Calomiris on reserve requirements
In today’s WSJ, Charles Calomiris calls for higher reserve requirements:
The Federal Reserve should raise the minimum cash reserve requirements on bank deposits. This will have virtually no immediate impact on credit flows, but it will serve as an insurance policy against the growing risk of inflation.
This will have virtually no immediate impact on credit availability in the economy because the excess reserves banks voluntarily hold above the minimum requirement are much greater than half a trillion dollars. Thus, the higher requirement will not pinch until loans and deposits get much higher.
In 1936-37 the Fed doubled reserve requirements as an insurance policy against inflation, and some monetary economists have argued that this contributed to the recession of 1937-38. But recent microeconomic analysis of bank reserve holdings by Joseph Mason, David Wheelock and me in a 2011 working paper available from the National Bureau of Economic Research showed that the higher reserve requirements were small relative to the banks’ pre-existing excess reserves and had no effect on interest rates or the availability of credit.
I think there is an argument for higher reserve requirements, but Calomiris has not convinced me. My own research on the Depression suggests that private gold hoarding was the biggest factor depressing NGDP in late 1937 and 1938. But higher reserve requirements almost certainly played some role in the slump, and the reduction of reserve requirements in the spring of 1938 probably played a role in the subsequent recovery.
I see two flaws in Calomiris’s reasoning. First, he assumes that if nominal interest rates didn’t rise, then the increase in reserve requirements could not have represented tight money. As you know, I think nominal interest rates are a lousy indicator of monetary policy. At a minimum, he’d want to look at real rates. During this period nominal rates were near zero; rising slightly between 1936-37, and then falling slightly during 1937-38. Meanwhile inflation as measured by the WPI was nearly 10% from mid-1936 to mid-1937, and then fell to roughly negative 10% over the following 12 months. Thus it seems like that there was at least some increase in ex ante real rates. The early period constituted a “gold panic” as massive dishoarding of gold led to huge increases in world monetary gold stocks, and fears of much higher inflation. In contrast, after mid-1937 a “dollar panic” developed when private gold hoarding increased in anticipation of a possible devaluation of the dollar. These swings in gold hoarding had a dramatic impact on expectations of future monetary policy, and future price levels.
To summarize, if the reserve requirement increases had been highly contractionary, I would have expected nominal rates to stay close to zero, with perhaps just a tiny increase. Indeed highly contractionary policies by the Bank of Japan in 2000 and 2006 merely increased short term rates by about 1/4% to 1/2%, and yet tended to push Japan back toward deflation. Ditto for the small increase in Eurozone rates last spring.
My second objection is that Calomiris ignores the crucial role of expectations. In modern new Keynesian models of the sort developed by Woodford, Eggertsson, Krugman, etc, current AD and current NGDP inflation is strongly affected by changes in future expected inflation. This led Krugman to suggest that the BOJ should “promise to be irresponsible” i.e. promise some catch-up inflation once they had exited the “liquidity trap.” Put aside the question of whether this was good advice, surely there can be no doubt that higher expected future inflation will tend to raise current inflation, and current AD. This means that Calomisis will be wrong about the impact of his policy, if it achieves his own stated goal. Go back to the first paragraph I quoted. He says it will reduce the risk of an increase in inflation. Thus if successful, it will reduce inflation expectations, on average. It will commit the Fed to not be “irresponsible.” And that means it will be contractionary right now, regardless of the impact on nominal interest rates. He never actually says it wouldn’t be contractionary, but surely that’s the implication that readers would draw from the third paragraph I quoted.
There is a good argument for higher reserve requirements, and Calomiris concludes his paper by making that argument:
Higher cash reserve requirements also make sense from a regulatory standpoint. A bank can reduce its risk of default either by increasing its capital ratio by selling more stock or by holding more cash assets. In practice, however, cash held at the central bank is real, while capital is an unreliable accounting fiction. Banks that fail to recognize loan losses often show higher book capital than they really have.
