My blog in the next week or so will be possibly rather holiday-like given the time of the year and the fact that I have rather a lot of travel and related commitments to fulfil over that period. So I will be pacing myself to fit it all in. Today, a brief comment on an article that appeared in the December 2015 issue of The Region, a publication of the Federal Reserve Bank of Minneapolis – Should We Worry About Excess Reserves (December 17, 2015). It is that one of those articles that suggests the author hasn’t really been able to see beyond his intermediate macroeconomics textbook and understand what is really been going on over the last several years.
The essence of the article is that:
Banks in the United States have the potential to increase liquidity suddenly and significantly—from $12 trillion to $36 trillion in currency and easily accessed deposits—and could thereby cause sudden inflation.
Why is that? Well, according to the author, US banks have large volumes of excess reserves, and:
… the nation’s fractional banking system allows banks to convert excess reserves held at the Federal Reserve into bank loans at about 10-to-1 ratio. Banks might engage in such conversion if they believe other banks are about to do so, in a manner similar to a bank run that generates a self-fulfilling prophecy.
Note the use of the word ‘might’, an uncertainty that is characteristic of these ridiculous, speculative type articles. To style of prose is along the lines of ‘well the sky might fall in’ all ‘all hell could break loose’ if pigs learned to fly – that sort of reasoning.
The author wants to generate, in the more irrational readers, a sort of hysteria that something dreadful might happen unless the ’cause’ is immediately addressed.
Of course, they clothe their predictions in such uncertainty that they can never be wrong.
But, while their predictions are qualified by ‘might’ and ‘could’ type words, their depiction of how the monetary system and the banking sub-system within it operate can be incorrect and in this case it clearly is.
The article is really just a rehearsal of the intermediate textbook notion of the money multiplier.
For background, please read the following blogs:
Consider the statement that the “nation’s fractional banking system allows bank to convert excess reserves held at the Federal reserve into bank loans”.
An innocent reader would be forgiven for concluding that banks loan out their reserves to customers who seek credit.
So if the commercial banks in the US banking system “currently hold $2.4 trillion in excess reserves: deposits by banks at the Federal Reserve over and above what they are legally required to hold to back their checkable deposits” then such a reader would conclude that the banks, in general, have massive extra capacity to make loans.
Such a reader would then also be forgiven for concluding that if banks suddenly released those excess reserves into the economy then there would be so much money sloshing around that inflation would accelerate quickly and chaos would ensue.
The problem is that the innocent reader might be forgiven but their ‘understanding’ would be wrong at the most elemental level.
The author of this article draws on several aspects of mainstream economic theory that is categorically been shown to be errant.
First, the old classical Quantity Theory of Monetary (QTM) is wheeled out so that characters like David Ricardo and Milton Friedman are noted and their contention that “the amount of liquidity held by economic actors determines prices” is stated, without qualification.
The author says “Greater liquidity is associated with higher prices”, although he does note that “the correlation between changes in M2 and prices is not tight in the short run”. There is a curious dissonance here between correlation and the assertion of causality.
Mainstream economists link the expansion of the money supply with accelerating inflation. It is the most intuitive part of the neo-liberal story and the one that resonates with the public.
While the QTM was formulated in the 16th century, the idea still forms the core of what became known as Monetarism in the 1970s.
First, a small bit of theory. The QTM postulates the following relationship: M times V equals P times Y, which can be easily described in words as follows. M is a symbol for how much money there is in circulation, that is, the money supply. V is called the velocity of circulation in the textbooks but simply means how many times per period (say a year) the money supply ‘turns over’ in transactions.
To understand velocity, think about the following example. Assume the total stock of money is $100, which is held between the two people that make up this hypothetical economy. In the current period, Person A buys goods and services from Person B for the $100 it currently holds. In turn, Person B uses the $100 to buy goods and services from Person A.
The total transactions equal $200 yet there is only $100 in the economy. Each dollar has thus been used ‘twice’ over the course of the year. So the velocity in this economy is two.
When we make transactions we hand over money, which then keeps being circulated in subsequent purchases. The result of M times V is equal to the total monetary transactions in the economy per period, which is a flow of dollars (or whatever currency is in use).
