Banking theory disguised as monetary theory?

[I wrote this yesterday but held off--as I often do for "spacing" reasons.  In the interim Nick Rowe did a post on the same paper.  I recommend you read his reaction if you only have time for one.  It's much better.]

The Bank of England was kind enough to send me a new report explaining monetary policy.  Unfortunately I think the report is way off target. On the other hand if they knew anything about my blog they would have known that would be my reaction.  Let’s start here:

This article has discussed how money is created in the modern economy. Most of the money in circulation is created, not by the printing presses of the Bank of England, but by the commercial banks themselves: banks create money whenever they lend to someone in the economy or buy an asset from consumers. And in contrast to descriptions found in some textbooks, the Bank of England does not directly control the quantity of either base or broad money. The Bank of England is nevertheless still able to influence the amount of money in the economy. It does so in normal times by setting monetary policy — through the interest rate that it pays on reserves held by commercial banks with the Bank of England. More recently, though, with Bank Rate constrained by the effective lower bound, the Bank of England’s asset purchase programme has sought to raise the quantity of broad money in circulation.

I hate the term ‘modern.’  The money directly produced or “printed” by the central bank is called base money. I don’t know about Britain, but in America the share of total money that is base money is actually higher than 100 years ago.  So there is nothing “modern” about our current system.  And the BoE does directly control the amount of base money, at least in the sense of “directly control” that the BoE uses when they describe direct control of short term interest rates.  Yes, if you set an interest rate target then the base becomes endogenous. But it’s equally true that if you set an inflation target then interest rates become endogenous.  However changes in the supply and demand for base money remain the lever of monetary policy.  And notice the BoE implies that once they stopped targeting interest rates they were no longer even doing monetary policy (or perhaps it’s just misleading language.) The BoE controls the base in such a way as to target interest rates in such a way as target total spending in such as way as to produce 2% inflation.  And yet in that long chain interest rates are singled out as “monetary policy.”

Reserves are an IOU from the central bank to commercial banks. Those banks can use them to make payments to each other, but they cannot ‘lend’ them on to consumers in the economy, who do not hold reserves accounts.

Lots of people use the term ‘reserves’ when they would be better off using the term ‘monetary base.’  Back in 2007 the part of the US monetary base that was “coins” was larger than “bank reserves.”  So it would have been more accurate to talk about central banks injecting coins into the system.  And prior to 2008 new base money mostly flowed out into currency in circulation within a few days, even if the first stop was the banking system.  Banks were not important for monetary policy, although of course they were a key part of the financial system.

I recall that Paul Krugman was once criticized for saying banks can “lend out” reserves.  I generally don’t say things like that because I ignore banks.  But there was nothing wrong with Krugman’s claim.  Yes, it’s true that when money is lent out and the borrower withdraws the loan as cash, the borrower does not literally “hold reserves.”  So the BoE is technically correct. But that’s a meaningless distinction, as it’s all base money, and reserves are just the name given to base money when held by banks, and cash is the name given to base money held by non-banks.

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.

I recall that once when Krugman was faced with this sort of argument he said something to the effect of “it’s a simultaneous system.” Banking is an industry that provides intermediation services.  Banks have balance sheets with assets and liabilities. It makes no sense to say that one side of the balance sheet causes the other.  If people want to borrow more, then bank interest rates on loans and deposits adjust in such a way as to provide a new equilibrium, probably with a larger balance sheet.  But that’s equally true of the situation where people want to hold larger amounts of bank deposits.  It’s completely symmetrical. Consider the real estate broker industry.  Does more people buying houses cause more people selling houses, or vice versa?

Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves.  While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates.

In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the Bank of England.

I’m not a fan of the money multiplier model, but it’s sometimes unfairly maligned. Textbooks don’t treat it as a constant, any more than they treat velocity or the fiscal multiplier as constants.  They may do an example where it is constant, but then they discuss reasons why it changes.

