Lending is capital- not reserve-constrained

Today I have been reading up on the new proposals from the Basel Committee to tighten the capital requirements and introduce new liquidity rules as a further strengthening of the regulatory framework on banks. There is a mountain of literature to get through on all of this. But I came across two divergent views on the new proposals. Some commentators are arguing that these requirements hinder the banks’ ability to create credit and hence put a regulative drag on growth. If they are tightened then growth will be lower than otherwise. The other view expressed by a noted “progressive” economist disputed this view but then got confused in a mainstream macroeconomics labyrinth. It brought home the fact that people often confuse capital adequacy requirements and reserve requirements.

We should start by making sure we don’t get into the confusion that seem to commonplace in this sort of debate. 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.

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.

In that blog I go through the system of regulation implemented by the BIS starting with Basel I and now moving into Basel III. I described how this system of bank regulation aims to establish a transparent framework on how banks (and other deposit-taking institutions) manage their capital.

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. For example, while the US implemented Basel i rules and signed onto Basel II in 2004, they did enforce the rules (which changed the risk-weightings) and the banks failed to comply. This was a major regulatory oversight.

Basel III will introduce the liquidity coverage ratio as a response to the global crisis and the BIS is proposing that all international banks hold unencumbered assets equal to all the liabilities that are coming due within the next 30 days. This buffer is designed to offset any bank runs and thus preserve overall liquidity and reduce the need for government bailouts.

The other major change is in Basel III, is that banks would have to maintain a “net stable funding ratio” of 100 percent. This means that they would have to have an amount of longer-term loans or deposits equal to their financing needs for 12 months, including off-balance-sheet commitments and anticipated securitizations.

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 flaw 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. Securitisation refers to a process where a bank originates mortgage loans, pools them and takes them off their balance sheets by selling them to a third party (a so-called Special Purpose Vehicle). The SPV then markets the assets to investors as fixed-income securities and the cash proceeds go back to the bank (after fees are deducted).

By shifting the loans off their balance sheets (that is, pushing them to the SPV) the bank can increase its capital ratio but the overall leverage in the system is unchanged. Further, the risk-weightings are in broad bands and the bank may have sold high quality assets (at the top of the band) and retained poorer quality (at the bottom of the 100 per cent band). In simple ratio terms, the bank looks better but in terms of risk it is more exposed to failure.

The new Basel proposals are designed to stop this sort of evasion.

Most advanced nations have fully implemented Basel I and II which define lending limits 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.

Reserve requirements place not such limit on lending for reasons I have explained often. 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. The US is currently considering eliminating the positive requirements.

Reserve requirements are an artefact 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 no 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. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. 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.

The major insight is that 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.

Please read my blog – Money multiplier and other mythsBuilding bank reserves will not expand creditBuilding bank reserves is not inflationary and Oh no … Bernanke is loose and those greenbacks are everywhere – for more discussion on this issue.

However, capital requirements do place a limit on the expansion of a commercial bank’s balance sheet at any point in time. This primer is good on capital requirements although I do not agree with all that is said.

That was the motivation behind the Basel Committee’s regulatory framework (Basel I and Basel II and soon Basel III). It was to actually reduce the risk of banking and hence create a more stable financial system. The more stable investment climate (for productive capital) would translate into higher rates of economic growth.

It is clear that the bank meltdowns that precipitated the current real crisis which quickly spilled over into the real economy with massive consequences for income generation and welfare. The real economy around the world will take years to recover from the damage that the recession has caused.

In some countries, for example, Latvia, GDP has shrunk by around 20 per cent and forecasts are that it will continue to deteriorate by some 4-5 per cent in 2010 before it shows any sign of recovery. That is one-fifth of the real economy has gone because of the financial excesses of the banking system.

So I think it is difficult to argue that any reforms that reduce the risk of the meltdowns in the future will not deliver greater economic benefits.

But one Andrew Ross Sorkin in his New York Times column last week (March 29, 2010) entitled – The Issue of Liquidity Bubbles Up – was arguing that any move to increase capital requirements for banks in the US would stifle economic prosperity.

He recounts a conversation last week with one US Treasury Secretary Geithner about increased capital requirements and their likely impact on US banks. He says:

The answer to Mr. Geithner’s question will have a huge impact on Wall Street — specifically, how much money banks are required to keep in their rainy-day accounts. That matters because the more banks hold onto, the less they can lend to growing businesses … Of course, protecting against even infrequent crises probably means forcing banks to keep a lot of cash on hand in case their bets go bad. But that would come at the expense of economic growth as banks would make fewer loans.

Mr. Geithner insists that if there is one change that needs to be made to the banking system to protect it against another high-stakes bank run like the one that claimed the life of Lehman Brothers, increasing capital requirements is it.

So Sorkin is correct in arguing that increased capital requirements will change the capacity of banks to lend. After all, we have to understand that bank lending is capital constrained rather than reserve constrained.

But I think that he is wrong to assume this will reduce economic growth. There is a large literature that has attempted to examine this question since the introduction of the Basel regulatory framework. There is no clear consensus emerging from that literature in part because banks have been able to skirt round some of the rules via capital arbitrage.

There is limited but inconclusive evidence that banks do substitute towards the riskier assets in the weighting class which increases the riskiness of the banks’ overall portfolios.

There is fairly sound evidence “that banks respond to capital ratio pressures in the manner they believe to be most cost effective” over the business cycle and that “(r)aising new capital or boosting retained earnings may be easier in booms whereas cutting back loan books may be more cost effective in economic troughs” (Source: BIS).

This is also consistent with the view that capital adequacy is usually most challenged during times when the economy is performing poorly and demand for credit is low anyway. So it is hard to argue that the credit is being constrained by the capital requirements. They both are being impinged by the parlous state of aggregate demand.

The BIS paper noted above also asks whether “fixed minimum capital requirements create credit crunches affecting the real economy”. The conclude after examining the extant literature that:

It is likely to be the case that in some periods banks in a particular country may find it difficult to maintain the fixed minimum capital requirements and therefore may be forced to cut back lending. It would in fact be strange if fixed minimum capital requirements did not bite in some periods, thereby constraining the banks, given that the purpose of bank requirements is to limit the amount of risk that can be taken relative to capital …

One difficulty in looking at this question is that periods in which banks are severely capital constrained are likely to be those when they are making large write-offs or specific provisions (reducing capital), and in such periods it is also possible that loan demand will be weak. It is also possible that banks may cut back lending, not because of capital constraints, but because of concerns about lending to particular risky sectors.

But to associate this with declining output you would have to say that “any shortfall in bank lending was not fully made up through lending by other intermediaries or by access to securities markets”. The evidence here is mixed although small companies typically suffer more because they rely more on bank lending.

The BIS also note that there is a “link between minimum capital requirements for banks and financial stability and thence output” – the point I made earlier. They say:

Capital requirements for banks attempt to limit excessive risk-taking relative to capital, thereby reducing the likelihood of failures. If they are successful in this, the requirements could, overall, have a positive effect on output.

So tighter capital requirements may limit some credit expansion but provide the conditions for more durable growth cycles by avoiding the speculative bubbles.

Further, from a Modern Monetary Theory (MMT) perspective, there should be no relationship between growth overall and the limiting of private credit. If the increased capital requirements stifle private credit access then there is more space for public goods production and public infrastructure provision.

So lets repeat: bank lending is capital constrained not reserve constrained. Fundamental point that comes out of an understanding of how the monetary system works.

I was then surprised to read the following day (March 30, 2010), so-called “progressive” US commentator Dean Baker attacking Sorkin with this – Sorkin is Wrong: There Is No Tradeoff Between Growth and Bank Capital Requirements.