Moreover, the presence of cash increases the value of the bank during hard times, which reduces the incentives for banks to raise the riskiness of their loan portfolios during downturns (so-called risk shifting). In contrast, book capital requirements alone encourage banks to disguise losses and raise risks during downturns, which can leave taxpayers holding the bag.
This makes sense, but I’d recommend the Fed wait until after interest rates have risen above zero before making that change. Once rates are again positive, they will be able to adjust their fed funds target to prevent any undesirable impact on aggregate demand. Admittedly they could also do this right now, with lots more QE, but the Fed is rather clumsy in its application of non-conventional monetary policies, so it’s probably wiser to wait a bit. In addition, if this is being done for regulatory reasons, I see no reason not to allow banks to count T-bonds as part of their “reserves.”
PS. Astute readers will notice that the same “precautionary principle” applies to fiscal austerity, but the difference is that fiscal stimulus is far more costly than waiting a few years before making a regulatory change in reserve requirements.
HT: David Glasner
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12. March 2012 at 07:19
Reseve requirements tend to prevent banks from adjusting the quantity of deposits money according to the demand to hold it. They are a bad idea at all times.
Requiring banks to accumulate lots of safe assets during good times seems plausible. However, some fixed proportion rule means that you are preventning them from taking advantage of them in bad times.
Raising the proportion during bad times seems counterproductive.
On the other hand, when we realize that high reserve requirements mean that the central bank can directly allocate credit, fixing all of the myriad of market failures, especially the key one where businesses who fail to give large campaign contributions to politicians are allowed to borrow just because they are willing to pay good interest for sound projects, then QED.
Or, if that isn’t good enough, high reserve requirements mean that central banks can fund more of the national debt at zero interest. Given all of the massive social needs and the unwillingess of people to pay taxes, high reserve requirements are a great idea. So what if bank depositors earn less interest and pay more fees to the banks. The politicians can always set up a financial consumers protection agency in response to those complaints.
And, of course, most importantly, the Fed never makes errors, and doubling reserve requirements in the Great Depression didn’t cause a problem.
12. March 2012 at 08:03
Another aimer at nominal GDP – though too low of a rate. But his standard of success is NGDP.
A quote:
An ordinary recession can be ended by the central bank lowering the interest rate again. A deleveraging is much harder to end. According to Mr Dalio, it usually requires some combination of debt restructurings and write-offs, austerity, wealth transfers from rich to poor and money-printing. A “beautiful deleveraging” is one in which all these elements combine to keep the economy growing at a nominal rate that is higher than the nominal interest rate. (Beauty is in the eye of the beholder: Mr Dalio expects America’s GDP growth to average only 2% over a 15-year period.)
End quote.
Has our deleveraging been beautiful? Well – judging by the European one – at least it has not been a complete disaster,
http://www.economist.com/node/21549968
12. March 2012 at 08:54
Bill, That’s why I said allow banks to hold Government securities, not just reserves, as part of their capital requirements. Securities earn interest, and hence would be better for bank consumers.
JimP, Yes, we are doing better than Europe.
12. March 2012 at 09:15
Calomiris wins the Jean-Claude Trichet award for 2012.
Seriously, this kind of a policy now would almost surely deliver a contractionary monetary disturbance.
And he’s dead wrong about the Fed’s actions not helping to precipitate the 1937-1938 recession. Look at real base growth just ahead of that recession:
http://research.stlouisfed.org/fredgraph.png?g=5DW
Now, the gold sterilization/panic may well have played a larger role in causing that recession after a rapid but incomplete recovery. But to argue we should risk upending a less rapid and incomplete recovery (with only about 4% average NGDP growth) because of inflation risks due to a rebound in C&I lending seems utterly absurd.
But be on alert for more of it: the 1936-1937 tightening was done because members of the Fed were worried that the rebound in bank lending (which revived in 1936) was set to unleash inflation and speculation. The crushed it along with NGDP.
The BOJ’s monetary misadventure in 2006 also occurred after bank lending had begun to revive for the first time since the real estate/eqiuty bubbles had burst. The stopped it by stopping NGDP.
