Indexed bank reserve support schemes will not expand credit

On the Wikipedia page for economist Ricardo Reis we learn he was “Influenced by: Greg Mankiw”, which basically should tell you everything. Everything that is that would lead to the conclusion that his macroeconomics is plain wrong. Yet his connections in the profession are strong and has prestigious academic appointments, is ensconced in senior editorial positions on influential economics journals, advises central banks in the US and has regular Op Ed space in a leading Portuguese newspaper (his home nation). These facts tell you what is wrong with my profession. That someone can write articles that are just so off the mark yet have significant influence in the profession and be held out in the public debate as to be someone who is worth listening to and being reported on. I have received many E-mails in the last few days about the proposal offered by Reis at Jackson Hole last week. Many readers are still confused and actually thought the proposal had credibility. Let me be clear – bank lending is not influenced by the reserve positions of the banks. Without credit-worthy borrowers lining up to access loans, the banks could have all the reserves in the world and the central bank could invoke any number of nifty ‘indexing’ or other support payment schemes on those reserves, and the banks would still not lend. And with those credit-worthy borrowers lining up to access loans, the banks will always lend irrespective of their current reserve position or the nifty support schemes the central bank might dream up. Core Modern Monetary Theory (MMT) 101!

The paper – Funding Quantitative Easing to Target Inflation – was presented to the Jackson Hole Economic Policy Symposium, hosted by the Federal Reserve Bank of Kansas City, which was held last week (August 25-27, 2016).

The theme for the Symposium was “Designing Resilient Monetary Policy Frameworks for the Future”.

Apparently “Some 100 economists and Fed officials — each one able to fill a room if they gave a speech in New York or Washington — attend the two-day event” (Source).

It just goes to show that the neo-liberal Groupthink is alive and well if the ideas that are presented in the Reis paper are taken as worthy of filling a room of high-paid officials.

We shouldn’t be surprised though.

His influence – Greg Mankiw – still teaches students that central banks can control the money supply and that the textbook money multiplier is still a valid concept to learn.

In his Principles of Economics (I have the first edition), Mankiw’s Chapter 27 is about “the monetary system”. In the latest edition it is Chapter 29. Either way, you won’t learn very much at all from reading it.

In the section of the Federal Reserve (the US central bank), Mankiw claims it has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system”. So I suppose on that front he would be calling for the sacking of all the senior Federal Reserve officials given the massive collapse that occurred under their watch.

The second “and more important job”:

… is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).

And in case you haven’t guessed he then describes how the central bank goes about fulfilling this most important role. He says that the:

Fed’s primary tool is open-market operations – the purchase and sale of U.S government bonds … If the FOMC decides to increase the money supply, the Fed creates dollars and uses them buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars it receives for the bonds are out of the hands of the public. Thus an open market sale of bonds by the Fed decreases the money supply.

This is the influence that Mankiw dishes out.

It is completely fictitious account of the way central banks operate.

Central banks cannot control the “money supply”.

In the September 2008 edition of the Federal Reserve Bank of New York Economic Policy Review there was an interesting article published entitled – Divorcing Money from Monetary Policy.

It demonstrated why the account of monetary policy in mainstream macroeconomics textbooks (such as Mankiw etc) from which the overwhelming majority of economics students get their understandings about how the monetary system operates is totally flawed.

The FRBNY article states clearly that:

In recent decades, however, central banks have moved away from a direct focus on measures of the money supply. The primary focus of monetary policy has instead become the value of a short-term interest rate. In the United States, for example, the Federal Reserve’s Federal Open Market Committee (FOMC) announces a rate that it wishes to prevail in the federal funds market, where overnight loans are made among commercial banks. The tools of monetary policy are then used to guide the market interest rate toward the chosen target.

This is practice is not confined to the US.

In reality, in a credit money system, this ability to control the stock of “money” is undermined by the demand for credit. The overall broad money aggregate (‘the money supply’) is determined as the outcomes that follow after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).

The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 is just an arbitrary reflection of the credit circuit. Please read my blog – Understanding central bank operations – for more discussion on this point.

Further expanding the monetary base (bank reserves) as I argued in these blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.

And that brings me to the Reis paper, which was reported on by Reuters (August 27, 2016) – Fed could use reserves payments to stimulate U.S. economy: paper – as if it contained an ingenious new idea.

It is, in fact hard to know where to start discussing this sort of paper, which, sadly, represents the standard understandings in the mainstream of my profession.

There are so many clangers – like:

1. “The interest on reserves controls inflation” – how?

2. In relation to the growing reserves in the banking system, Reis claims “The main risk is that the central bank becomes insolvent … central bank insolvency is equivalent to hyperinflation, which happens often, all over the world.”

To learn why this is such a stupid claim, please read my blogs:

Further, “often” means “frequently”. The record of hyperinflations would suggest the descriptor “rare” is more appropriate.