Hmm, I was expecting to read the progressive line that I outlined above that perhaps capital requirements by making the system more stable allow the economy to enjoy sustainable growth without the huge damaging booms and busts. So averaged over a long cycle the impact of the capital requirements would be positive.

I was disappointed.

This is what Baker said about Sorkin:

NYT columnist Andrew Ross Sorkin warned readers that higher bank capital requirements, intended to ensure safety: “would come at the expense of economic growth as banks would make fewer loans. This is not true.

The Federal Reserve Board decides on the level of reserves that it wants to pump into the financial system based on the level of economic activity. If economic activity is too slow, it can increase the volume of loans available to banks by putting more reserves into the system. Contrary to what Sorkin asserts, it is not necessary for the banks to raise their leverage of the same amount of reserves in order to generate more loans for businesses.

Oh dear. How do you think Dean would go in our weekly quiz? Not too well I think!

In the first paragraph Sorkin was referring to capital requirements. Then Dean introduces reserve requirements in the second paragraph. A basic no-no.

But even worse, is his conceptualisation that the central bank can influence the capacity of banks to expand credit by adding more reserves into the system. Basic error.

Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion on this point.

If “economic activity is too slow” then the central bank can do very little to expand private credit other than to cut interest rates. The availability of reserves will not increase bank lending. This is the old fashioned money multiplier version of banking where there the “money supply” is some multiple of the monetary base (provided by the central bank).

By manipulating this “multiple” the mainstream economists claim, erroneously, that the central bank can control the money supply. Absolutely wrong. So I am amazed that our so-called “progressive” Dr Baker is perpetuating this tripe. Perhaps it is a statement of how bad things are in the US when this nonsense represents progressive commentary.

The obvious way a bank which is sitting on its requirement capital ratio can expand its capacity to lend is to increase its capital – which is exactly what the framework is designed to induce.

Back to Sorkin for a moment. Later in his article he discusses the tension between the banks and the regulators. The former complaining that any limitations on their leverage ratios reduces their profitability. Yes. So what?

He quotes the now totally discredited Alan Greenspan:

A bank, or any financial intermediary, requires significant leverage to be competitive …. Without adequate leverage, markets do not provide a rate of return on financial assets high enough to attract capital to that activity. Yet at too great a degree of leverage, bank solvency is at risk.

While this is correct, it makes a good (unintentional) case for public banking. Over what period do we compute the rate of return? What do we include in this calculation?

If we were to include the massive losses and public bailouts that were required to prevent the entire world financial system from collapsing then the risk-weighted returns would be negative by a long way. A public banking system can deliver financial stability and durable returns (social) with much less risk overall.

But overall, it is sensible to regulate private banks via the asset side of the balance sheet and that is the strategy employed by the capital requirements frameowrk. It is also clear that higher capital requirements and more attention to “off-balance” sheet activity is now necessary.

In a system where the capital requirements are too low, the public exposure to bank failure is that much higher and the moral hazards are high. While the best option is to nationalise the banking system and make it 100 per cent focused on public purpose, the more realistic case is to ensure private banks have adequate buffers to insulate the system against panic.

That will reduce profitability (narrowly defined) but enhance social returns.

The other angle is that private investors would probably accept lower returns if there were tighter capital requirements because their risk exposure is lower. However, total costs to the sector rise when capital requirements rise.


It is amazing that notable progressive commentators are still working within orthodox frameworks and perpetuating basic errors about the way the monetary system operates. It diminishes our side of the debate.

So Dean – if you are unsure – keep your typing hands still, please! If you think you know what you are talking about here – then please go back to the basics and get up to speed on how the system you are proclaiming expertise about actually works.

That is enough for today!

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50 Responses to Lending is capital- not reserve-constrained

  1. There is another important point to be made in regard to those who think that strict capital ratio rules will solve the problem. Bill rightly points out that the system was gamed by the banks via securitisation. Consider this: Lehman is a case-in-point. On September 10, 2008, Lehman reported 11% “tier one” capital and very conservative “net leverage“. Less than ONE WEEK, later, on September 15, 2008, Lehman declared bankruptcy. The capital positions reported by large complex financial institutions are virtually impossible to calculate with any degree of accuracy, which goes back to another important MMT point. Optimal regulation is achieved via regulation of the ASSET side of the bank’s balance sheet, not the liability side. The objective should not be to create reactive buffers (or “insurance policies”) when the banks’ complex derivatives products begin to go bad. Rather, the activities which fail to promote public purpose should be banned outright. The whole point of regulatory capital is to ensure buffers in case of a really bad downturn. When the really bad downturn happens the buffers will be (naturally) be used. Why not ban (or heavily tax) the activities that caused the really bad downturn in the first place?

  2. BH says:

    What role do deposits play in bank lending now and how will a net stable funding ratio of 100% affect it?

    Does new lending to borrowers who purchase newly issued bank shares impact somewhat on the idea of banks being capital constrained?


  3. pebird says:

    I’ve read in other blog sites that capital acts as a “buffer” to draw on during bad times. This does not sound right to me. During good times, yes if you are hitting your capital limits, you need to raise more to grow (but why should you have a hard time raising capital if your loan portfolio looks good and growth is forecast?).

    In bad times, if you are hitting your capital – you can’t raise more very easily, you become insolvent and so you are going down fast (see Lehman). So, capital does not function as a buffer during crisis – I think this is another old gold standard myth.

    Instead, capital functions to focus owners/managers on risk and to provide metrics for regulators. But even here I have a problem – for capital to function as risk for individuals, the position of the institution is less important than the position of the individual (again an gold standard way of thinking). Raising capital through the public markets doesn’t necessarily mean that owner/managers have any more skin the game – it is dependent on transparency, securities regulators and how diligent financial portfolio managers are, as well as bank regulators.

    Too big to fail by definition socializes private speculative activity – we can’t socialize health care, but we sure as hell can socialize private financial risk taking. The capital risk tiers are based on quality of assets (which is good) – but what about equity positions?

  4. pebird says:

    Interfluidity states the capital problem I was trying to articulate so much better –


  5. NKlein1553 says:

    “The capital positions reported by large complex financial institutions are virtually impossible to calculate with any degree of accuracy…”

    Steve Randy Waldman just put up an excellent essay about this on his website interfluidity:


    Mr. Waldman writes:

    “For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.”

    His solution is “dumber banks.” I think it meshes well with Professor Mitchell’s post about breaking up the banks.


    Profesor Mitchell, maybe it’s just my computer, but the link to the “primer,” on capital requirements you don’t entirely agree with seems to be broken.

  6. Per Kurowski says:

    I could write chapters and chapters of comments on this post but let me concentrate on what is the biggest fault of the current capital requirements and which is totally ignored, here there and everywhere, namely that they discriminate against risk.

    A borrower with an AAA rating is already receiving by means of low interest rate spreads a favourable treatment from a market of capital that, no matter what is said about excessive risk-taking we all know to be fundamentally coward.

    But when the regulator discriminate based on their own agenda of avoiding defaults, lay on an additional layer of benefits to what is rated AAA assigning it silly low capital requirements for banks, they are actually pushing the financial markets toward what is perceived at a particular moment by some few rating agencies as having a low risk and thereby, in relative terms putting a penalty on risk.

    What happened? Capitals got overly pushed into the subprime safe-AAA havens which therefore became overcrowded and extremely dangerous.

    The issue for society is not to avoid default risks, it is to learn to take the right default risks, but this is something that those small-minded scheming regulators of Basel can never comprehend.

    Besides, where did regulators get that silly idea that what is perceived as being risky is more risky when we know that makes the financial markets proceed with more care? There has never ever been a financial crisis derived from something perceived as risky… they have all originated from lending or investing that were falsely perceived as not risky.