The ECB’s insane tightening in April and July 2011, which set off a run on Spanish and Italian debt markets, also occurred after some measures of bank lending had begun to revive. Now all are in retreat due to an avoidable secondary NGDP shock.
And Calomiris wants the Fed to repeat the policies of the 1936/7 Fed, the 2006 BOJ and the 2012 ECB? Massive fail.
12. March 2012 at 09:24
ssumner:
My own research on the Depression suggests that private gold hoarding was the biggest factor depressing NGDP in late 1937 and 1938.
You mean it wasn’t because the Fed wasn’t printing enough funny money?
OK, so if it’s gold hoarding that did it, then you have to ask WHY that occurred. Why did people suddenly hoard gold?
NGDP should have been depressed in 1937-1938, because the Fed dramatically increased bank reserves from 1931-1937.
All of this increase in cash balances were not due to voluntary increases in gold money production, but simply inflation of the paper money supply. Banks and bank clients were fully justified in hoarding gold coins and bullion. When the paper money is being attacked, it makes sense to go into real values to preserve purchasing power.
If the Fed and the rest of the state stopped messing with the economy in 1937, and let market forces resume, then the fall in NGDP would have been followed by falling prices and costs, including wages, and the economy would have recovered the proper, honest, and sustainable way.
I know you’re just trying to give an analytical explanation for why NGDP fell, but I too am just giving an analytical explanation; an explanation for what would have made the economy recover quickly and sustainably.
Meanwhile inflation as measured by the WPI was nearly 10% from mid-1936 to mid-1937, and then fell to roughly negative 10% over the following 12 months. Thus it seems like that there was at least some increase in ex ante real rates.
More accurately, the WPI fell due to a dramatic decline in net investment, brought about by an initial rapid rise in paper inflation, then a rapid fall in paper inflation.
The early period constituted a “gold panic” as massive dishoarding of gold led to huge increases in world monetary gold stocks, and fears of much higher inflation. In contrast, after mid-1937 a “dollar panic” developed when private gold hoarding increased in anticipation of a possible devaluation of the dollar. These swings in gold hoarding had a dramatic impact on expectations of future monetary policy, and future price levels.
Actually the swings in gold hoarding were themselves due to expectations of future monetary policy. They didn’t determine those expectations. People don’t just arbitrarily change their gold holdings and then sit back and look at the resultant changes in expectations as a result. That’s switching cause and effect.
I’d recommend the Fed wait until after interest rates have risen above zero before making that change.
You say that as if the Fed is powerless over the fed funds rate that is currently just above zero. The Fed doesn’t “wait” for the fed funds to rise. The Fed is the entity controlling what the fed funds rate is by the Fed’s inflating reserves faster or slower, to make the banks set a higher or lower fed funds rate.
Indeed highly contractionary policies by the Bank of Japan in 2000 and 2006 merely increased short term rates by about 1/4% to 1/2%, and yet tended to push Japan back toward deflation.
You again just contradicted yourself. You keep going back and forth like a yo-yo. Now you’re back to saying central bank inflation into the banking system lowers short term rates, and that reduction in inflation into the banking system increases short term rates. This is right after you said central bank inflation into the banking system increases interest rates, which was right after you said the Fed can inflate to lower interest rates via the liquidity effect.
And back and forth we go.
Put aside the question of whether this was good advice, surely there can be no doubt that higher expected future inflation will tend to raise current inflation, and current AD.
It can only raise current price inflation to what is possible given the current supply of money and volume of spending. It can’t raise current prices beyond that. For example, if there is $1 trillion in aggregate money and spending, then no matter what future inflation expectations happen to be, economic actors as a whole cannot possibly put forth an aggregate demand higher than $1 trillion. The promise of future inflation hasn’t occurred yet. Demand is always limited to the money that people actually have, not what they will have. For example, if Bill Gates has $50 billion in total wealth, and Bernanke told him that next year he is going to inflate the money supply by 100%, then Bill Gates cannot possibly increase his demand by 100%, from $50 billion to $100 billion, TODAY. TODAY, he can only sell his wealth for $50 billion cash and put forth a demand of $50 billion for goods and services. He cannot sell $50 billion of wealth for $100 billion and double his demand just because Bernanke told him there will be more money and spending in the future.
