Regular readers will know that I have spent quite a lot of time reading the…
Building bank reserves will not expand credit
In his latest New York Times article (December 10, 2009) – Bernanke’s Unfinished Mission – Paul Krugman reveals that he doesn’t really understand much about macroeconomics. Sometimes you read a columnist and try to find extra meaning that is not in the words to give them the benefit of the doubt. At times, Krugman like other columnists sounds positively reasonable and advances arguments that are consistent with modern monetary theory (MMT). But then there is always a give-away article that appears eventually that makes it clear – this analyst really doesn’t get it. In Krugman’s case, he doesn’t seem to have learned from his disastrous foray into Japan’s “lost decade” policy debate.
In the late 1990s, Paul Krugman joined a number of academic economists in urging the Bank of Japan to introduce large-scale quantitative easing to kick start the economy. The Bank, reluctantly, heeded their advice and in 2001 they increased bank reserves from ¥5 trillion to ¥30 trillion. This action had very little impact – real economic activity and asset prices continued their downward spiral and inflation headed below the zero line.
Many economists had also claimed that the huge increase in bank reserves would be inflationary. They were also wrong. Please read my blog – Balance sheet recessions and democracy – for more discussion on this point.
In this 1998 article on Japan’s trap, Krugman claimed that Japan was “in the dreaded “liquidity trap”, in which monetary policy becomes ineffective because you can’t push interest rates below zero”. This is similar to the argument he is making about the US at present.
He said that when the nominal interest rate is at zero and therefore stimulatory interest rate adjustments can no longer be made, the real rate of interst that is required to “match saving and investment may well be negative” (as an aside – this sort of reasoning is derived from the highly flawed loanable funds doctrine).
As a Keynesian, he recognised that there was a spending gap in Japan at the time and while fiscal policy would possibly work it is constrained by “a government fiscal constraint” and further that the Japanese Government would only be wasting its spending on “roads to nowhere”.
So he then considers monetary policy as the best way forward. In that context, Krugman says that the nation needs a dose of expected inflation so that the real interest rate becomes negative (and flexible). He concluded that monetary policy had been ineffective because:
… private actors view its … [Bank of Japan] … actions as temporary, because they believe that the central bank is committed to price stability as a long-run goal. And that is why monetary policy is ineffective! Japan has been unable to get its economy moving precisely because the market regards the central bank as being responsible, and expects it to rein in the money supply if the price level starts to rise.
The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.
This sounds funny as well as perverse. … [but] … the only way to expand the economy is to reduce the real interest rate; and the only way to do that is to create expectations of inflation.
So he was completely wrong in this diagnosis. The only thing that got Japan moving again in the early part of this Century was a dramatic expansion of fiscal policy.
In another related article Krugman elaborated on quantitative easing. He said:
The Bank of Japan has repeatedly argued against such easing, arguing that it will be ineffective – that the excess liquidity will simply be held by banks or possibly individuals, with no effect on spending – and has often seemed to convey the impression that this is an argument against any kind of monetary solution.
It is, or should be, immediately obvious from our analysis that in a direct sense the BOJ argument is quite correct. No matter how much the monetary base increases, as long as expectations are not affected it will simply be a swap of one zero-interest asset for another, with no real effects. A side implication of this analysis … is that the central bank may literally be unable to affect broader monetary aggregates: since the volume of credit is a real variable, and like everything else will be unaffected by a swap that does not change expectations, aggregates that consist mainly of inside money that is the counterpart of credit may be as immune to monetary expansion as everything else.
But this argument against the effectiveness of quantitative easing is simply irrelevant to arguments that focus on the expectational effects of monetary policy. And quantitative easing could play an important role in changing expectations; a central bank that tries to promise future inflation will be more credible if it puts its (freshly printed) money where its mouth is.
So once again he is claiming that an expansion of reserves will increase bank loans because he asserts it will be inflationary and alter the drive the real interest rate into the negative domain.
More recently, Krugman wrote – It’s the stupidity economy. Once again when you read this article you appreciate how far Krugman is from understanding modern monetary theory (MMT), which means he really doesn’t get the way the fiat monetary system works.
His options of how to deal with the ineffectiveness of monetary policy are, in his order of preference, which just rehearse his earlier work in relation to Japan:
- First best: “… credibly commit to higher inflation, so as to reduce real interest rates”. So he is still thinking monetary policy is the best way to proceed.
- Second best: “… a really big fiscal expansion, sufficient to mostly close the output gap. The economic case for doing that is really clear. But Washington is caught up in deficit phobia, and there doesn’t seem to be any chance of getting a big enough push.”
- Third best: “… subsidizing jobs and promoting work-sharing.”
Krugman clearly still believes that monetary policy is the preferred counter-stabilisation tool despite the evidence that it is relatively ineffective in this regard and relies on difficult to determine distributional assumptions about the spending propensities of creditors and debtors.
He also thinks that quantitative easing will expand resources to borrowers by creating an inflationary adjustment to real interest rates. So in this case he wants to tweak monetary policy into action by creating inflation – to move the real interest rate below zero.
Now to the most recent article. Krugman’s record is stuck in the groove it seems.