    Look what they done to my bank Ma! ….. They placed 8 percent capital requirements on all lending to small businesses and entrepreneurs and only 1.6 percent on what is rated AAA and even zero percent when lending to an AAA rated sovereigns… when my banks have really no business lending to AAA rated borrowers or sovereigns…. Ils ont changé mon bank Ma!

  7. Yeah, I’m trying to figure this out myself. I thought a deposit won’t add to bank capital, right? So if I deposit a pile of money at Bank of America, they still owe me the money back. That bank capital would be all the money that’s left after everything is paid out.

    I thought, as of right now, the TBTF’s all still actually insolvent. That everyone’s looking the other way as far as what the capital is worth and if we really dug around the basement the value would still come up negative. The bank profits are a results of a public policy to rebuild the balance sheets, and the bankers still get their big bonuses based on this (boo)..

    So I’m not sure what role capital requirements would have? Wouldn’t we have a pretend limit based on a pretend bank capital?

  8. I fully agree with the first sentence of this para of Bill’s, but the second sentence is not quite right.

    “Further, from a Modern Monetary Theory (MMT) perspective, there should be no relationship between growth overall and the limiting of private credit. If the increased capital requirements stifle private credit access then there is more space for public goods production and public infrastructure provision.”

    Reining in the incompetents and criminals who run banks means there is “more space for” non credit dependent activity in both the public AND private sectors. I.e. in place of bank lending, we just dish out more monetary base to Main Street. Moreover, ordinary people in Main Street act in a limited way as banks. I recently lent my niece money to buy a house, and a friend of mine recently borrowed money off his mother to buy a van for his business.

    In support of my claim that senior bankers are criminals, I cite the following.


    Also, the following article is relevant: it claims (far as I can see) that Bernanke is hooked on credit: that is he doesn’t realise the potential of channelling monetary base to Main Street.


  9. MMT_Thinker says:

    Looks like we could have a powerful new ally in the US. I read this blog often and it’s generally well balanced and informative though more market oriented. Quite popular in the states: http://pragcap.com/the-concept-of-vertical-and-horizontal-money-creation

  10. flow5 says:

    Both the bank’s assets & liabilities (i.e., financial innovation), should be severely circumscribed. & billy blog “Capital is divided into Tier I Capital (contributed equity plus RETRAINED EARNINGS) + …” Let the banks grow & fail thru competent bank management. Let retained earnings reflect the bank’s credit-worthy borrowers & its conservative but compounding investments. However, capital accounts are not low just because of inferior bank capital quality (or off-balance sheet maneuvers), but because of the vast portfolio of earning assets obtained thru the excessive rate of expansion in the money stock (the Reserve authorities’ are charged with validating the business cycle).

    As for fictional MMT, that depends upon the degree of ignorance or collection of prejudice those advocates are forever laboring under. billy blog “Reserve requirements…do not reduce bank risk nor do they comprise a buffer that can be drawn on when there is a run on a bank”. Absolutely, reserve requirements are a CREDIT CONTROL DEVICE. The money supply is not self-regulatory. Never in US history has our money supply ever been able to be managed, by any attempt, by our Central Bank or any other, to control the cost of credit. And the current recession/depression is no exception.

    Our excessive rates of inflation (especially since 1965), has been due to an irresponsibly easy monetary policy. Between 1965 and June of 1989, the operation of the trading desk has been dictated by the federal funds “bracket racket”. Even when the level of non-borrowed reserves was used as the operating objective, the federal funds brackets were widened, not eliminated. Monetarism has never been tried. Monetarism involves controlling total reserves, not using non-borrowed reserves (as Paul Volcker failed & tried with).

    Ever since 1989 this monetary policy procedure has been executed by setting a series of creeping, or cascading, interest rate pegs. This has assured the bankers that no matter what lines of credit they extend, they can always honor them, since the Fed assures the banks access to costless legal reserves, whenever the banks need to cover their expanding loans – deposits.

    Our monetary mismanagement has been the assumption that the money supply can be managed through interest rates. We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about. THE EFFECT OF TYING OPEN MARKET POLICY TO A FED FUNDS RATE IS TO SUPPLY ADDITIONAL (AND EXCESSIVE (AND COSTLESS) LEGAL RESERVES), TO THE BANKING SYSTEM WHEN LOAN DEMAND INCREASES.
    Since the member banks had no excess reserves of significance (before this crisis — since 1942), the banks had to acquire additional reserves to support the expansion of deposits, resulting from their loan expansion.

    Apparently, the Fed’s technical staff (& the advocates of MMT), either never learned, or forgot, how Roosevelt got his “2 percent war”. This was achieved by having the Fed stand ready to buy (or sell) all Treasury obligations at a price which would keep the interest rate on “T” bills below one percent, and long-term bonds around 2 -1/2 percent, and all other obligations in between. This was achieved through totalitarian means; involving the control of total bank credit and the specific rationing of that credit we had official price stability and “black market” inflation.

    The production of houses and automobiles was virtually stopped, and credit rationing severely reduced the demand for all types of goods and services not directly connected to the war effort. This plus controls on prices and wages kept the reported rate of inflation down.

    Financing nearly 40% of WWII’s deficits through the creation of new money laid the basis for the chronic inflation this country has experienced since 1945. Interest rates, especially long-term, would have averaged much higher had investors foreseen this inflation. This was reflected in the price indices as soon as price controls were removed.

    There were recently 5 interest rates (ceilings tied to the Primary Credit Rate @.50%), that the Fed could directly control in the short-run; the effect of Fed operations on all other interest rates is still INDIRECT, and varies WIDELY over time, and in MAGNITUDE.

    Contrary to John Maynard Keynes, the money supply can never be managed thru pegging governments, or thru “floors”, “ceilings”, “corridors”, “brackets”, etc. IORs signal the death of democracy.

    The FED cannot control interest rates, even in the short-end of the market, except temporarily. By attempting to slow the rise in the remuneration rate the FED will pump an excessive volume of costless legal reserves into the member banks.

  11. bill says:

    Dear NKlein1553

    The link is now fixed. It was my error. Sorry.

    best wishes

  12. NKlein1553 says:

    Thank you Professor Mitchell.

    Pebird, it looks like we are reading similar stuff. =) I find Steve’s essays are almost always wonderful.

    Per Kurowski, great to see you commenting over here. I always find your comments at the Baseline Scenario to be very informative. I hope you’ll be back to give us some of those “chapters and chapters.”

  13. Adam (ak) says:


    I will repeat the same argument which I have already used on Steve’s blog. Using the reserve requirements to control lending by denying banks access to discount window will simply lead to repeated liquidity crises and bank runs but there is no guarantee that remaining banks would behave any better. Bankers do not care what will happen in 10 years time. They plan making profits ahead for 6 months.

    Reintroduction of hard reserve constraints will simply move us back to the 19th century and there is absolutely no guarantee that such a system will work any better than the current one. There were some historic reasons (mainly related to needs to finance wars and repeated crises) why the current centralised system was put in place.

    Why do you want to fix something what is not broken? Did the post-war inflation in the US do any real harm? I would say that Keynesian policies of the 1950-1960-ties led to winning the economic and technological race with the Soviet bloc. Would the old monetary system enable the Americans to send astronauts to the Moon?

    Now let’s imagine two countries , one of them has fiat currency and modern banking system regulated in the way outlined by prof Mitchell. The other country has just reverted back to free banking and gold money (or its substitute). Which country will win the competition for limited resources? Which country can have low unemployment rate? Even if some inflation occurs in the country running the modern monetary system – it is real wealth and technical, social development what matters.

    The myth that there will be no demand gap and no involuntary unemployment when there is no state intervention needs to be exposed. It is based on a-priori reasoning. It is totally unscientific as it ignores what happened in real societies in 18 and 19 centuries. We can clearly see that these societies were not idealised structures consisting of rational agents.