Reis claims that as a result of Quantitative Easing (QE), “the central bank becomes one of the largest individual holders of government debt” and if the government forces “upon the central bank a write-off of the government debt” during a “fiscal crisis” then “the central bank may find itself unable to prevent this loss”.

Which means nothing.

The central bank accountants if they wanted to record positive capital would just type in whatever number they liked into their records.

End of story – after all, as Reis acknowledges the central bank is “the monopoly issuer or the unit of account”. It can never go broke.

3. “Government bonds now carry sovereign risk, which reserves do not, since they are the unit of account”.

Government bonds issued by a sovereign, currency-issuing government are risk free because such a government can always repay liabilities issued in that currency.

4. “An effective helicopter drop would likely require the end of QE, with a dramatic shrinkage of the quantity of reserves” –

What?

We read that a ‘helicopter drop’ (pp 20-21) involves:

… the government sending economic agents checks, just like it does with other social transfers … and issuing government bonds to pay for these. The central bank would then print banknotes to buy these government bonds and immediately write them off from its balance sheet. This leads to the same end result, where private agents receive banknotes from the central bank, but now using the fiscal authority as the distributor. This version is sometimes called overt monetary financing of the deficit.

Crucially … the increase in the monetary base must be permanent. With more money chasing the same goods, the argument goes, the price level would have to rise back towards target.

Why would a government expand its deficit to achieve a level of economic activity that Reis describes as the “same goods”?

The increased deficit would increase spending but, presumably, given the logic of wanting to increase the deficit, lead to higher levels of production of goods and service, with no necessary price level effects.

It does not make sense to have a static output side in the face of an expanding nominal demand side.

Further, Reis’ description of OMF (overt monetary financing) is selective.

First, the increase in government spending would not require any debt issuance at all. The government would instruct the central bank to credit its spending account (and a double entry number would spring up somewhere in the debt side of the central bank).

Electronic key strokes.

Second, the government spending would show up as deposits in private bank accounts of the recipients of the government spending. No bank notes (currency) would have to be issued.

Third, the bank reserves (monetary base) would grow accordingly. The central bank could drain those reserves if it chose through open market operations (selling bonds). But at that point there is “no money chasing the same goods”.

Fourth, these deposits were in payment for goods and services or, if they were transfers, were to fulfill income support and other obligations.

In the first case, the recipients presumably responded to the deposit by increasing production. In the second case, the deposits may feed into expenditure fully or partially.

But the increased demand would stimulate further production.

Further, any increase in fiscal deficits increases bank reserves. So if QE was abandoned and the government adopted (sensibly) OMF, then bank reserves would continue to grow unless the central bank chose to drain them.

The claim that there would be a “dramatic shrinkage of the quantity of reserves” reflects an ignorance of the impact of vertical transactions (deficit spending) on the reserve positions of banks – core Modern Monetary Theory (MMT) 101.

Reis also claimed that:

… helicopter drops might be ineffective because the Fed already turns over its profits to the government and might reduce these transfers after such a move, leading the government to cut spending in the future.

Again, one gently shakes one’s head (gently because it would be wrenched off reading a paper like this if it was anything but).

If the treasury side of government can instruct the central bank side of government to shift spending power from one pocket (account) into another pocket, then it doesn’t matter if the central bank stops remitting anything (profits on foreign currency activity, etc) to the treasury.

Once institutional arrangements had reached the sensible point that the both sides of government were actually fully exploiting the currency-issuing capacity, without artificial and voluntary constraints, then the treasury would realise it could always E-mail the operations desk at the bank and instruct it to credit any account it chose, irrespective of anything else!

The other part of Reis’ paper that gained press intention was his proposal to “use bank reserves as a stimulus mechanism, indexing payments to the inflation rate.”

The Reuters report claimed:

That would give banks an incentive to lend when the economy is weak and prices are rising more slowly.

Reis wrote in his paper (p.23):

The central bank is the monopoly issuer of reserves, which are the unit of account. In the same way that in an economy saturated with reserves, the central bank can choose whichever nominal interest rate it wishes to pay on those reserves, it could alternatively choose to remunerate reserves differently.

Which is absolutely correct.

The consequences of the choice of different rates impacts on the capacity of the central bank to sustain its policy target rate.

If it offers no support rate on excess reserves then the short-term interest rate in the Interbank market (where banks lend among themselves to ensure the viability of the payments system) would fall to zero.

This would effectively mean that the central bank loses control of its monetary policy position, unless that position was consistent with a zero policy target rate.

The choice of payment has no direct impact on the capacity of the banks to make loans (more about which soon).

Reis then proposes his ‘pièce de résistance’ (p.23):

Instead of promising an interest rate, the central bank could offer reserves that promised an indexed payment. For each $1 of reserves, the bank could receive a payment tomorrow that was indexed to the price level then.

Any central bank could clearly do that. So what?

