winterspeak.com

Why the PIGS might end the EMU

2010-02-05T16:04:00.000-08:00

I've meant to talk further about the link between savings and investment brought up in the previous post, but have not had time.

Next week will be interesting as we see what happens with the PIGS, and the European Monetary Union. PIGS stand for Portugal, Ireland, Greece, and Spain, for Euro countries with weak economies, high unemployment, and large public deficits. European Monetary Union means that these countries cannot issue currency the way the US, or Switzerland can, and operate with real budget constraints, much like US States. But US States can at least hope for Federal largess -- there is no Federal currency issuer in the EU who can write a cheque to the PIGS and bail them out. So they have to choose between debt deflation, and Great Depression level unemployment, or exiting the EMU, reclaiming national sovereignty, and if their obligations are euro denominated, defaulting.

Interest rates have gone parabolic today, as the logic of Diamond-Dybvig pushes those countries toward their only, stable equilibrium.

You'll see columnists talk about how the EMU would be fine if there was more labor mobility etc. This is nonsense. What they need is a super-currency issuer who knows what they are doing. You will also see columnists talk about how the PIGS debt default (if it comes to that) also foreshadows risks in countries like the US and the UK. This is also nonsense, because those countries retain a sovereign currency and thus need never default.

Long thread at interfluidity

2010-01-31T14:37:00.000-08:00

Steve and I go back and forth on this long thread at interfluidity. JKH makes a couple of appearances, injecting sanity into the discussion, so it's worth reading for that alone.

I think Steve understands how loans create deposits, but he does not understand how savings is how you account for real investment. I'm bad at explaining loans->deposits, and I'm even worse at explaining investment->savings.

Here is a very good explanation of how savings and investment are connected (thanks Scott!)

The Fed cannot inflate. Buy Bonds.

2010-01-27T11:06:00.000-08:00

Ben Bernanke is famous for saying that the Fed can always inflate if needs be by "dropping money from helicopters".

But the Fed cannot "drop money from helicopters". Only the Treasury can. Helicopter drops of money are fiscal policy, not monetary policy, as they create net new financial assets for the non-Govt sector. The Fed cannot inflate.

If you think about the mechanisms the Fed has, it becomes clear that they do not have to tools to create inflation. They can control interest rates, but rates are a double edged sword as the non-Govt sector has both borrowers and lenders. Low rates help borrowers but hurt savers, and high rates do the opposite. At a sector level, the impact of interest rates is muddled at best, there certainly is no clear mechanism to generate inflation.

The Fed can also alter the level of bank reserves. If banks lent out reserves, this might have some impact on private sector credit expansion, but as banks do not lend out reserves, it does not. There's been a long debate in various blogs about whether, on the margin, a vast sea of reserves might have some impact on bank behavior, but nothing definitive came out of it. As a mechanism, it's weak.

The only thing left is belief, something that Nick Rowe came very close to admitting in a post a few months back. "Monetary policy does not actually work, but if people believe it works, it might". There you have it, Fed as Placebo. I think much of the runup in the S&P has been based on two things: 1) cheap labor (which helps corporate profits) and 2) a belief that the Fed will get the economy restarted. If 2 weakens, then all that's left is unemployment to enrich corporations by helping their bottom line, but there is no demand to help them grow their top line. It's a very ugly scenario, and one that Japan's been enjoying for about 20 years now.

The Obama administration's recent moves to cap deficits means that the hawks have taken control of that, and the Government will stop creating the net financial assets that the private sector so desperately wants. This will put a ceiling on aggregate demand, Another equity downleg and it may be all over.

I blame Robert Rubin. I met him many years ago at U Chicago, and he was intelligent, articulate, and completely different from then Treasury Secretary Snow who begged us to ask him about his Africa trip with Bono because he didn't understand any of the derivative regulation questions we were peppering him with. The Clinton gang, in particular Rubin, believe that the Clinton surpluses were what generated the boom the US enjoyed in the 90s. That is the driver for Obama to get tough on the deficit. In reality, of course, the Clinton surpluses dramatically increased the fragility of the private sector by draining it of savings, leaving it more levered BEFORE the Greenspan orchestrated real estate bubble. The dot com asset bubble, and various other lukcy drivers of aggregate demand papered over this increasing fragility, but sector level balance sheets don't lie. At any rate, Rubin learned the wrong lessons from that episode, and Obama is setting the economy up for a 2010 that will either be bad or worse.

Even at 3% (or whatever) I recommend you buy Treasuries.

Mankiw becomes drunk on power

2010-01-25T21:22:00.000-08:00

Mankiw is a cheap date. He doesn't even need real power, just the smell of it is enough. Look at this opening:"One of my many friends working for President Obama sends me this email, along with permission to share it with my blog readers". OMG. One of his many friends, who work for President Obama, who not only leak, but give him permission to share it with his blog readers. Heady stuff, to be sure. And what is the great inside scoop?

The most vivid case in point is the recent policy announcements about implementing the Volcker ideas about separating investment and commercial banking.

This policy process has been in the works for months, and it came to fruition in the normal course of policy operations after extensive meetings and consultations among Treasury, NEC, the PERAB board, and other parties.

So, the Volcker plan is not because the Dems just lost Massachusetts and healthcare, it's been in the works now for months, and the timing was coincidence.

Greg, who seems to be anybody's after smelling the glass of wine concurs: "Thanks for helping to get the true story out." Others are less credulous. They may believe that the Volcker plan was exactly what it seems like, a panicked response to an unexpected, and terrible, electoral loss after a whole raft of unpopular policies have failed to make a dent in unemployment. And the leak is an attempt to get friendly bloggers to pass along the official party line. Thoughts like this are the basis of conspiracy theories.

Sanity and Insanity at Macro Man

2010-01-22T20:27:00.000-08:00

An excellent comment thread at Macro Man. The context: Macro is complaining because the Volcker plan will limit what banks can do, and try to separate out prop trading from taxpayer backstopped institutions.

And while it is probably imprudent to comment too much until the details are known, on the face of it [the Volcker plan's] draconian approach is both woefully misguided and appallingly naive. We can probably all agree that it's in no one's best interests to have a situation where a Lehman Brothers owns $50 billion+ in residential and commercial real estate turds, which brings down the firm and threatens the global financial system.

But there's a big difference between that and having a team of punters (not dissimilar to your author) who coordinate and utilize the market intelligence available to large banks (which is enormous and extremely valuable) to make informed bets in the marketplace.

In the comments, Gary smacks Macro down:

My junior guy, like myself, was unwilling to try to hedge the subordinate tranches from all the deals the securitization group was making. Obviously, securitizing toxic waste was a huge money maker as long as you pretended the risk wasn't there.

Every bank bought the toxic waste, put it in a REMIC/CDO/ABS whatever and sold off the senior tranches. The subordinate tranches stayed on the banks books and were hedged.

When the volume of deals got high enough, the true cost of hedging increased. Experienced traders of course wanted to pass that cost back to the securitization desk -- which would have made many deals less profitable if not unprofitable.

The solution was two fold -- "promote" the senior traders to some other department, get rid of the trained staff, and bring in yes men straight out of college. The newbies wouldn't realize the risk, much less the cost of that risk. They would be happy to book the accounting profits; that they were massively short gamma didn't bother them in the least.

Essentially, these guys were making money by being short straddles in size -- often 20-25 times the banks capital. As soon as there was any volatility, the banks were finished.

Later, the garbage was put into SIVs to conceal the risk (and its size) from the banks' balance sheets. To add fuel to the fire, the short straddles were "financed" with overnight money that would be pulled if (when) the risk became known.

Experienced traders knew this and didn't want their deferred compensation to get hit (deferred comp used to be common in many firms). So management replaced them with crony newbies were happy to go along.