The P times Y is the average price in the economy (P) times real output produced (Y), which sums to what we call nominal Gross Domestic Product (GDP). The national statistician estimates the total sum of all the goods and services produced to get real GDP and then values this in some way using the price level to get a monetary measure of total production.
So P times Y is the total money value of the output produced in the period.
At this level, the relationship M times V equals P times Y is nothing more than an accounting statement that says that the total value of spending (M times V) in a period must equal the total monetary value of output (P times Y), that is, a truism.
It is true by definition and thus totally unobjectionable. How does the QTM become a theory of inflation? The answer is that the inflation theory uses a sleight of hand.
The Classical economists, who pioneered the use of the QTM, assumed that the labour market would always be at full employment, which means that real GDP (the Y in the formula) would always be at full capacity and thus could not rise any further in the immediate future.
They also assumed that the velocity of circulation (V) was constant (unchanged) given that it was determined by customs and payment habits. For example, people are paid on a weekly or fortnightly basis and shop, say, once a week for their needs. These habits were considered to underpin a relative constancy of velocity.
These assumptions then led to the conclusion that if the money supply changed, the only other thing that could change to satisfy the relationship M times V equals P times Y was the price level (P).
The only way the economy could adjust to more spending when it was already at full capacity was to ration that spending off with higher prices. Financial commentators simplify this and say that inflation arises when there is ‘too much money chasing too few goods’.
This is the simplistic contention that appears in this Federal Reserve of Minneapolis article.
The problem with the theory is that neither of the required assumptions holds in the real world.
First, there are many studies which have shown that velocity of circulation varies over time quite dramatically. Second, and more importantly, capitalist economies are rarely operating at full employment.
The Classical theory essentially denied the possibility of unemployment. The fact that economies typically operate with spare productive capacity and often with persistently high rates of unemployment, means that it is hard to maintain the view that there is no scope for firms to expand the supply of real goods and services when there is an increase in total spending growth.
If a firm has poor sales and lots of spare productive capacity, why would it hike prices when sales improved?
Thus, if there was an increase in availability of credit and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will respond by increasing the supply of goods and services to maintain or increase market share rather than push up prices.
In other words, an evaluation of the inflationary consequences of increased spending in the economy should be made with reference to the state of the economy.
If there is idle capacity then it is most unlikely that an increased nominal spending growth will be inflationary. At some point, when unemployment is low and firms are operating at close to or at full capacity, then any further spending will likely introduce an inflationary risk into the policy deliberations.
But that sort of conditionality is nothing at all like what this article is claiming.
Further, there is the sleight of hand between use of the term ‘liquidity’ and ‘spending’ in the article. The two are not equivalent. Spending can create an inflation risk (as above) but liquidity held as bank deposits cannot.
However, there is something even more basic wrong with this article.
The author says:
What potentially matters about high excess reserves is that they provide a means by which decisions made by banks—not those made by the monetary authority, the Federal Reserve System—could increase inflation-inducing liquidity dramatically and quickly.
The author buttresses this outrageous claim with the additional assertion that “the belief by some banks that other banks are (or will soon be) converting their excess reserves to loans could cause them to convert their own: The belief can become a self-fulfilling prophecy.”
He likens this to a “bank run (or panic) or an attack on a fixed exchange rate regime”.
Underlying this narrative is the author’s belief in the money multiplier mechanism, a basic element of mainstream monetary theory – and one of the most incorrect parts of that body of work.
Students are introduced to the money multiplier early in their studies. It is an article of faith in mainstream thinking.
It is asserted, erroneously, that by manipulating the monetary base, the central bank can control the money supply.
Milton Friedman, the father of Monetarism, once said in relation to the US monetary system that:
… the Federal Reserve System essentially determines the total quantity of money; that is to say, the number of dollars of currency and deposits available for the public to hold. Within very wide limits, it can make this total anything it wants it to be.
[Reference: Friedman, M. (1959) ‘Statement and Testimony’, Joint Economic Committee, 86th US Congress, 1st Session, May 25. http://0055d26.netsolhost.com/friedman/pdfs/congress/Gov.05.25.1959.pdf].