In the context of the forecasts from Federal Reserve chairman Bernanke that the US can only look forward to “modest economic growth next year – sufficient to bring down the unemployment rate, but at a pace slower than we would like”, Krugman explores the policy options to stimulate faster growth.
He is also more pessimistic than Bernanke and thinks that unemployment might in fact rise. He is correct when he says:
I don’t think many people grasp just how much job creation we need to climb out of the hole we’re in. You can’t just look at the eight million jobs that America has lost since the recession began, because the nation needs to keep adding jobs – more than 100,000 a month – to keep up with a growing population. And that means that we need really big job gains, month after month, if we want to see America return to anything that feels like full employment.
Given this challenge he says that “the political reality is that the president – faced with total obstruction from Republicans, while receiving only lukewarm support from some in his own party – probably can’t get enough votes in Congress to do more than tinker at the edges of the employment problem.”
So he is asserting that fiscal policy has reached the end of the road in the US. This is consistent with claims by the President that the US has run out of money. Please read my blog – The US government has run short of money – for more discussion on this point.
In this context, Krugman says that the US Federal reserve “can do more”. He says that:
The most specific, persuasive case I’ve seen for more Fed action comes from Joseph Gagnon, a former Fed staffer now at the Peterson Institute for International Economics. Basing his analysis on the prior work of none other than Mr. Bernanke himself, in his previous incarnation as an economic researcher, Mr. Gagnon urges the Fed to expand credit by buying a further $2 trillion in assets. Such a program could do a lot to promote faster growth, while having hardly any downside.
So we are back to quantitative easing, which failed to stimulate lending in Japan and is currently failing to stimulate lending in the UK, for example. Please read my blog – Quantitative easing 101 – for more discussion on this point.
The point is that quantitative easing is not really capable of stimulating lending. Krugman clearly doesn’t understand the banking operations that link monetary policy to bank reserves. Developing this understanding is a core differentiating feature of MMT.
But banking professionals also understand it. This recent working paper from the Bank of International Settlements – Unconventional monetary policies: an appraisal is very useful in advancing this understanding.
It argues that mainstream economists have not really thought much about the unconventional monetary policies that have been used in this downturn by central banks.
In relation to these policies, their:
… distinguishing feature is that the central bank actively uses its balance sheet to affect directly market prices and conditions beyond a short-term, typically overnight, interest rate. We thus refer to such policies as “balance sheet policies”, and distinguish them from “interest rate policy”.
In making this distinction, they show that these policies are intended to work by altering “the structure of private sector balance sheets” and targetting “specific” markets. The major points they make are as follows:
First they say that:
… rather paradoxically, some of these policies would have been regarded as “canonical” in academic work on the transmission mechanism of monetary policy done in the 1960s-1970s, given its emphasis on changes in the composition of private sector balance sheets.
That is, the recent history of macroeconomics has attempted to obliterate insights that were well understood during the “Keynesian” period. If you look at a recent macroeconomics textbook, for example, you will struggle to find any reference to liquidity trap (I just searched Barro, Mankiw and Blanchard).
The feature of the “new” textbook era in macroeconomics which began in the 1980s and has intensified in recent years is that students are confronted with one highly stylised “model” of the economy without competing views being presented. The historical debates (like those between Keynes and Pigou – the so-called “Keynes and the Classics” debates – are rarely presented in any coherent form yet remain relevant today.
Students have no scope within these books to dispute the paradigm being presented. It is a take it or leave it approach. The problem is that the stylised models presented have very little relevance for the macroeconomic behaviour they purport to study.
All these books fail to present an accurate rendition of the modern monetary system and so students leave their studies with a wrong-headed understanding of how the monetary system operates and how it interacts with the real economy.
They then say that a:
… key feature of balance sheet policies is that they can be entirely decoupled from the level of interest rates. Technically, all that is needed is for the central bank to have sufficient instruments at its disposal to neutralise the impact that these policies have on interest rates through any induced expansion of bank reserves (holdings of banks’ deposits with the central bank). Generally, central banks are in such a position or can gain the necessary means. This “decoupling principle” also implies that exiting from the current very low, or zero, interest rate policies can be done independently of balance sheet policies.
The “decoupling principle” is based on the way in which the central bank remunerates bank reserves relative to the policy rate, which is the rate it announces as its statement of monetary policy.
Consistent with MMT, there are two broad ways the central bank can manage bank reserves to maintain control over its target rate. First, central banks can buy or sell government debt to “adjust the quantity of reserves to bring about the desired short-term interest rate” a practice that has been “well known to practitioners for a long time” (page 3).
MMT posits exactly the same explanation for public debt issuance – it is not to finance net government spending (outlays above tax revenue) given that the national government does not need to raise revenue in order to spend. Debt issuance is, in fact, a monetary operation to deal with the banks reserves that deficits add and allow central banks to maintain a target rate.
Try finding this explanation for public sector debt issuance in a macroeconomics text book.
Second, “central banks may decide to remunerate excess reserve holdings at the policy rate” which “sets the opportunity cost of holding reserves for banks to zero”. The “central bank can then supply as much as it likes at that rate.” The important point is that the interest rate level set by the central bank is then “delinked from the amount of bank reserves in the system” just as in the first case when the central bank drains reserves by issuing public debt.