The "banking" crisis occurred in 2003-2004 when these short straddle positions became many times larger than the banks themselves. It wasn't until 2007 when the accounting caught up to the risk

My former junior guy is doing quite well now at a hedge fund. The newbie the bank managers put in is now selling sunglasses in Florida. And the bank is now one of the many zombie banks being propped up at taxpayer expense

BTW Macro Man -- I have no idea how many bank CEOs tried to conceal their problems versus how many simply didn't understand the risk was on their books. I suspect (but could not prove) some of both.

Regardless, if you understand the culture / politics of big banks, then you know the department that is generating massive profits often runs the place. If the CEO "stands up to them", they mutiny and the CEOs job is in jeopardy -- either the group leaves and the firm's profits drop, or the group goes to the board of directors to get the CEO fired.

And there is no way to prove beyond a reasonable doubt that the securitization group really understood the risks -- they just knew one trader was willing and another was not. It sounds bad in 20/20 hindsight, but you can't prove anything beyond a reasonable doubt (i.e. in a court of law).

Even knowing my ex-CEO for years, I couldn't say for sure what he was thinking.

The corporate culture of big banks is why they should not be allowed to prop trade -- the culture prevents good risk management.

Private partnerships err on the side of being a little too cautious -- its their own money they are risking on something they don't understand.

Deferred comp systems only work if management doesn't have lucrative severance packages and if the comp is deferred many years (until the assets mature).

Big banks risk / accounting is decided by committee -- so its quality is completely politics. Ultimately, you have to decide whether to pick a fight and lose YOUR job; or do you keep quiet and let the suckers (aka shareholders) take the hit. Its a classic agency problem

The heart of banking is making loans that get paid back. Every element in their structure and regulatory environment should sharpen this goal, not dull it.

Scott Brown vs Timothy Geithner

2010-01-21T20:48:00.000-08:00

Paul Volker has been passing his cup along for a long time now, and has been used for nothing more than window dressing in the Obama Administration. Volker isn't a PhD, and is thus free from a lot of nonsense that's being taught in Economics departments, but he isn't an accountant by training nor has he ever had an operational role in a bank. So he isn't good, he just isn't appallingly bad.

Volker's skills, though, are not what catapulted him from the periphery of the Obama administration to its political center. It was Scott Brown's win in Massachusetts, and the end of Obama's health care hopes.

Timothy Geither and Larry Summers, by transferring money from taxpayers to the banks, and telling Obama that "once that banks are healthy the economy will follow" have killed healthcare. Banks are pro-cyclical, and Geither and Summers' advice was wrong. Employment is at 10%, and banks are making record profits. Obama has lost Massachusetts, he's lost healthcare, and the midterm results are just going to make things worse. I wonder if he's mad at Geithner, Bernanke, and Summers.

The Volker proposal is a step in the right direction. It isn't nearly far enough, but he labors under the same "gold standard" fallacy that infests the profession, but is thankfully free of "banks should be unregulated" nonsense pushed by Greenspan. I don't think that this proposal will go very far either, though.

Taxing Wall Street Down to Size

2010-01-20T09:44:00.000-08:00

I do not agree with the prescription in this NYTimes Op Ed, but I agree with much in the description.

WHILE supply-side catechism insists that lower taxes are a growth tonic, the theory also argues that if you want less of something, tax it more. The economy desperately needs less of our bloated, unproductive and increasingly parasitic banking system. In this respect, the White House appears to have gone over to the supply side with its proposed tax on big banks, as it scores populist points against the banksters, too.

At a structural level, the economy needs a financial sector that adds value, and that is certainly a smaller one. But it also needs more net private savings, which a bank tax (or any tax) will not do.

Make no mistake. The banking system has become an agent of destruction for the gross domestic product and of impoverishment for the middle class. To be sure, it was lured into these unsavory missions by a truly insane monetary policy under which, most recently, the Federal Reserve purchased $1.5 trillion of longer-dated Treasury bonds and housing agency securities in less than a year. It was an unprecedented exercise in market-rigging with printing-press money, and it gave a sharp boost to the price of bonds and other securities held by banks, permitting them to book huge revenues from trading and bookkeeping gains.

A bigger problem than low interest rates was poor capital controls. Capital controls are what limit lending, not reserves, and capital controls have absolutely stunk for a while now at every level. The situation is worse now as private capital is no longer in a first loss position.

In supplying the banks with free deposit money (effectively, zero-interest loans), the savers of America are taking a $250 billion annual haircut in lost interest income. And the banks, after reaping this ill-deserved windfall, are pleased to pronounce themselves solvent, ignoring the bad loans still on their books.

This is an excellent point that is totally lost on the monetary fanatics who walk the halls of the Academy -- low interest rates rob the private sector of interest income, and thus have a deflationary impact as well as their supposed inflationary impact. The harder one looks for an inflationary mechanism though, the harder it is to find. Low interest rates may, net, hurt the economy.

To argue, as some conservatives surely will, that a policy-directed shrinking of big banking is an inappropriate interference in the marketplace is to miss a crucial point: the big Wall Street banks are wards of the state, not private enterprises.

This is another, excellent point, but if anything too narrow. Banks in general are public private enterprises, with their access to reserve accounts giving them money printing ability that other parts of the private sector do not have. The Federal Reserve is technically a private organization too, but that's obviously nonsense -- it is part of the Government. Banks and GSEs have more in common than they realize.

To be sure, the most direct way to cure the banking system�s ills would be to return to a rational monetary policy based on sensible interest rates, an end to frantic monetization of federal debt and a stable exchange value for the dollar.

Monetary policy has almost no impact on the economy. The most direct way to cure the financial system's ills would be to fund the demand for private sector savings via a payroll tax holiday. Banks should be restructured to an extent that makes Glass Steagal look like Barak Obama's financial "reform" act.

Weekend links

2010-01-16T07:15:00.000-08:00

Billy Blog has the post-Keynesians take on the Austrians here. The whole thing is a little inside baseball, so only read it if you care. The irony is, of course, that when Keynes displaced the Austrians, their description of economic reality was actually closer to the truth, as Austrianism understands gold standard economies pretty well, and the General Theory is a muddle. When Keynes was overtaken by the Monetarists, you essentially had the Austrians re-establish themselves, but under an even more confused and muddled barrage of mathematics, in a fiat monetary system that complies pretty well with the General Theory!

Finally, a word on Obama's bank tax.

Like Megan, I do not support it, although my reasoning is different. The private sector is not done deleveraging, and any action that drains private sector savings, be it quantitative easing or a bank tax, is bad as it will undermine aggregate demand when that is still very weak. If you hear the phrase "it will be good for taxpayers" then it will almost certainly be bad for taxpayers as the US needs higher deficits still right now, not lower ones.

Also, banks are still undercapitalized, especially if they recognize the market value of their assets. The Fed has waived capital requirements so this does not impact them operationally, but those requirements, I assume, will come back some day and an adequately capitalized banking sector is something that the economy needs. Banks are de-capitalizing themselves through absurdly large salaries and bonuses, which is bad, but taxing them has the same effect. The UK approach -- taxing the bonuses themselves -- is better in this regard.

As a tax payer, I don't want to get my bailout money back. I want to see that we got something for the money, namely a sanely managed financial system. I'm not seeing that yet.

Updates to weekend reading

2010-01-09T10:35:00.001-08:00

Warren Mosler has more on the decline in private sector credit.

Also, Scott Fullwiler has an excellent post on why Ben Bernanke's "helicopter drop" is fiscal not monetary.