    Only the system which would have prevented Irish famine in 1845 could be considered as acceptable in the 21th century.

    Regarding main article I obviously agree with prof Mitchell who knows a lot more than me about banking – this is the step in the right direction but will it go far enough?. I would only like to ask a question whether there will still be no gaps in the regulation allowing for obfuscation (for example using repos) and doing “business as usual” in the shadow banking system.

  14. cos says:

    While agreed reserves had nothing to do with loan availability, they were/are a way to limit leverage.

  15. pebird says:


    Steve is a fantastic writer and brilliant – he doesn’t post every day; when he does it is a great ride. I was thinking about Bill’s point about the impossibility of managing from the liability side (which includes equity) of the BS and wondering how capital actually functions in the banking system, and then there is this great illuminating post. Here is another excerpt:

    “Given these facts, and I think they are facts, even “hard” capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed to some post-modern quantum mechanical nightmare wherein “Schrödinger’s Banks” are simultaneously alive and dead until some politically-shaped measurement by a regulator forces a collapse of the superposition of states into hunky-doriness?”

  16. Kent H says:

    Technically, lending may not be constrained by a reserve RATIO (the money multiplier thing) if banks can indeed acquire reserves needed to fund loans after the fact. BUT, to say that reserve policy in general doesn’t have the capacity to constrain lending doesn’t make any sense. As Bill notes, “as long as the spread between the interest on the loan and the interest the Fed charges at the discount window is sufficient, the bank will lend.” But when one stops to think about it, that statement means the interest the Fed charges can have a HUGE impact on a bank’s ability to lend in the real world, where the number of willing borrowers drops as the interest rate the bank is offering rises.

    Obviously, Bill knows this. I’m just pointing out that it as a bit misleading to say that “reserves” cannot constrain lending. Clearly, if the interest rate to acquire needed reserves from the Fed ex post facto climbs high enough, absent a banks ability to acquire the needed reserves elsewhere bank lending would be constrained. Maybe it wouldn’t be constrained as effectively as if the bank had maxed out their capital requirement and could not find more capital, but it would be constrained nonetheless, no?

  17. Panayotis says:

    Two points and food for thought.

    1. There is a reverse crowding out effect. Higher risk aversion and higher risk of default constrain credit and brings higher interest rates as I demonstrated in previous comments on billyblog. Then there is a defficient aggregate demand and output shortfall that allows non revenue constrained public deficit spending to fill the gap.

    2. If money funds are not a production input (production neutral), then they do not add an input share to the competitive production of capital (Euler exhaustion of output) and their cost contribution is zero. However, in the presence of private debt financing, firms must have market power in order to charge a mark- up on production costs to capture revenue and cover a positive interest cost. This means that price changes via the mark-up channel (Minsky) are positively related and induced by interest cost. Therefore, conventional monetary theory interest rate rules(Taylor, etc.) that imply an inverse relation between short to long interest rates and inflation via money market interactions are erroneous.

  18. pebird says:

    Kent H:

    Lets not confuse reserves with the cost of reserves. While interest rates can be raised sufficiently to constrain loans, I don’t think that does much about loan quality. If anything, you constrain lending on conservative (low return) loans, while speculative loans are what is left. As Herbert Hoover wrote regarding attempts to slow down the 1929 speculation fever:

    “At one moment the Federal Reserve Board’s action forced money rates for speculative purposes up to 20 per cent per annum. But people who dreamed of 100 per cent profit in a week were not deterred by an interest rate of 20 per cent a year. Mr. Young fully demonstrated the futility of the idea upon which the Reserve System had been founded that it could control booms.”

  19. apj says:

    Bill, just in case you were having a good day……one of the screeching bat children of the Austrian school….


  20. bill says:

    Dear apj

    Thanks for being so nice and looking out for my well-being.

    The writer knows very little about any of the topics that are covered in his text. Pretty much babble.

    best wishes

  21. flow5 says:

    ADAM — “Using the reserve requirements to control lending by denying banks access to discount window will simply lead to repeated liquidity crises and bank runs but there is no guarantee that remaining banks would behave any better”.

    Politicians & bank regulation have created the bank’s & non-bank’s liquidity & solvency problems. The member banks should be put on notice that if they need funds for expansion of loans & investments they will individually have to liquidate some of their liquid assets, Tres. bills, etc. And the discount window will only be open for emergency borrowing. Then the manager of the Open Market Account should be instructed to regulate his operation in terms of the proper volume of legal reserves which the member banks should hold (except for temporary instances in which support operations for the Treasury are necessary — and this excessive expansion of legal reserves can be removed after the support period has passed).

    Paul Volcker increased the volume of total legal reserves at the onset of the mis-named Depository Institutions Deregulation & Monetary Control Act (until year-end 1980) at a 17% annual rate of change. Obviously he wasn’t trying to control the money supply & his incompetence was self-evident as demonstrated by the 19.2% annual rate of increase in nominal gnp during the 1st qtr of 1981. Paul Volcker’s experiment was with controlling non-borrowed reserves which has nothing to do with monetarism.

    Of course the FED’s technical staff along with their banking collaborators (or is it the other way around), have all but eliminated legal reserves. Economists now overwhelmingly agree that the member banks are unencumbered and unimpaired in their lending operations (with the exception of bank capital adeqacy requirements).

    Legal reserves are a credit control device. IOR’s are just a way the politicians & the bank’s lobbyists pay the bankers thru the back door. The banker’s are now getting paid twice.

  22. flow5 says:

    How IOR’s will destroy democracy: MONETARISM HAS NEVER BEEN TRIED: To counter what Greenspan described as “irrational exuberance” (at the height of the Doc.com stock market bubble), Greenspan initiated a “tight” monetary policy (for 31 out of 34 months). A “tight” money policy is one where the rate-of-change in monetary flows (our means-of-payment money times its rate of turnover) is no greater than 2-3% above the rate-of-change in the real output of goods & services.

    Greenspan then wildly reversed his “tight” money policy (at that point Greenspan was well behind the employment curve), and reverted to a very “easy” monetary policy — for 41 consecutive months (despite 17 raises in the FFR-every single rate increase was “behind the curve”). Absolutely no monetary policy tightening occurred during this period of rising rates.

    Then, as soon as Bernanke was appointed to the Chairman of the Federal Reserve, he initiated a “tight” money policy, for 29 consecutive months (out of a possible 29, or at first, sufficient to wring inflation out of the economy, but persisting until the economy collapsed). And for the last 19 successive months (since Aug 2008), the FED has been on a monetary binge (ending at April’s month-end).

    Did you catch it??? Nobody got it. Greenspan didn’t start “easing” on January 3, 2000, when the FFR was first lowered by 1/2, to 6%. Greenspan didn’t change from a “tight” monetary policy, to an “easier” monetary policy, until after 11 reductions in the FFR, ending just before the reduction on November 6, 2002 @ 1 & 1/4%.

    I.e., Greenspan was responsible for both high employment (June 2003, @ 6.3%), and high inflation. The evidence of Greenspan’s inflation (rampant real-estate speculation, followed by widespread commodity speculation – peaking in July 2008), cannot be conclusively deduced from the monthly changes in the price indices. And because of monetary lags, Greenspan’s legacy extends into 2010, with the creation of even higher unemployment (10.0%).

    Part of the problem is the FED’s dual mandate; as the last reduction in the FFR occurred in the same month as the peak rate in unemployment (June 25, 2003). The FED can only hope to achieve stable rates of inflation. It’s their employment mandate that is unachievable.

    What? How many T-Bills does the “trading desk” have to buy before it is able to reduce the unemployment rate by 1%? Of course, this is utter naiveté.