So the build-up of bank reserves has no implication for interest rates which are clearly set solely by the central bank. All the mainstream claims that budget deficits will drive interest rates up misunderstand their impact on reserves and the central bank’s capacity to manage these bank reserves in a “decoupled” fashion.
The BIS paper then addresses the issue of the implications of the current build-up in bank reserves. They say:
… we argue that the typical strong emphasis on the role of the expansion of bank reserves in discussions of unconventional monetary policies is misplaced. In our view, the effectiveness of such policies is not much affected by the extent to which they rely on bank reserves as opposed to alternative close substitutes, such as central bank short-term debt. In particular, changes in reserves associated with unconventional monetary policies do not in and of themselves loosen significantly the constraint on bank lending or act as a catalyst for inflation.
So all you Austrian School devotees and mainstream economists who claim that the build-up of bank reserves will be inflationary – take a break for a moment and read what the insiders are telling you.
All mainstream economists including Mark Thoma and others who claim that higher bank reserves make bank lending easier – take a break for a moment and read what the insiders are telling you.
The propositions being developed by the BIS staff in this paper are central to MMT but are absent in any understanding a macroeconomics student will get from a mainstream teaching program. Further, you will not read this sort of analysis in any of the mainstream monetary research articles that are published in all the top-tier journals by academic writers. They simply fail to understand any of these insights because they start with a model that is wrong.
The section of the BIS paper – Are bank reserves special? – which starts on page 16 is very rewarding reading although in places it uses language that is misleading (such as, crowding out) which could be misinterpreted by a reader who is imbued with mainstream concepts.
The BIS authors start by noting that bank reserves “may be seen as special … in their ability either to act as a catalyst for bank lending or to contribute to market stability and confidence”. In this context, they conclude that while “there may be plausible reasons for such a view, the underlying justification is sometimes premised on dubious grounds”.
They argue that:
… bank reserves are uniquely valued by financial institutions because they are the only acceptable means to achieve final settlement of all transactions. From this perspective, reserves may play a special role during times of financial stress, when their smooth distribution within the system can be disrupted. At such times, financial institutions may wish to hold larger reserve balances to manage their heightened illiquidity risk. Indeed, this was the case in the initial stages of the current crisis, when the precautionary demand for reserves increased materially …
They note that the need to maintain financial stability was one of the main reasons why the Bank of Japan expanded bank reserves between 2001 and 2006.
However, it is clear that the liquidity role can be accomplished when the central bank offers flexible arrangements to supply reserves on demand (via exchanges for near-reserve equivalents like short-term government paper).
In other words, there is nothing particularly special about bank reserves in this context.
The reason they consider bank reserves to be “special” lies in their operational significance for monetary policy. The central bank clearly sets the interest rate and generally aims to ensure that the overnight (interbank) rate is equal to it. In this context, bank reserves are:
… powerful and unique … [and] … obliges the central bank to meet the small demand for (excess) reserves very precisely, in order to avoid unwarranted extreme volatility in the rate … But in order to induce banks to accept a large expansion of such balances in the context of balance sheet policy, the central bank has to make bank reserves sufficiently attractive relative to other assets … In effect, this renders them almost perfect substitutes with other short-term sovereign paper. This means paying an equivalent interest rate. In the process, their specialness is lost. Bank reserves become simply another claim issued by the public sector. It is distinguished from others primarily by having an overnight maturity and a narrower base of potential investors.
That statement is not written by one of us (the MMT developers) – rather it comes from the BIS officials. It very clearly demonstrates how the reserve dynamics impact on monetary operations and require the central bank to issue debt or pay a return on reserves to maintain control over its monetary policy target rate.
It also demonstrates that bank reserves are near-equivalents to public debt issuance a point that is lost to mainstream economists.
Finally, the BIS paper considers the reserves – bank lending – inflation nexus. The authors say:
The preceding discussion casts doubt on two oft-heard propositions concerning the implications of the specialness of bank reserves. First, an expansion of bank reserves endows banks with additional resources to extend loans, adding power to balance sheet policy. Second, there is something uniquely inflationary about bank reserves financing.
They correctly point out that those who think that an expansion of bank reserves provides banks with additional resources to extend loans assumes that “bank reserves are needed for banks to make loans”. Accordingly, mainstream economists (such as Mark Thoma) think that the “bank lending is constrained by insufficient access to reserves or more reserves can somehow boost banks’ willingness to lend.”
The BIS authors go on to say that:
… an extreme version of this view is the text-book notion of a stable money multiplier: central banks are able, through exogenous variations in the supply of reserves, to exert a direct influence on the amount of loans and deposits in the banking system.
MMT outrightly rejects these propositions. Bank reserves are not required to make loans and there is no monetary multiplier mechanism at work as described in the text books.
The BIS authors concur and say that:
In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly.
It is obvious why this is the case. Loans create deposits which can then be drawn upon by the borrower. No reserves are needed at that stage. Then, as the BIS paper says, “in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system.”
The loan desk of commercial banks have no interaction with the reserve operations of the monetary system as part of their daily tasks. They just take applications from credit worthy customers who seek loans and assess them accordingly and then approve or reject the loans. In approving a loan they instantly create a deposit (a zero net financial asset transaction).