A comment on this last point. The last refuge of scoundrel economists, who argue that monetary policy is all you need, is the assertion that a helicopter drop is somehow "monetary" too when it is clearly fiscal. if you redefine monetary to mean fiscal, then yes, monetary is all you need, but let's be honest about what's actually happening. It's fiscal. Here's a clip from some email correspondence I had illustrating this exact subterfuge:

Academic economist: At least to me, it's clear that your example [helicopter drop] is two operations.
1) Adding 1M to bank reserves gratis is fiscal policy. Effectively it was a $1M transfer. (We've added to government liabilities without adding anything to its assets, so that's fiscal policy via my definition.)
2) Because an addition to bank reserves has increased the money supply, it's also monetary policy.

winterspeak: By this definition, all fiscal policy is monetary policy. Whenever the Treasury spends, it changes the money supply, Whenever the Treasury taxes, it changes the money supply.

Can you please define monetary policy in a way that is not fiscal policy.

There you go. If you believe that bank reserves do a damn thing, which in a normal environment they do barely as they influence the FFR, and in this environment they really don't because the Fed is paying interest on reserves, then anything that impacts reserves is monetary policy. And since deficit spending can impact reserves, all fiscal becomes monetary.

Weekend links

2010-01-08T20:50:00.001-08:00

Kevin Murphy was the smartest person I met at Chicago. Becker ran a close second. It's sad to see them write editorials like this one in the WSJ:

In terms of discouraging a rapid recovery, other government proposals created greater uncertainty and risk for businesses and investors. These include plans to increase greatly marginal tax rates for higher incomes. In addition, discussions at the Copenhagen conference and by the president to impose high taxes on carbon dioxide emissions must surely discourage investments in refineries, power plants, factories and other businesses that are big emitters of greenhouse gases.

The stuff on reserves and the banking system is standard academic macroeconomics, and therefore completely wrong. I cannot think when "the market hates uncertainty" sounded more tone deaf.

A number of articles pointed to the ongoing de-leveraging within the private sector. This is the key story of the economy, with the only question being whether the Govt funds this de-leveraging by actively running deficits, or instead uses unemployment as a policy tool and does nothing, letting automatic stabilizers fund private demand for savings.

Consumer Credit outstanding fell a greater than expected $17.5b m/o/m in Nov vs an estimated drop of $5b and follows a revised $4.2b decline in Oct. It is the 13th month of the last 14 that has seen a reduction and is the biggest monthly drop ever. The decline was led by a sharp 18.5% annualized drop in revolving credit which consists mostly of credit cards. Nonrevolving credit outstanding fell 2.9% annualized and is made up mostly of auto loans. Total consumer credit outstanding now stands at $2.464T, the lowest since July �07 and has fallen $117b from the record high in July �08. To put the last decade of credit growth into perspective, nominal personal consumption rose 55% (same increase as overall GDP) while consumer credit rose 61% over the same period. Thus, highlighting how dependent on credit the US became rather than on savings in generating growth.

People want to save more. Will the Govt help or hinder?

Why you should walk away from your mortgage

2010-01-06T22:20:00.000-08:00

Megan McArdle argues that underwater homeowners should continue to pay their mortgages, and not "ruthlessly default" by walking away if they can continue making their mortgage payments. She argues that the social norm to honor debt are important to a well functioning society, and if this norm was eroded we would all pay through higher interest rates etc.

I disagree. In the context of the credit bubble, banks made loans to customers who could not service that debt out of income. It was a two way bet on rising asset prices. Since that bet did not work out, the borrower should walk away, and the bank should write the asset down. If the loan had been made on the basis of income, then I would agree with Megan.

Waldmann, and I think Salmon, view the tightening of credit as a feature rather than a bug, of course--they'd like to return to the days of paternalistic credit markets

Waldmann and Salmon want to return to the days where banks made loans that would be paid back. This is not paternalism, this is Sanity.

Amazingly, Megan has managed to write a post on the credit bubble without realizing there was a credit bubble at all.

Richard Koo, who is so close, is still wrong

2010-01-02T20:30:00.000-08:00

In an earlier post I highlighted why predicting what will happen in the future is so difficult. Geither, Obama, and Summers have no idea how the monetary system works and therefore are unpredictable in whether they will act to improve the situation or make it worse. Richard Koo, who understands the situation in Japan (which is very very similar) quite well still makes suboptimal recommendations because he too does not understand how the financial system works. Here's him in an article in Barron's:

I'm explaining to the Americans that the disease you've got, is the disease we got 15 years earlier. Most Americans are flabbergasted by the fact that the Federal Reserve has lowered interest rates to zero, flooded the market with liquidity -- and the economy is still going absolutely nowhere. Unemployment is still increasing, people are still retrenching, deleveraging. When the central bank brings rates down to zero, a lot of things are supposed to happen, but there's nothing happening. But that's what we experienced in Japan. The Bank of Japan brought the rates down to zero, did massive quantitative easing, with no result whatsoever. This happens because of a balance-sheet recession.

This is exactly correct. The private sector in the US has taken on more debt than it can/wants to support out of income. Therefore, it is de-leveraging, paying down debt and saving, which is driving aggregate demand lower. Only fiscal action through higher deficits can support aggregate demand while this happens. So, Koo gets that right, but then there is this:

In an ordinary, garden-variety recession, as we learned in school, the private sector uses money more efficiently, and a budget deficit is considered bad. But when the private sector is completely absent and paying down debt at zero interest rates, and the government doesn't borrow this money, what happens? Even a child would understand the whole thing could collapse. The only way the government can turn this economy around is to do the opposite of the private sector -- borrow the money the private sector saved and spend it, which means fiscal stimulus. That's what saved Japan from entering a Great Depression.

He's correct in saying that massive fiscal stimulus saved Japan. They really were on the brink of their Great Depression in the 80s, and have avoided it without going to War. This is good, but none of it was necessary, so really represents a massive failure.

Koo thinks that the Govt is spending the money the private sector has saved. In fact, Govt spending is what is giving the private sector its savings! Government is not borrowing anything. Japan should really just massively slash taxes and fund its private sector. Let the balance sheets heal already!

Koo does not talk about all the terrible malinvestment that the Governments fiscal spending did. The US should simply implement a payroll tax holiday until inflation starts to tick up.

Right now, the US's savings desire is not as high as the Japanese's, but a double dip might get it closer. That just means the US will need even higher deficits. It took Japan 20 years to start getting comfortable with sufficiently large deficits. Now might be a good time to go long the Nikkei, actually.

Happy New Year

2009-12-31T16:01:00.000-08:00

Let's look back at the past decade. Two things stand in stark contrast.

First, the world is blessed with incredibly talented creators. The iPod, iPhone, Google, Prius, DSLR, Harry Potter, Matrix 1 etc. are remarkable achievements and will impact us for many years. Maybe generations. It is great to be alive now and enjoy this wonders.

Second, the world is cursed with appallingly bad Governance. We have a banking system that is supposed to make loans that get paid back. It fails. We have a Govt whose job it is to fund savings and maintain employment. It fails. We have a regulatory system that is supposed to focus banking on its proper purpose. It fails. We have an academy that is supposed to understand how the financial system works and explain it to others. It fails. Managing a fiat monetary system correctly is one of the top 3 responsibilities of a Government, and the US has demonstrated incredibly incompetence in this regard. Bernanke, Obama, Geithner, Summers, Rubin, Greenspan, are all culpable.

Moreover, just as the financial crises has exposed Macroeconomics to be a heap of rubbish with equations, what about Climategate? It has vanished down the memory hole, as if it never happened. The problems at the Academy, and the Academy/Agency nexus are just not getting fixed. The situation is unfixable.

Here's a graph of the Nikkei from 1984 to 1994.

It should scare be bejeesus out of you. I could make it scarier by extending the graph another 10 years up to 2004. The situation is parallel: the private sector built up debt levels above their ability to service out of income, and suffered a credit collapse. 20 years later, the Government has still refused to fund the private sectors demand for net savings by running insufficiently high deficits, and the economy has operated at a fraction of its available capacity. Worse still, the economic activity produced by the Japanese has been misdirected to harmful ends and the island is covered by ugly concrete.