The real problem here is “binding constraint.”  In economics there are almost never binding constraints on anything.  If you at a binding constraint position then odds are you are not optimizing.  A reduction in the supply of apples will generally raise apple prices even if not at the binding constraint where one less apple would cause starvation.  By (permanently) adjusting the supply of “reserves” (again base money is what they actually mean) the central bank can affect the value of the medium of account (base money), and hence all nominal variables in the economy.  That includes the nominal size of the toilet paper industry, the nominal size of the steel industry, and the nominal size of bank balance sheets. Most importantly NGDP. If wages and prices are sticky they can also affect real GDP in the short to medium run.

Not sure why the Bank of England is so interested in the nominal size of the bank balance sheets, and not other industries.  Surely there are other nominal industry outputs that better correlate with the goals of monetary policy (NGDP) than the banking industry!  Why not focus on those industries?

The deeper problem here is the BoE mixes up microeconomics (the relative size of the banking industry) with macroeconomics (the determination of nominal aggregates), in a very confusing way.  You need to model the medium of account to have any sort of coherent explanation of monetary policy.  The interest rate approach combined with a banking sector and a “slack/overheating” model of inflation just won’t cut it.  Certainly the BoE report is not as bad as some of the things you see from MMTers, it nods to the old-style monetarists in its discussion the problems that might arise from of excessive growth of the aggregates.  But it nonetheless fails to come up with a model of the price level or NGDP. It can’t tell us why Britain has 20% inflation one year, and 2% another.  You need to explicitly model the supply and demand for base money to do macroeconomics.

PS.  And why doesn’t the BoE subsidize and run a NGDP prediction market?

PPS.  Perhaps my report was too negative. I suppose it’s a fine explanation of monetary policy if you go for the interest rate approach to monetary economics, it’s just that I hate that approach.


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133 Responses to “Banking theory disguised as monetary theory?”

  1. Gravatar of benjamin cole benjamin cole
    13. March 2014 at 16:48

    It is posts like this that make me feel like blind dog in a meathouse. I think I know which way to turn…

    Dang! I want a monetary policy that works.

    I come back to this: leaving grocery bags of cash on the streets of lower-income neighborhoods. Not because low-incomers are virtuous but because they will spend it and I know that works…I think…but maybe the St. Louis Fed has a feason why my grocery bag plan will shrink GDP…or Stephen Williamson…

  2. Gravatar of Tom Tom
    13. March 2014 at 17:52

    Sorry Scott,
    “Surely there are other nominal industry outputs that better correlate with the goals of monetary policy (NGDP) than the banking industry! Why not focus on those industries?”

    This seems really silly. No Central Bank has a magic wand to adjust NGDP. Monetary Policy, in the real world, mostly means how many loans are being given out by banks.

    While you may well be right about the virtues of targeting NGDP (I sure think so), you fail to show what actions the Fed can take that do not mostly operate thru the bank intermediaries. And then you say banking and finance doesn’t matter (much).

    The best measure of loose or tight money is how easy it is to get a loan. But that’s not so easy to measure.

  3. Gravatar of Benjamin Cole Benjamin Cole
    13. March 2014 at 18:06

    Okay, as long as I am ranting…

    I am a Market Monetarist, and I subscribe to the description of banking just enumerated by Scott Sumner…but that means about one-helf the econ textbooks and even some current Fed regional bank websites are essentially filled with crank literature…and that about one half of economists are cranks…

    This picture become even worse, when you consider that even among non-crank economists there is often an unhealthy obsession—a monomania—with inflation.

    This is newish—if you read “serious” and popular econ literature from the mid-1980s (recently after the inflationary epoch), you find many “serious” economists satisfied with inflation in the four percent to five percent range…you even find right-wing literature condemning then-Fed Chairman Paul Volcker as a Carter appointee who is too tight….

    The modern-day inflation hysterics would be termed “cranks” by the right-wing economists of the 1980s…and there is reasonable question about how accurate meaning inflation can be…so the cranks are obsessing about a thermometer that may be off…

    It gets stranger yet…many center and right-wing economists from Milton Friedman, to Allan Meltzer, to Ben Bernanke, to Frederic Mishkin to John Taylor, went to Japan in the 1990s and told them to go to QE and don’t quit until they see the whites of the eyes of real inflation and growth…

    Now, that same group says QE could result in unforeseeable but catastrophic financial imbalances…you even have economists who say QE causes deflation (Williamson), or that expanding QE fourfold will result in only a little growth and inflation (St. Louis Fed).