    Unfortunately the Federal Reserve doesn’t gauge the volume and timing of its open market operations in terms of the amount and desired rate of increase of member commercial banks COSTLESS legal reserves, but rather in terms of the levels of the federal funds rates (the interest rates banks charge other banks on excess balances with the Federal Reserve).

    By using the wrong criteria (interest rates, rather than member bank reserves) in formulating and executing monetary policy, the Federal Reserve became the bubble’s engine.

  23. Kent H says:


    I wasn’t confusing reserves with the cost of reserves. I’m simply pointing out that the cost of them can and does have an impact on their procurement, and that, as you acknowledge, raising rates sufficiently can constrain lending. Full stop. The title of the blog post is “Lending is capital- not reserve-constrained”. The crux of Bill’s argument for why this is so is because banks can acquire the requited reserves (from a variety of sources) after the fact. But he acknowledges that the bank will only loan if the cost to acquire the reserves is less than the profit on the loan. That’s a big caveat. One could even go so far as to say that the whole counter-argument that reserves CAN be used to constrain lending rests on that premise.

    As I said earlier, I’m not trying to suggest that reserves requirements constrain lending in as direct or effective a manner as strict capital requirements. It seems like both can be useful to constrain lending in different ways. If a bank wished to lend more but lacked the ability to raise the required capital, that would obviously be a harder brake on their ability to lend. But, as you are certainly aware, when they are up against the capital requirement wall they have other options as well. They can securitize loans to move them off the books, or, as was the case in the lead-up to the crash, they would purchase default swaps on loans and then go to their regulators and say, “look, we’ve hedged these so sufficiently via swaps that we feel we should be able to move them off our books.” Ands the regulators said “okey dokey.”

    Also, as seems obvious to me, one option the Fed has that Bill doesn’t discuss is the theoretical ability to simply close the discount window altogether. If that were to happen AND the system as a whole was short reserves such that banks couldn’t acquire them by borrowing overnight from each other, then that seems like it would put a break on lending pretty damn hard too.

    One thing I agree with is that raising the interest rate COULD actually weed out the sounder and safer loans and pretty much force the banks to chase higher risk.

  24. Lucky Punch says:

    Per Kurowski says:
    Tuesday, April 6, 2010 at 3:10
    Look what they done to my bank Ma! ….. They placed 8 percent capital requirements on all lending to small businesses and entrepreneurs and only 1.6 percent on what is rated AAA and even zero percent when lending to an AAA rated sovereigns… when my banks have really no business lending to AAA rated borrowers or sovereigns…. Ils ont changé mon bank Ma
    Thanks Per for keeping the discussion real for the non boffins who, like me, enjoy learning about MMT.
    At the end of the day its the borrower with an idea that will result in the expansion of employment (not speculation) that needs supporting. Not some investor (via bank) who is looking to lend money to a AAAA (yes 3 A’s was a bit risky as it turns out) that really doesn’t need to borrow anyway. It wouldn’t bother me if MMT put the needs of the creators of jobs at the top and figure out a way for the system to support them. All a bank is is a supermarket for money and you pay with a promise to return the item with interest. Ban lending for speculation and the speculators will go back to creating real output in real business creating real jobs.
    Cathryn Mataga says:
    Tuesday, April 6, 2010 at 4:02
    So I’m not sure what role capital requirements would have? Wouldn’t we have a pretend limit based on a pretend bank capital?
    Anyone answer this for Cathryn?

  25. Kent H says:

    BTW, my whole take on the ability of the Fed to constrain lending when they choose is that one way or another they pretty much have ultimate control over that. They can increase interest rates, increase the reserve ratio, increase capital requirements, etc. But if you stop and think about it for a minute, raising interest rates is the single best way to do constrict credit WHILE MAXIMIZING BANK PROFITS.

    Where Bill is correct too is in noting that when the Fed wants the banks to INCREASE lending they have much less control. Which presents a problem in a deflationary environment. Because at the end of the day, all economic technicalities aside, they can’t force people to borrow money. The current desire of the public to net save has been covered here well, but it still makes me irritated as hell when Tea Party types object to the stimulus package. If you’re the Fed and interest rates are at zero and you still want/need to increase the money supply and the banks can’t or won’t lend enough, what is left to do? Stand on the corner and hand out cash? Tea Partiers/conservatives have no answer. ALL the private banks can do is lend money into the economy. But the government is the ONLY entity that can both lend AND SPEND money into the economy. That right there is enough to justify the stimulus package. Conservatives love to gripe about what it got spent on, but the pure truth is that that matters less than the fact that the money got out there in the first place.

  26. mdm says:

    Kent H said:

    one option the Fed has that Bill doesn’t discuss is the theoretical ability to simply close the discount window altogether. If that were to happen AND the system as a whole was short reserves such that banks couldn’t acquire them by borrowing overnight from each other, then that seems like it would put a break on lending pretty damn hard too.

    I\’m unsure of whether or not Bill has mentioned this point, but MMTers certainly have. The thrust of the argument is that, if the central bank closes its discount window then there is no longer a ceiling in which overnight rates are contained. Fluctuations in exchange settlments (reserves) due to transactions to and from the treasury and payments between bank customers will see a highly volatile over night rate. Furthermore, there is the potential that the overnight rate will be bid up above the inoperative discount rate, as banks take on precautionary measures.

    If the system in the aggregate does not have sufficient exchange settlements to return all exchange settlement accounts to balance, then the entire system cannot clear and I do not know what would happen at this point. Perhaps someone else may clarify.

    If the central bank does not accommodate the demand for exchange settlements and closes its discount window, then we can expect a fluctuating overnight rate. If the system at the aggregate has a shortage, then we can expect the overnight rate to be continually bid up. The ramifications for the rest of the economy would be disastrous.

    If I have made any mistakes please point them out and correct them for me. Thank you.

  27. Adam (ak) says:


    Thank you for your response. I believe that you have actually provided very strong arguments against using monetary policy to control economy in general – exactly the point MMT scholars are trying to make. Limiting the volume of lending (credit creation) during the dot-com bubble would have resulted in strangling the productive economy as speculators expecting 100% gains p.a. would have easily outbidded companies trying to borrow money for manufacturing real goods (return a few % p.a.) for access to limited funds.

    Whether hard reserve requirements instead of fiddling with interest rates on bank reserves would have made any difference – I doubt. The information channel from banks to individual borrowers most often contains pricing signal rather than “credit denial” information. The purpose of capital requirements is to stabilise the banking system itself and prevent risky behaviour resulting in systemic collapses.

  28. Tom Hickey says:

    The essence of a progressive agenda is reform, and where reforming an existing system is either impossible or impractical, replacement. This is what progressives should be pushing:

    If we were to include the massive losses and public bailouts that were required to prevent the entire world financial system from collapsing then the risk-weighted returns would be negative by a long way. A public banking system can deliver financial stability and durable returns (social) with much less risk overall.

    It is grossly unfair for the Fed to target inflation using unemployment as a tool and to act as lender of last resort, when government does not act as employer of last resort and uses bank regulation and government intervention in markets to protect equity holders and bond holders from their own imprudence, not to mention a double standard in the application of the law. Moreover, the downside is not merely quantitative but also qualitative. This isn’t just about numbers, it’s about lives.

    Just as the preferred means of reforming healthcare is eliminating the inefficiency of the middleman through single-payer, e.g., Medicare-for-all, so too, reforming the financial system would be best accomplished by public banking and outlawing all financial activity that detracts from public purpose.

    The debate needs to be reframed. The burden should be on the private sector to show why and how it can provide for public utilities, such as health care and money creation, in a way that is more efficient and effective than public provision.

    The question is whether the country is going to have a government of the people, by the people, and for the people, or be ruled by plutocratic oligarchy in which an aristocracy of wealth and power is privileged.