The only thing that constrains the bank loan desks from expanding credit is a lack of credit-worthy applicants, which can originate from the supply side if banks adopt pessimistic assessments or the demand side if credit-worthy customers are loathe to seek loans.
The BIS authors then demonstrate that:
A striking recent illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan’s “quantitative easing” policy in 2001-2006. Despite significant expansions in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly
And during that time, Paul Krugman was urging the Bank of Japan to conduct quantitative easing to provide more resources to the banks which he claimed would allow them to lend more easily. It is clear that he didn’t get it then and still fails to understand basic banking operations.
I will examine the BIS arguments about reserves and inflation in another blog.
The reason that quantitative easing will not work is very simple – credit will be extended when there are demand for funds from the private sector. That was absent in Japan. Please read my blog – Balance sheet recessions and democracy – for more discussion on this point.
Richard Koo in his 2003 book Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications (John Wiley & Sons) said:
The reason why quantitative easing did not work in Japan is quite simple and has been frequently pointed out by BOJ officials and local market observers: there was no demand for funds in Japan’s private sector.
In order for funds supplied by the central bank to generate inflation, they must be borrowed and spent. That is the only way that money flows around the economy to increase demand. But during Japan’s long slump, businesses left with debt-ridden balance sheets after the bubble’s collapse were focused on restoring their financial health. Companies carrying excess debt refused to borrow even at zero interest rates. That is why neither zero interest rates nor quantitative easing were able to stimulate the economy for the next 15 years.
It may be true that the politics in the US are so destructive that its sovereign government is constrained from using its fiscal instruments to advance public purpose.
From my perspective – of understanding the intrinsic operations of the modern monetary economy – it is extraordinary that we allow ideological constraints to be imposed on our governments which conspire to prevent millions of disadvantaged workers from being able to work and force them and their families to live in poverty.
When there are insufficient jobs the answer is simple. Create more. The national government can always create enough jobs by expanding net public spending. The most direct way to ensure this is to create the jobs itself in the public sector.
But when influential economists like Paul Krugman avoid this reality and instead continually advance economic notions that misunderstand the operations of the monetary system and have been proven over and over again to be vacuous when converted into policy initiatives, you have to wonder what is going on.
The other point is that there has to be activism to bring the political system more in line with the extent of the opportunities that a national government has in a fiat monetary system.
This Post Has 36 Comments
Brilliant post, Bill. One of your best. I’m already spreading it around.
I just checked the Baumol and Blinder’s Macroeconomics (10th edition, 2007 update – don’t have the latest) and sure enough, I didn’t find any reference to liquidity trap, but the money multiplier was there.
Interest in MMT is starting to grow. Warren Mosler showed up on Corrente, a small readership progressive blog yesterday. I commented there about the need for a web site dedicated to a simple presentation of MMT, especially as it relates to policy-making. There’s a lot of info here in previous posts, as well as on Warren’s blog, the economic Perspectives from Kansas City posts, especially those of Randy Wray and Scott Fulwiler, and Marshal Auerbach’s posts at New Deal 2.0. But this stuff needs to be boiled down to simple presentation geared to people interested primarily in policy, together with links to professional references for backup, that is available in one place. Blogs are great for what they do, but a static site is needed to deliver the information. References to MMT, Chartalism, Neo-Chartalism, etc, also need to added to Wikipedia, and the existing articles updated and added to by people qualified to state the matter professionally, but in simple terms that folks who are neither economists nor financial types can easily get. A lot of the content has already been written. It just needs to be organized and present with good navigation and links on a dedicated MMT site on which a variety of voices are heard.
The opportunity cost of not getting this out there as widely and quickly as possible is too great. As you conclude, “there has to be more activism…”
Bill says in his penultimate para: “You have to wonder what is going on”. Possibly it’s this.
It looks like Krugman is under contract to produce a number of column inches per week for the New York Times and perhaps other papers. There are journalists in the UK who I know to be intelligent knowledgeable people, but they have undertaken to write a certain number of articles per week. They end up, in some cases, spewing out so much hot air that I just ignore them.
Dictators allegedly end up believing their own propaganda. Perhaps people who sign the above sort of contracts with newspapers are in danger of believing their own hot air: they end up damaging their own brains perhaps.
I agree Mr Hickey
The message needs to be spread about MMT. We are strangling ourselves economically for no good reason.
One thing that might help is to drop the “T”. Or at least find another word besides theory to use. Maybe “Modern Monetary Tabulations”.
In this day and age the word theory is ripe for criticism from the conservative side. Ya know they need proof, except when its one of their pet ideas.
Oh and BTW
I sent an email to Comedy Central asking that they contact Mr Mitchell about appearing on John Stewarts or Steven Colberts show. No better forum for him to get his ideas mainstreamed. John and Steven are more trusted than Cronkite in his day.
“References to MMT, Chartalism, Neo-Chartalism, etc, also need to added to Wikipedia”.
I agree that this is a great way spread the word (based on my frequent personal use of this site anyway). When I searched for modern monetary theory I was redirected to the page on “chartalism” –
I thought the article was a good introduction to the topic. Maybe more information could be added but you then run the risk of overloading the reader looking for a high level introduction. The page also refers (in the space of a single sentance) to Randy’s use of the term “neo-chartalism”.