Reis then claims that “if the price level was running below target” (pp.23-24):

… the central bank could lower the payment on reserves, and in doing so raise prices. The intuition for how this works is the following. When the central bank promises a smaller payment on reserves are a less attractive investment, so banks will not want to hold them, and their real value must fall. But since their real value is the inverse of the price level, prices must rise. As banks initially move away from reserves and into loans, the movement in savings and investment caused by a change in the promised payments will give firms the incentive to change their prices until equilibrium is restored. By promising a payment on reserves, the central bank gains a new tool with which to control the price level.

Intuition is a dangerous guide to anything if it is not backed by knowledge of how the monetary system actually works.

The Reuters report understood this as saying:

The fluctuations in bank lending due to price changes could help the Fed keep inflation on target.

The problem is that Reis’s “somewhat radical” (his words) proposal is nonsense and belies an understanding of what constrains commercial bank lending.

I outlined what actually happens in this blog – Building bank reserves will not expand credit.

Here is a brief summary (you can read the full exegesis if so motivated).

One of the myths of QE is that by increasing bank reserves (in exchange for central bank purchases of financial assets held by the banks), the banks’ capacity to lend would increase.

Reis clearly falls into that mistaken understanding as does Paul Krugman, Gregory Mankiw and a host of New Keynesian mainstream economists.

The Bank of International Settlements admitted in this paper – Unconventional monetary policies: an appraisal – that:

… 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.

Got it!

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” (quote from BIS paper).

The BIS then say:

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.

This is a core MMT position that has been in the literature for more than 20 years now – long before the central banks or New Keynesians started turning their attention to the existence and meaning of excess bank reserves.

The core MMT explanation goes as follows.

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 reason that Reis’ “radical plan” is nonsense is thus very simple – bank credit will be extended when there are demand for funds from the private sector.

Reserves will be added later if needed to sustain the payments system if required.

Richard Koo in his 2003 book Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications (John Wiley & Sons) provided another angle on this:

The reason why quantitative easing did not work in Japan is quite simple and has been frequently pointed out by BOJ officials and local market observers: there was no demand for funds in Japan’s private sector.

In order for funds supplied by the central bank to generate inflation, they must be borrowed and spent. That is the only way that money flows around the economy to increase demand. But during Japan’s long slump, businesses left with debt-ridden balance sheets after the bubble’s collapse were focused on restoring their financial health. Companies carrying excess debt refused to borrow even at zero interest rates. That is why neither zero interest rates nor quantitative easing were able to stimulate the economy for the next 15 years.

It is also why indexed payments on bank reserves will also have no impact of the type that Reis’s textbook understanding would imply.

Conclusion

Once again we see that the Jackson Hole Symposium dominated by dumb papers trying to defend the dominance of monetary policy as the primary counter-stabilisation tool.

This is the same old neo-liberal line – eschewing the use of fiscal policy – and promoting monetary policy.

They do this because they want to reduce the democratic oversight on macroeconomic policy and they think that these amorphous central bankers will be immune from political pressures to increase employment etc when there is very high unemployment.

They claim this gives policy more inflation-fighting credibility. It doesn’t at all.

A Job Guarantee run by the treasury would be a highly credible anti-inflation policy tool – because the government would be sending a signal that this powerful automatic stabiliser would always buy off the bottom at a fixed price and shift workers away from any inflating sector.

That would be the most powerful and least destructive anti-inflation tool that a government could use.

That is enough for today!

(c) Copyright 2016 William Mitchell. All Rights Reserved.

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    24 Responses to Indexed bank reserve support schemes will not expand credit

    1. Barri Mundee says:

      Dear Bill,

      Not that long ago banks would try to justify rises in interest rates that were out of kilter with RBA moves as due to “increases funding costs”. I assume this all just BS?

      There have also been suggestions that our banks borrow from overseas banks. Surely not ?

    2. Christer Kamb says:

      “Loans create deposits which can then be drawn upon by the borrower. No reserves are needed at that stage.”

      Thrue

      If the bank in it´s lending have no reserves at all the same bank will “finance” it´s loan in the interbank-market(next stage in the moneysupply-process). In simple theory this can be “the same money” that has been created(deposit/loan) by the bank. The thing is the bank always(normally) have a funding-cost for it´s lending, nevermind if´it´s reserves(i.e customer-deposits or shareholder capital) or external borrowing. Borrowing (short-term) from the cb will normally always be more expensive than interbank-money(loans).

      Yes it´s a neo-liberal “thruth” that cb always can manage inflation through monetary-policy. QE have shown it´s not thrue. There has to be a loan-demand from creditworthy customers to begin with. Something that seems to be forgotten by the New Keynesian mainstream economists. They take this phenomenon for granted in their belief-models.

    3. Andrew Wakeling says:

      Dear Bill. It may matter more how people think the system works than how it actually works. Greg Mankiw et al are influential; ie they affect behaviour. If / when you and MMT thinking get to dominate the consensus, then the system will be very different. Maybe that system will work ‘better’ (judged somehow)but we can’t yet know. It might be quite unstable and the transition could be scary. It would certainly seem more comfortable to get rid of the illusions. But social systems sometimes depend on illusions.