  29. pebird says:

    Kent H:

    The problem with interest rates is that it is a crude tool and the effects are complex – savers and investors are impacted differently, for example. And you don’t want to be bouncing the rates up and down – there should be some stability in the cost of money. It is very hard to predict what will occur. What we want to do is raise costs for risky endeavors in an “appropriate” manner. Obviously we want people to take risks, but we don’t need them to shut down the system and destroy the assets of innocent bystanders. We also don’t want to punish low risk, but productive investments. Yes, in theory (monetarist theory) it sounds like interest rates would work but it has demonstrated to not be the case.

    I don’t know that Bill actually said that the Fed wanted banks to increase lending via increased reserves as much as he said that was the assumption that many commentators had to the Fed’s actions. Reserves were expanded for ease of settlement and interest rate management, but perhaps the press and some in Congress thought more reserves would equate to increased lending. Joke on them.

    So its funny where interest rate increases and reserve reduction can restrain lending, but interest rate reduction and reserve expansion does not create lending. Again, Hoover pointed much of this out in the 1930′s experience (his memoirs are actually a decent read, even if I don’t agree with all his political conclusions) – so we need to move beyond this to a more sophisticated way of regulation along with a restructuring and break up of the financial system. Lets go back to calling them “trusts” – it’s so appropriate.

  30. flow5 says:

    MMT mis-allocates both credit & wealth (malinvestment). You can float this year’s debt by raising reserve ratios or raising the remuneration rate. Both have price tags.

    It’s not about making US banks more competitive world-wide. Paying the bankers is uneconomical & unconstitutional.

    If you want to increase employment (which the FED’s can’t), then get the commercial banks out of the savings business.

    It began with the General Theory. John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

    In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make the statement correct. This is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, Regulation Q ceilings, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, Financial Services Regulatory Relief Act of 2006, Emergency Economic Stabilization Act of 2008, sec. 128. Acceleration of the effective date for payment of interest on reserves, etc. (now MMT)

    The CBs have forced a contraction in the size of the thrifts, and created liquidity problems in the process, thru backstopping by the Reserve banks, & by outbidding the non-banks for the public’s savings. This process is called “disintermediation” (an economist’s word for going broke). The reverse of this operation cannot exist. Transferring saved bank deposits through the shadow banking system cannot reduce the size of the commercial banking system. Deposits are simply transferred from the saver to the financial intermediaries, to the borrower, etc.

    The drive by the commercial bankers to expand their savings accounts has a totally irrational motivation, since it has meant, from a system standpoint, competing for the opportunity to pay higher & higher interest rates on deposits that already exist in the commercial banking system.

    The shift from demand to time deposits has converted spendable balances into stagnant money. This transfer added nothing to the Gross National Product, and nothing will be added so long as the funds are held in the form of time deposits. Shifts from transaction deposits, to time deposits, simply increases the aggregate costs to the banking system and adds nothing to the system’s income.

    But it does profit a particular bank, Citigroup for example, to pioneer the introduction of a new financial instrument such as the negotiable CD until their competitors catch up; and then all are losers. The question is not whether net earnings on CD assets are greater than the cost of the CDs to the bank; the question is the effect on the total profitability of the banking system. This is not a zero sum game. One bank’s gain is less than the losses sustained by other banks.

    How does the FED follow a “tight” money policy and still advance economic growth? What should be done? The money creating depository banks should gradually be put out of the savings business (REG Q in reverse-but leave the non-banks unrestricted). What would this do? The commercial banks would be more profitable – if that is desirable. Why? Because, the source of all time/savings deposits within the commercial banking system, are other commercial bank customer’s deposits, directly or indirectly through currency, or the bank’s undivided profits accounts.

    Money flowing “to” the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of the intermediaries/non-banks cannot be at the expense of the commercial. banks. And why should the commercial banks pay for something they already have? I.e., interest on time/savings deposits.

    (1) The Commercial & Financial Chronicle Thursday, April 6, 1967 “MONETARY POLICY BLUNDER CAUSED HOUSING CRISIS”
    (2) The commercial & Financial Chronicle, Thursday, June 6, 1968 “REPEAT OF 1966-TYPE CREDIT CRUNCH UNLIKELY DESPITE TIGHT MONEY”
    See: Dr. Leland James Pritchard, PhD, Economics, Chicago, 1933, MS, Statistics, Syracuse

  31. rvm says:

    Tom Hickey: “….The question is whether the country is going to have a government of the people, by the people, and for the people, or be ruled by plutocratic oligarchy in which an aristocracy of wealth and power is privileged.”

    If the people know what MMT could do for them why do you think they won’t elect MMT government?
    Next most important thing would be if there are such people who, once elected, will properly apply the art to govern under MMT guidance nurturing public purpose all the time.

  32. Tom Hickey says:

    rvm: If the people know what MMT could do for them why do you think they won’t elect MMT government?

    I expect that it the people did know, they would elect such a government instead of allowing the massive rip-off that’s now taking place to continue. On this blog, this step from knowledge in books to legislation on the books is known as “the last mile.” The requisite operational knowledge has already been developed by the many economists that have contributed to MMT. Now activists need to get the word out so the public can make an informed choice at the ballot box.

    Next most important thing would be if there are such people who, once elected, will properly apply the art to govern under MMT guidance nurturing public purpose all the time.

    People have the ability to change their elected representatives periodically. If their representatives do not represent their interests, they can remove them through the ballot box. This is not true of those who run the private sector, many of whom are in fact only responsible to boards they control and not to stockholders that have no effective way of removing them.

    The other major problem in the way of reforming the system and insuring that it operates for public purpose is corruption. Corruption is endemic in the US political system owing to campaign finance, lobbying, and the revolving door, which constitute legalized bribery and conduce to plutocratic oligarchy masquerading as representative democracy. This corruption needs to be eradicated as a necessary condition for reform.

    Finally, as you say, application is an art. An economy doesn’t just run on automatic (in spite of what the invisible handers may think to the contrary). But at least we’ll be dealing with operational reality instead of ideological rigidity and theoretical fantasy in the political process of decision-making in matters relating to public purpose.

    MMT is also operational description rather than policy prescription. It can be applied in a variety of ways based on different value-systems. There remains plenty of room for debate across the political spectrum regarding how to balance public and private.

  33. Kent H says:


    The very first thing that needs to be quantified when talking about banks’ ability to make loans is whether or not there are willing borrowers – whether the banks deem them creditworthy or not. Whatever else happens, the process has to start there. To me, it’s completely disingenuous to point to the current situation and say “see, increasing reserves doesn’t increase lending” when it seems obvious that most people/businesses are hunkering down and trying to pay off existing debt. Increasing reserves obviously cannot FORCIBLY increase credit expansion, but nothing can do that. But increasing reserves could definitely facilitate increased lending given sufficient demand for loans.

    The big “secret”/elephant in the room here is that they changed the accounting rules. It’s quite possible that the banks are no more solvent than they were before the crisis. Indeed, many smaller ones keep going under. Given the change in the accounting rules, it follows that interbank lending would be more difficult, for at least two reasons I can think of. One is that banks sitting on a mountain of bad debt they may eventually have to mark to market may not be very eager to lend to other banks. Second, it follows logically that if bank A was without excess reserves but wanted to aggressively lend they would be in a position of having to acquire new reserves on a continuing basis. If we assume that other banks are in a hiding-a-bunch-of-bad-debt situation, that means that acquiring those reserves outside of the Fed discount window might be difficult and/or costly.

    Hence, in such a situation increasing reserves in the banking system as a whole could theoretically facilitate more lending.

    Of course, this is all academic since no one is allowed to properly audit the Fed and see the whole picture. And if those clowns have their way we never will. Imagine being able to check out the Fed’s commercial paper accounts since they started buying it directly? Talk about picking winners and losers….

