Why doesn’t this attract headlines?

Why doesn’t this article get headlines in the newspapers? Today I read a recent article – Why Are Banks Holding So Many Excess Reserves? – from two researchers at the New York branch of the Federal Reserve Bank. It is obvious that the authors understand much more about the modern monetary system than most of the journalists, economists and politicians who make so-called informed commentary about such matters. Three messages emerge: (a) bank reserves play an important role in the conduct of interest rate policy and budget deficits put downward pressure on interest rates; (b) the money multiplier conception of economics is inapplicable to a modern monetary system; and (c) the current build-up of bank reserves will not be inflationary. I thought that it would be nice for you to read this stuff from someone other than billy blog (and my fellow modern money travellers!).

To condition our minds, the following graph, taken from the Fed Report, shows the huge growth in the quantity of reserves held by American banks since September 2008. The authors note that:

Prior to the onset of the financial crisis, required reserves were about $40 billion and excess reserves were roughly $1.5 billion. Excess reserves spiked to around $9 billion in August 2007, but then quickly returned to pre-crisis levels and remained there until the middle of September 2008. Following the collapse of Lehman Brothers, however, total reserves began to grow rapidly, climbing above $900 billion by January 2009. As the figure shows, almost all of the increase was in excess reserves. While required reserves rose from $44 billion to $60 billion over this period, this change was dwarfed by the large and unprecedented
rise in excess reserves.

The questions of interest are: (a) “Why are banks holding so many excess reserves?”; and (b) What does this data “tell us about current economic conditions and about bank lending behavior?”

The Fed Report defines bank reserves (and this holds for Australia as well as any country) as:

… funds held by depository institutions that can be used to meet the institution’s legal reserve requirement. These funds are held either as balances on deposit at the Federal Reserve or as cash in the bank’s vault or ATMs. Reserves that are applied toward an institution’s legal requirement are called required, while any additional reserves are called excess.

The Report notes that these excess reserves are considered problematic by so-called informed commentators who believe their existence means banks prefer to hoard cash rather than lend – hoarding is then the reason for the credit crunch. For example, one of the top mainstream macroeconomics textbook writers Gregory Mankiw actually wrote in the New York Times on April 19, 2009 that something had to be done to stop banks “cash hoarding” and forcing them to lend. Other well-known mainstream monetary commentators have been recommending taxes on reserves and/or caps to stop the banks “hoarding”.

The authors appear to share my perspective – that these major players in the macroeconomics debate do not have a clue as to how the monetary system actually operates (or lie about it) and draw their commentary from standard mainstream macroeconomics textbooks which develop theory that is virtually about another planet – gold standard dynamics and constraints and money multiplier fractional reserve banking models. Clearly they don’t say it in this way but that is the message of their report.

You will also understand from this that our students across the world are being fed total nonsense in their macroeconomics courses and it is no wonder the myths are perpetuated when the leading professors are themselves unable to comprehend how the system operates.

Let me state again for the millionth time – banks can lend any time they want and do not need prior reserve balances to do so. Loans creates deposits which are then backed by reserves subsequently. The only reason that the banks are not lending at present is that they have tightened their conception of a credit-worthy customer because they have become risk-averse in the face of the crisis. The level of reserves is irrelevant to this “stand-off”.

The Fed Report tackles the ignorance of mainstream macroeconomists head on. It motivates the paper in this way:

The total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not affected by private banks’ lending decisions. The liquidity facilities introduced by the Federal Reserve in response to the crisis have created a large quantity of reserves. While changes in bank lending behavior may lead to small changes in the level of required reserves, the vast majority of the newly-created reserves will end up being held as excess reserves almost no matter how banks react. In other words, the quantity of excess reserves depicted in Figure 1 reflects the size of the Federal Reserve’s policy initiatives, but says little or nothing about their effects on bank lending or on the economy more broadly.

This conclusion may seem strange, at first glance, to readers familiar with textbook presentations of the money multiplier. After presenting our examples, we discuss the traditional view of the money multiplier and why it does not apply in the current environment … We also argue that a large increase in the quantity of reserves in the banking system need not be inflationary, since the central bank can adjust short-term interest rates independently of the level of reserves.