Those who got out of the market in 2009 and are wondering whether 2010 is the year to jump back in, look at Japan. The jump from 15K to 20K in 1993 was a 50% rise -- fully equivalent to the bump the US had in 2009. But it all went away and it's been zigzagging between those bounds ever since. For 20 years and counting.

The last 10 years have been low return, high volatility for stocks. The next ten years will be the same, unless we see some mechanism that supports the de-leveraging sought by the private sector.

Engineering and the Muslim World

2009-12-30T11:24:00.001-08:00

For a publication that prides itself on celebrating diversity and understanding other cultures, this article on why terrorists have engineering degrees is remarkably parochial. In the Muslim World, if you have some wealth, your son becomes a doctor if he is smart, an engineer if he is average, and an accountant if he's dumb. Daughters have their own menu of possibilities.

College, and college degrees, have a very different position and meaning in society there than they do in the US.

Two threads -- what I learned

2009-12-24T21:57:00.000-08:00

I strongly recommend the thread on Unqualified Reservations (not the post). Some key things I learned:

1. Even people in banking do not seem to understand how banking works. The Academy, and therefore the Fed, are most clueless though.
2. Post-Keynesians tend to focus on how loans create reserves, that then get cycled into deposits via the overnight interbank lending market. In practice, banks run a day-to-day Treasury function that tries to fund assets with liabilities other than borrowed bank reserves overnight. The degree to which banks utilize the overnight interbank market varies by bank and bank business model, but generally, they try to get deposits and other liabilities instead.

This makes sense since bank profit is generated by the spread, and the lower your cost of capital, the higher your profit margins (as lending is capital constrained).

Two threads

2009-12-23T14:14:00.000-08:00

It's worth looking at two threads.

First, the charming Nick Rowe takes his theories at their face and notices they do not accord with reality. His conclusion?

Either somebody up there likes us. Or there's something wrong with macroeconomic theory.

The post itself is banal, but there are good details in the comments from JKH about how post-Keynesian economics deviates from actual bank operation.

Where zanon is wrong is in his assumption that the required offsetting reserve inflow must be attracted directly from another bank. (btw, this is a common error made by PK readers.) In fact it normally isn't. The normal operation is to attract non-bank deposits where the source of the money coming in is drawn from non-bank accounts with other banks. The reserve inflow is attracted indirectly rather than directly.

Worth reading.

Another slice of reality enters in a thread over at Mencius Moldbug. It's the usual stuff about the evils of maturity transformation, perhaps true, but irrelevant to fiat monetary systems and therefore, reality today. Still, zanon (in comments) takes on Michael S, who works at a bank but perhaps has never thought about banking in a macro sense. We'll see how the conversation develops. Again, skip the post, but read the comments.

If you give a monkey a scalpel, will it do neurosurgery?

2009-12-18T16:40:00.001-08:00

The hardest thing about predicting 2010 is that the academic economists who direct policy makers have no idea what they are doing, and therefore could do anything. Exhibit A, the gloriously wrong Scott Sumner:

I am increasingly of the view that moral hazard is the central problem with our financial system. This is partly because I was already leaning that way, and partly because I found Charles Calomiris�s recent interview on EconTalk to be quite persuasive. Most people don�t think of it this way, but in 1934 we essentially nationalized the liabilities of the entire banking system. We teach our students that when you deposit $5000 in your bank account you are actually loaning $5000 to that bank. Not true. You are loaning $5000 to the Treasury, and they are re-loaning the funds to the bank. And the Treasury absorbs the losses if the bank defaults.

John Allison also wants to get rid of FDIC and Too Big to Fail policy. These are good ideas. But when you take a closer look, Allison falls into the same trap as many other libertarians; he is too dogmatic.

The FDIC is about the only thing that works right, and even it is not implemented correctly as it should have no cap, and thus put the unstable and dangerous money market fund out of business.

The thinking behind this nonsense is that banks somehow lend out deposits, and therefore depositors, like other investors, should be more careful about where they put their money. Unfortunately for Scott, and everyone else in a University, banks do not lend out deposits. Banks CREATE deposits by making loans. Therefore, risk management must happen at the moment of credit creation. Banks should make loans that will get paid back.

Banks are the instrument by which the Govt enables the private sector to create money. Their Equity is private capital put in first loss position to try to force good investment decisions. Deposits should be as safe as giving the money back to the Treasury for safe keeping.

The Rorschach Test that is the minimum wage

2009-12-17T20:26:00.000-08:00

Any discussion of the minimum wage turns into a Rorschach test for the ideology of the commenter. The latest discussion on whether lowering the minimum wage will have any impact on unemployment in this recession is typical. Everyone's wrong, and wrong for reasons that precisely reveal their ideological shortcomings. Here's a list of links.

Glibertarian Bryan Caplan reveals why microeconomics is just useless at analyzing the economy at a macro scale. If you cannot understand that spending equals income at an economy wide level, you'll spout a lot of two sentence nonsense.

Paul Krugman gets some crude Keynesianism right, but fundamentally he cares more about the Progressive agenda than anything else.

Gary Becker trots out old Chicago school critiques of Keynes, which may or may not have anything to do with what Keynes said. U Chicago sucks at Macro.

&c

Here's the post-Keynesian view.

Lowering the minimum wage in the current environment will have no impact on unemployment. Ordinarily, minimum wage laws reduce employment by pricing very low skilled workers out of the labor market. But in this environment, with very low aggregate demand, workers who are very productive cannot get hired either. Therefore, labor being priced out is obviously not the problem.

If the minimum wage is lowers, firms already hiring minimum wage workers may lower their wages. In this instance financial assets in the private sector are getting shuffled between entities. If the new entities have a lower propensity to spend, this may reduce aggregate demand (increase private sector savings ) more making things worse. I believe that corporations save more than low income workers, so this effect will be negative. There aren't that many minimum wage workers in the economy, though, so the negative effect will probably be too small to show up.

Reducing the minimum wage does nothing to increase the Federal deficit, and thus fund the net savings that the private sector is still trying to scrape together.

Comments about NAIRU etc are besides the point since interest rates only matter to the extent that the provide the private sector with income.

Academic Research, perfectly captured

2009-12-11T10:25:00.001-08:00

I can personally vouch that this comment (via Wretchard) perfectly captures how academic labs run. In order of fraudulence you probably have: 1) climate science, 2) computational anything more generally (unless it merely serves as inspiration for wet experiments), 3) anything that happens at the MIT Media Lab. When Mencius Moldbug argues for the separation of Information and State, this is part of what he's talking about.

Megan,

With respect, you�re setting up a strawman. None of the scientists who have �come out� as climate skeptics allege a massive conspiracy by scientists, any more than there is a massive liberal conspiracy in Hollywood. What you have is a self-emergent, self-organizing bias. I hope I can illustrate it briefly.

I work in academic science (check my IP address if you wish). Scientists are, in general, uncompromising idealists for objective, physical truth. But occasionally, politics encroaches. Most of my work is funded by DoE, DoD, ONR, and a few big companies. We get the grants, because we are simply the best in the field. But we don�t work in isolation. We work as part of a department, which has equipment, lab space, and maintenance staff, IT, et cetera. We have a system for the strict partition of unclassified/classified research through collaboration with government labs. The department had set a research policy and infrastructure goal to attract defense funding, and it worked.

The same is true in climate science. Universities and departments have set policies to attract climate science funding. Climate science centers don�t spontaneously spring into existence � they were created, in increasingly rapid numbers, to partake in the funding bonanza that is AGW. This by itself is not political � currently, universities are scrambling to set up �clean energy� and �sustainable technology� centers. Before it was bio-tech and nanotechnology. But because AGW-funding is politically motivated, departments have adroitly set their research goals to match the political goals of their funding sources. Just look at the mission statements of these climate research institutes � they don�t seek to investigate the scientific validity or soundness of AGW-theory, they assume that it is true, and seek to research the implications or consequences of it.

