After yesterday’s marathon blog, today will be easier going (and shorter). I was reading John Maynard Keynes recently – circa 1928 – that is, 8 years before the publication of the General Theory with his Treatise on Money intervening. He was railing against the principles and practice of ‘sound finance’, which he noted had deliberately caused billions of pounds in lost income for the British economy. He urged the Treasury and the Bank of England to abandon their conservative (austerity) approach to the economy and, instead, embark on wide-scale fiscal stimulus to create jobs and prosperity. He concluded that with thousands of workers idling away in mass unemployment that it was “utterly imbecile to say that we cannot afford” to stimulate employment via large-scale public works – building infrastructure etc. He considered the policy makers who opposed such options were caught up in “the delirium of mental confusion”. The stark reality is that 88 years later, he could have written exactly the same article and would have been ‘right on the money’. We are being led (euphemism) by imbeciles.
Earlier this month (February 12, 2016), Eurostat told us that – Industrial production down by 1.0% in both euro area and EU28.
The report said that:
In December 2015 compared with November 2015, seasonally adjusted industrial production fell by 1.0% in both the euro area (EA19) and the EU28 … In November 2015 industrial production fell by 0.5% in both zones …
Among Member States for which data are available, the largest decreases in industrial production were registered in the Netherlands (-9.4%), Estonia (-8.8%) and Germany (-2.3%) …
Which means that the overall monetary union is back in recession if industrial production is considered.
The other point to note is that the dominant neo-liberal narrative in Europe (and elsewhere) in relation to the ongoing consequences of the GFC focuses on individual nation failings – such as, lack of competitiveness, excessive wage rates, excessive regulation, etc – and the need for so-called ‘internal devaluation’ as a way of restoring ‘competitiveness’ and structural reform aimed at boosting productivity.
The problem with this narrative is that it is hard to maintain when industrial production is falling across a number of nations including Germany and the Netherlands, which are meant to be competitive leaders in the Eurozone.
The structural ‘reform’ agenda seems very transparent when confronted with this type of reality. Its aim is to redistribute national income in favour of capital and force workers to labour longer and harder for less reward. The European Commission is, after all, a branch of corporate power.
On July 31, 1928, John Maynard Keynes wrote a short article in the Evening Standard entitled – How to Organize a Wave of Prosperity. I have created a PDF version of the article because it is not easily assessable to those without expensive library subscriptions.
The context was the slowdown in British industry in that year and the subsequent rise in mass unemployment.
Moreover, the more successful the efforts which are being made to restore the margin of profits by ‘rationalisation’, the greater the likelihood – at first anyhow – of increasing unemployment.
And the more successful the efforts of the Treasury, in the pursuit of so-called `Economy’, to damp down the forms of capital expansion which they control – telephones, roads, housing, etc., again the greater the certainty of increasing unemployment.
The resonance with contemporary events some 88 years later is frightening.
Keynes wrote that the “fundamental blunder of the Treasury and of the Bank of England has been due, from the beginning, to their belief that if they looked after the deflation of prices the deflation of costs would look after itself.”
He also said that “an assault on wages is … maladroit, because the wage rates which will be most likely to yield before the assault will be those in which wages are already relatively low because of bargaining weakness.”
He also eschewed “rationalisation” – corporate and workplace restructuring etc because it worsened unemployment.
His preferred approach was to use policy to ensure that “plant and productive resources” were working “to a hundred per cent of capacity”.
This would help industry “afford the higher wages” and reduce unemployment (the “wastefulness of plant employed 10 or 20 or 30 per cent below capacity is extreme”).
But restoring full employment after a recession:
… lies entirely outside the power of individual business men to take the initiative. The first steps can be taken only by the Bank of England and the Chancellor of the Exchequer. Yet the consequences of their policy so far has been to ensure that businesses shall be unprofitable and that the level of unemployment shall not fall below the million level.
He wanted the Bank of England to ensure banks had reserves to back their lending activities if they could not get them elsewhere – so an aggressive ‘lender of last resort’ facility.
Moreover, he said that:
… the Chancellor of the Exchequer must remove and reverse his pressure against public spending on capital account.
Every public department and every local authority should be encouraged and helped to go forward with all good projects for capital expansion which they have ready or can prepare – roads, bridges, ports, buildings, slum clearances, electrification, telephones, etc., etc.
That is, a large-scale fiscal expansion.