It seems from the statistics feature of wikipedia (located as a link within the history tab) the that the word is getting out. The viewings of the page on “chartalism” showed a promising trend, and were as follows:
12/07 112 visits
12/08 344 visits
11/09 1092 visits
month to 13/12/09 377 visits
Perhaps another approach would be to update existing wiki pages with references to the modern money responses and models. For instance, the wikipedia pages on the topics “Quantitative Easing” and “Liquidity Trap” express the orthodox understandings and approaches critiqued by Bill in this post, but of course no MMT insights are expressed there. The comparison with visits to the “Chartalism” article, in the month to date, are as follows:
Quantitative Easing: month to 13/12/09 9,987 visits
Liquidity trap: month to 13/12/09 5,617 visits
I agree here with the sentiments and ideas of Tom and Greg, we need to use as many media and channels as possible to expose economists and people to these ideas. While updating existing articles to MMT ideas runs the risk (indeed likelihood) of entering into an editing war with mainstream economists, it is hard to say in advance whether it would be worthwhile or not.
Is there a small misunderstanding going on here? I am no economist, but reading the Gagnon paper, he recommends, not adding to bank reserves, but the Fed buying treasuries, i.e. printing two $trillion and pouring it into over into the private economy. I am not sure this is the same thing you mean by quantitative easing, i.e. adding to bank reserves, which are already sky-high. So, even though direct fiscal spending might be preferable for unemployment, the Gagnon model would also have beneficial macro effects, (partly by generating inflation/fighting deflation, partly by lowering long-term rates). He does fail to include unemployment in his model statistics of future growth under alternate plans, but his GDP recovery scenarios must involve commensurate employment gains.
Bill, you write:
This is an important and powerful point. It is always worth testing theory against practice and, having spent a number of years responsible for the loan book of an Australian bank, I can certainly vouch for the fact that the bank’s balances with the Reserve Bank had no bearing on lending decisions. The driving factors were risk and return. The risk being the risk that the borrower would default (quantified in practice by an internal method of risk-based capital allocation to each loan) and the return being both the fee and interest income generated on the loan itself as well as “cross-sell” opportunities in other products such as foreign exchange, derivatives, capital markets underwriting and transactional banking that may be more easily won if we provided a loan. Exactly how the risk and return was balanced could change over time as the bank adjusted it’s so-called “risk appetite” (this translated into a requirement of a minimum return on the risk capital). For us, lending was purely a margin business as the bank’s treasury area was responsible for providing the money for the borrower. Treasury would charge us a “transfer priced” rate of interest and we would charge the customer a margin above that to cover the required return for the credit risk. Indirectly the bank’s treasury could influence the balance of the lending risk/return equation by increasing or decreasing their transfer-priced funding rate to us, but that was a function of the rates of interest they were paying on retail and wholesale deposits rather than a direct attempt to change our lending practices.
All of that is a long winded way of saying that, as you have observed here and elsewhere, the extent of the bank’s lending was a function of how much credit risk we wanted to take on at a given price (supply) and how much our customers wanted to borrow from us at a given price (demand) and never a function of the amount the bank had in its exchange settlement account (reserves for US readers) with the central bank.
Welcome to the blog! Firstly in this blog the word “money” is used very carefully. Money is always someone else’s liability. Currency notes are government’s liability and bank deposits are bank liabilities. A more careful way of studying “money” is via balance sheets. “Pouring” has no meaning with central bank’s actions – the CB just exchanges one asset for another. You may find this post very useful Money Multiplier and other myths
“All these books fail to present an accurate rendition of the modern monetary system and so students leave their studies with a wrong-headed understanding of how the monetary system operates and how it interacts with the real economy.”
As an economics student at the moment I can attest to the fact that there is very little teaching of how the monetary system actually operates in Australia’s bluestone/ sandstone universities.
You would think that this teaching would be of value to our commercial, investment and central banks. Although, if I were to be cycnical there appears to be more money to be made in not getting it- but this isn’t reserved to the economics profession.
Far to great a reliance is placed on US economics text books in these courses, and everything has to be super dumbed down so it can be easily force fed to the kiddies.
Never mind that the theory that is propogated bears very little reference to reality.
Love the blog Bill, and look forward to a MMT text book in the very near future- so that we students can consider an atlernate perspective to that glibly served up at present.
So we have a US Comedy Central live hookup to the east coast of Australia. That would be good!
The use of the term “economics student” in the same sentence when you are studying out of the mainstream texts is somewhat of misnomer. Being a student suggests you are learning something worthwhile. Economics students just get their heads f***** over.
Thanks for the nice comments. The text book is emerging when Randy and I can find spare time (another oxymoron) to finish it.
QE is the exchange of reserves for financial assets (and as you note – long-term government paper). The only way it might be stimulatory is if the reduction in long-term rates (which it implies) generates a boost in investment. The evidence to support this claim is weak. It certainly does not expand the banks’ capacities to lend. So there is no stimulus coming from that sort of channel.
Further, it is not inflationary (as today’s post argues) despite the commonly held belief that a build-up of reserves is inflationary.