This filters through every level. Having created such a department, they must fill it with faculty that will carry out their mission statement. The department will hire professors who already believe in AGW and conduct research based on that premise. Those professors will hire students that will conduct their research without much fuss about AGW. And honestly, if you know anything about my generation, we will do or say whatever it is we think we�re supposed to do or say. There is no conspiracy, just a slightly cozy, unthinking myopia. Don�t rock the boat.

The former editor of the New Scientist, Nigel Calder, said it best � if you want funding to study the feeding habits of squirrels, you won�t get it. If you wants to study the effects of climate change on the feeding habits of squirrels, you will. And so in these subtle ways, there is a gravitational pull towards the AGW monolith.

I think it the most damning evidence for this soft tyranny is in the work of climate scientists whose scientific integrity has led them to publish results that clearly contradict basic assumptions in AGW modeling. Yet, in their papers, they are very careful to skirt around the issue, keeping their heads down, describing their results in a way obfuscates the contradiction. They will describe their results as an individual case, with no greater implications, and issue reassuring boilerplate statements about how AGW is true anyways.

For the field as a whole, it�s not a conspiracy. It�s the unfortunate consequence of having a field totally dominated by politically-motivated, strings-attached money. In the case of the CRU email group, well, the emails speak for themselves. Call it whatever you want.

Call it what you want.

Greeks needing gifts

2009-12-09T12:41:00.000-08:00

Greek banks offer deposit insurance, just as the US has FDIC. Unfortunately, Greece is no longer a currency issuer and therefore can experience a real run on its bank deposits. The FDIC cannot go bankrupt because it can get topped up by the Treasury if need be. But the Greek Government cannot go to the ECB for a "top up", and that leaves it vulnerable to runs.

When people were criticizing the Euro currency zone, the focused on how different economies would no longer be able to run different monetary policies, and applauded the deficit controls to bring discipline to the fiscal side. Years later we see that monetary policy doesn't matter, and it's the deficit control that is destabilizing by making the country needlessly susceptible to bank runs.

Related articles here (billy blog) and here (Mosler). There is no point to bank runs. Letting them happen is vandalism. Engineering them into the system is.... words fail.

Banks are even more super than I thought

2009-12-03T07:33:00.000-08:00

Banks have access to reserve accounts at the Fed, which enable them to lend unconstrained by reserve requirements. When you or I make a loan, we are limited to how much we can lend out by how much we have. Banks can lend out as much as they want because they loan gets deposited into another bank, and then through the reserve system, is made available to the first bank to lend out again. This means that the quantity of reserves in the system does not limit how much credit banks can extend, although it does impact the interest rate.

But this ability of banks to create money ex nihilo is not limited to loans -- it extends to every transaction they do where they are acting as a principal! Check out JKH's comments on this thread:

Me: Loans generating deposits are totally different to this as they expand balance sheets.

If the bank purchases something from the private sector, then it's a transaction, and you debit some cash account and credit an asset. The seller debits some asset and credits their cash account. You've rearranged assets in the private sector, as there is a transaction, but no new money has been created, and balance sheets stay the same size. This is why I asked Nick about the IBM server vs. the IBM bond (or whatever other privately held asset he wants to ponder)

JKH: Winterspeak,

"Is there something different when a bank is the buyer?"

Yes. It is completely different. But no different than a loan. I gave the overview above.

Try again.

So we assume the server is accounted for as an investment.

That means it stays on the balance sheet.

So:

Bank cuts cheque �from nothing�.

Bank pays for server.

IBM deposits money in bank (assume same bank; it doesn�t matter).

This is an increase in money supply.

The change in the balance sheet is that the bank has a new asset (real investment) and a new liability (deposit).

There is no change to the bank�s equity account.

Very simple.

No difference between a new loan and the acquisition of any other new asset, financial or real, in terms of new money created, provided that the counter party is not a bank.

(And expenditure has exactly the same effect. This is much more counterintuitive, but very worthwhile to understand if you really want to understand money creation and destruction. If Scott F. is reading, this is just starting to touch on Steve Keen's circuit modeling area of interest.)

Me: Ye Gads!

Note that the money creating nature of bank spending (not bank credit extension) and the money destroying nature of bank revenues exactly parallels with money creating nature of Government spending and the money destroying nature of Govt taxation.

Wow!

Overall, the thread was mixed though. I learned something new, which is great, yet Nick (the poor academic we were ganging up on) remains as wrong as ever about how money, banking, and the economy works. And we got the best post ever on how banks actually work from JKH:

Nick,

A thought provoking post, thanks. It prompted me to flesh out a model of my own. Apologies for the length of this �comment�; it will require someone to have an unusual level of interest in order to read it.

I�ve responded to some of your points specifically near the end, but first here�s my model:

CAPITAL AND RESERVE MODEL (JKH)

Let the world consist of two banks, A and B, and a central bank CB.

The employees of Bank A are a reserve manager, a capital manager, a loan manager, and a deposit manager.

Bank B has a similar staff.

The CB just has one employee � its own reserve manager. The 3 reserve managers� jobs interface with each other in a way to be described.

Banks A and B start out the day �in balance� from all perspectives. Their assets equal their liabilities plus equity. And their world resembles Canada in that required reserves are zero. Both banks are at zero reserves.

There is one transaction to start. Bank A�s loan manager wants to make a loan of $ 10 million to customer X. (Think of X as a large blue chip corporation, or perhaps a wildly leveraged but fully prescient Canadian university professor betting the farm and all of his family�s and friends� collateral on gold.) The loan manager does the credit analysis and approves it. Suppose the capital manager has an existing surplus capital position due to prior retained earnings that have not yet been allocated to risk assets. Assume that surplus capital is temporarily invested in treasury bills, which have a zero risk weight for capital purposes. The capital manager decides on the amount of capital required to support the loan risk, and allocates it accordingly as capital underpinning for the loan, in the event the loan transaction is completed. He allocates $ 1 million.

The reserve manager is notified of the pending loan drawdown. He assumes an outflow of reserves when the loan is draw down. He wants to attract an offsetting reserve inflow somehow in order to square his reserve account by the end of the day. Assume he has treasury bills in a liquid asset portfolio that represent the investment of capital funds that have so far been in surplus � i.e. not previously used to support risk assets. He plans to sell those bills for cash and redirect that internal capital to the new risk asset of $ 10 million. He needs additional funding of $ 9 million. He advises the deposit manager than he will require that funding.

The loan manager prices the loan. His inputs are the cost of capital, which he obtains from the capital manager, the benchmark cost of deposits, the cost required to cover expected credit losses, and other expenses assumed in pricing the loan such as related administrative salaries, etc. All of these costs can then be translated to an equivalent all in credit spread over a benchmark cost of funds. The loan is priced at that cost plus the credit spread.

I use �benchmark cost� here because the actual source of new funds in a �universal� bank can be wholesale or retail. New retail funds are �sold� internally into a central collection point at such a benchmark rate, providing retail bankers with a deposit spread to cover their own administrative and other costs. In the case of this simplified example, I�ll just assume now that the benchmark cost is the same as the actual wholesale cost of funds that the bank will end up paying in the market to fund this loan.

The loan manager goes to the deposit manager for a quote on the cost of funds � i.e. the expected wholesale deposit rate. The deposit manager may build in an additional small spread to allow for risk that the market price may �move� while the transaction is in progress.

The loan manager advises the customer of the all in cost based on the quoted market rate plus the credit spread. The customer accepts.

The loan manager completes the loan and advises the reserve manager and the deposit manager jointly.

Knowing that the lending transaction has been priced and accepted, the reserve manager then sells $ 1 million in treasury bills (previously funded by excess capital). The deposit manager puts out a bid for $ 9 million in additional funds.