Later in 1968, as the Monetarists were gaining traction in the public debate, Friedman, in his famous – Presidential Address – to the American Economic Association, said that the central bank should publicly adopt:
… the policy of achieving a steady rate of growth in a specified monetary total …
Unfortunately, like most aspects of the Monetarist doctrine, the theory doesn’t match the reality.
The ‘monetary base’ is measured as the notes and coins in circulation or in bank vaults plus bank reserves held at the central bank. It is understood that central banks can add ‘money’ to the bank reserve accounts whenever they choose.
After all, they can create money ‘out of thin air’.
The money supply is defined in a range of ways – from very narrow (a small number of components) to broad (more components). The narrowest measure, M1, includes only notes and coins in circulation and bank and cheque account deposits on demand (that is, funds that can be withdrawn instantly).
Broader measures such as M3 include items such as longer-term deposits, which require more than 24-hours’ notice before withdrawal is permitted. The definitions also vary across nations.
The money multiplier is then defined as the money supply divided by the monetary base. The textbook argument goes that the central bank controls the ‘base money’ in existence and then the act of credit creation in the private banking system multiplies this base up to create the money supply.
The determinants of the money multiplier need not concern us here but relate to various parameters in the banking system (for example, the quantity of notes and coins that depositors wish to hold and any required reserves that the banks must hold).
A simple story to get the concept across is that someone deposits a sum in a bank to earn some interest. The bank then keeps some of that deposit in reserve to meet the daily withdrawal behaviour and lends the rest out at a higher interest rate in order to profit.
The recipient of the loan spends the money, which ends up as a deposit in some bank or another. That bank, in turn, lends most of this new deposit out, and the process continues. The resulting money supply expands as these deposits multiply.
The conception of the money multiplier is really as simple as that.
The Federal Reserve of Minneapolis article channels this type of reasoning – “Since each dollar of bank deposit requires approximately only 10 cents of required reserves at the Fed, then each dollar of excess reserves can be converted by banks into 10 dollars of deposits. That is, for every dollar in excess reserves, a bank can lend 10 dollars to businesses or households and still meet its required reserve ratio.”
He then produces some arithmetic, presumably to demonstrate he can add up and multiply, which shows the consequences of this 1-to-10 multiplier effect.
The only problem is that he appears oblivious to the flaws in the theory.
There are two major flaws.
First, the empirical evidence clearly shows that empirical estimates of the money multiplier are not constant and so can hardly be used to make predictions.
The following graph shows the estimates of the ‘money multiplier’ for the US using the so-called M1 measure of the money supply. The pattern would be the same if we had used a broader measure of the money supply.
If one is to postulate a causal relationship between the monetary base and the money supply mediated by this so-called money multiplier then the multiplier would have to be stable or predictable.
The multiplier has not exhibited stability in either the US or anywhere else for that matter and thus serves no useful basis for predicting the money supply.
Mainstream commentators attempted to argue that with QE driving up excess reserves in the banking system, the multiplier fell, which was an attempt to explain the sudden drops you can see in the graph.
However, this defence is an example of the ad hoc reasoning that permeates economic theory. Whenever the mainstream paradigm is confronted with empirical evidence that appears to refute its basic predictions, it creates an exception by way of response to the anomaly and continues on as if nothing had happened.
Students are not told that the measured multiplier is a moving feast and moves around like a Mexican jumping bean. Moreover, the measured multiplier was clearly unstable in the pre-crisis period, which means the special crisis case explanation for the instability fails.
Second, the stylised textbook model of the banking system isn’t remotely descriptive of the real world.
In the real world, banks do not wait for depositors to provide reserves before they make loans. Rather, they aggressively seek to make loans to credit worthy customers in order to profit.
These loans are made independent of a bank’s specific reserve position at the time the loan is approved. A separate department in each bank manages the bank’s reserve position and will seek funds to ensure it has the required reserves in the relevant accounting period.
hey can borrow from each other in the interbank market but if the system overall is short of reserves these transactions will not add the required reserves.
In these cases, the bank will sell bonds back to the central bank or borrow from it outright at some penalty rate. At the individual bank level, certainly the ‘price’ it has to pay to get the necessary reserves will play some role in the credit department’s decision to loan funds.