    4. John Doyle says:

      It seems to me to be becoming clear that all this misinformation is deliberate. It really is hard to believe that such economists as Mankiw are at the top of the economic tree yet spout easily contradicted theories as gospel.

      I did see somewhere that the idea that money can be freely created getting known outside in the public arena is so frightening that it must be suppressed. Otherwise everyone will demand free money! Economists know it’s not so simple, that in fact its only free to buy debt, and this complication would not get through.

      Any answers?

    5. Willy says:

      This is not an epistemic crisis. It is more a disinformation program by a powerful few aimed at the distracted many. Thank god myself of the many and others has the clarion call of Prof. Mitchell’s writings to keep us sane while constantly reminding ourselves that the emperor really is naked, no matter how gussied up he is by his lackeys.

    6. J Christensen says:

      Andrew Wakeling re comment at 20:33: Do you mean the “system” whereby the progeny of a few sly foxes who invented the “system” live like parasites while others suffer the drain on their energies?

      The MMT school just makes it clear that the how much, and, the way the money is distributed within society is controlled by government and always by pure political will. There is no one to blame for a failing economy other than those who control the political power. These are the people who must be held accountable, and it would be best if that were public knowledge to ensure that they will be.

    7. SUNIER, Jean-Jacques says:

      Dear Bill,

      I wrote to you a few years ago. I have been an avid reader, but I never post. You are one of the true lights. I was an undergrad at UCLA from 1979 to 1983. I had Leijonhufud, Clower, Hirshleifer and later Muller (Global Reach), among other professors. I am now 55 and work at Julius Baer Zurich– as the right hand of our CIO- Y Bonzon. We actually read the General Theory–much of what was written by JMK certainly gets “neoliberally” interpreted today. Feel free to contact me in the future by mail or phone 41 58 886 2789.

      Never I have seen the world at the mercy of career aparatchiks in central banking that have it ” all wrong”. If you have time, could you once describe the Chinese/ PBOC situation and their role in the world–or what they are doing that is “right” or “different”– how they create money etc. Overall, do you believe events could lead to a change in the monetary standard that we have had since August 1991–and what would that system look like in an ideal world. Merci !

    8. Jordan from Croatia says:

      “As credit is repaid the money supply shrinks.”

      May I cheer that with : Finally someone said it!!!!!
      I never before I read it so clearly even tugh i folow MMT for over 5 years. MMT mostly mentions destruction of money with taxes, but nothing EXPLICITLY about private sector.

      I believe that this is the winning point (even though it will lead to Marxists conclusions).
      Since i incorporated it in my talks about MMT description of monetary systems i get much less resistance from people. It goes:
      Banks “print” money when they give you credit which you asked for and then destroy it as you pay it off and only interest payment is kept as profit of the bank.

      Mentioning printing money by banks raises alarm bells in a listener which is imediately calmed after hearing that such money is then destroyed.
      I believe that it is a big misstake that this part is most often skiped when describing banking and MMT.

      Another point i need respond to is about deposits to reserves process which i never can find description in MMT.
      As most offten is said that time deposits become bank reserves recorded (not kept) at CB i keep thinking about no time deposits alas, checking accounts deposits.
      Since my payment to account holder in different bank then my brings sending reserves of my bank to receiver’s bank reserves in CB. Deposits and payment is from a checking account, it follows that checking accounts are also part of bank reserves not only saving accounts and cash. I have not read Dirk Bezemer’s new book yet where i believe that process is described.

      This is my own simplistic and street language description of banking and monetary system in capitalism:
      “When you want a credit to buy something otherwise could not, banks print money and give you. As you pay it off they destroy that money and only interest payment is kept as profit for the bank. This process is done by just opening a new account in your name and just typing in the numbers. destroying money is done by reducing that new money in your account as you pay it. They type it in, thats all, by law on banking. It is by law they have to do it, they have to destroy it as you pay in.

      After credit is spent it goes back into a banking system and it must be sent imediately into bank reserves at CB. It is recorded that its there, no paper is sent there only by internet. It is a record in CB that you have such money in your account, thats all.
      Yet, those reserves can be lent out but only to states and other banks which are deemed as 100% safe?
      Would you want your savings in a bank given to some looser as a credit? Would you want your savings be lost? You see, that is why banks are allowed to print nobody’s new money so there is no loss of somebody’s savings. As savings go into bank reserves at CB which are lent only to states and banks, and savings are constantly increasing, so government debts can go on increasing indefinetly. That is how government debts are acctually private sector savings. And gov debts can only increase and not be reduced because that would mean a destruction of private savings. (most often this last sentence is skipped since it can confuse and lead to problem of inflation description).

      This description of how money is destroyed and printed is describing iliquidity problem of present day economies or othervise called deleverage. Deleverage sounds as something positive even dough it is the most dangerous thing for a capitalist economy. More money being destroyed then printed is the most dangerous effect of debt economy.