The Report begins by providing a simple accounting example to show that central bank actions determine the level of reserves in the banking system. I won’t repeat that example here as it is basic accounting. Some readers might find it interesting though to concentrate ones mind on the framework being discussed.

The authors then consider the impact of excess reserves on the interest rate. In the US, bank reserves have historically earned zero interest. In Australia, the RBA pays 25 basis points below its target interest rate on overnight reserves.

Using an example with two commercial banks interacting with the central bank (The Fed), the Report shows that:

If Bank A earns no interest on the reserves it is holding … it will seek to lend out its excess reserves or use them to buy other short term assets. These activities will, in turn, decrease the short-term market interest rate. Recall, however, that we assumed that the central bank has not changed its target interest rate. The central bank thus has two distinct and potentially conflicting policy objectives in our example.

The appropriate short-term interest rate is determined by macroeconomic conditions, while the appropriate lending policy is determined by the size of the problem in the interbank market. If the amount of central bank lending is relatively small, this conflict can be resolved using open market operations. In particular, the central bank could sterilize the effects of its lending by selling bonds from its portfolio to remove the excess reserves.

So you see that when there are excess reserves and the central bank offers no return on them to the banks, the latter drive down the short-term money market rate (interbank rate) as they try to rid themselves of the excess reserves. This brings the reality in the interbank market into conflict with the central bank’s monetary policy target rate (assumed to be unchanged). In other words, the central bank loses control over its monetary policy position.

The only way they can regain control is to prevent this interbank competition from occurring and they do that through “open market operations” – that is, selling government bonds “from its portfolio to remove the excess reserves”. Fundamental operation. Debt issuance to remove excess reserves rather than to finance net government spending.

Further, so-called horizontal transactions between non-government entities net to zero. The Fed Report says:

… it is important to keep in mind that total reserves in the banking system are determined almost entirely by the central bank’s actions. An individual bank can reduce its reserves by lending them out or using them to purchase other assets, but these actions do not change the total level of reserves in the banking system.

If you read my blog – Money multiplier myths – you will find more about the reasoning here. It is a crucial point. Only vertical transactions between the government and non-government sector can add or drain reserves. All the leveraging transactions between non-government entities only redistributes reserves. If there are excess reserves in the system, only an intervention from the government can reduce them – so a bond sale will do that.

Note that budget deficits will result each day in excess reserves. If the central bank does not drain these reserves then interest rates will fall. Clearly, budget deficits in their own right put downward pressure on interest rates. The debt issuance then allows the central bank to curtail this market pressure and maintain higher rates according to its current monetary policy stance.

But the higher rates have nothing to do with the net spending – or having to “finance” it – as you will read to your detriment in the standard macroeconomics textbooks under “financial crowding out”. The higher rates are just a statement of the central bank’s intended monetary policy stance and it can change that whenever it wants to.

Now how does paying an interest rate on the excess reserves change things? The bond sales in the previous case choked off the incentive that the banks who held excess reserves had to lend the reserves out. This curtails the downward pressure on the interest rate. If the central bank doesn’t want to sell treasuries (bonds) then it has another alternative.

The central bank can:

… eliminate the tension between its conflicting policy objectives … [by paying] … interest on reserves. When banks earn interest on their reserves, they have no incentive to lend at interest rates lower than the rate paid by the central bank. The central bank can, therefore, adjust the interest rate it pays on reserves to steer the market interest rate toward its target level.

Simple as that! There are no opportunity costs to banks in holding reserves and the central bank’s target interest rate becomes independent of the level of reserves in the banking system.

What about the money multiplier?

The authors note that:

The idea that banks will hold a large quantity of excess reserves conflicts with the traditional view of the money multiplier. According to this view, an increase in bank reserves should be “multiplied” into a much larger increase in the broad money supply as banks expand their deposits and lending activities. The expansion of deposits, in turn, should raise reserve requirements until there are little or no excess reserves in the banking system. This process has clearly not occurred following the increase in reserves depicted in Figure 1.