    Like I said, an earnest student of monetary policy can feel like a blind dog in a meathouse…

  4. Gravatar of Nick Rowe Nick Rowe
    13. March 2014 at 18:08

    Good post Scott. Our two posts are complements.

    I especially liked this bit: “So the BoE is technically correct. But that’s a meaningless distinction, as it’s all base money, and reserves are just the name given to base money when held by banks, and cash is the name given to base money held by non-banks.”

  5. Gravatar of dannyb2b dannyb2b
    13. March 2014 at 18:48

    “Not sure why the Bank of England is so interested in the nominal size of the bank balance sheets, and not other industries. Surely there are other nominal industry outputs that better correlate with the goals of monetary policy (NGDP) than the banking industry! Why not focus on those industries?”

    Does that mean that the balance sheet of the fed is also in the domain of microeconomics? The banking system has a larger balance sheet than the fed.

  6. Gravatar of Mike Sax Mike Sax
    13. March 2014 at 19:12

    It’s amazing that you’re having this debate with Mark Carney-or at least his CB-rather than Warren Mosler.

  7. Gravatar of Matt Waters Matt Waters
    13. March 2014 at 20:29

    “Does that mean that the balance sheet of the fed is also in the domain of microeconomics? The banking system has a larger balance sheet than the fed.”

    It matters how the balance sheet of banks and the Fed applies ultimately to macroeconomic variables, namely unemployment and inflation. Ideally of course you want the lowest unemployment and the lowest inflation possible, and everything in economics sort of works outwards from those two goals. For anything to increase productivity, the end goal could be thought equivalently as reducing inflation. NGDP is a better indicator of unemployment and demand-side inflation, which is why market monetarists want to target it, although the end goals are unemployment and inflation.

    Also, everything in an economy affects those two variables. So the balance sheet of the Fed, of banks, of Wal-mart, of the local cheap motel also all affect those main two goals, but some things have more effect than others. The balance sheet of the Fed or of banks, in and of themselves, does not have a huge effect on those two variables. The amount of required reserves in 1999-2008, for example, did not increase even though both bank balance sheets (including shadow banking) and NGDP increased significantly. Since then, the Fed’s nominal balance sheet has shot through the roof, but NGDP and inflation have barely budged.

    Furthermore, the two variables relationship with something like bank balance sheets is hard to disentangle because most nominal indicators are endogeneous to NGDP. Banks see more loan activity, but so home builders, toilet paper manufacturers, yoga teachers etc. also see more revenue as NGDP goes up. That’s because loan activity depends on how much toilet paper manufacturers, yoga teachers, etc. see their expected revenue go up; toilet paper manufacturers’ revenues depend on bankers, yoga teachers, etc. seeing their revenue go up; and yoga teachers’ revenues depend on bankers, toilet paper manufactuers, etc. revenues going up.

    The Nash equilibrium in this model is that these three papers all WILL settle on a common forecast for revenue. If any one has a forecast which differs from significantly from the common forecast, that person will see a worse payoff than having a forecast near the common forecast. Therefore, the ways the Fed directly influences the revenues for the economy as a whole (NGDP) AND how the Fed influences the expectations for the revenues for the economy as a whole is what matters.

    The Fed balance sheet, for example, actually saw a steady increase from 1979-1983, even though it sent interest rates through the roof to tackle inflation. For some micro reason, the actual bank reserves plus cash went up even as the Fed had to sell enough assets to get to an 18% Fed Funds rate.

    http://greshams-law.com/wp-content/uploads/2011/08/Federal-Reserves-Liabilities-Since-the-Collapse-of-the-Bretton-Woods-Agreement1.png

  8. Gravatar of Tom Brown Tom Brown
    13. March 2014 at 20:37

    Benjamin Cole, you write:

    “I come back to this: leaving grocery bags of cash on the streets of lower-income neighborhoods.”

