Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
On December 23, 2015, the Democrat Presidential candidate Bernie Sanders published an Op Ed – Bernie Sanders: To Rein In Wall Street, Fix the Fed – which, correctly, in my view, concluded that Wall Street (taken to be the collective of banksters wherever they might be located) “is still out of control” and policy reform has done little to alter the “too big to fail” problem that was identified in the early days of the GFC as one bank after another lined up for government assistance. Larry Summers replied to the Op Ed in his blog – The Fed and Financial Reform – Reflections on Sen. Sanders op-Ed – challenging several of the proposals advanced by Sanders. The problem is that the progressive voice of Bernie Sanders labours under some basic misconceptions about how the monetary system operates and therefore plays into the hands of those who have created the mess. Conversely, Summers clearly understands basic elements of the monetary system but continues to advocate policies which avoid addressing the main issue – the power of the financial markets.
Bernie Sanders got off on the wrong foot by suggesting that if any of the big financial institutions:
… were to fail again, taxpayers could be on the hook for another bailout, perhaps a larger one this time.
We, of course, know that taxpayers did not fund the last bailouts, the currency-issuing capacity of the consolidated US government provided the cash injections to ensure that any financial institution it desired to remain solvent did so.
I think it is essential that would-be progressives cease to use these loaded terms such as ‘taxpayer funds’ etc and instead promote new understandings which more accurately reflect what the intrinsic capacities of the currency-issuing government are.
Please read my blog – Taxpayers do not fund anything – for more discussion on this point.
As an aside, some years ago (August 20, 2010), I wrote a blog – The consolidated government – treasury and central bank – which explained why the notion of a consolidated government sector is a basic Modern Monetary Theory starting point, which allows us to demonstrate the essential relationship between the government and the non-government sectors whereby net financial assets enter and exit the economy.
In part, the notion this counters the mainstream macroeconomic obsession with central bank independence, which is nothing more than an ideological attack on the capacity of government to produce full employment. When I have attempted in the past to discuss this consolidation with members of my profession (the mainstream arm) I have been met with varying degrees of derision.
There appears to be a belief that the central bank operations are quite distinct from Treasury operations and that in the interest of inflation stability, the Treasury has to run fiscal policy consistent with the independent interest-rate target set by the central bank.
The problem with this view is that it misunderstands the intrinsic link between the daily operations of the central bank in managing liquidity in the cash system and the daily spending and taxation impacts of Treasury (that is, fiscal policy).
A Staff Report from the Federal Reserve Bank of New York (No 754) published in December 2015 – Floor Systems and the Friedman Rule: The Fiscal Arithmetic of Open Market Operations – argues that “focusing primarily on the finances of the consolidated public sector, which includes both the fiscal authority and the central bank …[is] … useful for studying a wide range of issues because it allows one to clearly state the economically meaningful constraints while abstracting from institutional details”.
I guess my mainstream colleagues will become enthusiastic for consolidated analysis from now on. Sheep.
Anyway, back to the main story.
Bernie Sanders considers the appropriate starting point for reining in Wall Street is to:
… begin by reforming the Federal Reserve, which oversees financial institutions and which uses monetary policy to maintain price stability and full employment. Unfortunately, an institution that was created to serve all Americans has been hijacked by the very bankers it regulates.
He uses the example of the recent interest rate hike in the US, which he considers served the interests of the “big bankers and their supporters in Congress” and will unnecessarily maintain higher than desirable unemployment.
It was designed “to fight phantom inflation”.
One can only agree with that assessment. Please read my blog – There was no reason for the US to raise interest rates – for more discussion on this point.
I also agree with his analysis of the conflict of interest that bedevils leading US financial institutions and membership of the central bank boards.
He wants to broaden the membership of the central bank boards to “include representatives from all walks of life – including labor, consumers, homeowners, urban residents, farmers and small businesses” but, as Summers notes “There is a tension between acquiring expertise and avoiding cooptation or cognitive capture”.
From a Modern Monetary Theory (MMT) perspective, the goals of economic policy have to be to advance the well-being of all citizens, and, in particular, ensure that those who want to work can access a job with decent pay and conditions.
The government should also ensure that the destructive and destabilising tendencies of capitalism are tightly regulated.
