term loan. Until the “credit crunch” day comes, and you can’t borrow overnight anymore. This seems to have damaged the psyche of not only the banking system, but corporations as well because they are now holding much more cash instead of relying on money markets and revolving credit lines. Since they deposit their cash in a bank, our excess reserves may belong to corporations.

    The most flattering description of QE is it was a “Hail Mary” thrown by the Fed, and the Fed has no idea where the pigskin is headed, but they are hopeful it will be a crowd pleaser.

    But then there are other potential problems with it.

    1. Philip Pilkington

      MMTers don’t claim that all their theories are original.

      But then, I could scoff snobbishly at you and go, “Marriner Eccles? Keynes? Uh! THEY didn’t come up with the notion that loans precede reserves — there’s definitely hints of that in Capital Vol. III.”

      Well, that was fun — but it was also stupid and childish. Bill Mitchell is well aware that his theories have precedents in Marx — and Wray is well aware that he’s carrying on the work of Keynes and Minsky. So what?

      1. Cedric Regula

        It stands for Modern Monetary Theory. It is almost all standard keynesian economics, even Galbraith said so, with an emphasis on monetary aspects. They just like explaining it all inside out and backwards…so it sounds young! Just a terrible waste of time if you already more or less get it in the old verbiage.

        Some so called better known practitioners…Galbraith, Michael Hudson, Randall Wray, Bill Mitchell. Anyone that belongs to Roosevelt 2.0 must claim to understand MMT. Knowing Roosevelt 1.0 is an option however.

  22. flow5

    The loans come first, not the reserves” What your not saying is that this is the operating procedure that has created all of the boom-busts & 75% of the inflation since 1965.

    It is a fact that the money supply can never be managed by any attempt to control the cost of credit. Keynes’s liquidity preference curve is a false doctrine. The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves.

    It is also an historical fact that all prudential reserve banking systems have heretofore “come a cropper”.

    (1) And New York Fed President William Dudley said “Money & banking textbooks written before 2008 are now obsolete as the FED now has the ability to pay interest on excess reserves.”

    (2) “There is general agreement that, for almost all banks throughout the world, statutory reserve requirements are not binding” – 2006-FRBST

    And the U.S. does not have a fiat system. A fiat system is where the volume of currency issued is dictated by the deficit-financing requirements of the issuing government. In contrast, the essence of our managed-currency system (the existing modus operandi), is a system in which the volume of currency in circulation is impersonally determined by the total effective demands of the public, or the amount which meets most closely the needs of trade.

    45% of WWII’s debt was monetized and that might be labeled fiat based. However the FRBNY’s purchases of governments during QE1 & QE2 were sterilized by using IORs.

    “The M1 multiplier is the ratio of M1 to the St. Louis Adjusted Monetary Base” – St. Louis FED

    (1) Even though the monetary base expands when the volume of excess reserves expands, the monetary base is not now, nor has ever been, a base for the expansion of new money & credit.

    Currency, comprised 92% of the base on Aug 2008, & subsequently fell to 43% of the base at present. An increase in the currency component of the base is contractionary – unless offset by open market operations of the buying type. I.e., there is no expansion coefficient associated with currency held by the non-bank public, etc.

    (2) Also: “Remember that “excess reserves” is an accounting concept, not a physical item. The physical item (asset) is deposits at Fed Res Banks. These deposits may be used to satisfy statutory reserve requirements; any “excess” deposits are labeled as “excess reserves.” This terminology dates from the 1920s, and I find it obsolete.” — FRBST

    And why didn’t you tell your readers why reserve aren’t binding? Deregulation of legal reserves made the Great Recession possible:

    Reserve requirements are no longer binding because increasing levels of vault cash (larger ATM networks), retail deposit sweep programs, fewer applicable deposit classifications, & lower reserve ratios, have combined to remove most reserve, & reserve ratio, restrictions.

    1. Philip Pilkington

      “A fiat system is where the volume of currency issued is dictated by the deficit-financing requirements of the issuing government.”