I also think Ramanan’s comments are worthy of consideration. You have to be very careful using the term “pouring money” into the economy. Adding resources is hardly worthy of that sort of imagery.
Morgan Stanley (UK) released a report on the effects of Quantitative Easing where they seem to understand the accounting i.e. loans create deposits, and that the ‘multipliers’ have been tiny. And then advance a A partial solution? lower remuneration on a portion of reserves akin to Sweden.
I suspect if they (Comedy Central) contact you and you really wow them they will bring you to NewYork for a face to face interview with John or Stephen (hope for John he’s a little better interviewer), no need for a live hook up to east coast of Australia.
One of the authors of that piece, Charles Goodhart, has written extensively about Chartalism and is an Academic endorser of Warren Mosler’s SCE site yet his views on QE seem to contracdict SCE/MMT. Must be something about the Brits as Tim Condgon, another British economist, is an endorser-contradictor as well.
Thanks for this.
I assume you have seen this.
our governments which conspire to prevent millions of disadvantaged workers from being able to work and force them and their families to live in poverty.
“Disadvantaged workers” ??? How about workers NOT PRODUCTIVE ENOUGH to generate a level of nominal income (profit) high enough to fund BOTH new investments AND sunk costs? Government “aid”, both in the form of money creation and deficit spending, functions as a net driver of economic growth ONLY when it refuses to throw good money after bad in the form of funding sunk costs. WHAT IS THE ENTIRETY OF THE BAILOUTS THUS FAR OTHER THAN FUNDING SUNK COSTS? For example, in a properly functioning banking system, bankers would not be hoarding printed cash (so called “reserves”) to continuously fund bad investments in the form of legacy SIVs being brought back on balance sheet. Instead, they would write these loans off, take the losses and either go out of business or begin lending again. There would be no need for fake reserves. Instead, we kick the can down the road.
The core problem in a deflationary economy is the inability of the existing stock of investments to create enough nominal income to fund debt service costs on investments made previously. For a market economy to begin functioning normally (growing) again, the existing stock of (mal)investments MUST be written down to a level capable of being funded by the newly deflated economy. If this writedown is forestalled or postponed (see current U.S. fiscal and monetary policy), economic stagnation and crony capitalism are two inevitable results. In simple terms, the economic narrative becomes more about “who knows who” rather than “who knows what” because the capital allocation function of the markets is circumvented by political fiat.
being able to work and force them and their families to live in poverty.
Oh, yea…and who “forced” many of these SAME families into buying $650K, 3500 sq ft homes with 2% down payments and Option ARM loans? Flip side of your question.
Thank you for the post.
This is a subject that I have been thinking about quite a lot and I have been meaning to ask. In my limited exposure and knowledge the Post Keynesian view that loans create deposits and that banks are not reserve constrained seems sound. Why is it then not universally accepted by the mainstream? Surely ignorance and ideology cannot explain it away completely – there must have been some dialogue between ‘Post Keynesians’ and the mainstream*.
I’m also unsure as to why banks pay an interest on deposits. I read a blog post recently over at the ‘Coordination Problem’ (previously Austrian Economics), which seems to claim this as definite proof that banks loan out deposits – I am unsure how to explain why this would occur under the “loans create deposits” framework. My thoughts are that the bank provides an incentive for the customer to keep their deposit with that bank, rather than switching to another bank (which as I understand would lead to a reserve drain as the bank balances its exchange settlement account).
Though I have a feeling I may be wrong on this.
*I should note that my macro textbook last semester actually presented a horizontal money supply curve in conjunction with the standard vertical one, along with something like (from memory) “some economists content that the central bank cannot control the money supply whilst targeting interest rates” but then it was quickly back to the standard neo-classical view of banks being reserve constrained.
I agree that banks are certainly not constrained by the capital requirements when they wish to write a new loan. Liquidity therefore is never an issue (loans create deposits etc etc).
However, because of capital requirements, they are still required to hold a certain level of equity capital for all the loans they make. So although making more loans –> more profit, this also means that –> more required equity –> same return on equity.
So it seems to me that the capital requirements do not create a liquidity constraint; however they create a return constraint because after a certain point return on equity stops rising, eradicating the incentive for the bank to write new loans.
Am I right? Please respond (anyone!) because this is a question that is considerably bugging me!
That sounds spot on to me. It is the capital regulation that stops a bank issuing as many loans as there are customers to take them. That’s why banks spend so much time and money trying to make it look like they have lots of regulatory capital using various nefarious means.
The other constraint is the price of the liquidity since that is added to the ‘turn’ that the banks charge to give the total cost of the loan. That total price then limits the number of customers coming in the front door.
So a bank either hits its regulatory capital limit or its ‘number of customers willing to pay the price’ limit and the lower of those determines the amount of loans it can issue profitably. (Obviously it can go beyond the customer limit if it wants to lend unprofitably – just subsidise the interest rate – but it shouldn’t be able to go above the regulatory limit).
Liquidity costs and capital are generally balanced. When a bank is perceived as having little or no capital then liquidity costs go through the roof. Issuing loans is not itself a problem for any bank with any capital position. All issued loans bring in cash flow. The problem is to settle those loans (i.e. deposits) on demand.
