{"id":14772,"date":"2011-06-07T06:00:03","date_gmt":"2011-06-06T20:00:03","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=14772"},"modified":"2011-06-07T06:00:03","modified_gmt":"2011-06-06T20:00:03","slug":"beware-the-wolf-in-sheeps-clothing","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=14772","title":{"rendered":"Beware the wolf in sheep’s clothing"},"content":{"rendered":"

\t\t\t\tSeveral readers have written to me asking me to comment on a recent paper that the New York Federal Reserve released as a Staff Report (May 2011) – A Note on Bank Lending in Times of Large Bank Reserves<\/a>. Apparently, there is an impression that the federal reserve economists might be seeing the light a bit about the banking system and the way economists think about it. The reason that some readers have concluded that is because the substantive conclusion of the paper is that credit expansion is independent of the level of banking reserves held at the central bank. This conclusion is totally consistent with Modern Monetary Theory (MMT) but is at odds with the standard mainstream macroeconomic view (as taught in textbooks) that relies on the money multiplier to draw a (spurious) connection between bank reserves and the money supply. As you will see – my advice is to be very careful when reading such papers – they are not what they seem. The FRNY paper reaches the correct conclusion using erroneous theory which they partition as a special case arising from the extreme circumstances surrounding the crisis. Even in defining their “model” as a special case, they employ flawed logic. It is a case of being beware of the wolf in sheep’s clothing.
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\nThe paper begins by noting that “(t)he amount of reserves held by the U.S. banking system reached $1.5 trillion in April 2011” and if we note the latest (May 2011) data from the US Federal Reserve – Aggregate Reserves of Depository Institutions<\/a> – the reserves have risen to near $US1.6 trillion as a result of the Fed’s program to purchase ($US600 billion) Treasury securities (which finishes next month).<\/p>\n

The following graph shows the evolution of US bank reserves from January 1959 to May 2011 including the extraordinary escalation during the current crisis.<\/p>\n

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The FRNY authors are clearly challenged by the reserve dynamics revealed in the graph and seek to explain why the “such a large quantity of bank reserves” has not led to “an overly expansive bank lending as the economy recovers”,<\/p>\n

From the perspective of Modern Monetary Theory (MMT) such a question is a non-issue. It is as simple as understanding that banks do not<\/strong> lend bank reserves. They are integral to the payments (settlements) system only. Banks are never reserve constrained when it comes to lending and will extend credit to any worthy customer who seeks it.<\/p>\n

So the problem that the FRNY paper poses is a non-problem once you fully understand how the monetary system and the banking institutions within it operate.<\/p>\n

Please read the following blogs – Building bank reserves will not expand credit<\/a> and Building bank reserves is not inflationary<\/a> – for further discussion.<\/p>\n

The reason the FRNY is puzzled by the lack of credit expansion in the face of an unprecedented build-up in bank reserves is because they start from the mainstream textbook approach.<\/p>\n

They also note that:<\/p>\n

\n… several economists and financial market participants claim that large levels of bank reserves will lead to overly expansive bank lending … Despite such concerns, little formal analysis has been conducted to show such an effect under the current banking system. It is incumbent on commentators claiming otherwise to specify how large reserves would lead to excessive lending.\n<\/p><\/blockquote>\n

Many leading mainstream monetary economists have been issuing warnings since the US Federal Reserve Bank started expanding its balance sheet in this way that there would be a boom in credit and “all that money” would be loaned out and inflation would result.<\/p>\n

But the reality has been different. This has been one of the many demonstrations during this crisis of how impoverished mainstream theory is. There completely erroneous predictions cannot be explained by the fact that during the crisis there has been more volatility and uncertainty than usual which has impacted on forecasting accuracy across the board.<\/p>\n

Rather, their failure is an intrinsic one – they deploy a totally flawed model which neither saw the crisis coming nor has been able to detail anything credible about how we might attenuate it.<\/p>\n

The FRNY paper realises that the mainstream textbook model that underpins most of the public commentary on macroeconomics at present is in trouble and tries to develop what they claim is a new approach to the problem. As you will see there is no saving grace in their approach.<\/p>\n

To prepare the readers for what they will eventually deem to be a “special case” of the mainstream model, the authors claim that:<\/p>\n

\nThe current banking system in the United States and worldwide no longer resembles the traditional textbook model of fractional reserve banking. Historically, the quantity of reserves supplied by a central bank determines the amount of bank loans. Through the “money multiplier”, banks expand loans to equal the amount of reserves divided by the reserve requirement. However, in many countries, reserve requirements have been reduced either to zero, or to such small levels that they are no longer binding.\n<\/p><\/blockquote>\n

Their version of history is seriously deficient. The textbook monetary model has always been an erroneous depiction of the way the system operated.<\/p>\n

The money multiplier, which is central to the way the mainstream understand banking, has always been amiss. They think in these terms.<\/p>\n

The mainstream theory alleges that the money multiplier m<\/em> transmits changes in the so-called monetary base (MB) (the sum of bank reserves and currency at issue) into changes in the money supply (M). Students then labour through algebra of varying complexity depending on their level of study to derive the m<\/em>, which is most simply expressed as the inverse of the required reserve ratio.<\/p>\n

So if the central bank told private banks that they had to keep 10 per cent of total deposits as reserves then the required reserve ratio (RRR) would be 0.10 and m would equal 1\/0.10 = 10. More complicated formulae are derived when you consider that people also will want to hold some of their deposits as cash. But these complications do not add anything to the story.<\/p>\n

The formula for the determination of the money supply is: M<\/em> = m<\/em> times MB<\/em>. So if a $1 is newly deposited in a bank, the money supply will rise (be multiplied) by $10 (if the RRR = 0.10). The way this multiplier is alleged to work is explained as follows (assuming the bank is required to hold 10 per cent of all deposits as reserves):<\/p>\n