You see, you are making the same error that Keynesians make, which is to ignore cash balances, and inadvertently you tacitly presuppose infinite cash balances, such that if inflation expectation next year is 10%, or 20%, or whatever, then people can always increase their present demand out of their alleged infinite cash balances.
But everyone has a finite cash balance. If you tell the average Joe on the street that inflation will be 100% next year, then he won’t be able to double his demand. He doesn’t have double the cash that he has now. He has what he has now.
The same thing is true for every other economic actor. Every actor is limited to the cash they have now, not what they might have in the future after inflation of the money supply. If any seller increases his prices, and yet his customers don’t have increased cash balances, then he’s going to sell fewer goods. Since sellers are typically profit maximizers, he can make more profits selling his goods at lower prices, not higher prices, to be in line with current demand, not future expected demand.
Another example: A home buyer who wants to sell their home for $500,000 today can only do so if there are buyers with $500,000 in money to demand the house. If the buyers are not multi-billionaires, and the maximum price they are able and willing to pay is $500,000, then it won’t matter if the buyer and seller are told that home prices are expected to triple next year. The seller cannot offer the house for $1.5 million to buyers who only have $500,000 to spend in the present. No, just because there exists Bill Gateses in the world who could potentially increase their demand to $1.5 million for that house, it doesn’t mean they will pay it. Gates can only gain utility from so many homes, after which he would sacrifice too much of other things, like his foundation. So he won’t offer $1.5 million for the home. Sales tend to go to marginal buyers, not just the wealthiest buyers. Poor people who are paying $300 a month for run down apartments are still outbidding the wealthiest people in the world for those apartments. Outbidding doesn’t mean only the wealthiest “win.” Everyone is cash strapped and everyone has to make decisions on what to buy and therefore what NOT to buy. Theoretically Bill Gates could spend $1 billion over 6 months buying all the food from a single grocery store in a small town, thus making it much more difficult for the locals to buy food. But he doesn’t do it out of altruism, but because he doesn’t have any selfish use for that much additional food, because he values other things more highly for that sum of money.
Once rates are again positive, they will be able to adjust their fed funds target to prevent any undesirable impact on aggregate demand.
Continuing with the theme of you having things backwards, the Fed doesn’t “wait” for short term rates to rise. The Fed targets a higher short term rate by reducing the extent to which it inflates. If the fed funds rate is going to rise, it will be brought about by the Fed’s actions. The Fed isn’t passive when it comes to short term interest rates. They are the primary driver of those short term interest rates.
Since my position is that price inflation is, provided the Fed keeps doing what they are doing now, going to become very, very high in the coming months and years, they will be compelled at some point to reduce inflation. Once that happens, soon after you are going to see yet another exposing of malinvestments and misallocations of scarce resources and labor. I have no idea how much exactly, but a positive portion of the recent rise in employment and investment is due solely to inflation, and not to calculated planning by investors in accordance with true consumer preferences.
Since you and other monetarists, as well as all Keynesians, remain utterly clueless on how the monetary system affects the real economy (on the basis that you don’t understand how a free market would operate because you don’t understand economics), I will clue you in as to when to expect a coming crash. The near term is highly favorable to equities, commodities like precious metals (but be in these for the long term because the state keeps changing the rules to depress gold and silver prices like repeatedly hiking margin requirements), and agriculture.
Once the Fed is compelled to reduce the extent of creating new reserves, thus increasing short term rates rise, and M2 increases come back down, then depending on the extent of the fall in M2, it could be a mild or steep correction. Since the Fed and world central banks didn’t let the economy fully correct in 2008, and we’re in world-wide printing mode, the next collapse is going to make 2008 look like a cakewalk.
