I have been travelling for most of today so I have to keep this post…
I have noticed some discussions abroad that criticise Modern Monetary Theory (MMT) on the basis that none of the main proponents have ever actually worked on the operations desk of a central bank. This sort of criticism is in the realm of “you cannot know anything unless you do it” which if true would mean almost all of the knowledge base shared by humanity would be deemed meaningless jabber. It is clearly possible to form a very accurate view of the way the monetary system operates (including the way central banks and the commercial banks) interact without ever having worked in either. However, today, I review a publication from the Bank of International Settlements which dovetails perfectly with the understandings that MMT has provided. It provides a case for why we should abandon mainstream monetary textbooks from the perspective of those who work inside the central banking system.
I would not want it thought that I think that practical experience isn’t valuable. Clearly a mix of research and analysis and practical experience is useful in developing an understanding of how things operate in the real world. MMT has, in fact, evolved via the interaction of academic and financial market players and is quite unlike most academic theoretical development in economics.
Sometimes we have to look beyond the superficial relations that confront us in a practical manner though. For example, while the arrangements of government that the legislature has put into place may require from an accounting sense that funds taken from the private sector go into a specific central bank or treasury account prior to funds from the government sector being withdrawn from that account and spent into the non-government sector this doesn’t mean that governments require in any operational sense the private funds before it can spend.
Intrinsically, a sovereign government issues the currency so it is never revenue constrained. MMT brings that sort of duality into relief. While the mainstream leave the impression that the private sector funds the government and then spins a number of related stories about that which make it difficult for people to accept that government spending is useful, it would be a different narrative if we all knew that the institutional arrangements surrounding debt-issuance (for example) were just voluntarily-imposed structures that were ideologically based on the presumption that government deficits were inherently bad.
So if we knew that the analysis that declares government deficits bad was actually based on an assumption that it was bad rather than any intrinsic financial constraint then the debate would be different.
MMT aims, in part, to expose these faux starting points so we can differentiate between a financial constraint and a political/ideological constraint more clearly.
But it is also useful when a central banking institution publishes material that is consistent with the core tenets of MMT. It is hard to then label the views as emanating from a small clique.
In February 2010, the Bank of International Settlements published Working Paper No 297 – The bank lending channel revisited (thanks Luigi).
The paper challenged the “central proposition” of mainstream “research”:
… that monetary policy imparts a direct impact on deposits and that deposits, insofar as they constitute the supply of loanable funds, act as the driving force of bank lending. These ideas are manifested most clearly in conceptualizations of the bank lending channel of monetary transmission, as first expounded by Bernanke and Blinder (1988). Under this view, tight monetary policy is assumed to drain deposits from the system and will reduce lending if banks face frictions in issuing uninsured liabilities to replace the shortfall in deposits. Essentially, much of the driving force behind bank lending is attributed to policy-induced quantitative changes on the liability structure of bank balance sheets.
If you read almost any university-level macroeconomics or monetary economics textbook you will find narrative along these lines. The story is that the central bank controls the money supply via open market operations (buying and selling bonds) and that bank lending is reserve (deposit) constrained.
This narrative employs “either on the concept of the money multiplier or a portfolio-rebalancing view of households’ assets”.
The BIS paper notes that the mainstream believe that “changes in the stance of monetary policy are implemented through changes in reserves which, in turn, mechanically determine the amount of deposits through the reserve requirement”.
Alternatively, the mainstream “portfolio-rebalancing” approach posits that “monetary policy actions alters the relative yields of deposits (money) and other assets, thus influencing the amount of deposit households wish to hold”.
Whichever approach is adopted, the narrative says that monetary policy tightening reduces the deposits in the system, which means that banks have to rely on more expensive wholesale funding, and as a result the supply of credit declines.
In other words, “changes in deposits are seen to drive bank loans”.
MMT has provided a comprehensive challenge to that view of banking based upon a thorough analysis of how banks actually operate and practical experience of banking which reinforces the conceptual development.
Please read (among other blogs) – The role of bank deposits in Modern Monetary Theory and Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.
Banks do not need reserves to lend? The mainstream view is that reserves are deposits that haven’t been lend yet. Banks do not lend reserves!
The commercial banks are required to keep reserve accounts at the central bank. These reserves are liabilities of the central bank and function to ensure the payments (or settlements) system functions smoothly. That system relates to the millions of transactions that occur daily between banks as cheques are tendered by citizens and firms and more. Without a coherent system of reserves, banks could easily find themselves unable to fund another bank’s demands relating to cheques drawn on customer accounts for example.
