Potpourri
At long last, my crazy traveling schedule is winding down for a few weeks at least. Here are some things of note:
* Yesterday I was a guest on Peter Schiff’s radio show. (I think this link takes you right to the interview. Note that you DON’T have to buy membership to Schiff’s site to listen to the podcast, even though it might look like you do.) Now kids, I don’t recommend this for up-and-coming authors, but I did something quite extraordinary just after the 8:00 mark. Schiff lobbed me a softball, asking me to talk about my books, but instead I launched into an explanation of the “worst mistake of my career.” As I say, this is an advanced move; the conventional wisdom says that when a radio host asks you about your books…you start hawking your books. (Incidentally, I was on a cell phone in a Cracker Barrel parking lot, which is why Schiff and I sometimes were talking over each other.)
* Here’s my recent article on quantitative easing. It has a scary “black swan scenario” at the end.
* Vijay Boyapati is yet another person to discover the power of The Point.
* I’m not saying the last two sentences of this Caplan post are wrong, nor am I saying that this earlier Caplan post is wrong. What I am saying is that they can’t both be right.
* A lot of people are trying to figure out if the Fed is good or bad, in response to this fascinating paper by Selgin, Lastrapes, and White. My favorite reaction was (of course) from Tyler Cowen, who said that the 1929-1932 period showed the dangers of not having a Fed. (At least Cowen conceded that this was an odd statement to make, since the Fed was established in 1913.) Say what you will about Krugman, I don’t think he has ever categorized 2009-2010 as a “world without stimulus.”
* If you haven’t already seen it, check out the Taleb video on QE2 that Wenzel showcases.
* Here is the 34-minute talk I gave today at the Mises Institute’s High School Seminar. It was on the division of labor. It was pretty funny, if I do say so myself. Many more yuks than in Adam Smith.
I listened to the radio show when you were on air and I was quite exited about Murphy and Schiff combined. Anyway, I was a little disappointed with the interview. I had the feeling that Peter occasionally forgot that he was actually supposed to ask you and instead started to talk about his own views. I would have loved to hear you elaborating a little bit more about your views on Krugman and Keynesian theories like the liquidity trap. After all, we should not forget that Krugman is not an idiot whom we just haven’t ridiculed enough (which Peter sometimes seems to believe). He knows his stuff and he has got his arguments and his data and proving him wrong is not going to be an easy endeavor.
Bill Woolsey mentioned on his blog that you made a mistake in your analysis of QE. Have you seen that? I’d love to hear your response.
Thanks for the tip; I hadn’t seen it before. Yeah I think he’s right that I skipped a step. It doesn’t change my basic analysis, but I see what he is saying. I will either do a blog post, or perhaps even a longer Mises.org article on it.
You implicitly called Scott Sumner a Keynesian. Poor guy.
In this essay, Mr. Murphy explains how the banking system is never reserve constrained.
http://mises.org/daily/4499
But in the essay referenced above, he makes the claim “At some point, some commercial banks will find it more attractive to begin lending out their nearly trillion dollars in excess reserves, rather than keeping them on deposit with the Fed, where they currently earn 0.25 percent” and also a scenario could play out where “excess reserves begin flying out of the commercial banks.”
Now I’m not saying which essay is wrong, but they both can’t be right.
Where do I explain “how the banking system is never reserve constrained” in that first essay?
Ask AP “Hut Tax” Lerner to explain how the magic benevolent state is NEVER revenue constrained.
And how government deficits are the cause of private savings.
In the essay, you state: “The people who receive those checks are going to deposit them in their own banks; and, during normal interbank clearing operations, the original bank will receive requests to transfer out $9,000 of its reserves.”
The process you describe in the essay is the basic concept of loans creating deposits in the banking system, and a normal functioning interbank market being used to satisfy reserve requirements. Loans create deposits, and reserves requirements can always be met in the interbank market. You (incorrectly) describe this process as ‘creating money out of thin air.’ In reality, what you describe is what happens in a normal function inner bank market.
The operating reality of the banking system is reserve requirements are irrelevant. As you noted, reserve requirements can always be met in the interbank market, and since loans just create more deposits and more excess reserves in the banking system, reserves requirements can always be met. The banking system is never reserve constrained (or, as you put it, can always just ‘create money out of thin air’ – saying the banking system is never reserve constrained is the same thing, just less scary sounding, and more accurate).