12. March 2012 at 10:29
For more on Calomiris thinking;
http://www.econtalk.org/archives/2012/03/calomiris_on_ca.html
12. March 2012 at 10:56
Isn’t Calomiris’ “good” argument for higher reserve requirements really an explanation of why banks have an interest in accumulating reserves during bad times? We learn that higher reserves reduce banks’ risk of default, signal to the market a more reliable measure of value and (thus) raise the value of the bank during hard times.
In other words, isn’t it an argument that regulation is unnecessary since the market incentives already faced by banks will generate the desired behaviour?
12. March 2012 at 11:51
1. deposits are only about half of bank liabilities for large banks.
2. capital is far more restrictive and banks are busy hoarding capital for imminent basel 2.5 rules, fed stress tests, mortgage settlement, yada yada yada.
3. Yes, banks are holding more capital as safe assets (reserves). partly by design (Fed IOR policy and capital requests). partly by prudence.
4. larger banks tend to have bigger non-deposit balance sheet items, and non-lending related businesses (like mortgage servicing rights).
increasing reserve requirements would at best have no effect on a large bank who can shuffle things around, and at worst be contractionary for smaller banks that rely more heavilty on deposits.
The Fed/OCC/FDIC already have a very large infrastructure and machinery to vet “capital” well beyond the “book accounting” and look into things like credit models and reserves (ok they should have been doing the forensics 10 years ago but better late than never).
So increasing reserve requirements to foster safety to be blunt, is based on a 19th century view of what banks do. At best, it will do nothing, and at worst it will be contractionary with unintended consequences (like overly affecting smaller banks and incentivizing the non-deposit-centric businesses larger banks are in).
12. March 2012 at 12:14
I was going to recommend the Calomiris podcast but Patrick beat me to it. He talks much more about cash reserves and reserves in general there — very interesting. Also his take on the history of how the financial system got to where it is today is worthwhile. And he reports a couple of interesting working breakfast conversations he had during the financial crisis.
My take is he is a banking guy, not a macro guy, his opinion on cash reserves is very credible from a banking/financial system point of view (containing the possible damage coming in from the Euro crisis, etc.), he thinks it wouldn’t cause macro harm but he’s not the expert on that.
All IMHO, FWIW.
12. March 2012 at 12:19
Tommy, Both the BOJ and ECB have already repeated the mistakes of 1937, so it’s not a stretch to think the Fed might do the same (as you say.)
Major, You said;
“You again just contradicted yourself. You keep going back and forth like a yo-yo.”
The only think yo-yoing is your ability to understand anything I’ve said.
Thanks Patrick,
David, I think he’d argue that lots of banks have failed recently, so obviously they weren’t accumulating enough safe assets. That’s my view anyway. But as I said, it doesn’t have to be reserves, T-securities would do just fine.
dwb, Those are good points, but I’m happy if we move away from deposits, as the big risk to taxpayers is actually programs like FDIC, much more so that TARP.
12. March 2012 at 12:20
Thanks for that info Jim.
12. March 2012 at 12:27
ssumner:
The only think yo-yoing is your ability to understand anything I’ve said.
Now that you got that out of your system, how about actually addressing the contradiction you keep making? You know, about the central bank inflating into the banking system resulting in both lowering and increasing interest rates? I know you can do it!
12. March 2012 at 13:35
I’m happy if we move away from deposits, as the big risk to taxpayers is actually programs like FDIC.
Sure, but the point was to “serve as an insurance policy against the growing risk of inflation.” what growing risk of inflation anyway?? If we want to move away from deposits (or, reduce the taxpayer risk of FDIC) surely there are ways that are not understood as macro-money policy adjustments to tame inflation. Large banks already have much deeper access to capital markets than small banks, so anything that discourages deposits as a funding source will probably also encourage consolidation.
12. March 2012 at 14:09
Reserve requirements should be abolished.
Lending is more risky when the path of NGDP is more variable.