Depending on the insitutional arrangements (which relate to timing), all central banks stand by to provide any reserves that are required by the system to ensure that all the payments settle. The central bank charges a rate on their lending in this case which may penalise banks that continually draw on the so-called “discount window”.
Banks thus maintain reserve management units to daily monitor their status and to seek ways to minimise the costs of maintaining the reserves that are necessary to ensure a smooth payments system.
Banks may trade reserves between themselves on a commercial basis but in doing so cannot increase or reduce the volume of reserves in the system. Only government-non-government transactions (which in MMT are termed vertical transactions) can change the net reserve position. All transactions between non-government entities net to zero (and so cannot alter the volume of overall reserves). I explain that in more detail including the implications of that point in the trilogy of blogs – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3. The blogs helps to explain why budget deficits place downward pressure on interest rates – which is contrary to the mainstream macroeconomics textbook depiction captured by “crowding out”.
The important point is that when a bank originates a loan to a firm or a household it is not lending reserves. Bank lending is not easier if there are more reserves just as it is not harder if there are less. Bank reserves do not fund money creation in the way that the money multiplier and fractional-reserve deposit story has it.
Bank loans create deposits not the other way around. These loans are made independent of their reserve positions. Adequately capitalised banks lend to any credit-worthy customers.
At the individual bank level, certainly the “price of reserves” will 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 (the worst case scenario) 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 does not capture the way the banking system operates. 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.
So it is quite wrong to assume that the central bank can influence the capacity of banks to expand credit by adding more reserves into the system. 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).
The BIS paper agrees with this assessment. It says:
… the emphasis on policy-induced changes in deposits is misplaced. If anything, the process actually works in reverse, with loans driving deposits. In particular, it is argued that the concept of the money multiplier is flawed and uninformative in terms of analyzing the dynamics of bank lending. Under a fiat money standard and liberalized financial system, there is no exogenous constraint on the supply of credit except through regulatory capital requirements. An adequately capitalized banking system can always fulfill the demand for loans if it wishes to.
Note the reference to an “adequately capitalized banking system”. I covered that topic in this blog – Lending is capital- not reserve-constrained.
In terms of the money multiplier, the BIS paper goes on to say that:
Inherent in this view, which has a long heritage in monetary economics, is that policy changes are implemented via open market operations that change the amount of bank reserves. Binding reserve requirements, in turn, limit the issuance of bank deposits to the availability of reserves. As a result, there is a
tight, mechanical, link between policy actions and the level of deposits.
Their simple refutation of the money multiplier as a valid description of monetary policy is that central banks express monetary policy through “a target for a short term interest rate”.
In relation to our discussion above about the motives for holding reserves, the BIS paper says that there are two reasons: (a) “to meet any reserve requirement”; and (b) “to provide a cushion against uncertainty related to payments flows.”
In many countries the first motive is redundant because there are no formal reserve requirements. The second motive relates to our discussion above about the integrity of the payments (cheque clearing) system.
The BIS paper concludes that:
The quantity of reserves demanded is then typically interest-inelastic, dictated largely by structural characteristics of the payments system and the monetary operating framework, particularly the reserve requirement. When reserves are remunerated at a rate below the market rate, as is generally the case, achieving the desired interest rate target entails that the central bank supply reserves as demanded by the system. In the case where reserves are remunerated at the market rate, they become a close substitute for other short-term liquid assets and the amount of reserves in the system is a choice of the central bank. In either case, the interest rate can be set quite independently of the amount of reserves in the system and changes in the stance of policy need not involve any change in this amount.
Which means that banks normally desire to hold a certain quantity of reserves as per their expectations of the claims that will be made on it via the daily clearing house.
Further, unless the central bank pays a market return (short-term interest rate target) on overnight reserves, it has to be ready to supply whatever reserves are required to match the desired demand by banks or else lose control of the target rate.
One example that MMT provides is a version of this and also serves to demonstrate how budget deficits put downward pressure on interest rates, is that when a government is running a deficit, it involves a net add to bank reserves (after all the transactions which arise from the deficit spending are conducted by consumers/firms etc). If the resulting quantity of reserves is in excess of the quantity that the banks perceive will satisfy their payments needs (plus reserve requirements if relevant), then the banks will try to loan those reserves out in the interbank market.
