Yesterday, parachute gangs from the ECB and the IMF were being dropped into various EMU nations whose only problem is that they are members of an unworkable monetary system and happened to get hit by a major demand shock. Today the IMF cavalry are apparently heading to Dublin for a “short, focused consultation”. Conclusion: Ireland is being invaded by hostile forces. I also read rumours overnight that Germans are refusing Euro notes not printed in the Bundesland. It is probably an outright lie of a similar quality to the many being spread by the deficit terrorists seeking to regain their “credibility” (an impossible mission) any way they can. In this context I get many E-mails from people each week telling me that I do not understand that the latest decision by the US Federal Reserve Bank “to flood the world with printed money” is putting it on the brink of insolvency! I also read that in a Bloomberg Business Week feature article today. And people believe this stuff. It is as much a lie as the fallacious stories recently about the US President’s Asian travel costs which the right-wing in the US (Beck, Limbaugh, Savage etc) perpetuated without scrutiny (see this analysis to see how this lie began). Anyway, rest easy … the US Federal Reserve cannot go broke!
I recently considered the QE2 decision by the US Federal Reserve in this blog – Religious persecution continues. I thought that I had said enough in that blog about the latest monetary policy choice in the US to ease the concerns of people who read this blog.
But I was wrong. Upon reading this latest Bloomberg Op Ed (November 17, 2010) – In Fed’s Monetary Targeting, Two Tails Are Better Than One – I realised the hysteria from the terrorists is taking further steps into insanity.
Overnight I was asked whether the Federal Reserve might become insolvent. Short answer: No? Relax. But here is the slightly longer answer in relation to this Bloomberg article.
The article was written by two US academics. Prospective students will know I am compiling a list of institutions you should avoid if your desire is to learn how the monetary system actually operates. As a result of this article I have now issued a further warning to anyone studying economics at the Columbia Business School and Oberlin College – don’t and if you are leave!
The authors claim that QE2 “has already damaged its credibility” and the plan:
… may destabilize global trade and finance, damage the Fed’s credibility, and cause inflation to jump.
They claim that the reassurances of the Federal Reserve that “an inflationary surge is unlikely” are “hollow” because the “Fed might be unable or unwilling to respond to a rapid expansion of bank credit supply by contracting its balance sheet sufficiently in time to prevent inflation”.
Then they get to reasoning and what a shambles unfolds. Apparently, as growth resumes and demand for credit rises the banks will “disgorge their roughly $1 trillion in excess reserves”. To “educate” (read: totally confuse) their readers they offer this gem of nonsense:
Think of the excess reserves as under-utilized lending capacity. Banks might respond quickly to global lending opportunities, and their response could be rapid and highly correlated. The money multiplier, which has fallen to historic lows during the crisis, could snap back like a rubber band, implying hundreds of billions, or even trillions, in credit expansion, unless the Fed responded by dramatically contracting its balance sheet.
My first response was the “English colloquialism” – Please? (that is, spare me from this nonsense).
If they are teaching their students this rubbish then it is no wonder there are so many confused people out there in professional life. Excess reserves are not “under-utilized lending capacity”.
In November 2009, the Bank of International Settlements (BIS) released a working paper (no 292) entitled – Unconventional monetary policies: an appraisal – which discussed these issues in detail. I provided a detailed examination of that paper in these blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary.
These academics should resign their posts and resume their education. It is clear there first attempts at becoming learned have failed.
The BIS paper argues that the “distinguishing feature” of quantitative easing policies:
… is that the central bank actively uses its balance sheet to affect directly market prices and conditions beyond a short-term, typically overnight, interest rate. We thus refer to such policies as “balance sheet policies”, and distinguish them from “interest rate policy”.
In making this distinction, they show that these policies are intended to work by altering “the structure of private sector balance sheets” and targetting “specific” markets.
QE2 is nothing more than an asset swap. In an Q&A that Bernanke gave some students earlier in November (see video and more detailed commentary below) he said (at the 22.00 minute mark) in relation to a question about how the Federal Reserve will unwind QE2 when growth returns:
What the purchases do, is, if you think of the Fed’s balance sheet, when we buy securities, on the asset side of the balance sheet, we get the Treasury securities, or in the previous episode, mortgage-backed securities. On the liability side of the balance sheet, to balance that, we create reserves in the banking system. Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed. Now the question is what happens the economy starts to grow quickly and it’s time to pull back the monetary policy accommodation. There are several tools that we have …
Note: swapping government bonds for bank reserves. One asset for another. No additional “money” enters the system. Further, bank lending is not constrained by the volume of reserves!