The main risk that banks underestimated was not the risk of assets they held, but the risk that the Fed would fall asleep at the monetary wheel.
12. March 2012 at 15:04
Reserve requirements should be abolished.
Lending is more risky when the path of NGDP is more variable.
The main risk that banks underestimated was not the risk of assets they held, but the risk that the Fed would fall asleep at the monetary wheel.
amen
12. March 2012 at 15:33
Lending is more risky when the path of NGDP is more variable.
Lending is even more risky when a stable NGDP growth path requires accelerating inflation of the money supply – which in theory and by consistency with empirical data show is the case – and investments being subjected to future inevitable choice by the counterfeiters to either save the currency and allow a correction to occur, with all the bankruptcies and losses therewith, or continue to accelerate inflation and bring about hyperinflation / monetary breakdown.
Since 1913, in the US at least, the Fed has always chosen saving the currency rather than hyperinflation, and that’s why we empirically see the boom bust cycle correlated with monetary policy. But the ultimate constraint that prevents inflation from avoiding corrections is resource scarcity. If central banks refuse to capitulate to resource scarcity, and they accelerate inflation, then resource scarcity will eventually win out no matter how many new dollars are created and spent, and the result will be any given quantity of new money failing to sustain the productive structure, and hyperinflation will result. The reason so few economists understand this is because they are too distracted by historical data and correlations, due to positivist corruption. They can’t think abstractly because they were never taught how to do it, or they never taught themselves. They see historical correlations between Fed tightening and depressions, and they fallaciously believe that if only the Fed keeps inflating, and maintains a given rate of price inflation, or a given rate of aggregate spending, that they can perpetually avoid the corrections to problems that inflation brings about. While they’re resting content believing everything is fine as long as NGDP, or nominal employment, or nominal output, grows at necessarily arbitrary rates, brought about by the utter emptiness in intellectual foundation that precludes a rational justification for those rates and no others, as if there is something mystical about humans producing goods at a rate of 3%, and prices increasing at a rate of 2%.
Future generation are, hopefully, going to look back at market monetarists of 2012, and think of them what we think of ancients who ascribed magical powers to the number 3.
12. March 2012 at 15:47
I favor a 100% reserve requirement with reserves earning interest at the Fed Funds rate. But not for macro reasons! The reason to do it is strictly micro. It removes the distortion of deposit insurance.
13. March 2012 at 03:48
Lee Kelly:
Reserve requirements should be abolished.
If reserve requirements really should be abolished, then the monetary costs of abolishing it should be incurred by the parties which choose to engage in zero reserve banking contracts. In other words, if zero reserve requirements is to be implemented, then there ought not be any externalizations of money costs on others who are not signed into a specific nexus of contracts concerning a zero reserve bank.
If one advocates for zero reserve banking on the basis that it is consistent with private property rights, then one cannot possibly argue for “insurance” policies which backstop zero reserve banks and their clients, that are themselves a violation of private property rights, such as FDIC.
The main risk that banks underestimated was not the risk of assets they held, but the risk that the Fed would fall asleep at the monetary wheel.
The risk of an asset is intimately tied with Fed action. You cannot separate the two. If banks misjudged the Fed, then by implication they misjudged the risk of their assets.
13. March 2012 at 05:58
Major, If you’d taken a basic course in econ you’d know that monetary policy has both short and long run effects (liquidity, income, expected inflation, etc.)
dwb, I agree, and that’s why I oppose this policy. My point was that it would be possible at a later date to raise capital requirements without distorting the macroeconomy.
Lee, dwb, and Max, How about this compromise: Remove all RRs. But require that 100% of FDIC insured-liabilities be backed with safe assets like cash or government bonds. When banks made risky loans, they’d use non-FDIC insured funds.
13. March 2012 at 08:42
Major, If you’d taken a basic course in econ you’d know that monetary policy has both short and long run effects (liquidity, income, expected inflation, etc.)