  34. zanon says:

    Tom Hickey:

    Problem is not electorate or policy makers. They believe what newspapers tell them, and newspapers tell them what academics tell them.

    MMT does not have “last mile” problem of getting to politicians. MMT has “first mile” problem of getting into macroeconomic textbooks. All the MMT “economists” out there are non-entities in their academic discipline. Universities, far from being creators of truth, seem to be… something else.

    It makes me question everything that comes out of academic — especially as I have deep personal experience there so i know what a sausage factory of garbage it is. But I know you still believe in the church of the academy.

  35. Kent H says:

    There are other factors to consider when evaluating the excess reserve situation too. Maybe Bill could chime in here….

    One issue is that if the Fed started paying interest on reserves, how does that distort the picture? That effectively turned a bank liability into an interest-bearing asset, no? That alone may be the reason the banks are building up reserves and not lending.

    Secondly, while the bank regulation battle is being fought, don’t banks have every incentive to sit on their reserves and restrict credit to play hardball? Might THAT also be an explanation why the Fed started paying interest on reserves – so the banks could sit on them and actually make a little money instead of hemorraging it while the battle is fought?

    Another reason could be that the retained interest earnings from excess reserves can add directly to the banks’ capital base, which many desperately need to shore up in the event of a return to a mark to market world.

    Any one or all of these factors need to be considered in evaluating whether or not the current situation proves excess reserves don’t increase lending. You can’t create unusual/atypical incentives for banks to sit on reserves and then say it proves increasing them wouldn’t increase lending under more normal circumstances.

    As an FYI I’m just playing devil’s advocate here, but might the “mainstream” folks who think stockpiling reserves can cause an expansion of credit simply be operating under the assumptions of a more normally-functioning economy?

  36. Tom Hickey says:

    But I know you still believe in the church of the academy.

    Zanon, wrong again. I left academia long ago because of its ideological rigidity. The mainstream seeks to maintain the status quo in order to protect its investment by marginalizing what it deems to be challenges from the “fringe.” I wouldn’t be here if it were mainstream.

    I don’t think that the last mile is getting into the mainstream textbooks. I suspect that will come last. Those folks are going to die hard. As far as the mainstream medial goes, they will follow public opinion. This is going to go viral in the alternative media like the blogs first.

  37. Stupid says:

    Bill I think you are being too hard on Baker. At a high enough interest rate, loans that would have otherwise been profitable, cease to be, so less are made.

  38. rvm says:

    Tom Hickey,

    I agree with everything you said, and I feel really happy when spreading the word about MMT.
    I see that private sector is not of very good use in health care or banking system. I want to believe that there will be niche for the private capital, maybe in the real economy, where its greed, ego, entrepreneurial spirits, competitiveness will be put to serve public purpose as well. The case for MMT would be much stronger.

  39. pebird says:

    Kent H:

    I agree that you have to have “willing” borrowers. But I submit that the public’s demand for money is infinite, it is not the willingness of the borrower but the willingness of the lender to take the risk. In the final analysis the bank makes the decision to loan or sets the terms such that the borrower is unable/unwilling to agree.

    Reserves were expanded to provide liquidity and provide interest rate target maintenance. Despite what commentators said, I believe the Fed understood there would be no increase in lending activity – so that there was no risk in the reserves being transformed into quadrillions of bank money.

    In a growth/normal environment loan deposits will create their own reserves either directly or via interbank lending. The constraint is not reserves but finding profitable loan opportunities and risk management. In such a situation, easy liquidity (excess reserves) would influence risk and probably generate very speculative loan activity – depending on what other regulations were in place. It may or may not be “increased” lending – the composition might change – its hard to predict. But it is not that the reserves are being lent out – despite the appearance.

    The question you have to ask if reserves increase lending is why banks have not been very responsive to restructure household debt. This doesn’t increase overall loan balance, but does reduce systemic risk – by using these “lower cost” excess reserves. This has not occurred to any significant degree – clearly the increased reserves failed to facilitate debt restructuring. It is almost as if the banks would prefer to foreclose and take the hit on their balance sheet – which you could argue that the increased reserves facilitate that activity more so than any increased lending.

    I agree that by most sensible assessments many if not most large banks are insolvent. The smaller banks are failing due to their inability to reposition/dump on the public their portfolio as effectively as the TBTF players. To Big To Fail also means Too Small Will Fail in the current environment of financial consolidation.

  40. zanon says:

    Tom Hickey:

    By \”ideologial rigidity\” you must mean insufficiently left wing for your tastes.

    I was talking about Truth, which is distinct from all ideology.

    So, in your world, first the powerful blogs convince the people, who then convince the politicians. The newspapers then run articles from respected academic economists (such as form the Harvard, who you believe can say no lies) saying while politicians are no-good sellout dufuses, but you have senator Dodd telling Nobel Prize winner Paul Krugman that he does not understand economics.

    Then, all those prize winning economists slap their heads and say \”oh thank you smart deneator, you are so correct. My field is a crock of nonsense that has been peddling rubbish. Students — rip up yor textbook for it is rubbish!\” and the might blogger has mobilized public opinion to correct mandarins in academy and overturn 80 years of nobel winning \”research\”.

    Pigs will fly that day too no dout.

    If Climategate cannot shut down climate \”science\”, then some bloggers will not be able to shut down Macroeconomics. There is not even nobel price for climate \”science\” just yet, although peace prize is coming pretty close.

  41. Tom Hickey says:

    I was talking about Truth, which is distinct from all ideology.

    “No one has the ocean in their bucket.”

    It is now pretty well established scientifically that human consciousness is not the perfect mirror of reality that correspondence theories of truth presume. As Ludwig Wittgenstein put it in his later writings, All seeing is seeing as. What he meant was that as soon as one conceptualizes a fact as a proposition, one has interpreted it in language, and language is meaning-laden. Meaning is cognitively complex and introduces at least a particular perspective from which “seeing” takes place. When people communicate about “facts” through propositions, they are not doing so phenomenologically, e.g. as in a scientific protocol. Cognitive science has shown, for example, that even the most “rational” of concepts also carries an emotional charge. The notion of “pure reason” is an 18th century fiction that can no longer be sustained in light of brain research ( See Antonio Demasio, Descartes’ Error:Emotion, Reason and the Human Brain).

    A cursory look at epistemologyshows that the question of truth has been problematic since ancient times —Plato investigates it in depth, e.g., in Theaetetus. It remains unresolved in the sense that there is no agreement on a particular epistemological viewpoint. The closest that we have come to an agreed upon theory is that of science, which is tentative since every general proposition is at risk through a single counter-instance.

    In Plato’s terminology, what passes for truth (ἀλήθεια) is belief or opinion (δόξα). Opinion is shaped by culture through memes that establish the conventions that underlie institutions. One of the most powerful conventions is language, and its accustomed use lies at the foundation of one of the most powerful institutions of a culture, the prevailing universe of discourse, because language propagates the conceptual memes that underlie cultural conventions. (See Douglass C. North’s brief paper, Economics and Cognitive Science for a summary.)

    Presently, there are a variety of factors influencing the prevailing universe of discourse and while academia is one these factors, it is neither exclusive nor predominant. For example, a great deal of political and economic discourse is shaped by “think tanks” that are actually propaganda arms for special interests. These think tanks are powerful forces influencing the mainstream media, which is perhaps the most powerful force influencing public opinion.

    It is very difficult to determine in advance how change will come about. However, one thing is very highly probable based on occurrence. Change happens. Often it happens slowly, like bread rising through the action of yeast. Sometimes it happens quickly due to suddenly changing circumstances. But change happens, and it is happening here and now. When anyone puts something up on a blog, it instantly enters cyberspace, and anything is possible given the reach of this medium. Blogs do influence conceptual memes, and the media does pick up on things that appear first in blogs. So I would not underestimate this medium at all.