Meanwhile, customer X has drawn down the $ 10 million in funds (in the form of a cheque drawn on A) and places them on deposit with his bank B.

Similar communications starting happening in bank B, and the reserve manager there is soon informed of the inflow of funds from bank A. He will now have an excess reserve position that he doesn�t want. At the same time he knows from market gathered information that bank A is looking for funds. He�s been informed by his loan manager that bank A continues to be a good credit risk. And his capital manager is comfortable in allocating capital to an interbank deposit transaction.

Away from the two transacting banks, the CB reserve manager observes that the market interest rate for interbank funds is quoted slightly above the interest rate he pays to banks for excess reserves. He�s satisfied with market conditions and leaves the system excess reserve setting alone.

The deposit manager in bank A has a bid out for $ 9 million in funds. Bank B�s reserve manager accepts that bid and places a $ 9 million interbank deposit with bank A.

Bank B also buys the $ 1 million in treasury bills sold by A through an investment dealer.

After the transaction, reserve accounts are flat again.

Had bank A been unable to attract funds from bank B for any reason in this example, A�s reserve manager could have gone to the central bank to borrow funds.

Additional internal activity within Bank B:

The balance sheet has increased with X�s $ 10 million deposit, $ 1 million in treasury bill assets, and the $ 9 million interbank loan to bank A. Bank B�s capital manager allocates $ 250,000 from his bank�s own pre-existing surplus capital to the interbank loan. This is a lower proportionate amount than Bank A allocated for X�s loan, because Bank A is itself a higher quality credit than A�s customer X. Again, B was in a surplus capital position prior to placing money with A. The assets in which this capital was previously invested (e.g. existing treasury bills) are now in a sense funded instead by $ 250,000 from the new deposit funding just raised. This is just internal book keeping reconciliation in order to keep track of the new allocation of risk capital and the corresponding depletion in surplus capital.

We assumed the CB reserve requirement was zero, so the new deposits for both banks have no impact on the CB�s strategy for the system reserve setting. In a system with positive reserve requirements, the CB would have supplied new reserves, perhaps through system repos with non bank dealers who took on new collateral purchased from non banks. The two banks would have competed for new deposits that had been created in conjunction with that reserve injection sequence, in order to attract their share of additional newly required reserves. And the process would compound from there. This is actually the textbook multiplier working in reverse, whereby the central bank responds to system deposit expansion by supplying any reserve requirement that follows from that. This is the actual mechanism when there are positive reserve requirements. The textbook description with the reverse causality is wrong. (See further discussion below.)

In a system with positive reserve requirements, banks can factor in the opportunity cost of holding zero or low interest paying reserves, if necessary, as part of their asset-liability pricing methodology; e.g. the opportunity cost of zero interest could be factored into the loan spread as a reflection of additional funding required to support the additional reserve requirement associated with the primary funding. However, factoring in the opportunity cost in the case of a rate of interest paid on reserves that corresponds closely to the short term risk free rate (or short term policy rate) is a bit trickier, because that sort of rate is more or less already justified by virtue of the fact that reserves are a risk free asset.

Anyway, that�s the complete set of transactions in my model.

Both A and B were subject to capital constraints. There seems to be some sensitivity evident in several recent comments, surrounding this term �constraint�. Minimum capital requirements are specified as a ratio of risk weighted assets. Banks must hold at least that amount of capital in order to be capital fit from a regulatory perspective. The regulatory requirement, as well as any self-imposed capital requirement that may be stronger than the regulatory standard, constitute an effective lower bound limit for capital held against an existing position. I call that lower bound limit a constraint. Banks may hold actual capital in excess of that lower bound, in which case they are said to have excess capital. Whether or not that sort of excess capital position is viewed as evidence of a non-binding capital constraint is a matter of preference. The minimum capital constraint is non-binding in the sense that the bank has ready access to additional internal capital not yet allocated to risk. The minimum capital constraint is binding in the sense that the level of aggregate minimum capital for the bank will actually shift higher when a new risk asset is added. As well, it is binding in the sense that the loan officer must still get approval from the capital manager in order to receive an allocation of capital for the risk he wants to take. Under either interpretation, the minimum capital constraint is a fact in the form of a lower bound limit for capital required against total risk assumed. That said, the terminology �constraint� is also borrowed from it�s converse use in the case of reserves, where MMT�ers (Modern Monetary Theory advocates) often say that banks are not reserve constrained in lending. Finally, substituting the word �restraint� in the case of capital seems a bit soft on the real meaning of capital requirements, because there is definitely a lower bound hard limit on required capital, corresponding to a given risk asset position.

In this case, although both A and B were subject to capital constraints, those capital constraints were dealt with smoothly by the presence of pre-existing excess capital in both banks. However, the transaction meant that the amount of capital actually allocated to risk taking, for each bank and for the system as a whole, needed to increase. That amount of additional capital had to be ready prior to the act of assuming the risk. And it was ready, in the form of an excess capital cushion.

A prudently run bank will tend to have surplus capital as a stock (unallocated) and expect new surplus capital as a flow (incoming retained earnings). That puts the bank in a position to acquire new risk assets without having to go to the new issue equity market for every additional transaction. The incoming flow of retained earnings is normally enough to satisfy new capital requirements over time. This recent credit crisis has been extraordinary in that sense; e.g. Canadian banks were very active in tapping the new issue market for equity capital, which is not normal. (They also tapped the market for qualifying debt capital, which is a more normal and a more regular occurrence in one form or another).

Both A and B had to notify their respective capital managers of a pending new utilization of capital for risk allocation. The stock of utilized capital had to increase, due to the lower bound limit set by regulatory and/or internal capital limits. Unutilized capital had to be available before the transaction could be approved. That�s what it means to be capital constrained. Thus, lending insofar as capital was concerned was an issue of both availability and pricing. The required capital was available because the capital manager had a surplus capital position and approved the transaction on the basis of the risk assessment and the capital it would require.

The case of reserves is very different. What happened in the model transactions is consistent with the MMT observation that banks are not reserve constrained in lending. This means simply that the central bank always provides sufficient reserves to the system in order for banks to square their required positions. In the example, and in Canada�s case, this means meeting a requirement of zero. Under normal market conditions, sufficient reserves should be available for nearly all if not all banks to meet their requirement through various transactions with customers and/or between the banks themselves. Under volatile markets conditions, which can be accompanied by relatively volatile reserve distributions among banks, some banks may need to access borrowing from the central bank. Banks with good collateral will be able to borrow and bring their reserve accounts back to requirement, which is zero in this case.

It is important to note that �absence of a reserve constraint� is intended to characterize the reserve effect, other things equal. This assumes that banks are of good enough credit and liquidity quality to able to source funds and attract the reserves they require in the normal course. In particular, it assumes that banks have met their capital requirements and are perceived by the market to have met them. If not, they may fail to meet their reserve requirements as well. This is the case with a run on the bank. And if a bank is unable to square its central bank reserve position because neither the market nor the central bank is willing to provide it with funds, that bank must go into some form of wind up such as the FDIC process, a situation ultimately attributable to an inadequate level of capital. In the model example of banks A and B, both banks were normally healthy and therefore not reserve constrained in the intended meaning of that phrase.