      “But only the CB can print money” i hear then and my response is: Any time banks need cash, they can exchange their digital reserves at CB, which they themselves printed, for cash from CB”

      I need your response, dear Bill, i keep getting the silence from most of the leading MMTers on such description.
      I have never encountered full connection of private banking and public banking in MMT as i have described it. Is it a worthy description of monetary system as MMT sees it?

      Everyone is free to use my simplified explanation of monetary system in describing it to non-MMTers and i hope that it helps clear some ambiguities from MMT and help it spread more as future is comming that desperatly needs it.

    9. CharlesJ says:

      Bill,
      FYI Joseph Stiglitz has written a book about the Euro. He advised the Scottish pro-independence side of the the referendum, saying that a currency union with the rest of the UK was viable, but has since changed his mind about that, and the euro.

      During the 2014 referendum campaign, the Columbia University professor said a currency union between an independent Scotland and the rest of the UK could work. The plan to share the pound, which then-Chancellor George Osborne said would not be possible, was based on work by the Fiscal Commission Working Group, a sub-set of the council of economic advisors on which Mr Stiglitz served.

      However, in an interview with the BBC’s Good Morning Scotland programme, Mr Stiglitz said that in hindsight this may have been a “mistake”.
      ……
      “I think in hindsight that may have been a mistake. It would be a mistake to join the euro by the way, so what they would have needed to do is perhaps to resurrect the Scottish pound, and let it float.”

      Clearly Stiglitz is late to the party, but maybe this is a good contribution.

      http://www.bbc.co.uk/news/uk-scotland-scotland-politics-37219612

      Kind Regards

    10. CharlesJ says:

      Bill,
      Further to my above comment. I have no plan to buy Stiglitz book given that you have already covered that.

      A TV advertisement in the UK says that ” if you pay them to make that kind of stuff – they’ll just make more of it”

      Perhaps you could tell us if Stiglitz’ book is worth buying.

      Kind Regards

    11. Matt B says:

      Barri, I assume overseas borrowing by banks is purely to cover currency conversion, unless the overseas banks have AUD on the interbank reserve market for some reason.

    12. Some Guy says:

      Jordan from Croatia: Any time banks need cash, they can exchange their digital reserves at CB, which they themselves printed, for cash from CB”

      This seems to be saying banks printed their digital reserves at the CB, which is quite wrong. Only the CB, only the government can create reserves, a government liability.

      Banks can print bank money. But only the CB can print central bank money.

    13. Tom Hickey says:

      @ Jordan, Some Guy

      There seems to be some confusion over the statement, ‘loans create deposits and deposits create reserves.”

      Deposits create reserves in the sense that the central bank acting as the lender of last resort automatically lends settlement balances (“reserves”) to member banks at the penalty rate when a member bank has insufficient funds in its deposit (reserve) account at the cb at the close of a period. As Some Guy points out, it is the cb that creates the reserves (cb money) on its spreadsheet by crediting a member bank deposit account at the cb (in the payments system) with a loan.

    14. Jordan from Croatia says:

      Tom
      That would say that all bank reserves are borrowed funds. Nope it doesnt follow from reserves being gold in the past. Evolution of banking would not go so much astray.
      As far as i know for sure is that reserves are tie deposits: CD, savings, investment funds and so on. Onl part is borrowed per need basis. And would not banks get rid of excess reserves if it was borrowed? today they are flooded with excess

    15. Brendanm says:

      “… buy off the bottom at a fixed price and shift workers away from any inflating sector.”

      This is an interesting point that I have not picked up before. Am I right in interpreting this to say that JG would have a sector specific damping impact on inflation? That this is achieved by stealing workers away from the inflationary sector? This seems counter intuitive. I would have expected workers to move from JG to the inflating sector and for this to raise production and hence moderate inflationary pressures. But JG is only a finite source of labour and presumably obeying some law of diminishing returns as JG workers will not have sector specific skills. Thus there is a maximum level of inflationary pressure that JG can control and of course it is hard to see how it would affect a hard resource constraint (such as peak oil) at all.

    16. Rob Holmes says:

      Dear Bill. I get the impression that your writing is directed only to economists and cognicenti. When I hit a paragraph that is particularly dense with jargon, you’ve lost me – no point in struggling on. I believe that if more of the lay public had a grasp of MMT then things might just begin to change for the better. For me it is important – I need to stand on firm ground if I am to argue the case for MMT. Apart from the Billy Blog there is just nowhere else to go for the topics that you so thoughtfully provide. Having worked my way through MMT Simplified, your’s & Wray’s book, YouTube seminars & so on with lots of cross-referencing to economic dictionaries one might expect an easier read of the Billyblog. I really don’t think economics is that difficult – it’s just the compaction of dense jargon that is the problem.

    17. Tom Hickey says:

      @ Jordan

      “That would say that all bank reserves are borrowed funds.”