He finished with his classic assessment of the resistance to using fiscal policy in this way:
When we have unemployed men and unemployed plant and more savings than we are using at Home, it is utterly imbecile to say that we cannot afford these things. For it is with the unemployed men and the unemployed plant, and with nothing else, that these things are done.
To have labour and cement and steel and machinery and transport lying by, and to say that you cannot afford to embark on harbour works or whatever it may be is the delirium of mental confusion.
Marx, before him, had noted that it was an indecency of capitalism that when there was overproduction (deficient spending) it was the producers (the workers) that could not access the means of subsistence (wages).
Keynes even articulates the view that the Treasury and Bank of England, through their devotion “to the timidities and mental confusions of the so-called `sound’ finance”, have deliberately “reduced the wealth of the country by not less than £500,000,000”.
The other resonating fact is that Keynes wrote:
The nature of the error committed will never be exactly understood by the public.
Things have not changed much. We are once again in the thrall of ‘sound finance’ which Keynes so long ago demonstrated was damaging to the prosperity of the nation and only imbeciles would believe in it.
The UK Guardian article (February 29, 2016) –
China’s central bank attempts to boost economy with cash injection – reveals, yet again, how central bankers are caught up in a mindless Groupthink and do not even understand the policy instruments they are dealing with.
It also indicates that the journalists who wrote the article need to rethink their understanding of the material they write about.
Part of the ‘sound finance’ dogma pertains to the superiority of monetary policy as a counter-stabilisation tool – that is, a tool to ensure spending fluctuations are minimised and growth and employment remains strong.
The UK Guardian article reports that:
China’s central bank has stepped up action to bolster its cooling economy by loosening the rules on banks’ cash reserves in the hope that they will offer cheaper loans.
By cutting the reserve requirement ratio (RRR) – the amount of cash that banks must hold as reserves – the People’s Bank of China has in effect injected $100bn (£72bn) of long-term cash into the economy, experts said.
This is the fifth cut since last year, in addition, to cuts in short-term interest rates – the rate at which banks lend to each other.
Further, who are these ‘experts’? One is mentioned – a person who works for the “Economist Intelligence Unit” – which is a British company that in its own words helps ” businesses, financial firms and governments to understand how the world is changing and how that creates opportunities to be seized and risks to be managed”.
Might they be advised to sort out their own understanding of the basics of the monetary system first.
Let us be clear.
Lowering reserve requirements will do very little if anything to encourage bank lending in China or anywhere else.
This is the same sort of nonsense that has led central bankers to introduce negative interest rates in the hope that imposing a tax on bank reserves in the middle of a recession will mysteriously lead banks to lend more despite the fact that their are not too many borrowers knocking on their doors for funds – such is the stagnant state these policy makers have created.
Please read my blogs – The ECB could stand on its head and not have much impact and The folly of negative interest rates on bank reserves – for more discussion on this point.
There are many reasons why relaxing reserve requirements will not suddenly stimulate more bank lending.
First, the reality is that the reserve requirements that might be in place at any point in time do not provide the central bank with a capacity to control the money supply.
In the real world, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank if it is short of reserves (requirements or not).
The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.
Bank lending is not reserve constrained. Rather, limits are placed on banks by their capital.
In this blog – Bond markets require larger budget deficits – I outlined the system of banking supervision based on capital adequacy requirements which has been developed by the Bank of International Settlements.
There is a fundamental difference between capital adequacy requirements on banks in a regulatory framework and reserve requirements. The two sorts of rules are quite distinct but are often conflated by those who do not know how the monetary system operates.
Banking regulation (capital adequacy) is now up to the Basel III framework.
The general approach of the Basel framework is to express a bank’s capital relative to its risk. Capital is divided into Tier I Capital (contributed equity plus retained earnings) and Tier II Capital (preferred shares and a proportion of subordinated debt).
The risk is expressed in terms of risk-weighted assets, which range from cash and government bonds (zero weighted) to 100 per cent weighted riskier loans etc.
Capital requirements place a limit on the leverage ratios that banks can run with and thus attempt to limit risk-taking. They also constrain the size of the banks because capital is costly. Finally, they reduce the public-private partnership ratio inherent in any banking system where governments will bail out the depositors in event of failure. The higher the capital held against its assets the more the shareholders are exposed to bank failure.
Different nations compute bank capital differently.