The BIS paper addresses the issue of the implications of the current build-up in bank reserves. They say:
… we argue that the typical strong emphasis on the role of the expansion of bank reserves in discussions of unconventional monetary policies is misplaced. In our view, the effectiveness of such policies is not much affected by the extent to which they rely on bank reserves as opposed to alternative close substitutes, such as central bank short-term debt. In particular, changes in reserves associated with unconventional monetary policies do not in and of themselves loosen significantly the constraint on bank lending or act as a catalyst for inflation.
So there is no sense that the build up of bank reserves “makes bank lending easier”.
Around page 16, the BIS authors note that:
… bank reserves are uniquely valued by financial institutions because they are the only acceptable means to achieve final settlement of all transactions. From this perspective, reserves may play a special role during times of financial stress, when their smooth distribution within the system can be disrupted. At such times, financial institutions may wish to hold larger reserve balances to manage their heightened illiquidity risk. Indeed, this was the case in the initial stages of the current crisis, when the precautionary demand for reserves increased materially …
However, it is clear that the liquidity role can be accomplished when the central bank offers flexible arrangements to supply reserves on demand (via exchanges for near-reserve equivalents like short-term government paper).
In other words, there is nothing particularly special about bank reserves in this context.
The reason they consider bank reserves to be “special” lies in their operational significance for monetary policy. The central bank clearly sets the interest rate and generally aims to ensure that the overnight (interbank) rate is equal to it. In this context, bank reserves are:
… powerful and unique … [and] … obliges the central bank to meet the small demand for (excess) reserves very precisely, in order to avoid unwarranted extreme volatility in the rate … But in order to induce banks to accept a large expansion of such balances in the context of balance sheet policy, the central bank has to make bank reserves sufficiently attractive relative to other assets … In effect, this renders them almost perfect substitutes with other short-term sovereign paper. This means paying an equivalent interest rate. In the process, their specialness is lost. Bank reserves become simply another claim issued by the public sector. It is distinguished from others primarily by having an overnight maturity and a narrower base of potential investors.
That statement very clearly demonstrates how the reserve dynamics impact on monetary operations and require the central bank to issue debt or pay a return on reserves to maintain control over its monetary policy target rate.
It also demonstrates that bank reserves are near-equivalents to public debt issuance a point that is lost to mainstream economists.
Finally, the BIS paper considers the reserves – bank lending – inflation nexus. The authors say:
The preceding discussion casts doubt on two oft-heard propositions concerning the implications of the specialness of bank reserves. First, an expansion of bank reserves endows banks with additional resources to extend loans, adding power to balance sheet policy. Second, there is something uniquely inflationary about bank reserves financing.
They correctly point out that those who think that an expansion of bank reserves provides banks with additional resources to extend loans assumes that “bank reserves are needed for banks to make loans”. Accordingly, mainstream economists think that the “bank lending is constrained by insufficient access to reserves or more reserves can somehow boost banks’ willingness to lend.”
The BIS authors go on to say that:
… an extreme version of this view is the text-book notion of a stable money multiplier: central banks are able, through exogenous variations in the supply of reserves, to exert a direct influence on the amount of loans and deposits in the banking system.
MMT outrightly rejects these propositions. Bank reserves are not required to make loans and there is no monetary multiplier mechanism at work as described in the text books.
The BIS authors concur with the MMT viewpoint on this and say that:
In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly.
It is obvious why this is the case. Loans create deposits which can then be drawn upon by the borrower. No reserves are needed at that stage. Then, as the BIS paper says “in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system”.
The loan desk of commercial banks have no interaction with the reserve operations of the monetary system as part of their daily tasks. They just take applications from credit worthy customers who seek loans and assess them accordingly and then approve or reject the loans. In approving a loan they instantly create a deposit (a zero net financial asset transaction).
The only thing that constrains the bank loan desks from expanding credit is a lack of credit-worthy applicants, which can originate from the supply side if banks adopt pessimistic assessments or the demand side if credit-worthy customers are loathe to seek loans.
The BIS authors then demonstrate that:
A striking recent illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan’s “quantitative easing” policy in 2001-2006. Despite significant expansions in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly
So dear readers there will be no elastic bands snapping back (“the money multiplier … could snap back like a rubber band”) and flooding the world with these reserves.