      I love when people just make up their own definitions…

      Let’s do a quick Google to see if the world agrees with Flow5′s definition…

      Wiki — nope:

      “Fiat money is money that has value only because of government regulation or law. The term derives from the Latin fiat, meaning “let it be done”, as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.”

      And…

      “The term fiat money has been defined variously as:

      * any money declared by a government to be legal tender.
      * state-issued money which is neither legally convertible to any other thing, nor fixed in value in terms of any objective standard.
      * money without intrinsic value.”

      What about Keynes? — nope:

      “Fiat Money is Representative (or token) Money (i.e something the intrinsic value of the material substance of which is divorced from its monetary face value) – now generally made of paper except in the case of small denominations – which is created and issued by the State, but is not convertible by law into anything other than itself, and has no fixed value in terms of an objective standard.”

      Business dictionary? — nope:

      “Common type of currency issued by official order, and whose value is based on the issuing authority’s guarantee to pay the stated (face) amount on demand, and not on any intrinsic worth or extrinsic backing. All national currencies in circulation, issued and managed by the respective central banks, are fiat currencies.”

      I could go on — but I won’t…

  23. F. Beard

    We COULD pay workers in moon dust. But we don’t. Philip Pilkington

    Because it’s much cheaper to borrow from the government enforced counterfeiting cartel and pay the workers with their own stolen purchasing power.

    1. Philip Pilkington

      “Because it’s much cheaper to borrow from the government enforced counterfeiting cartel and pay the workers with their own stolen purchasing power.”

      You should set up a court… somebody needs to prosecute these crimes. Tell me how far you get… hell, I’ll work on the defence — all you have to do is pay me in those useless dollars you have sitting around…

      1. F. Beard

        You should set up a court… somebody needs to prosecute these crimes. Philip Pilkington

        Nope. What is needed is to eliminate all government privilege for banking and what should be purely private money supplies. That would include repealing legal tender laws for private debts, abolishing the Fed, repealing the capital gains tax, abolishing government deposit insurance, etc.

        1. Philip Pilkington

          “…what should be purely private money supplies…”

          That should read: “what I THINK should be purely private money supplies”.

          I’d advise that you stop conflating your opinion with fact — or law for that matter.

  24. F. Beard

    Oh, and central bankers aren’t Nazis… Philip Pilkington

    Since the Great Depression was a major cause of WWII and since the Fed has admitted causing the Great Depression then the death of 50-86 million people can be attributed to central bankers.

    1. Philip Pilkington

      Your leaps in logic are truly outstanding… truly outstanding indeed.

      Come on… seriously, this is tin-foil hat talk…

      1. F. Beard

        Your leaps in logic are truly outstanding… truly outstanding indeed. Philip Pilkington

        Ben Bernanke has admitted the Fed caused the Great Depression and wiki has this to say about the causes of WWII:

        The main causes of World War II were nationalistic tensions, unresolved issues, and resentments resulting from the First World War and the interwar period in Europe, plus the effects of the Great Depression in the 1930s. from http://en.wikipedia.org/wiki/Causes_of_World_War_II

        Plus I note the Fed also financed US entry into WW I which was another major cause of WW II.

        1. Philip Pilkington

          “Ben Bernanke has admitted the Fed caused the Great Depression…”

          Well, that settles it then doesn’t it? Interesting that Bernanke suddenly becomes a reliable source when he backs your point…

          In other news, I cannot believe that you can have such a simplistic view of history. Many things were a factor… actually, no… I’m not having this argument — I’d better spend my time picking my nose.

          1. F. Beard

            In other news, I cannot believe that you can have such a simplistic view of history. Philip Pilkington

            Two main causes of WWII were Germany’s humiliating defeat in WWI which was financed by the Fed and the Great Depression which was caused by the Fed.

  25. F. Beard

    That should read: “what I THINK should be purely private money supplies”. Philip Pilkington

    The government has no business enforcing a money monopoly for private debts. Nor does it have a need to.