The main motivation of the capital adequacy regulations was to limit the bank’s capacity to originate loans and providing incentives for them to increase their capital.
The initial flaws in the approach was that the risk-weighted ratio could be increased by increasing capital (the numerator) or reducing assets (denominator). The latter could be achieved by balance sheet restructuring which is exactly what banks did.
The resort to capital arbitrage (for example, securitisations) was one major way banks could get around the capital adequacy rules.
Basel III attempts to deal with those sorts of evasion.
Lending limits are defined as a multiple of a bank’s capital. So the fundamental principle is that bank lending is capital constrained under this regulatory framework despite the devious ways banks have been able to evade the rules or the laxity of enforcement of the rules in certain nations.
But reserve requirements place no such limit on lending.
Commercial banks hold reserve accounts at the central bank for the sole purpose of facilitating the payments system (clearing house). Many countries have no reserve requirements other than the accounts must not be in the red on a sustained basis.
Reserve requirements are an artifact of the old gold standard and are irrelevant in the current monetary system. They do not reduce bank risk nor do they comprise a buffer that can be drawn on when there is a run on a bank.
To understand why reserve requirements do not constrain lending you have to understand how a bank operates. Banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share (this is one of Minsky’s drivers).
These loans are made independent of the banks’ reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these horizontal transactions will not add the required reserves.
In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the ‘discount window’. There is typically a penalty for using this source of funds.
At the individual bank level, certainly the ‘price of reserves’ may play some role in the credit department’s decision to loan funds.
But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.
So the idea that reserve balances are required initially to ‘finance’ bank balance sheet expansion via rising excess reserves is inapplicable.
1. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements.
2. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.
3. Any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the ‘penalty’ rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.
4. It is the Basel capital requirements that place a limit on the expansion of a commercial bank’s balance sheet at any point in time.
The other point in relation to China at present is that bank lending remains relatively robust anyway and it is a fraught growth strategy to rely on on-going private credit buildup to sustain activity.
If China wants to ensure it maintains strong economic growth rates then it might invest more in poverty alleviation in the regional areas – and rely on the increased incomes to drive domestic demand.
Hoping that monetary policy will deliver stable growth is a pipe dream.
On the same theme, there was an article in the Australian newspaper The New Daily yesterday (February 29, 2016) – Central bank bosses are failing us – which talks about “Decades of faith in ‘monetarism’ made central bankers sure they knew how to restore global growth. It isn’t working, but there’s one more lever to pull’.
The article segues off the recent statements by former Bank of England governor Mervyn King who has criticised the blind faith in ‘monetarist’ doctrine.
The journalist argues that:
Eight years after the GFC, it’s clear that the decades-long belief in monetarism has been stretched to breaking point.
Cutting interest rates to very low levels, or to zero, or even artificially creating ‘negative interest rates’ has failed to stimulate the world’s developed economies as they were supposed to.
I helped him with the story yesterday and he quoted me as saying that “Monetarism” was “ideology, never founded in fact”.
He also wrote that:
After 2008, says Mitchell, it was the huge and coordinated use of fiscal policy around the world that actually produced renewed economic growth, not ultra-low interest rates. The China stimulus, for instance, sent Australian hard commodity prices through the roof and ‘saved’ Australia.
And yet by 2012, even in Australia, the “ideology” of monetarism regained the upper hand – the benefits of fiscal intervention were overlooked as media attention focused on the ‘debt and deficit’ problem that stimulus splurge had created.
I would be a fool not to agree 100 per cent with that (-:
And just like Keynes warned 88 years ago:
… the elected faces in Canberra – as opposed to the unelected central bankers they appoint – are virtually barred from fiscal stimulus by the powerful, monetarist narrative of ‘debt and deficit’ and ‘living within our means’.
What a sorry state the world is in!
Keynes warning was prescient at the time and remains a robust understanding of the causes of mass unemployment and the best policy cures.
He was fighting against ‘sound finance’ then and by the end of the Second World War had won the battle and the world entered a marvellous period of full employment and income growth with diminishing inequality and poverty.
But the conservative ideology is like a cockroach – hard to get rid of. And for the last three or so decades the world has been mired in its imbecilic nostrums that culminated into the GFC.
Rising poverty, mass unemployment and all the related ills are back – and we are too stupid to see these leaders for the imbeciles that they are!
That is enough for today!
(c) Copyright 2016 William Mitchell. All Rights Reserved.