“Krugman clearly still believes that monetary policy is the preferred counter-stabilisation tool despite the evidence that it is relatively ineffective in this regard and relies on difficult to determine distributional assumptions about the spending propensities of creditors and debtors.”
Big fail for you. The distributional assumptions about the spending propensities of creditors and debtors are empirically easy to determine. Poor people spend more, rich people spend less. poor people are debtors, rich people are creditors.
There may be other periods and places were poor people are creditors and rich people are debtors, but this is very, VERY easy to research at any given time. Most of the time, rich people save and poor people spend, and the empirical evidence for this is overwhelming.
Accordingly the correct distribuational assumptions are trivial to research. Any policy which benefits debtors and erodes creditors is economically beneficially right now, for the same reason as taxing the rich and giving it to the poor is beneficial. Negative interest rates — a depreciating currency — would have that effect. Taxing the rich and giving the money to the poor is *known* to be good for the economy (not to mention the health of the political system).
I suggest you correct this. Krugman is absolutely right that eroding the wealth of the rich through negative interest rates would work, if it were implementable. You may consider this an absurdly indirect way of doing things, but it has enough auxiliary benefits it’s worth taking much more seriously than you do.
Tessera, beautifully accurate.
Shortsighted, you’re right about deposits; banks compete to prevent deposits from going to *other banks*. There’s a second effect though, they are also competing with such entities as “money market funds” (shadow banking at its finest); and a third effect, they’re competing with things like stocks and bonds; and a fourth effect, they’re competing with money under the mattress.
Banks are required by regulation to have a certain amount of deposits — which is determined largely by the amount they are lending — or be shut down. Hence, increased lending drives increased demand for deposits.
It used to be that banks had no alternative to deposits (except corporate bonds which are similar, and equity which is fickle) and were genuinely and permanently reserve-constrained. That was before the Federal Reserve and similar “lenders of last resort” were invented. The creation of the “shadow banking system” created a new group of genuinely reserves-constrained “shadow banks”, subject to bank runs.
I’m not sure the MMT folks have fully analyzed the meaning of this. Perhaps some study of the 19th century US period with private banks issuing private banknotes might be informative. Despite sharing the same “unit of account” as the government-issued currency, a money market account is not government-backed money in the way that a central-bank-backed bank account is government-backed money; it clearly has the behavior of money but it is private money, and it is not clear to me that it is under government control at all.
Dear Nathanael (at 2011/04/02 at 4:27)
While we know conceptually that poor people spend more etc, it is actually very difficult to estimate this accurate. I have been working on that for many years and like others it is a vexed area. You have to take into account the spatial distribution of different cohorts as well as the fact that there is no such thing as “poor” people (as a block category). Further you have to consider income tax thresholds etc.
So yes we know broadly – but not specifically.
“Shortsighted, you’re right about deposits; banks compete to prevent deposits from going to *other banks*. There’s a second effect though, they are also competing with such entities as “money market funds” (shadow banking at its finest); and a third effect, they’re competing with things like stocks and bonds; and a fourth effect, they’re competing with money under the mattress.”
I am not sure you have fully analysed the meaning of this. The only valid point is about mattress. But in this case all money saved under the mattress comes from the central bank. However much people want to put under the mattress everything to the penny comes from the central bank. So how do banks compete for it?
The entire phrase in page 3 is:
“(o)ne is to use OMOs [open market operations] adjust the quantity of
reserves to bring about the desired short-term interest rate, implicitly or explicitly drawing on
an identified demand schedule. Neither in the past nor in the current review have we even
briefly entertained the notion that this is realistic.” (Tucker (2004, p. 12, italics added))”
So I understand this like a negation of what MMT says, no? or I’m wrong?
Tessera: “it seems to me that the capital requirements do not create a liquidity constraint; however they create a return constraint because after a certain point return on equity stops rising, eradicating the incentive for the bank to write new loans.”
Hi Tessera, Minsky argued that banks continuously innovate new products so that they can reduce their reserves while still ensuring that those borrower’s have vicarious access to the Fed discount window. The classic example is CP, which is liquidity-backstopped by banks but incurs no reserve or capital requirements. If the borrower finds they are unable to roll over their CP, the bank can always provide sufficient liquidity to repay the outstanding CP because it can discount the CP with the Fed to access liquidity itself and lend that to the borrower to repay the CP. That greatly reduces the interest rate that CP borrowers must pay, but it also means that banks are able to lend regardless of capital or reserve constraints. Minsky argued for greater oversight of banks lending books by the Fed to make sure that they weren’t exploiting such innovations to dangerously increase leverage in the system.
Banks loan primarily based on likelihood that the borrower, will pay back the loan plus interest. But why do they care whether the borrower can pay back the loan, since they are simply typing the loan into existence on a computer. It seems the bank doesn’t really stand to lose anything real, if the loan doesn’t get paid back?
Also, If loans are typed into existence without reference to reserves or any other constraint other than risk of the loan not being repaid, why are banks required to keep deposits? Do deposits have an actual function? If so what is it, if not, why keep them?
the bank A could not care about the loan being repayed if it was the only one bank “in town”. But borrower can take his loan deposited at bank A and move it to bank B. Bank B will not accept deposit from bank A (which is liability for bank) without corresponding movement of bank reserves (reserves are assets) from bank A to bank B. Now if borrower defaults on his loan bank A loses not only interest on the loan but also all the amount of the loan as reserves (an asset) were moved to bank B.