      Not so. Most reserves in the payment system are the result of government spending rather than cb lending. Reserve balances credited to member banks deposit accounts at the cb are used as settlement balances in the payments system and excess reserves are borrowed and lent among banks in the interbank market, the interest rate of which is managed by by the cb using monetary policy.

      When the cb is not paying IOR and choses not to set the interest rate to zero, it adjusts available liquidity in the payments system to hit its target rate by shifting the composition of its balance sheet, leaving non-government net financial assets unchanged in aggregate.

      CBs also stand ready to provide liquidity to their member banks that choose not to borrow in the interbank market for whatever reason. As long as a member bank is in good standing, it has access to cb lending at a higher rate. In the US, this is the difference between the federal funds rate and the discount rate. Generally, borrowing at a penalty rate is seldom used by banks even though it is available to them because banks choose to manage their assets and liabilities to minimize costs.

      Moreover, frequent use of the discount window is regarded as poor management by regulators. The Fed had to jawbone the banks to use it during the liquidity crisis for this reason, even twisting the arms of the big banks to use it to set an example, even if they did not need to do so.

      Use of cb lending expands in emergencies when greater liquidity provision is needed. The chief responsibility of a cb is to provide sufficient liquidity so that the system clears. As a financial crisis unwinds, cb lending decreases.

    18. Jordan from Croatia says:

      Tom
      You gave no answer to my question. Sorry but it is so.
      Deficit spending is new CB money into bank reserve. At the same time government borrows those reserves. Net new reserves is ZERO. Deficit spending is filling reserves while gov debt takes them out. Deficit and net additional spending is close to equal ammount.
      So, again, if reserves are not time deposits also that came mostly from credit issuance, and also from checking accounts as from my question earlier, where are reserves comming from?

      Cash in a bank is counted as reserves. If i deposit cash into my checking account, such cash become bank reserve while i still have digital money in my checking and most probably will never need that cash again.

      Again, this example also shows that every cash deposit in bank goes to bank reserves, whether into checking or saving account.
      Can you give me a real world explanation, not again how reserves are borrowed when needed?

    19. Tom Hickey says:

      @ Jordan

      “where are reserves comming from?”

      Bank reserves can only come from the central bank. Bank reserves include 1) reserve balances held by banks at the cb in the payments system on the cb’s books and 2) vault cash. Reserve balances and federal reserve notes are liabilities of the Fed.

      Bank deposits are liabilities of banks on whose books they reside and which are can only be created by the respective banks.

      They look the same since they are recorded in the same unit of account, but the liabilities are different — government and non-government.

      Banks’ reserve balances are banks’s deposit accounts held on the books of the central bank and are denominated in the government’s unit of account (USD in the US). They are liabilities of the central bank (government) in that unit of account. Deposits in customer accounts at banks are denominated in the same government unit of account as the central bank, but they are liabilities of the respective banks on whose books they reside.

      They appear to be the same since the unit of account is the same but they different because one set of liabilities belongs to government and the other to nongovernment. This is how net financial assets are created in nongovernment when nongovernment books must sum to zero. There can only be net financial assets in aggregate in the nongovernment financial system if some liabilities come from outside the system.

      The central bank’s books and the bank’s books are separate sets of books — government and nongovernment. Although both are denominated in the unit of account set by government, “central bank money” and “bank money” are different in that central bank money is a cb (government) liability that appears as an entry on government books, while “bank money” is a liability of the bank on whose books it appears as an entry. There is a hierarchy of money operative.

      Central bank money in the form of banks’ reserve balances at the cb are required for final settlement in the payments system after netting, as well as to settle with the government for taxes, purchases of government securities, to pay fees and fines, etc. Banks also need reserve balances at the cb to exchange for vault cash to meet window demand. If there is a reserve requirement, then banks must obtain reserves to meet it since they cannot create reserves themselves since reserves are central bank liabilities that only the cb can create.

      Those reserves (reserve balances and physical currency),being cb liabilities, only enter the banking system through 1) overt money financing either with or without corresponding Treasury security issuance as mandated by government or 2) from banks’ borrowing from the cb directly, e.g., at the discount window, or using repurchase agreements (OMO) or selling assets (usually government securities) to the cb (POMO). (QE initially included some MBS.)

      Banks cannot create central bank money (cb liabilities), either reserve balances or cash. Vault cash that passes through the banks’ windows into circulation no longer counts toward bank reserves, e.g., for the purpose of meeting reserve requirements, for example, even though federal reserve notes are still a Fed liability. Funds held in deposit accounts constitute a bank liability (non-government).

      There is no one to one relationship between bank money and bank reserves (reserve balances plus vault cash). Banks are not required to hold reserves equal to the amount of deposits they create or hold, absent a 100% or “full” reserve requirement. Although there is a push for “full reserve banking,” all that would do is increase the “tax” on banks by increasing government mandated costs.

