26 Aug 2010

Ellen Zentner on Marketplace: Fool or Genius?

Financial Economics 5 Comments

OK I was originally going to rip apart this analysis (on NPR’s Marketplace) from Ellen Zentner, senior economist at the Bank of Tokyo Mitsubishi:

Chairman Bernanke has come out and specifically said that one of the further measures they could do to get the economy moving was lowering that rate that they pay on excess reserves. That’s the rate that they pay banks in order to hold excess reserves at the Federal Reserve, that by lowering that rate, the idea would be that the banks would then start to lend money. St. Louis Fed President Bullard came out and said absolutely not, that’s a dead[-end] policy and it won’t work. But at the same time, I have to agree with Bullard, because right now, there’s just disincentive for banks to lend when the banks can borrow from the Fed at a quarter percent interest and dump it into treasuries at 2.5 to 3 percent. They get a nice tidy gain, risk-free return. And essentially, it’s been tying up about $1 trillion in available credit. So in a sense, the Fed has been causing part of the problem by leaving rates so low.

Originally, my problem with this statement is that if the banks are buying Treasurys, then they are lending out the money. After all, if Uncle Sam sells you a Treasury, he’s borrowing money, right? So if he’s borrowing, the person on the other end must be…lending.

My other big problem was that I wasn’t sure if Zentner was talking about the fed fund market or the discount window. If the former, then the banks aren’t borrowing from the Fed at all. And if the latter, then the borrowed funds are created out of thin air, so it’s not “typing up credit.”

But then I was really thinking it through, and I got stuck. So now I’m thinking maybe Zentner’s basic point is correct.

Here’s what’s tripping me up: Let’s say you’re a bank and you’ve got $100 million in excess reserves. Normally the bank would make $100 million in new loans to its customers, by opening new checking accounts and magically crediting the accounts with $100 million total in balances. (I explain this magical process here.)

But what if, instead of “lending out” the $100 million in excess reserves in the textbook fashion, instead the bank buys $100 million in a new Treasury auction?

Well, in one sense it shouldn’t affect the analysis. Instead of throwing a new mortgage onto its balance sheet, now the bank throws on some IOUs from the Treasury. And on its liabilities side, the bank has an outstanding claim of $100 million in the form of the check it wrote to Uncle Sam.

But it seems there is something crucially different between the two scenarios. In the textbook case, the money supply (think of M1 or M2) goes up by $100 million in the first round.

Yet in the case of buying Treasuries, I don’t think M1 goes up. It’s not as if the bank opens a checking account and credits the Treasury with $100 million; I think the bank just (effectively) hands over the $100 million in reserves to Uncle Sam, who then spends it until that money quickly finds its way back into the stockpile of excess reserves.

It seems like I’m analyzing this properly, but I have two problems:

(1) What specifically is the difference between the two cases? I’m having a hard time putting my finger on it.

(2) If the first bank can acquire $100 million in Treasury bonds, and that original $100 million ends up back as excess reserves, then why couldn’t the banks eventually buy all the Treasury bonds in the world, with that same $100 million turning over time and again?

…

Ah, OK, I think I’ve figured out what step I’m leaving out. Well, it’s late. I’m not going to change the above. I’m back to thinking Zentner’s analysis is messed up, but since it took me 10 minutes to get it straight myself, we can cut her some slack.

I will end now, and make this post like an Encyclopedia Brown story. “Hey kids, what did Dr. Bob realize about banks investing their excess reserves in U.S. Treasuries?”

5 Responses to “Ellen Zentner on Marketplace: Fool or Genius?”

  1. Yogi says:
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    Isn’t the cash reserve ratio applicable if you are lending to Government ?

  2. Sukrit says:
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    In ” Law, Property Rights and Air Pollution” Murray Rothbard argues against the mainstream legal principle of vicarious liability, saying it should be abolished as it’s inconsistent with justice, as only the individuals who committed a wrong should be held responsible – not their employers.

    However, he later applies a suspiciously similar principle to explain how road owners should be sued for the wrongs of the individual car owners who use their roads (p. 90):

    While the situation for plaintiffs against auto emissions might seem hopeless under libertarian law, there is a partial way out. In a libertarian society, the roads would be privately owned. This means that the auto emissions would be emanating from the road of the road owner into the lungs or airspace of other citizens, so that the road owner would be liable for pollution damage to the surrounding inhabitants. Suing the road owner is much more feasible than suing each individual car owner for the minute amount of pollutants he might be responsible for. In order to protect himself from these suits, or even from possible injunctions, the road owner would then have the economic incentive to issue anti-pollution regulations for all cars that wish to ride on his road. Once again, as in other cases of the “tragedy of the commons,” private ownership of the resource can solve many “externality” problems.

    Isn’t this inconsistent?? Or am I not understanding the meaning of “vicarious liability”?

  3. ADA says:
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    According to Rothbard in Mystery of Banking, banks simply expand credit to buy government securities just like any other loan. So if a bank has $100 in reserves, it could buy up to $900 of government bonds for a 10% reserve requirement.

  4. david says:
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    I am confused (again).

    Zentner seems to be equating holding bank excess reserves with banks holding treasuries or at least arguing that the current Fed rate/treasury rate spread is the cause of the current high level of excess reserves. Holding excess reserves and holding treasuries are substitutes. A more attractive Fed rate/treasury rate spread should, ceteris paribus, reduce excess reserves, not increase them. In fact, if it was such a sweet deal, the banks would be holding more assets in the form of treasuries and less in the form of excess reserves. Haven’t I got that right?

    Plus, everyone makes a big deal about banks being able to borrow from the Fed at zero interest rates but isn’t it the spread that is relevant to the banks’ decision to hold treasuries, not the level at which they borrow. Just quickly eye-balling the data, it appears that there was a similar spread in the early 1990s and from about 2002-2005 or so. FWIW.

  5. david says:
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    Forgot to mention: my assessment of the cause of high excess reserves (and high corporate cash holdings) – regime uncertainty. Cause of regime uncertainty? Excessive government intervention in many forms but mostly polluting market signals via counter-cyclical fiscal “stimulus”.

    Fiscal stimulus is not a complement to expansionary monetary policy, it is the opposite (i.e., it elevates the demand for money).