But the reserve position per se will not matter.
For its part, the central bank will always supply the necessary reserves to ensure the financial system remains functional and cheques clear each day.
The upshot is that banks do not lend out reserves and a particular bank’s ability to expand its balance sheet by lending is not constrained by the quantity of reserves it holds or any fractional reserve requirements that might be imposed by the central bank.
Loans create deposits, which are then backed by reserves after the fact.
It appears that this Federal Reserve of Minneapolis author hasn’t understood any of this nor read recent research papers from other central banks, for example, the Bank of England.
In recent years, in the face of all this hyperinflation angst, several central banks published articles which showed how far fetched the monetary theory is that is taught to students and espoused by mainstream economists and financial commentators.
They showed that real world banking doesn’t operate in the way the textbooks claim.
Among the enlightening reports was the Bank of England article in the First-quarter edition of the 2014 Quarterly Bulletin – Money creation in the modern economy.
The two central conclusions were:
The reality of how money is created today differs from the description found in some economics textbooks:
- Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
- In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.
These conclusions are devastating for mainstream economics and for the analysis presented in the Federal Reserve of Minneapolis article, specifically.
The Bank of England further notes that “in reality … commercial banks are the creators of deposit money … the reverse of the sequence typically described in textbooks” and that the “money multiplier theory … is not an accurate description of how money is created in reality”.
These insights lead to the conclusion that “neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available”.
In terms of the determinants of the broad money supply, the Bank of England ratifies the Modern Monetary Theory (MMT) argument that “lending creates deposits”, which then creates money.
The Bank of England also highlighted the:
… related misconception … that banks can lend out their reserves … Reserves can only be lent between banks … consumers do not have access … [to central bank reserve accounts].
This insight is also confirmed in an interesting article published in September 2008 by the Federal Reserve Bank of New York in their Economic Policy Review entitled – Divorcing money from monetary policy.
We learn that commercial banks require bank reserves for two main reasons. First, from time to time, central banks will impose reserve requirements, which means that the bank has to hold a certain non-zero volume of reserves at the central bank. Most nations only require the banks to keep their reserves in the black on a daily basis.
Second, the FRNBY states that “reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions”.
There is daily uncertainty among banks surrounding the payments flows in and out as cheques are presented and other transactions between banks are accounted for.
The banks can get funds from the other banks in the interbank market to cover any shortfalls, but also will choose to hold some extra reserves just in case. If all else fails the central bank maintains a role as lender of last resort, which means they will lend reserves on demand from the commercial banks to facilitate the payments system.
When the central bank adds funds to these reserve accounts (for example, when conducting quantitative easing), the Bank of England tells us that:
… the new reserves are not mechanically multiplied up into new loans and new deposits as predicted by the money multiplier theory.
The Bank of England also concludes that the existence of new reserves, even if they are well in excess of the banks’ requirements to operate an orderly clearing system, “do not, by themselves … change the incentives for the banks to create new broad money by lending”.
The question then is, why are students in our universities forced to learn material that has no foundation in the system they are purporting to understand? The answer is that the educational opportunity is replaced by a propaganda exercise to suit ideological agendas.
The other question is, why does a branch of the Federal Reserve Bank in America allow an author to publish such misrepresentations of the way the banking system operates?
I won’t consider the formal gymnastics that the author implies to justify why none of the claims made in the article have eventuated.
In the conclusion, the author really demonstrates the problem that arises when a flawed model of the monetary system is used.
He says that a:
… potential solution is for Congress to make the policy and legal changes necessary to convert excess reserves into required reserves by dramatically increasing required reserve ratios, perhaps to 100 percent …
Which would make zero difference to the capacity of the banks to make loans.
Please read my blog – 100-percent reserve banking and state banks – for more discussion on this point.
One might hope that the years of expanded central bank balance sheets and the deflationary tendencies around the world at present might have given some of these mainstream economists a reason to pause and really seek to understand what was going on.
In some cases (for example, the researchers at the Bank of England) that has happened. But there is still a hard-core of my profession that has waited for the clouds of crisis to lift and have simply returned to business as usual.
That is, peddling nonsense.
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.