      Banks create deposits by crediting deposit accounts (customer asset-bank liability) that are offset by loans (bank assets-customer liabilities). Banks don’t lend reserves and don’t need reserves to make loans. Reserves are only needed to meet reserve requirements if required and for final settlement after netting. There is no reserve requirement in Canada and the reserve requirement in the US 10%. Required reserves are unnecessary operationally, and constitute a “tax” on banks. Banks could still initiate loans creating deposits and then get reserves by borrowing from the cb if needed, given the cb as lender of last resort.

      Operationally, banks only need reserves (rb and vault cash) to clear in the payments system after netting and to meet window demand for cash. Banks obtain reserves to settle and for meeting rr by taking deposits that transfer reserves to them from other banks during settlement, from cash deposits, or by borrowing them in the interbank market or from the cb, (or selling assets to the cb). Banks obtain cash from taking cash deposits but since banks cannot issue cash, they must ultimately obtain it by exchanging reserve balances at the cb for vault cash to meet window demand.

      Reserve balances held in banks’ deposit accounts at the Fed come from the only entity that can create reserve balances — the Fed. Reserve balances at the cb are cb liabilities that can only be created by central banks on their own books.

      The Fed creates reserve balances in the Treasury’s account at the Fed for the Treasury to spend, which the Treasury spends by directing the Fed as the Treasury’s fiscal agent to create bank accounts. The Fed both credits the Treasury account with reserves and also debits the Treasury account when Treasury spends, while crediting banks’ reserve balance accounts at the Fed. The banks then credit customer deposit accounts iaw Treasury spending directives. While it is true that rb created by Treasury spending flow either to taxes or Treasury securities in the case of deficits, making it “a wash.” It’s the flow that counts. Top line government spending is injected into nongovernment and flows through the economy. At the same time, savers that prefer “safe assets” to riskier ones are provided for with Treasury issuance resulting from deficits. It’s not only dynamic but also symbiotic, providing flow of funds through the economy and provisioning safe assets to satisfy saving desire.

      In case of a deficit, the Treasury and Fed coordinate operations with the Treasury issuing liabilities in the form of Treasury securities that the Fed auctions to the primary dealers. The primary dealers settle with the Fed using reserve balances. The Fed credits the proceeds of the auctions to the Treasury as assets of the Treasury. All accounts balance at the end of each accounting period which is ordinarily daily in banking.

      Deficit spending is matched “dollar of dollar” by Treasury issuance of US Treasury liabilities. The exact amount that spending credits to bank reserve balances (bank asset-cb liability) , which banks then credit to deposit account (customer assets-banks liabilities), is debited to customer deposit accounts at banks for payment of tax liabilities and US Treasury securities (Treasury liabilities) issued to cover any deficit. All accounts balance at the close.

      Payment for the purchase of Treasuries drains the excess reserve balances from the payments system without affecting non-government aggregate net financial assets created by spending because the liability, whether cb or Treasury, lies on the side of government and the assets created lie on the side of non-government. Only the composition changes from zero maturity to non-zero maturity (along with the interest differential that adds to nongovernment aggregate net financial assets as a government liability and nongovernment asset).

      Although analysis using T-accounts may make this appear static, these operations are dynamic and non-simultaneous. In banking everything must come into balance at the end of the day and a lot goes not during each day. The banks’ ALM (asset and liability management) departments conduct operations from the banks’s side of the Fed’s spreadsheet to meet requirements while the Fed and Treasury coordinate operations from the government side so that everything balances at the end of day, too. All payments clear on time all the time.

      The Treasury also uses TT&L accounts at banks to retain reserve balances in non-government in order to be able to smooth operations in that way. Under normal operations, that is, when the Fed neither pays IOR nor choses to set the rate to zero, the Treasury and Fed work together on a daily basis to regulate the amount of reserve balances held by banks so that liquidity is always sufficient to clear and the Fed can hit its target in the interbank market. The Fed uses OMO (open market operations using repurchase agreements) to manage the amount of reserve balances for conducting its monetary policy when the Fed is doesn’t set the rate to zero or pay IOR. Since the excess reserves have been drained into Treasury securities, the amount involved in OMO is limited to ensuring that there is enough liquidity to clear while hitting the target rate.

      The Fed conducts OMO using Treasuries issued through deficit spending and reserve balances that it creates through keystroking banks’ reserve accounts at the Fed in the payments system. When the Fed wishes to increase reserve balances to manage the interest rate, it purchases Treasuries by crediting banks’ reserve accounts with it own liabilities, and when it wishes to reduce the amount of reserves balances then it sells Treasuries, which reduces the amount of reserve balances held by banks since banks can only pay for Treasuries using reserve balances. The Fed manages the target rate this way when it does not choose to set the rate to zero and is not paying IOR. This normally the way the Fed operates. Since the government that is sovereign in its currency has a monopoly on its currency, it can set the price by adjusting quantity available in the market, or if it chooses, just set the price, as the Fed is currently doing.