The reality of banking operations is loans are never not created because of the reserve requirement. Banks will always make loans to those the bank deems worthy, up to their capital position. If it’s 10% or 100%, the reserve can and will always be met in a normal functioning interbank market, and a banks reserve position is never taken into consideration during origination. Never. Spend a few days on a loan trading desk or in an origination department, and this becomes obvious.
And of course all this goes back to the big misunderstanding of excess reserves causing inflation. That’s false, since the banking system is never reserve constrained, it is essentially always in a state of excess reserves. Thus, the Fed creating more excess reserves is irrelevant in regards to future inflation.
So just to be sure. What you are saying is that
“At some point, some commercial banks will find it more attractive to begin lending out their nearly trillion dollars in excess reserves, rather than keeping them on deposit with the Fed”
can’t possibly happen because the bank doesn’t have to reduce its excess reserves to make new loans.
Is that correct?
Hi Christopher – yes, that’s more or less correct. The operational reality of the banking system is reserve requirements can and will always be met in the interbank market since loans create additional deposits. Since a normal functioning banking system is never constrained by reserve requirements, it’s incorrect to assume “At some point, some commercial banks will find it more attractive to begin lending out their nearly trillion dollars in excess reserves, rather than keeping them on deposit with the Fed”. The entire idea that excess reserves are inflationary is false, since banks are never short on reserves to begin with.
Also, it is also important to differential between reserves and capital. The reserve requirement says nothing about a banks capital position, and the banks capital position will always influence the loan origination decision. The reserve requirement will never impact the loan origination decision. Reserve requirements impact the liquidity of a banks balance sheet, not the size.
No AP, you are not describing my position in that article correctly. I did NOT say, “Loans create deposits, and reserves requirements can always be met in the interbank market.”
In fact, I was doing the opposite: I was explaining how banks (in the standard textbook description of FRB) only lend out 90% of a new deposit because they are afraid of losing reserves to other banks.
Look, I have talked with bankers and they agree with you, that when they are thinking of granting a new loan, nobody says, “Wait a second, what are our excess reserves like, right now?” I am still trying to reconcile that with the No Banking Experience Textbooks that we economists grew up on.
But there is no inconsistency in my two articles. You simply misunderstood what I was saying in the first one.
(To say it in other words: I might be wrong, but if I am, I’m consistently wrong in both articles. :))
AP, even if you are right that excess reserves are a useless statistic, at times you seem to imply that they aren’t even well-defined. But of course they are. That’s why the Fed can graph them over time, and we can see how they’ve shot up.
“I did NOT say, “Loans create deposits, and reserves requirements can always be met in the interbank market”
No, you never said those words, but the process you described in the original essay is pretty close to what I’m saying. You did say “The people who receive those checks are going to deposit them in their own banks; and, during normal interbank clearing operations, the original bank will receive requests to transfer out $9,000 of its reserves” which is just another way of saying the loan is then deposited somewhere else in the banking system creating a new deposit (loans create deposits) and then reserves are shifted back and forth between the banks in the interbank market. One purpose of this shifting of reserves in the interbank market is to meet reserve requirements.
“In fact, I was doing the opposite: I was explaining how banks (in the standard textbook description of FRB) only lend out 90% of a new deposit because they are afraid of losing reserves to other banks”
This statement is operationally false and your textbook should be shredded. Banks will loan out multiples of their deposit base if their capital position allows them to because they know they can always meet their reserve requirements in the interbank market, or at the Fed window. Thus, reserves are never in short supply, and not a concern when originating loans. Capital constrain loan growth, not reserve requirements. The standard textbook description is, unfortunately, 100% wrong, and has contributed to generation of economists that do not understand the banking/monetary system of the US.
“I am still trying to reconcile that with the No Banking Experience Textbooks that we economists grew up on.”
I can help you out on this one: the textbook is wrong. Shred it 🙂
“at times you seem to imply that they aren’t even well-defined”
Then I apologize for not being more clear. They are well defined, but yes, they are also a useless statistic when gauging future inflation.
Hi AP Learner,
Thanks for the answer. I understand your point now. I have two questions if you have the time.
1. Would banks be reserve constraint in the absence of a FRB system i.e. 100% reserve requirement?
2. If that wouldn’t make a difference, why do we have reserve requirements at all? Why not go to 0? And why does the FED create new reserve deposits, if the banks doen’t even care about them?
I would appreciate an answer. Thanks for your time!