The Bloomberg authors clearly do not understand the previous discussion. They go on to allege that because the “Fed’s balance sheet has changed dramatically” it may not be able to “respond effectively” when credit demand returns bceause it has around 50 per cent of its balance sheet tied up in “illiquid mortgage-backed securities” and a “quick sale of these assets would reduce their long-term recovery value and cause the Fed to realize huge capital losses”.
Then it gets really murky:
Large potential losses could threaten Fed solvency and force the central bank to ask Congress to recapitalize its balance sheet. There is a risk that Congress or the administration might block recapitalization to prevent a Fed contraction … While the Fed might contract its balance sheet using other means, those might also imply large losses. Under the scenario outlined here, a rise in long-term interest rates could impose large losses if the central bank sold long-term Treasuries ($600 billion of which it is in the process of purchasing). The Fed could try to stop credit expansion by raising the interest rate on excess reserves. If the profitability of bank lending rises sufficiently, a large increase in interest rates paid on reserves would be needed, which could also threaten Fed solvency.
So it comes down to that. The central bank will go broke. Sorry it won’t.
It is clear that the US central bank is a strange beast. Here is a good place to start.
The Federal Reserve System is not “owned” by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects.
As the nation’s central bank, the Federal Reserve derives its authority from the U.S. Congress. It is considered an independent central bank because its decisions do not have to be ratified by the President or anyone else in the executive or legislative branch of government, it does not receive funding appropriated by Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms. However, the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute. Also, the Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government. Therefore, the Federal Reserve can be more accurately described as “independent within the government.”
The twelve regional Federal Reserve Banks, which were established by Congress as the operating arms of the nation’s central banking system, are organized much like private corporations–possibly leading to some confusion about “ownership.” For example, the Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.
So it is really a “joint-stock” institution that is owned by private commercial banks but operationally an integral aspect of the consolidated government (along with Treasury).
The other important point about the Federal Reserve is that unlike other central banks it does not create the currency. That responsibility (power) is vested in the US Department of the Treasury. You can learn about HERE.
So if the Federal Reserve made these “losses” as it tried to unwind the excess reserves and it found itself with “negative capital” which in a private corporation would amount to balance sheet insolvency (that is, it was broke) what would happen?
First, it would not mean anything in terms of it capacity to meet any financial obligations that the central bank might have. There can never be a “run” on the Federal Reserve because its monetary liabilities are non-redeemable and all assets and liabilities are denominated in US dollars. It can always pay interest on reserves if it chooses and provide reserves as required.
Further, the private analogy is inapplicable in the same way that the household-government budget analogy is flawed when applied to a fiat monetary system.
For a private corporation (like a commercial bank), they would have to swap sound assets for equity when recapitalising. This would not apply to the Federal Reserve under the current Federal Reserve Act. Things are actually much easier for the Federal Reserve.
So assume it might need to be recapitalised at some point. Note that I am not implying it would ever get into this situation – that is, I am not accepting all the bunk about the consequences of it draining the excess reserves at some point in time. I am just going along with that part of the conservative argument to get to the insolvency nonsense.
So how can it recapitalise? Answer: the US Treasury can just give “its” central bank whatever value of Treasury bonds are required to recapitalise it is a formal balance sheet sense. Simple as that! Rest easy.
Some would reply by saying this would be politically costly or amount to a loss of central bank independence. It might have political consequences but just as the ECB has become a quasi “fiscal authority” in the Eurozone to stop that system imploding (it will implode if they stop) all manner of contrivances emerge very quickly in modern politics to “save the day”.
The US Treasury would not hesitate to “bail” the Federal Reserve out if required. It cannot go broke. The US government is never revenue constrained because it is the monopoly issuer of the currency. It is not a household nor a private corporation.
On November 5, 2010, the Federal Reserve Chairman gave a lecture followed by a Q&A session to some university students in Florida. Here is the Video which runs for 45 minutes.
He discussed the two broad functions of the central bank: (a) to promote financial stability (basic rationale for creation of US Federal Reserve) via two tools – lender of last resort capacity and regulation; and (b) the dual macroeconomic mandate – maximum employment via managed growth and price stability. Federal reserve manipulates the short-term interest rate to influence aggregate demand and growth.
He noted in terms of the first function that the central bank has to be prepared to stop any short-term cash runs on the commercial banks by lending freely to institutions that are temporarily illiquid. He said that the last three years have been extraordinary and to defend financial stability all the tools available were used.