      In the case of setting the rate to zero or paying IOR, the amount of reserve balances is irrelevant for managing monetary policy through rate setting. Now the Fed is paying IOR, so the amount of reserve balances is irrelevant relative to demand in the interbank market, since the Fed is using IOR to set the rate of its choosing. Through POMO (permanent open market operations by purchasing Treasuries) the Fed expanded its balance sheet and creates massive excess reserves that would drive the overnight rate to zero if the Fed were not paying IOR to maintain the rate above zero, where the Fed chooses to set it.

      The important points are 1) that the ratio of reserve balances to Treasuries is irrelevant other than wrt the way the cb chooses to run monetary policy, and 2) that the quantity of reserves is not directly related to demand for credit from banks. Rather the price of reserves in the interbank market that the Fed chooses affects the interest rates that the banks charge customer because banks it is a cost that banks must cover along with other costs. Banks use the rate that the Fed sets as a base rate in figuring their spread, which affects costs of loans in the economy, like mortgage rates.

      QE, in which the Fed used POMO rather than OMO to greatly expand its balance sheet and create a great deal of liquidity in the interbank market while setting the rate using IOR, did not spur bank lending as the quantity theory predicts it should based on the so-called money multiplier. QE showed that the so-called money multiplier is an ex post residual rather than an ex ante cause. It also shows that issuance of Treasuries is not needed operationally but rather is a voluntary restraint imposed by the legislature, as well as that the quantity of base money is unrelated to inflation.

      Long ago Warren Mosler recommended that the Fed set the rate to zero and provide unlimited liquidity to solvent banks as needed, and that the Treasury issue only short term bills of not more than 90 days.

      The take-away is that central bank money is only created by the cb as a cb liability and bank money is only created by banks’ credit deposit accounts at the bank. Taxes withdraw central bank money and loan repayment withdraws bank money from deposit accounts. In both cases the respective liabilities are extinguished.

      This all shows how reserve balances are only relevant operationally wrt settlement in the payments system at the cb, where they are more properly called settlement balances. The amount of settlement balances is irrelevant other than for clearing, unless the cb chooses to set a rate above zero while not paying IOR. Then it sets price by adjusting quantity available and the amount of excess reserve balances becomes relevant to money policy.

      This is a summary that is pretty close to what happens in the “real world” using the US as an example. It’s different in different countries and this summary leave out a lot. See Eric Tymoigne’s Money & Banking entries at New Economic Perspectives (link in the nav bar at the top right of the page).

    20. Andrew Anderson says:

      The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. Bill

      Yes, because of what is, in essence, a government-privileged usury cartel of depository institutions who alone in the private sector may have convenient, inherently risk-free accounts at the central bank itself.

      Why is it that citizens may not deal with their nation’s fiat except in the form of unsafe, inconvenient physical fiat (bills and coins) but must instead lend (a deposit is legally a loan) to a government privileged usury cartel to lower the borrowing costs of the banks themselves and to lower the borrowing costs of the most so-called creditworthy, the rich?

      When will this systematic oppression of the poor end? Whatever happened to equal protection under the law?

    21. mahaish says:

      hi jean jaques

      “If you have time, could you once describe the Chinese/ PBOC situation and their role in the world–or what they are doing that is “right” or “different”– how they create money etc.”

      11 trillion gdp and 33 trillion in total social financing debt – a fair whack of it mis allocated me thinks, 3 trillion in official foreign currency reserves to defend the loosish peg. sounds a lot but a loss of confidence can wipe that away in a matter of years, and the inevitable chinese policy over reaction which its rulers have been pre disposed to over the last 2200 years.

      trouble coming ;)

    22. Neil Wilson says:

      It’s always easier if you think of ‘Bank Reserves’ as forced overdrafts. The commercial bank is forced by nature of its banking licence to supply loans to the central bank at a rate determined by the central bank and a quantity determined by the central bank.

      Those loans create deposits like any other loan. That’s how government spending works.

      The central bank allows the quantity to float because otherwise they can’t control the rate – since you can only control one or the other if you want the payment system to keep working. You can try to control both, but the system will blow up if you do.

    23. Andrew Anderson says:

      if you want the payment system to keep working. Neil Wilson

      There’s no reason we must have only one payment system – the one that must work through depository institutions, aka “banks” – since everyone could have inherently risk-free accounts at the central bank itself and government provided deposit insurance and all other privileges for the banks abolished.

      Then the banks would no longer hold the economy hostage since all remaining deposits with them would be at-risk, not necessarily liquid INVESTMENTS, not co-mingled with necessary liquidity.

    24. mahaish says:

      “Not so. Most reserves in the payment system are the result of government spending rather than cb lending. Reserve balances credited to member banks deposit accounts at the cb are used as settlement balances in the payments system and excess reserves are borrowed and lent among banks in the interbank market, the interest rate of which is managed by by the cb using monetary policy.”

      i dont think this is the complete picture.

      a look at the feds balance sheet, would need to take into account all the extraordinary assett purchase programs undertaken in the guise of qe. reserve balances are the end result of a liquidity swap, but thats not just about treasury securities

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