Bank A�s deposit manager did not have to assume anything analogous to an additional requirement for capital, as in the availability of a pre-existing �unused� stock of reserves, either for his own bank or for the system as a whole. That�s because he knew to expect that the funding necessary to attract reserves to return to bank A would be available in the normal course. Even if market conditions had been particularly �choppy� on that particular day, A could have assumed the risk of having to borrow from the central bank on a temporary basis. And most importantly perhaps, A�s deposit manager knew that A�s capital condition was such that A was perceived to be a good credit risk itself in the market place, and that therefore A should have no problem attracting deposits in the normal course. Provided A�s own capital constraints are not contravened, A should have no problem attracting required reserves in what is a closed system of reserves supplied by the central bank. Any problem in squaring reserve positions can only be attributed logically to market perceptions of capital inadequacy, which is generally how bank runs start. And even then, the bank can borrow from the central bank with good collateral. With adequate capital, the only issue for reserve management is pricing, not availability of reserves. Bank A was not reserve constrained in lending because the reserves required to square A�s position at the end of the day had to be available from somewhere. The normal function of a liquid market, including the central bank�s management of the short term interest rate, will ensure that regular transactions such as the interbank loan from B to A will accomplish the required rebalancing of reserves. The lending exercise insofar as reserves were concerned was only an issue of pricing. The required reserves were assumed to be available and in fact were available somewhere in the system, given the closed nature of the reserve system, and given bank A�s strong capital position and therefore its good credit rating.

Thus, the critical idea in the notion that banks are not reserve constrained is the willingness of the central bank to supply reserves to banks systemically and to banks specifically, sufficient to meet their required reserve levels systemically and individually, provided they are in sufficiently good capital health. Central banks supply required reserves on a daily basis. There is obviously no corresponding idea underlying the notion of capital constraints. Central banks may or may not supply required capital about every 80 years or so, in the midst of extraordinary financial crises and depression type risk environments. Otherwise, there is a constraint placed on the private sector commercial banking system to produce a net stock of capital at least equal to its minimum capital requirements, individually and therefore collectively. That collective capital stock must increase as risk assets increase. That is a constraint on the banking system. It must confirm additional unused capital availability or issue new capital in order to expand its risk assets and it must source this capital in the normal course without central bank or government provision of same.

Moreover, the causality sequence in the case of capital demonstrates the power of the constraint in comparison to the case of reserves. Banks must have required capital in place prior to the moment in time when their risk assets increase by lending or some other risk taking activity. The capital requirement precedes the risk expansion. This is opposite to the causality with respect to reserves, where the reserve acquisition that is required to square offside positions due to asset expansion follows the asset expansion in order of time sequence.

There is an enormous irony here around the issue of causality. MMT observes correctly that the central bank supplies required reserves in response to the banking system�s creation of new loan and deposits, most obviously in those systems that have positive rather than zero reserve requirements. This correct description positions the traditional textbook described �multiplier� causality as literally backwards. The irony is that the textbook causality direction applies correctly to capital, not reserves. Not only does a significant proportion of the economics profession not yet understand that the textbook model is wrong, but they don�t yet understand that the correct version of the same causality applies to capital rather than reserves, and they really don�t understand that they have effectively been confusing reserves with capital all along. Economists in general are typically weak on the subject of bank capital. That�s probably why they got the role of reserves wrong in the first place. The MMT group has distinguished itself in getting it right. Macroeconomic theory that directs itself toward an understanding of the financial system in general and the banking system in particular needs to do a MAJOR REBALANCING of conceptual thinking around the dual subjects of capital and reserves.

In sum, banks are not reserve constrained in lending because they source required reserves from each other�s existing positions and/or from the central bank, and they do so after the fact of new loan and deposit creation. Banks are capital constrained in lending because they must source new capital for risk allocation either internally or externally, and they can�t get it from the government (normally), and they must have this source of risk capital in place before the act of lending.

So my conclusion as always is that bank lending (as well as other forms of risk taking) is capital constrained but not reserve constrained.

ADDTIONAL NOTES ON NICK�S POST

The following points roughly follow the order presented in Nick�s post:

As discussed, but to address Nick�s first example, the textbook theory of the multiplier is wrong. The main reason it is wrong is the aspect of causality. Banks do not require reserves before lending. The central bank supplies the reserves required by banks as a whole based on the deposits created by bank lending and the statutory requirement pertaining thereto. The reason the central bank supplies required reserves is to control the upper bound for the target fed funds rate or range. Otherwise, banks would bid the actual rate above target should the aggregate reserve supply be inadequate according to the requirement created by deposits. The reserve requirement in Canada is zero. That is different than saying there is no requirement. The requirement is zero because the central bank expects banks to target for a flat reserve position over time.

Nick�s �Loan Officer Theory of Money Supply� is interesting. It initially assumes perfectly inelastic �inputs�. But then Nick seems to assume the desired conclusion, which is that inputs of assumed influence on loan supply become influential if their supply becomes elastic. The conclusion is presupposed; e.g. reserves influence loan supply when their supply becomes elastic. Nick proves it by assuming that�s what happens when supply changes from inelastic to elastic. But that�s not what happens in fact. Banks do not depend on an injection of reserves before the fact in order to lend, as explained earlier.

Nick�s �Bank Capital Theory of Money Supply� starts out roughly OK in terms of the idea of a required capital ratio. But it veers off course because it ignores the difference between risk and nominal assets. The purpose of capital is to absorb unexpected losses. Capital is allocated based on the risk of unexpected loss. That is why nominal asset amounts are �risk weighted� when determining a required capital allocation. The risk weighting for a (Canadian) residential mortgage is far less than the risk weighting for an equivalent nominal amount of junk bonds. Treasury bills have zero risk weighting. Central bank reserves have zero risk weighting as a commercial bank asset. So Nick is not accurate when he says that a capital model fails merely because a (nominal) loan/capital ratio varies. The nominal ratio varies constantly based on changes in the risk weighted composition of the nominal asset base over time.

Then we get into the notion of the supply elasticity of capital. I�m not sure the idea is that relevant. The important idea is that the cost of capital at any time is a major input into loan pricing, as already described above. Banks are capital constrained in lending, as I�ve defined it, which effectively means that banks must source required capital, internally or externally, normally from non government sources, and necessarily before the fact of risk taking, i.e. before they can book a net new risk asset. I�ve said that banks typically run surplus capital positions as buffers in good times, even while generating capital internally from retained earnings. They don�t take on new risk and then go find some external capital to support the risk. For starters, they�d be outside of regulatory capital guidelines in taking on that incremental risk without capital support in place. And they�d be fools to assuming such a strategic pricing risk on the most expensive and riskiest form of funding there is, even if there were no capital regulations, but in the latter case we�re into a contradiction about why they�d need to go get more capital anyway. In any event, the type of unconstrained approach that would be reckless in the case of capital is a matter of fact way of dealing with reserves in a normal and prudent fashion. Banks need only square reserve positions after making a new loan. The operative temporal causality is the reverse of that of capital. Banks require capital before the fact to lend. Banks don�t require reserves before the fact, because the system (including the ultimate lender of last resort � the central bank) will always be willing to supply reserves from somewhere to a capital-healthy bank in response to its need for reserves. And that is because the central bank is the monopoly supplier of total reserves at its chosen price, and because it will ensure that the market with respect to healthy banks will clear at that price. There is no such central pricing mechanism with respect to either the availability or the pricing of bank capital. That blunt difference is in part what we mean by saying that banks are capital constrained but not reserve constrained.

With respect to loan supply, neither the interest rate on reserves nor the marginal cost of capital affects the supply of loans, provided that prior to the lending transaction the bank has an identified source of new capital as required, either internally or externally. Capital costs obviously affect the pricing of loans, which I described above as part of my model, and pricing obviously affects demand. In the case where new risk capital supply is not available internally, and the bank perceives the cost of externally sourced capital to be too high, it may shut down the supply of loans. But this is due to the bank�s judgement that the demand for loans will be insufficient at such a market price for new capital, given the associated high cost of externally sourced capital that must be factored into incremental loan pricing. This is not due to an inability to supply loans at that cost of capital, assuming external supply can be sourced at that cost. It is due to an expected insufficient demand at that pricing point. Supply potential is definitely affected by the availability of unused or surplus capital; that�s in part what it means for lending to be capital constrained.