    Also, the concept of separate government and private money supplies is implicit in Matthew 22:16-22.

    So you see, it is not just my opinion.

    1. Philip Pilkington

      *Rubs eyes* *Looks at computer screen* *Rubs eyes again*

      Did you just quote the Bible? You did, didn’t you? Wow… just wow!

      1. F. Beard

        The Bible has quite a lot to say about economics including usury, debt forgiveness, diversification, hoarding, counterfeiting, fraud, theft, etc.

        1. Philip Pilkington

          Okay, we’ll post a few copies to Bernanke and King… We’ll have this economic system fixed in no time.

          Throw out Keynes — throw out Minsky — EMBRACE JEBUS!!!

          *Drops to knees* Praaaa-asie the lawd!!!

          1. skippy

            Funnily enough it didn’t work so well back then either, yet kings and emperors were appointed in gods name (by gods invisible hand).

            Skippy…every 7ish years_global_default (snake diet)…peachy…purge the devil!!!

  26. JD

    I think most banks are not lending because of expected losses which will undoubtedly hit their balance sheets in the near future. Bank balance sheets hold mostly securities (trading) and loan assets currently valued at-or-near cost which are unlikely to redeem anywhere approaching this value. In light of this, they favor the many low/no risk short term trading strategies that current U.S. government programs offer to generate a cash cushion and offset losses (which can also be highly levered for higher returns). Banks can choose to extend more credit to consumers, but I suspect their view is this only adds less liquidity and more risk to a very uncertain existing portfolio of holdings. The timing and magnitude of losses is anyones guess at this point, but most understand it will not be trivial. For the banks as a result, short term cash generation is king.

    A word on how banks extend credit to consumers:
    In practice, most banks make loans to individuals through product programs which target very specific consumer markets (2009 Tuition Loans-Northeast NY State for example). These programs, from which all consumer loans are extended, outline rules for credit extension and allow the bank to manage a large volume of small loans through a volume approval process. They have an independent budget for expenses and write-offs, a defined schedule for periodic review, and a (target) profit model. It is common for banks to adjust program model rules to increase the amount of loans (and risk) to adjust target profitability of each program.

    It seems very unlikely to me, even considering the current economic environment, that banks are unable to develop any profitable program and as a result have scaled back all consumer product programs. It’s more likely that senior management has drastically scaled back approval of any new program regardless of (key – long term) profitability in favour of using available resources for short term gains.

  27. flow5

    Philip Pilkington says: “I love when people just make up their own definitions…”

    Some people create dis-information to pander to their socialist preferences.

    MONEY 7 BANKING, second edition, Houghton Mifflin – to wit:

    The differentiating & existing modus operandi is defined by the process by which currency is put into, and taken out of circulation, i.e., thru the banking system. The volume of currency held by the public needs no specific regulation since it is impossible for the public to acquire more of a given type of currency without giving up other types of currency, or else bank deposits. In other words, under our managed system it is impossible for the public to add to the total money supply consequent to increasing its holdings of currency.

    1. Martin Finnucane

      Some people create dis-information to pander to their socialist preferences.

      Pander to a personal preference? I thought one pandered to crowds, or to masses, or something. And what’s a socialist preference? “No liberty for me, thank you, I prefer socialism.” Is it possible that such a preference makes one worse than Hitler?

      Seriously: you’re a troll, right? http://www.nakedcapitalism.com/2011/05/on-trolls-and-plants.html

  28. Ricardo Santos

    Just wanted to comment that the constitution is very clear in that congress is the only one that is allowed to make money.

    Banks are companies and should not create money, PERIOD!

    The “Federal” Reserve is as federal as “Federal” Express. Seriously is a corporation started in “Puerto Rico”. (Look it up).

    Finally, todays money system is fantasy based, not resource based. The more money there is, the less valued is everyones money. Thereof every time the “Federal” Reserve issues new money is stealing a piece of everyones wealth. Of course people are too busy with their lives to notice this.

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