I recall one of my early teachers (an unnamed mainstream professor at a leading University) made the comment once in a lecture that given the “empirical facts or data” didn’t accord with neoclassical economic theory then we should conclude that the “facts were wrong”. He was serious. It was not a flippant comment. These characters are welded to their textbook theories and just deny the existence of any facts that are contrary to their models.

You can also see why a curious young mind not intent on climbing the corporate world would start looking to alternative theories to find some sense of understanding. My journey into modern monetary theory started way back then ….!

The money multiplier is one of those welded on concepts that the orthodox economists refuse to relinquish. They teach it day in-day out in universities – largely because the theory is taught via some algebra and some ratios that make the lecturers look scientific in the eyes of their students. The models seem to satisfy some childlike (anal) desires for formality and rigour (as they not me conceive it) . Who can tell why otherwise smart characters continue year after year to teach in great detail a model that has no bearing on the way the monetary system operates?

Anyway, the Fed Report seeks to explain why the money multiplier doesn’t help up understand the current situation. If you read the article you will soon realise that the authors themselves are struggling to jettison the myth. They say that:

The textbook presentation of the money multiplier assumes that banks do not earn interest on their reserves. As described above, a bank holding excess reserves in such an environment will seek to lend out those reserves at any positive interest rate, and this additional lending will decrease the short-term interest rate …

This multiplier process continues until one of two things happens. It could continue until there are no more excess reserves, that is, until the increase in lending and deposits has raised required reserves all the way up to the level of total reserves. In this case, the money multiplier is fully operational. However, the process will stop before this happens if the short-term interest rate reaches zero. When the market interest rate is zero, banks no longer face an opportunity cost of holding reserves and, hence, no longer have an incentive to lend out their excess reserves. At this point, the multiplier process halts.

Well not really. The real issue is that the money multiplier theory conceives of banks as waiting for deposits and when they come along they are then able to lend. That is deposits provide the reserves which then promote lending. That is not the way the system operates. Loans create deposits and reserves are added later.

The reason why banks try to lend out excess reserves in the interbank market is because they are assets that are earning no return. A somewhat different conception and motivation. And clearly, once the overnight rate is zero, the banks have no further profit opportunities to exploit. The other point is that they realise that this interbank activity does not rid the system of the excess reserves – it just shuffles them around as the competition is driving the interest rate down and wresting control of monetary policy target from the central bank.

But the Fed Report then says:

When reserves earn interest, the multiplier process described above stops sooner. Instead of continuing to the point where the market interest rate is zero, the process will now stop when the market interest rate reaches the rate paid by the central bank on reserves. If the central bank pays interest on reserves at its target interest rate, as we assumed in our example above, the money multiplier completely disappears. In this case, banks never face an opportunity cost of holding reserves and, therefore, the multiplier process described above does not even start.

So they are calling the interbank competition process the multiplier process which is stretching the conception in my view. But semantics aside, the process they describe is correct. Any support rate below the target monetary policy rate will create a corridor in which the interbank competition will move the overnight rate. Once the overnight rate is at the support rate (which may be zero), then the interbank competition stops because there are no further profit opportunities for any single bank.

We deal with this “corridor” issue in detail in my latest book – Full employment abandoned: shifting sands and policy failures.

Is the large quantity of reserves inflationary?

You will recall often that commentators consider the modern monetary approach to macroeconomics to be a recipe for hyperinflation. Even the debates about whether The Greens were neo-liberal or not centred, finally, on this claim.

The Fed Report addresses the issue head on and cites leading US mainstream macroeconomists (Feldstein, Meltzer etc) who claim that the reserves will underpin “faster money growth” and inflation.

The authors note (with some confusion I might add – that is, they stumble on the correct answer) – that:

When the economy begins to recover, firms will have more profitable opportunities to invest, increasing their demands for bank loans. Consequently, banks will be presented with more lending opportunities that are profitable at the current level of interest rates. As banks lend more, new deposits will be created and the general level of economic activity will increase. Left unchecked, this growth in lending and economic activity may generate inflationary pressures.