The dominance of the financial sector over the last three or more decades has demonstrated that these tendencies are rife and have been poorly managed by governments who have been largely co-opted by these financial interests.
The expertise that we want brought to bear to help design and implement economic policy decisions should understand the role of government as a mediator in class conflict rather than an agent of capital.
The financial sector has continually advocated suppression of real wages growth and has benefited from the ongoing redistribution of national income towards capital, which it appears to consider to be a desirable feature of the current policy settings.
Senior executives from that sector, who have pocketed millions at the expense of the workers and behaved in ways that have put millions of workers out of work, would appear not to be ideal candidates for recruitment for national public service positions that aim to advance the well-being of workers.
The more progressive approach is to advocate collapsing the central banking functions into a formally consolidated macroeconomic policy function within government.
What about central bank independence – my mainstream colleagues will scream, as if it means something.
Bernie Sanders is also correct in saying that the massive financial services industry does very little for anyone but the highly-paid participants.
Wealth-shuffling describes at least 95-96 per cent of the daily financial transactions in the world markets. They do not help humanity in general and when things go awry, as they did in 2008, the rest of us have to endure the negative real consequences (such as falling incomes and rising unemployment and poverty rates), while the felons (the ‘banksters’) escape unscathed (at least, relatively so).
He thinks the problem lies with the central bank.
The Fed must also make sure that financial institutions are investing in the productive economy by providing affordable loans to small businesses and consumers that create good jobs. How? First, we should prohibit commercial banks from gambling with the bank deposits of the American people. Second, the Fed must stop providing incentives for banks to keep money out of the economy. Since 2008, the Fed has been paying financial institutions interest on excess reserves parked at the central bank – reserves that have grown to an unprecedented $2.4 trillion. That is insane. Instead of paying banks interest on these reserves, the Fed should charge them a fee that would be used to provide direct loans to small businesses.
Anyone with an understanding of central bank operations would not make these claims. They are substantially wrong.
The inference is that by paying interest on excess reserves, the central bank is providing the commercial banks with a disincentive to loan those funds out to borrowers who would invest in the “productive economy” and “create good jobs”.
The conception that Bernie Sanders creates is that the banks are being diverted by the US central bank from lending those reserves.
On Monday (December 28, 2015), my blog – Central bank propaganda from Minneapolis – explained how banks do not loan out reserves and are not reserve-constrained in their lending activities.
Bernie Sanders is just plain wrong here and is surprising that he has been allowed to maintain this misconception. If his persistence in maintaining incorrect ideas about how the banking system operates is his own doing (that is, ignoring sound advice from his team), then he is unfit to be President. Simple as that.
In the real world, banks do not wait for depositors to provide reserves before they make loans. Rather, they aggressively seek to make loans to credit worthy customers in order to profit.
These loans are made independent of a bank’s specific reserve position at the time the loan is approved. A separate department in each bank manages the bank’s reserve position and will seek funds to ensure it has the required reserves in the relevant accounting period.
They can borrow from each other in the interbank market but if the system overall is short of reserves these transactions will not add the required reserves.
In these cases, the bank will sell bonds back to the central bank or borrow from it outright at some penalty rate. At the individual bank level, certainly the ‘price’ it has to pay to get the necessary reserves will play some role in the credit department’s decision to loan funds.
But the reserve position per se will not matter.
For its part, the central bank will always supply the necessary reserves to ensure the financial system remains functional and cheques clear each day.
The upshot is that banks do not lend out reserves and a particular bank’s ability to expand its balance sheet by lending is not constrained by the quantity of reserves it holds or any fractional reserve requirements that might be imposed by the central bank.
Loans create deposits, which are then backed by reserves after the fact.
Larry Summers appears to agree with Bernie Sanders on the claim that the central bank was errant in paying interest on excess reserves.
However, he clearly understands the central bank operations more fully.
However, when rates are raised it is a matter of necessity that the Fed either pay interest on reserves or what is essentially equivalent offer Treasury bills to banks which soak up their excess cash. In a positive interest rate environment, there is no way that banks will or should hold on to zero interest rate cash. I do not think there would be any expert support for Sanders views here.
Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly.