Bank capital is always important, Nick � not just in this recession. What is important in this recession is that capital levels have been under pressure in proportion to the unusual severity of the recession.

Reserves are only an �input� to the production of loans and money according to their pricing, which is determined by the policy rate set and controlled by the central bank. And even then, reserve pricing may only be a benchmark reference pricing point for the market rates that are applicable to new asset liability transactions with the customers of those banks, transactions which have the effect of transferring reserves from or to those banks as a consequence. In any event, reserves are not an input in terms of their availability, because the central bank is the monopoly supplier of reserves to the system at its chosen price, and capital healthy banks will have no problem attracting their required share of them based on that price, ultimately from other banks or from the central bank.

The marginal cost of reserves affects the pricing of loans but not the availability of loans. It is the risk assessment of loans and the availability of capital to allocate to that risk that affects the availability of loans. Note that banks have complex credit policies that may restrict their risk exposure in aggregate across all sorts of dimensions � e.g. industry, geography, loan type, etc. etc. This credit analysis, which is inextricably linked to capital availability, has nothing to do with any question about the availability of reserves. It has to do with the availability of capital to support that risk category under consideration.

As far as the supply of loan officers is concerned, it seems reasonable to assume that supply will affect both pricing and supply of loans, given the labour requirement to do risk analysis prior to supplying.

Regarding your closing paragraph, I agree in particular with two points made by Declan in an earlier comment:

�... capital requirements are directly influenced by policymakers as well. The question might better be framed as why economists concentrate so much on central banks as opposed to financial regulators ... the two constraints on lending are capital and the availability of willing/capable borrowers (in some sense these two constraints are one and the same if capital requirements are set accurately - basically banks can lend as much money as they want as long as they don't threaten their own solvency in so doing).�

There�s another discussion in the comments concerning the difference between loans and money and the meaning of capital constraints in this regard. This is a good place to emphasize that the purpose of capital is to absorb unexpected financial losses due to any kind of risk. Capital allocation is inextricably linked with risk assessment, and capital must be allocated to all assessed risks. So far we�ve been talking mostly about a simplified model that addresses loans and corresponding credit risks. But there are additional kinds of risks to which banks allocate capital � especially market risks such as interest rate risk, foreign exchange risk, and equity portfolio risk, which are analytically separable from credit risk, but frequently in combination with it in the form of counterparty credit risk contingent on market risk. And there are market related risks that are relevant for structural asset liability interest rate mismatches. All of these risks and more require allocations of capital. There is even a complex category called �operational risk�, in which activities just about anywhere on the balance sheet can attract additional risk capital requirements, including the deposit gathering function, depending on the risk assessment for operational disruption scenarios.

CONCLUDING COMMENT

Much of what I�ve said should be consistent with standard post Keynesian interpretation of banking system reserve dynamics, MMT in particular. As far as I can discern, MMT tends not to focus so much on capital directly, but more generally on the idea of creditworthiness as being the driver of lending supply rather than reserve availability. It should amount to the same thing as my capital interpretation. I don�t know if MMT experts would agree with everything I say about capital. But I wouldn�t expect enormous objection to it.

I would recommend again the following blogs for source MMT material:

Kansas City (Scott Fullwiler, Randall Wray, and others)

http://neweconomicperspectives.blogspot.com/

Winterspeak

http://www.winterspeak.com/

Warren Mosler

http://www.moslereconomics.com/mandatory-readings/soft-currency-economics/

Bill Mitchell (an interesting Australian banking comparison for Canadians)

http://bilbo.economicoutlook.net/blog/?page_id=1667

Dubai World

2009-11-30T13:52:00.000-08:00

Since I grew up there, I feel I can add something to the commentary about Dubai.

Firstly, Dubai is one Emirate (Kingdom) of the 7 that make up the country, the UAE. Imagine it as a State if Federalism really existed.

Secondly, Dubai does not have that much money, but loads of marketing savvy, and more business acumen than the other Emirates. Obviously not enough business acumen, but certainly more.

Abu Dhabi, the capital, is the wealthiest Emirate and is deeply jealous of Dubai for all the glitz it has built around itself. Dubai sits beside "London, Paris, and New York" on Barneys ads, while Abu Dhabi remains the punchline in a 1980s Garfield cartoon. (Yes, Garfield tried to mail Nermal to Abu Dhabi).

Each Emirate really is a Kingdom, and the Kings are kind of like an extended family. They feud. They party. etc.

Abu Dhabi will bail out Dubai, but it will want more political power over the Emirate, as well as some of its crown jewel businesses (Emirate Airlines, maybe some of the malls, maybe some of the Free Zones).

Happy Thanksgiving

2009-11-25T14:17:00.001-08:00

In lieu of a Thanksgiving post, I give you this excellent thread, where you can enjoy JKH schooling me on the importance of real assets while the charming Nick Rowe avoids being schooled at all. Read all the comments, they are worth it.

ClimateGate

2009-11-23T14:37:00.000-08:00

Climate fraud finally made it to the New York Times.

Hundreds of private e-mail messages and documents hacked from a computer server at a British university are causing a stir among global warming skeptics, who say they show that climate scientists conspired to overstate the case for a human influence on climate change. In one e-mail exchange, a scientist writes of using a statistical �trick� in a chart illustrating a recent sharp warming trend. In another, a scientist refers to climate skeptics as �idiots.�

The NYTimes also nails the likely reaction, which you can see amongst establishment wannabes like Marginal Revolution, and Jane Galt.

The evidence pointing to a growing human contribution to global warming is so widely accepted that the hacked material is unlikely to erode the overall argument.

Since everyone knows it's real, who cares if it's shown to be a fraud?

The nonsense that Steve McIntyre's been dealing with for years directly matches my experience in some of the most prestigious university departments on the planet. Of course, my work was pretty inconsequential, but the dollars and prestige (Gore, Nobel Prize Committee, Democratic Party, every European Government etc.) means that the mask could not afford to slip there. And now it has.

That said, I think the Times still has it right. So what if it's all bogus?

Saving is not Investment

2009-11-19T10:09:00.001-08:00

There's a long and ultimatily unsatisfying thread over at Nick Rowe's. Sadly, I cannot recommend it.

One clear idea emerged -- the confusion around "savings" and "investment".

If you get some money and don't spend it, then it's clearly savings. If you get some money and you use it to buy something you then consume (like a donut), then it's clearly "consumption". But how about when you spend your money on something that you hope will give you even more money in the future, like a share of Goldman Sachs, or a Treasury Bill, or a lottery ticket, or a house? Is that "consumption", "savings", or "investment"?

When you're thinking about and tracking the movement of money, then all of those "investment" activities should not be thought of as "saving". They should be thought of as "investment", and may, retroactively, be reclassified as "consumption" -- almost certainly in the case of the lottery ticket, and commonly nowadays in the case of the the house. So, you need all three definitions: saving (money in the bank or under the mattress), investment (money spent in the hope of getting it back), and consumption (money spent with no hope of getting it back). They key difference between these is that investment and consumption is money spent, it triggers income for some other party in the sector, while savings is not. If you are looking at demand or money, velocity, aggregate demand, or anything that involves transaction, you must understand that "saving" does not generate a transaction while both forms of "spending" (consumption and investment) do.

In the end, the amount of saving will equal the amount of investment (S=I) but the causality behind this is subtle, and requires complete attention be paid to the difference between real and nominal. That is a post for another time.

(Small note. In the above example, the Treasury Bill would count as "savings" because it does not trigger a spending event. Government spending is independent of anything the private sector does, and treasury bills simple change the term structure of outstanding reserves, as a mechanism to set interest rates, and are not a "funding" source for anything. Similarly, putting money in the bank does not "enable" the bank to make a loan, as bank deposits are CREATED through the act of lending)