    Different forces vie for control by influencing the predominant institutions through shaping conventions based on memes and memeplexes. This is going on all the time as various factions jostle for power and influence.

    David Sloan Wilson, the eminent evolutionary biologist, is in the process of writing a series of short posts at his blog Evolution For Everyone. The series is called Economics and Evolution as Different Paradigms. It speaks to the transformation that is going on in economics relative to politics and governance from the perspective of evolution as society adapts to the changing environment.

    Evolution is always an experiment. There are no guarantees of success for any species or any group within a species. But the principles that determine the course of evolution are getting clearer. Political economy doesn’t exist in a vacuum. It is an integral part of human adaptation to environmental change. History will tell who the victors turned out to be. Surprises may be in store.

  42. Adam (ak) says:


    I agree that the horizontal axis dynamics – credit money created by banks in the non-public sector (using MMT parlance) is what drives the system and makes it unstable. MMT scholars concentrate on the flows along the vertical axis.

    How can you get commercial banks out of the deposit business? It would be more feasible to consider introducing Islamic banking rules (I am serious here) where credit money is not explicitly created (it is still created implicitly) and there is no usury – banks make profit by charging rent fees on shared equity.

    Or better make shares expiring in 25 years time (the Steve Keen’s proposal ) and limit leverage (the size of mortgages). Then add some proposals of Georgists (land tax). If there is still a demand gap and system is marginally unstable – then the governments should step in and provide employment directly.

    If this is hard to achieve – maybe what MMT scholars propose is more feasible. Just print a bit…

    The current banking and corporate system is a product of a very long evolution where the fittest entities (the greediest) replaced anybody and anything else, often poisoning democratic process. Consider releasing rabbits on an island – they will all the grass and whatever else until bare rocks are left – and then the population of rabbits will crash, too. The same applies to humans and human institutions.

    I don’t agree that private savings are any better than public spending. If private investment is directed towards speculation – he have the great housing tulip mania of Australia. In the US these tulips fell out of fashion recently. This inherent instability cannot be fixed by fiddling with the banking sector alone. The whole society behaves like greedy rabbits multiplying and eating away all the resources. Because we are mammals too… We are not rational agents.

    We have here in Australia a public health care system which people in the US can only dream about despite all the recent effort to fix the system. I agree that public sector is often inefficient and the solutions advocated by MMT scholars sometimes go too far or are not ideal but we can only try to stabilise the system a bit – it will never be fixed.

    Regarding monetarism and some Austrian elements – I lived in a country where these ideas were actually tested. The country is called Poland and the experiment led to 20% unemployment and over 5% of the population leaving the country. True, what was left is the healthiest economy in the region which is quite resistant to any crises and records quite high GDP growth. BUT AT A WHAT HUMAN COST?

    “This winter has already taken 351 lives—mainly homeless people who have frozen to death or home dwellers who were poisoned by carbon monoxide leaking from faulty heaters.”

    I don’t want to see the same in the US or Australia.

  43. zanon says:

    You should have stayed in academy Tom Hickey. My tolerance for omphalitic drivel is zero

  44. pebird says:

    Now, now … posting a blog comment is slightly more than zero.

    FWIW, and it could just be complete coincidence but there seems to be more interest in MMT slowly permeating more mainstream blogs – due to the work (daily, informative, entertaining posts) of Bill and also Mosler and Auerback and others slowly hitting the brick wall with their heads and not giving up. Repetition and discipline is a powerful force available to the individual.

  45. BH says:

    So my question on deposits will have a response and for anyone else interested in reconciling why banks seek deposits with theory of chartalism/mmt, there is an discussion on deposits embedded within a wider discussion here:


  46. MDM says:

    Thank you for the link. Since I have been introduced to the endogenous money framework (originally via Steve Keen\’s blog) I have often wondered why banks would seek deposits and why they would create time deposits. I asked the question here a few months back but that blog post was \’dead\’, so it went unanswered. After a cursory reading of that post, I may have the answer.

  47. flow5 says:

    Adam (ak)

    I’m not slinging. All economists think “It would be more feasible to consider introducing Islamic banking rules” I won’t accept their stupidity, be it some product of ignornance, arrogance…whatever.

    I’m relentlessly told “Read the mandatory readings if you’d like to get a clue”. Can’t do it. They’re not even entertaining. If they’re not literate, their syllogisms are suspect.

    There is also a “Holy Grail”, a “Gospel”. I’ve discovered it in July 1979. Nobody knows it & anyone would be a fool to disclose it. Think what others wish or what is right. Being “alone” is rather gratifying.

    Read this clue:

    (1) The Commercial & Financial Chronicle Thursday, April 6, 1967 “MONETARY POLICY BLUNDER CAUSED HOUSING CRISIS”
    (2) The commercial & Financial Chronicle, Thursday, June 6, 1968 “REPEAT OF 1966-TYPE CREDIT CRUNCH UNLIKELY DESPITE TIGHT MONEY”
    See: Dr. Leland James Pritchard, PhD, Economics, Chicago, 1933, MS, Statistics, Syracuse

  48. Burk says:

    Forgive me for asking a dumb question, but I went back to this blog to figure out the mechanics of banking (As well as the Money Multiplier Myths blog). You say.. “The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact.” What I understand of the banking system is that loans need to be “funded” by the bank, and this involves either using deposits, reserves, or short-term loans from the overnight paper system. There has to be an external source.

    I guess the question is.. where does leverage originate in the banking system, given that banks have to go to external sources to “fund” each loan made? Where does their power to create “low power” money actually mechanically come from? And how would that be different from the classical fractional banking story? If a bank has a portfolio of $100 in loans, does it also have a matching portfolio of debts into the interbank market, minus its own deposits? Where does all this lending stop and someone actually creates the extra money?

    Connected with this is a quote from the Myths blog mentioned above “When a bank makes a $A-denominated loan it simultaneously creates an equal $A-denominated deposit. So it buys an asset (the borrower’s IOU) and creates a deposit (bank liability). For the borrower, the IOU is a liability and the deposit is an asset (money). The bank does this in the expectation that the borrower will demand HPM (withdraw the deposit) and spend it.”

    Again, where does the funding for all this High powered money come from? Doesn’t the bank have to procure the money being issued through the deposited loans externally? Is this some mystery of the reserve system?

    Thanks so much!

  49. Neil Wilson says:

    ” There has to be an external source.”

    No there doesn’t.

    Consider the situation where a person borrows money from a bank and the person they are paying has an account at the same bank, where they have a savings account.

    No external funding required at all.

    Loan creates deposit, payment transaction, deposit ends up as bank savings.

    The bigger the banks, the more this happens.

    Reserves are only required to handle *net* transfers between banks via the central bank, and the central bank offers unsecured lending intra-day to deal with shortages. That makes sure the payment system clears.

  50. flow5 says:

    Adam (ak) says: “Limiting the volume of lending (credit creation) during the dot-com bubble would have resulted in strangling the productive economy as speculators expecting 100% gains”

    But that’s exactly what Greenspan did:

    To counter what Greenspan described as “irrational exuberance (at the height of the Doc.com stock market bubble), Greenspan initiated a “tight” monetary policy (for 31 out of 34 months). A “tight” money policy is defined as one where the rate-of-change in monetary flows (our means-of-payment money times its transactions rate of turnover) is no greater than 2-3% above the rate-of-change in the real output of goods & services.

    Greenspan then wildly reversed his “tight” money policy (at that point Greenspan was well behind the employment curve), and reverted to a very “easy” monetary policy — for 41 consecutive months (i.e., despite 17 raises in the FFR, -every single rate increase was “behind the curve”). I.e., Greenspan NEVER tightened monetary policy.

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