But as noted above, the banks together can only shuffle the excess reserves. The act of each individual bank trying to pass on the excess reserves that it holds (noting some banks might still have reserve deficiencies even when the overall system is in excess because of the nuances of the pattern of cheques drawn and presented) manifests as an excess supply of funds which drives the overnight interest rate down. It will fall to zero if there is no central bank return on reserves paid or to the support rate (the return on reserves offered by the central bank). But the interbank competition under these circumstances compromises the central bank’s target interest rate.
Finally, when the central bank pays a return on reserves held with it equivalent to the target rate of interest then the maintenance of that target is independent of the quantity of reserves in the system. That situation describes the current state in many nations.
The upshot is (according to the BIS paper) that:
The same amount of reserves can coexist with very different levels of interest rates; conversely, the same interest rate can coexist with different amounts of reserves. There is thus no direct link between monetary policy and the level of reserves, and hence no causal relationship from reserves to bank lending …
The absence of a link between reserves and bank lending implies that the money multiplier is an uninformative construct.
To reinforce this conceptual conclusion the BIS paper offer the following graph (their Figure 1 Money Multiplier and Credit Growth). The red-line is an expression of the money multiplier (calculated as the ratio of broad money to base money). They conclude that the “movements in the money multiplier largely reflects changes in reserves, with the latter showing no perceptible link to the dynamics of bank lending”.
They also note that in “the case of Japan and the United Kingdom, the abrupt change in reserves was the result of each central bank’s quantitative easing policy”.
The conclusion is that “the amount of reserves in the banking system, which as noted above, is determined predominantly by exogenous structural factors. When
those factors change, central banks simply accommodate whatever new level of reserves is required by the system”.
So “standard macroeconomic textbooks” still in wide use like Mankiw, Abel and Bernanke, Mishkin and Walsh (2003) which continue to perpetuate the money multiplier myth are deceptive at best and students are being poorly treated by lecturers who use them.
The BIS paper then considers the “alternative …[mainstream] … way of motivating the link between monetary policy and deposits, consider the mechanics of household portfolio rebalancing”:
Here, the presumption is that policy actions that change the opportunity cost of holding deposits act as a catalyst for portfolio rebalancing that affects the level of deposits. This view essentially rests on the conventional interest elasticity of money demand as applied to deposits.
So monetary policy is meant to be able to influence bank lending by reducing the amount of deposits in the system. It is claimed that open market operations change the “relative yields of deposits (money) and other assets” which can discourage deposits.
The BIS paper outlines several reasons why this is unlikely to occur (apart from the obvious fact that bank lending is not restricted by deposits) which you can read about if you are interested.
The basic conclusion is that:
… quantitative constraints on bank lending should be de-emphasized. Even if one accepts the notion that deposits fall in response to tight policy, banks nowadays are able to easily access wholesale money markets to meet their funding liquidity needs … Importantly, since banks are able to create deposits that are the means by which the non-bank private sector achieves final settlement of transactions, the system as a whole can never be short of funds to finance additional loans.
If you think about this statement for a moment you will see that it is impossible for budget deficits to financially crowd out other expenditure. Components of aggregate demand can crowd each other out in a real sense if there is not sufficient real resources available to respond to the increased spending. But that is not the mainstream emphasis.
So we can conclude:
1. Budget deficits now will not cause interest rates to rise and thus damage interest-rate sensitive components of private spending. There is nothing in a valid depiction of banking operations to justify that central mainstream macroeconomics view.
2. The central bank does not (and cannot) control the money supply. So theories of the price level that are based on that presumption (such as the Quantity Theory) are erroneous.
The BIS paper also acknowledges that bank “loans drive deposits rather than the other way around”:
Bank lending … involves the creation of bank deposits that are themselves the means of payment. A bank can issue credit up to a certain multiple of its own capital, which is dictated either by regulation or market discipline. Within this constraint, the growth of bank lending is determined by the demand for and willingness of banks to extend loans. More generally, all that is required for new loans is that banks are able to obtain extra funding in the market. There is no quantitative constraint as such. Confusion sometimes arises when the flow of credit is tied to the stock of savings (wealth) when the appropriate focus should in fact be on the flow.
Again, no crowding out and only capital constraints on bank lending (that is, the asset side of the balance sheet) are binding.
The BIS could hardly be criticised for not have direct experience with central banking – being the central bank of the central bank. The paper reinforces some central tenets of MMT – regarding the role of bank reserves, the way in which budget deficits impact on the cash system and drive down interest rates, the impossibility of financial crowding out and the lack of control central banks have on the expansion of the money supply.
The question that all macroeconomists should ask is why they still teach the mainstream theories which clearly do not apply to the real world banking system.
That is enough for today!