And if you had taken a basic course in reading comprehension you would have known that I have already addressed this on many occasions, and repeatedly said that we are always IN the “short term”, because the Fed is an ongoing concern and those in the Fed continually act in creating new money slower or faster, thus having perpetual control over interest rates, especially the short term rates they specifically target, and recently long term rates via Operation Twist.
The Fed is engaged in a perpetual “liquidity effect” operation when it comes to interest rates. They lower interest rates than would otherwise be the case by INCREASING bank reserves, i.e. by inflating into the banking system, as I have repeatedly said, which you are going back and forth like a yo-yo between “no, inflation into the banking system increases interest rates” and “yes, inflation into the banking system decreases interest rates.”
This isn’t about short term versus long term. Not when the Fed is an ongoing concern and has perpetual control via targeting short term interest rates. In this situation, we’re always in the “short term” when it comes to what is happening to interest rates and how the Fed is lowering them from what they otherwise would have been absent the Fed’s actions.
I will repeat this until it is finally absorbed: The Fed lowers interest rates away from what they otherwise would have been by inflating money into the banking system. Yes, with enough inflation, interest rates will nominally rise, but those rates will still be lower than they otherwise would have been had the Fed stopped inflating into the banking system. So what you saw in South American in the 1980s were nominally high interest rates that were still lower than what they otherwise would have been the case had the central banks stopped inflating into their respective banking systems at those times.
You are making the mistake of seeing growing interest rates, ignoring the fact that they would have been even higher absent the central bank inflating into the banking system, and concluding that “central banks inflating into the banking system increases interest rates.” Yes, they bring about higher interest rates once the money leaves the banking system, but those rates are lower than what would have been the case had the central bank stopped inflating at those times.
Imagine me giving you free printed money every day, and the way that money leaves your hands is by you lending it out. The interest rates you will accept on your loans will be lower than they otherwise would have been if I stopped giving you money, because you know you’ll get more money from me the next day. Sure, if I increase the rate at which I give you money, then at some point, your lending will start to result in borrowers begging you to lend them money at higher rates, because they can profitable invest the loans anyway since prices are rising so fast. But, and this is what is crucial, whatever rate YOU agree to, will be LOWER than what you would have otherwise agreed to, because you STILL have me as a backstop to you. You are still getting free money from me. The rate you accept will be higher than it was before for sure, but it won’t be as high as it would be if I told you that I am going to stop sending you free money. If I stopped sending you free money, then you are going to ask for higher interest rates from your borrowers.
The market monetarist will look at what is happening and conclude that “too much inflation and higher interest rates have now dominated the liquidity effect”.
The reason they will think that is because they are focusing on the temporal change of interest rates, rather than understanding counter-factual argumentation based on economic principles. I will know that the rates you charge will be lower with me as an inflation backstop to you, you will focus on the temporal path of interest rates and see a nominal rise over time and conclude that my inflation to you is increasing interest rates and thus the liquidity effect is no longer present, when in fact it still is, where it always was, in the counter-factual argumentation sphere.
The liquidity effect and the inflation premium effect don’t have to consist in nominally declining or rising interest rates over time. They are counter-factual principle.
There is no way I can make this any more clear. If you don’t get it by now, then you should be given up on.
13. March 2012 at 09:29
“How about this compromise: Remove all RRs. But require that 100% of FDIC insured-liabilities be backed with safe assets like cash or government bonds. When banks made risky loans, they’d use non-FDIC insured funds”
I like it! Sounds a lot like Milton Friedman’s “Program for Monetary Stability” that we discussed on a previous thread. In the 1992 preface, he presented two options – full reserve banking where deposits are backed by Fed deposits, or “narrow banking”, where deposits are backed by government securities.
I’d add one caveat – this works as long as you also get rid of the discount window (I know you said in a previous post you want to get rid of it). Otherwise, the Fed would be implicitly backing non-FDIC accounts.