The first thing they did when faced with panic was to maintain liquidity – that is, ensure the banks could meet their cash obligations. They were just following the basic principle of central banking – lend to illiquid institutions to ensure they can pay off their liabilities. He said the basic lesson of central banking was to stand ready to make loans to stop panic.
In terms of the macroeconomic function – the “monetary policy” part of its operations he noted that very much like in the Great Depression, the financial crisis in 2008 led to a sharp global recession. The Federal Reserve tried to support the US economy by cutting short-term interest sharply. With interest rates almost at zero what else can the central bank do?
He then discussed the additional steps – quantitative easing – which involved buying guaranteed long-term securities from the market and providing “more liquidity” to the financial markets. He noted that these actions brought down interest rates in the financial markets.
He then discussed the tools available to reverse the balance sheet expansion and it is these issues that are causing all the conservatives sleepness nights at present. He then went on to list the tools. He said they can raise interest rates even though there are a large amount of reserves in the system? Why? Answer: because the Federal Reserve has the authority to pay interest on reserves. So by raising the interest rate they can raise short-term interest ratess throughout the system.
The BIS paper referred to above talks about the decoupling of reserves from interest rates. If the central bank couldn’t pay interest on reserves then they would have to drain them or lose control of its policy rate.
Bernanke then said that the Federal Reserve has a number of tools to “drain” or “immobilise” these reserves. They created time-deposits where the banks hold these reserves and this essentially freezes them. They also use reverse REPOs with drains them. He noted that both of these tools would be sufficient to drain the reserves. If for whatever reason they wanted additional draining – they could sell the assets which he said would increase interest rates on those asset classes and extinguish the reserves at the same time.
All of these tools form part of the standard liquidity management operations that the central engages in to maintain its policy target.
Later in the Q&A session things went awry and we hear some howlers about government deficits etc. He clearly doesn’t understand all that side of the monetary system or chooses to misrepresent it for political purposes. But that is another story!
More ridiculous stuff
I also read in the comments section of BBC economics writer Stephanie Flanders’ blog the following claim after the “expert” pointed out how you can identify Euro notes by nation of issue as a result of a letter code in the serial number. The “expert” then said: “There are rumours that euronotes from some countries are starting to be rejected in Germany. What economic effect this has I have no idea.” Apart from the grammar (has – would have duh) just typing these words reveals how little people understand things yet are willing to have a go at being an expert nonetheless and furthering the blind leading the blind path to nowhere.
Well please send all Euro notes with the letters T, Y, M and V before the serial number to me please and I will take appropriate action to ensure they don’t get to Germany.
A real issue
On November 15, 2010, the US Department of Agriculture (Economic Research Service) released its Household Food Security in the United States, 2009 report.
A selection of the major findings included:
- “In 2009 … 14.7 percent (17.4 million households) were food insecure … Food-insecure households had difficulty at some time during the year providing enough food for all their members due to a lack of resources. About a third of food-insecure households (6.8 million households, or 5.7 percent of all U.S. households) had very low food security, a severe range of food insecurity in which the food intake of some household members was reduced and normal eating patterns were disrupted due to limited resources …”
- “Rates of food insecurity were substantially higher than the national average among households with incomes near or below the Federal poverty line, among households with children headed by single parents, and among Black and Hispanic households”
The prevalence of very low food security was unchanged from 2008.
Most of this disadvantage is highly correlated with persistent (and long-term) unemployment.
Getting people back into employment should be the priority of the US government. QE2 will not do that. A jobs-rich fiscal policy expansion is desperately required.
That is my blog time for today! Now it is time to tune into the live updates from the Eurozone for the day to see what ridiculous things the bully boy bosses from Brussels and Frankfurt can dream up today.
I liked this statement in Ambrose Pritchard’s November 16, 2010 article – The horrible truth starts to dawn on Europe’s leaders:
My own view is that the EU became illegitimate when it refused to accept the rejection of the European Constitution by French and Dutch voters in 2005. There can be no justification for reviving the text as the Lisbon Treaty and ramming it through by parliamentary procedure without referenda, in what amounted to an authoritarian Putsch. (Yes, the national parliaments were themselves elected – so don’t write indignant comments pointing this out – but what was their motive for denying their own peoples a vote in this specific instance? Elected leaders can violate democracy as well.
Which relates to the way the Lisbon Treaty was used to push home the monetary union folly when it became clear that the wheels of the ratification process that was originally conceived as being the way this arrangement would be justified fell off – categorically!
That is enough for today!