… where no interest is paid on reserves, the central bank must remove nearly all of the excess reserves from the banking system in order to arrest this process … By raising the interest rate paid on reserves, the central bank can increase market interest rates and slow the growth of bank lending and economic activity without changing the quantity of reserves. In other words, paying interest on reserves allows the central bank to follow a path for short-term interest rates that is independent of the level of reserves. By choosing this path appropriately, the central bank can guard against inflationary pressures even if financial conditions lead it to maintain a high level of excess reserves.

This is a very important piece of text and it is crucial to understand the operations that are being described. The authors are saying that interest rate levels affect aggregate demand (we can argue about that but at this point that is not the issue). Assuming the central bank thinks that – then it seeks to adjust monetary policy (overnight interest rates) to reflect the state of demand in the economy relative to real capacity left to respond to that nominal demand (spending) growth). Pretty conventional really.

If they think there are inflationary pressures they seek to hold interest rates higher than otherwise and vice versa. The only way they can do that is to ensure that there are no excess reserves in the system at any point in time which will provoke interbank competition and drive the interest rate drown to zero (Japan case!). In that situation, the central bank would lose control of its target interest rate and monetary policy would be too loose for their liking.

So what do they do? They have to “remove … all of these excess reserves from the banking system”. How? By issuing government debt securities which provide the banks with a competitive interest-bearing asset instead of the non-interest bearing reserves. So government debt issuance is about interest-rate maintenance and has nothing to do with financing treasury fiscal positions. That is what the authors are saying in this paper.

But the central bank can avoid the necessity of draining the excess reserves quite simply by paying the banks an interest rate on the reserves. This is equivalent in operational terms to issuing debt but in this case it separates the central bank’s “path for short-term interest rates” from the level of reserves. They become independent of each other.

In other words, the banks have no incentive to loan out the reserves in pursuit of competitive returns on non-performing assets. This means the central bank can hold its target interest rate (which is targetting an anti-inflationary position) and according to that logic, stifle any inflation pressures arising from excessive aggregate demand.

So do all you hyperinflators out there get that? It should stop you raising this issue once and for all and also disabuse you all of the notion that debt issuance has something to do with financing fiscal policy positions. The Fed Reserve authors are not me remember!

Interestingly, the authors see advantages in retaining high reserve levels even in normal times. They say:

A central bank may choose to maintain a high level of reserve balances in normal times because doing so offers some important advantages, particularly regarding the operation of the payments system. For example, when banks hold more reserves they tend to rely less on daylight credit from the central bank for payments purposes. They also tend to send payments earlier in the day, on average, which reduces the likelihood of a significant operational disruption or of gridlock in the payments system. To capture these benefits, a central bank may choose to create a high level of reserves as a part of its normal operations, again using the interest rate it pays on reserves to influence market interest rates. The Reserve Bank of New Zealand has used this type of framework since 2006.8

Again, this should choke off a few of those hyperinflators as long as they have the grey matter left to actually understand how the system operates in practice rather than how they (erroneously) conceive of it operating – all the time being conditioned by textbooks that bear no relation to the real monetary system they purport to describe and explain.

Conclusion

So how about all that? Imagine the headlines:

1. Budget deficits driving down interest rates!

2. Debt build-up reflects central bank desire to hold target interest rate at current level!

3. Zero debt build-up if RBA pays competitive rates on excess reserves!

And the rest of it.

Of-course, none of you will be deceived. The payment of interest on the excess reserves is equivalent to paying interest on a government bond. It is performed in the same way (typing numbers into bank accounts), is not revenue-constrained, and provides a competitive return on reserves (held as reserves or IOUs).

Neither, monetary policy operation (debt issuance or interest-payments on reserves) presents the slightest problem for government solvency or its capacity to net spend to underwrite full employment.

It should also be clear that the macroeconomics that you will learn from a mainstream textbook has nothing sensible to say about the economy. Further, all students should start undermining their macroeconomics classes by demanding to know why their lecturers are persisting in lying to them.

Students might usefully start petitions, hold rallies and otherwise bring these characters to account.