In addition to setting a lending rate (discount rate), some central banks also set a support rate which is paid on commercial bank reserves held by the central bank. This support rate becomes the interest-rate floor for the economy.
Any central bank that does not offer a return on reserves would see short-term interest rate fall to zero whenever there was persistent excess liquidity in the bank system (excess reserves). In those cases, they would have to sell government bonds or the government would have to raise taxes to drain the excess liquidity.
The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate.
This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.
In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period.
At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate.
Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing.
Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates.
Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate.
When the system is in overall surplus, this competition will drive the rate down to the support rate.
The demand for short-term funds in the money market is a negative function of the interbank interest rate since at a higher rate less banks are willing to borrow some of their expected shortages from other banks, compared to risk that at the end of the day they will have to borrow money from the central bank to cover any mistaken expectations of their reserve position.
The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt.
When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt.
This open market intervention therefore will result in a higher value for the overnight rate.
Importantly, MMT characterises the debt-issuance as a monetary policy operation designed to provide interest-rate maintenance.
This is in stark contrast to orthodox theory which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending.
The preferred position of MMT proponents is to set the overnight interest rate at zero and then let the longer-term investment rate structure adjust to reflect risk and inflationary expectations.
Then there is no reason to pay interest rates on excess reserves and fiscal policy assumes the major counter-stabilisation role at the macroeconomic level.
Please read my blog – The natural rate of interest is zero! – for more discussion on this point.
Bernie Sanders also wants a range of transparency reforms to allow the public to better appreciate what goes on within the central bank boards. All public institutions should be accountable but I don’t think this is the main issue that needs to be addressed at this stage.
He touches on his belief in the need to “reinstate Glass-Steagall and break up the too-big-to-fail financial institutions that threaten our economy” and to “make banking work for the productive economy and for all Americans, not just a handful of wealthy speculators”.
The fact that the Glass-Steagall rules were undermined by concerted lobbying from the financial sector and incompetent responses from government, does not necessarily mean that they should be reinstated in law.
I know that restoring the Glass-Steagall rules is a popular ‘progressive’ position but there were reasons why they were no longer providing security and traction to policymakers as originally envisaged.
The aim of the 1933 Banking Act was to divide commercial banks into deposit-taking institutions that were regulated and secure, on the one hand; and risky, speculative investment institutions, largely unregulated, on the other hand.
The plan was to ensure that the deposit-taking banks were prevented from engaging in risky activity which could incur major losses to the depositors. On the other hand, the speculative institutions were prevented from taking deposits.
However, a number of innovations (for example, asset securitisation and the rise of the corporate issue of commercial paper) undermined the strict division envisaged in the 1933 Banking Act.
As Jan Kregel argues in his 2010 study – No Going Back: Why We Cannot Restore Glass-Steagall’s Segregation of Banking and Finance:
To remedy the competitive disadvantages, member banks were allowed extensive exemptions from the section 20 and 21 interdictions against dealing in securities and with security affiliates, eroding the strict segregation provided by the original 1933 legislation.
Further, rulings under Section 16:
… laid the basis for the creation of proprietary trading by banks for their own account, as well as derivatives dealing and the provision of structured derivative lending – both of which led to the rapid growth of the over-the-counter market in credit derivatives. Paradoxically, the justification was to provide regulated institutions, which were supposed to have a monopoly advantage, a level playing field with investment banks.
I would argue that a progressive position must focus on eliminating most of the derivative transactions that have perverted the banking sector.
Larry Summers argues that the activities of banks such as JP Morgan or Goldman Sachs in this regard are “egregiously under regulated”.
I would go one step further and make them illegal.
Please read the following blogs – Operational design arising from modern monetary theory and Asset bubbles and the conduct of banks for further discussion.
I like the way that Bernie Sanders is attempting to redefine the public policy debate and have sympathy for many of his positions and values.
But I don’t think it helps when progressive voices make simple mistakes that, ultimately, ply into the hands of those who have created the mess the world economy is now in.
Happy New Year
This is my last blog for 2015. I therefore wish all my readers a fine 2016.
Tomorrow, I’m travelling a lot and so my blog will be somewhat truncated. We will see by how much when we get there.
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.