Hi Christopher. I jotted down some quick responses but I think you’ll find the link I provided below to be much more useful since I do not want to fill the screen with a response!
“Would banks be reserve constraint in the absence of a FRB system i.e. 100% reserve requirement?”
Even with a reserve requirement of 100%, the bank could still grow it’s balance sheet since when a bank loans out funds, it just creates additional deposits in the banking system. The composition of the balance sheet would be very different relative to a lower reserve requirement, but the bank would still make loans it deems profitable assuming its capital position would allow growth. Mainstream economists and most macro text books teach a bank must acquire a deposit base before it can lend out funds. This is a false representation of the operating realities of the banking system.
“If that wouldn’t make a difference, why do we have reserve requirements at all? Why not go to 0?”
Many countries/central banks wrongly believe they can influence the money supply/inflation with reserve requirements and erroneously believe in the money multiplier. In reality, a reserve requirement is not necessary. Australia, Sweden, and many other countries do not have reserve requirements.
“And why does the FED create new reserve deposits, if the banks doen’t even care about them?”
In normal periods, the Fed adds/subtracts reserves to control the overnight rate. However, today, with QE and rates already at the zero bound, the Fed (foolishly) is adding reserves and subtracting long dated assets (no net new assets are created – it’s a swap) in an attempt to artificially boost wealth via the portfolio rebalancing channel. This is straight out of the Greenspan playbook, and historically has led to asset bubbles.
You may find this essay helpful. Bill Mitchell is hands down the best economist when it comes to understanding monetary and banking operations.
http://bilbo.economicoutlook.net/blog/?p=6617
AP Learner,
How does it lead to asset bubbles? I thought it just swapped one identical asset for another? Is it that not only central bankers, but also everybody on Wall Street, is fooled into thinking new money is being created by this process?
“How does it lead to asset bubbles?”
Via the portfolio rebalancing channel, which is explained in this link.
http://pragcap.com/mechanics-qe-transaction
Here’s a simple example. I hold $1M in 5 year treasury notes at 1.5%. The Fed comes in and replaces my 5 yr. note with a $1M in reserves paying 25 bps. Nothing new is created. My net assets have not changed. What has changed is the composition of my portfolio, not the size. So now I’m stuck with a lower coupon, shorter duration asset, but no net new assets. Since I need duration and/or income, I’m going to go out to the market and swap/bid out, say, a corporate bond (or any other asset) to replace the lost duration and income. Again, no new net assets are created, just the composition of my portfolio. Repeat this process enough, and presto you get a Ponzi scheme like asset bubble that will ultimately end in deflation. QE is a horrible policy, but for none of the reasons the inflationist’s claim since. No new net financial assets are being created.
“Is it that not only central bankers, but also everybody on Wall Street, is fooled into thinking new money is being created by this process?”
Uh, not sure who you speak to on Wall Street, but no, not everybody is fooled. Maybe the folks you speak with are the same folks that thought it was a good idea to lever CDO’s 30 times. The smart money knows exactly what QE is: an asset swap that forces portfolio rebalancing. Even Ben Bernanke knows no net financial assets are created, and admits he is trying to create asset bubbles. Scary, but again, for none of the reasons the inflationist’s claim.
http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372.html
What’s wrong with running a trade deficit? I run trade deficits with my local grocery store!
Well, that’s partly why I was so critical of Schiff in 2006 and (early) 2007. The stuff I had seen from him just warned of the dangers of trade deficits etc., and as you note, that per se isn’t a bad thing.
But, if the US is running trade deficits not just with individual countries, but with the whole world (and that’s the weakness of your grocery store analogy), and it’s doing so for 30+ years, and the pattern kicked in once the US went off the gold standard, then you start to worry.
Even if you wanted to call that a trade deficit (which it isn’t) you’d still be fine because at the same time you are running trade surpluses with you employer. If you didn’t you would be in trouble soon.
But the point is, what you’re doint isn’t really a trade deficit since both you and the grocery store operate in the same economy and use the same currency. So an apple for some cents is a fair deal. In international trade it doesn’t work that way. China’s economy isn’t operating in dollar. What they want from you is goods and services and they just accept dollars for the time being. But ultimately those dollars represent goods that America hasn’t delivered yet.
Just try to do the following. Instead of paying with dollar for the apple, go to the grocery store and write them a piece of paper saying that you owe the grocery store one apple. Do that every day and you’ll figure out what the problem with running trade deficits is very soon.