13. March 2012 at 15:10
bank liquidity requirements are complicated by non-deposit short term liabilities and collateral requirements, among other things. if i were rewriting the rule i would include #all# short term liabilities (incl deposits), potential collateral posting requirements (die to hedges that move against the bank), some fraction of risk-based capital requirements (which would include potential losses from a bank counterparty failing). add all that together and thats how much liquid cash. because of all the off balance sheet risk there is more to it, but basically there has to be enough cash to meet tbe most senior creditors- depositors. and a legal mechanism to protect depositors senior clsim in a bankruptcy.
13. March 2012 at 15:22
… keep in mind capital, liquidity, and reserve requirements are distinct but often jumbled. a lot of capital can be tied up in long term things like equity. often banks have plenty of capital but cannot survive a run due to insufficient liquidity to meet margim calls (depositors pulling money, inability to roll short term debt, or the failure ofa major counterparty that causes one or more of the former). i think what you are suggesting is not merely higher capital, but also higher liquidity. then yes, get rid if fdic
13. March 2012 at 15:51
Gentlemen,
There will always be a TBTF guarantee. Politically it will never go away. The only question is whether it is implicit or explicit. Much better to make it explicit. Then to limit risk in the system, you do three things.
1) Allow the Fed to flexibly set asset/equity ratios by asset class.
2) Require all highly compensated employees to receive a large portion of their compensation in equity, which does not fully vest until five years after termination of employment.
3) Give the banks a put to the Fed and the Fed a call to the banks on the bank’s equity at strike price set solely at Fed discretion. What this means is that if a bank gets in trouble, it can/must get an equity infusion from the Fed, but at a price which will penalize or wipe out the equity holders.
Require all large banks to participate. Make participation voluntary for smaller banks.
13. March 2012 at 18:02
major, You said;
“And if you had taken a basic course in reading comprehension you would have known that I have already addressed this on many occasions, and repeatedly said that we are always IN the “short term”,”
Don’t feel bad, a lot of people make this mistake. The term “short run” has nothing to do with “right now”. Long run is just as much right now as short run, maybe more.
Negation, Glad we agree.
dwb, I only worry about depositors, because of FDIC. It doesn’t matter if creditors lose money. We want them to lose money if banks misbehave.
dtoh, I don’t like to be defeatist. I’d prefer we abolish TBTF. No amount of regulation will prevent TBTF from causing damage.
13. March 2012 at 19:29
depositors are creditors by another name. It’s an artificial distinction. there is no functional difference between a bunch of high net worth investors parking their money in a 3-month discount note issued by a bank and a bunch of those same investors breaking their money into smaller pieces of brokered deposits, except that one is FDIC insured and one is not (and one might have seniority over the other). BoA has issued a 2.3 Bn tranche of wholesale FDIC insured “bonds” that mature next month… how is that different than those same bonds issued to 100s of individual “creditors”? BoA would naturally prefer to issue FDIC liabilities because they are cheaper.
The “creditors” of a bank’s short term liabilities are elusive. I would love to protect “depositors” but who are they exactly? Can someone define for me how a “despositor” differs from a “creditor” in a world with no FDIC guarantee? If I loan 100k to a bank how do I know if I’ve become a depositor or a creditor?
14. March 2012 at 10:39
dwb, We agree. I’d abolish all government insurance in the financial system. Unfortunately, it seems we need to protect depositors for political reasons. But we don’t need to protect other creditors for political reasons. So don’t do it. Minimize the harm done by moral hazard.
14. March 2012 at 12:35
ssumner:
“And if you had taken a basic course in reading comprehension you would have known that I have already addressed this on many occasions, and repeatedly said that we are always IN the “short term”,”
Don’t feel bad, a lot of people make this mistake. The term “short run” has nothing to do with “right now”. Long run is just as much right now as short run, maybe more.
I didn’t say the short run has nothing to do with “right now.” I said the short run effects from monetary policy are what we are experiencing when it comes to interest rates in a world where interest rates are constantly controlled and managed in the present by the central bank.
I know it’s hard to understand, especially when you suffer from extreme equilibrium minded thinking.
10. April 2015 at 05:47
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