That’s how I understand, but I’m only learning 😉
I have the impression that you either misunderstand or misrepresent Krugman’s argument. I have not read the Gagnon paper, so I really cannot say what the exact argument is there, and also what Krugman advocates in his 2009 column.
But I have read the Krugman article from 1999 on the liquidity trap in Japan, and the argument he makes there seems to be different from the one that you criticize.
First of all, in the 1999 article he clearly dismisses a role for fiscal policy out of a worry about fiscal constraints. I think he is wrong there, and I agree with your assessment. But that is not the position he is taking now, 10 years later in 2009, with regard to the US: He is clearly in favor of a fiscal “stimulus” program, and has said so many times. Right now, he judges that this is politically infeasible. I think this is correct, but it does not mean he believes that the government has run out of money. So I think it is disingenuous when you write that his position is “consistent with claims by the President that the US has run out of money.” Nonsense. He says that other people believe this – you say so yourself, when you criticize this as a misconception, which it certainly is. He does not say that he believes this.
My main point, however, is that you seem to misunderstand the argument in his 1999 article, and the same point that he currently (2012) makes with regard to possible action by the Fed. The idea, as I understand it, is to raise inflation expectations. If this can be done credibly, then people with liquid assets might be more willing and likely to swap them into real goods, stimulating the economy, instead of seeing the value of their liquid financial assets decline.
For this to happen, there need not be any mechanism that translates higher reserves into more credit, or into higher inflations. This is all about expectations and psychology.
You argue yourself that most people do not in fact understand that quantitative easing and higher reserves do not lead to an expanded money supply and to inflation. I believe that Krugman understands this as well. He writes in the 1999 liquidity trap article:
Isn’t this exactly what you are saying? To me, he appears to “get it”.
But this is completely beside the point, if most people do not understand it. If enough people believe that the central bank is pursuing an inflationary policy, and if the central bank signals this by doing something drastic (like large-scale quantitative easing), which might not have any effect at all, but is widely believed to have an inflationary effect, then people will react to this out of their (perhaps wrong) subjective expectations, and this might get them to swap liquid assets for real goods and services, thus stimulating the economy.
This might work or might not work, but it does not seems to be incompatible with the MMT view, and it does not rely on the idea that bank reserves expand credit – only on the (widely held, though wrong) idea that increased reserves are inflationary. You will certainly not dispute that many people hold that view and can be expected to act on it, will you?
” but is widely believed to have an inflationary effect, then people will react to this out of their (perhaps wrong) subjective expectations, and this might get them to swap liquid assets for real goods and services, thus stimulating the economy.”
And they might not.
The other entirely rational approach to increased ‘inflation expectations’ is to feel more fear about the future. And fear about the future translates into more saving. And more saving increases the paradox of thrift *because there is no way the savings market will clear short of a depression*.
So you are on dangerous territory trying to play mind games and deception. It’s like messing with cattle. You might just get killed in the resulting stampede.
Does Australia’s ‘Work for the dole’ scheme mirror in any way your full employment proposal? Is it a miniature version?
Dear John Kelly (at 2014/12/22 at 6:39)
The Job Guarantee bears no similarity with the Work for the Dole program that the Australian government implements nor any so-called workfare schemes that are in place around the world. These schemes are compliance and punishment regimes. The Job Guarantee is based on hope and inclusion and recognises the problem is a lack of jobs not a lack of effort by the unemployed.
To learn more read through the blogs under this link https://billmitchell.org/blog/?cat=23
What should I say professor Mitchell!? I have studied political economy, banking and monetary operations respectively in Blanchard’s textbook and in a funny boconian textbook. Moreover, I have some professors who teach us that deposits create loans, government deficit spending crowds out market agents and spreads up interest rates; that monetary policies have their spillover and healthy effects on aggregate investments and output, that central bank reserves are multiplied in more loans and deposits and ‘dulcis in fundo’, any government ‘finances’ its spending through treasury bills and bonds issuance and through taxes. The nice news is that I have been writing my thesis about MMT struggling with these professors and kinds of luminars…. But, what should I excepted from an university in which Cottarelli (Imf), Siniscalco (Morgan Stanley), Giarda (Banco popolare di Milano), with Polito (Corriere della Sera) acting as moderator, are invited in order to talk about the necessity of facing spending review here in Italy, so in the eurozone!? Indeed, here in Italy and through the whole euroland, we are dying of huge deficits!!!
However, let me say thank you to you professor Mitchell again, for another precious and exaustive paper about monetary and banking operations, as you have by now accustomed us to.
Prof.Mitchell says,”The reason that quantitative easing will not work is very simple – credit will be extended when there are demand for funds from the private sector. That was absent in Japan.”
Certainly, in Japan, the demand for funds was not strong by large corporations by taking out funds from internal reserves, but the Bank of Japan’s quantitative easing has the aspect of collecting government bonds that is a source of financial resources to the government. As a result, it urges the redemption of government bonds and prepares issued bonds and other “public short bonds” in special accounts.