    A couple of weeks back I thought of you when I asked Sumner a question along these lines: “Would counterfeiters help?” I thought I’d recalled you promoting counterfeiting at one time. Lol. His response was something like “I don’t favor counterfeiting because it’s inefficient.” I’m thinking he might say the same about your bags of cash idea. I don’t know what he meant by that exactly, BTW.

    Ah, here you go, my question:
    http://www.themoneyillusion.com/?p=26213#comment-319935

    Scott’s response:
    http://www.themoneyillusion.com/?p=26213#comment-319940

    However Nick Rowe maybe has other ideas:

    “Here is my general theory: when the central bank buys something, with central bank money, the money supply expands, because whoever sold them that something now holds extra money. Done. It does not matter whether the central bank buys a bond, or a computer, or whatever. Hell, it could just give the money away to its favourite charity (helicopter money), and the result would be the same.”

    I’m guessing Scott doesn’t agree with Nick’s “helicopter/charity” part of that paragraph.

  9. Gravatar of Benjamin Cole Benjamin Cole
    13. March 2014 at 21:15

    Tom Brown–

    I think Scott Sumner wants to be taken seriously, as he should, so he uses language and advocates programs that will work but are also politically acceptable…

    Leaving money bags will work better than the central bank buying bonds, but it is not PC….

    My favorite idea for a national Fed-financed lottery that pays out more than it takes in, pays in cash, small bets only and a $20k max on annual winnings never gets any traction either.

    So, our timid, inflation-phobic Fed is stuck buying bonds. That will work, but man you gotta pour it on. And the Fed wants to quit, just like the Bank of Japan.

    You are talking about an FOMC that used the world “inflation” more than 500 times in a single meeting, a part-day meeting at that, in 2008 at that.

    I have long advocated counterfeiters plying their trade in America, but only if they print really, really good fakes that are undetectable. And to get in touch with me if they can do this. I have also pleased with drug lords, gun runners, despots and others to take their huge cash hoards ($800 billion in Benjamin Franklins) and come to America, and spend all they can. Live it up!

    It is obvious we cannot rely on our central bank to lead responsibly, ergo we are justified in taking extraordinary actions.

  10. Gravatar of Tom Brown Tom Brown
    13. March 2014 at 21:18

    Scott,

    The following hypothetical is inspired by your “Cashless society” hypothetical (Case 7) here:

    http://www.themoneyillusion.com/?p=23314

    Say we had a cashless society, a CB, a single commercial bank, no government spending or taxation, no foreign trade, and a reserve requirement of 0%.

    1. Now say the CB targets a $0 stock of base money. I don’t see why that would cause the stock of M1 (bank deposits) to be $0. The bank could still earn equity for it’s shareholders by making loans. Do you agree? Also I don’t see why the price level P or NGDP would be at 0. Do you agree?

    2. Now say the CB changes its target and targets $X > $0 in base money which it accomplishes by buying $X in assets. What happens to the price level in the long term? A simple analysis says the price level should eventually rise by the same factor that base money does, correct? But that factor is infinity!

    What’s wrong with the logic wrt this hypothetical?

  11. Gravatar of Matt Waters Matt Waters
    13. March 2014 at 21:43

    As far as dropping money bags or creating a state-sponsored money-losing lottery, I’m not a big fan of those sort of ideas myself because of how it would make the Fed nominally insolvent.

    With normal open-market operations, both assets and liabilities are increased in equal amounts. The Fed has “equity” in the form of banks’ required purchased of stock in their regional Fed banks. It also pays a bizarre 6% dividend a year, which is one of the reasons the whole bank aspect of monetary policy should be done away with. It may have made sense at the time, to get buy-in from banks who were opposed to the Fed, but now a 6% risk-free coupon from the government is pure graft. Plus banks have 6/9 of the vote of 4/9 of the FOMC makes no sense (banks elect 6 out of 9 people on boards of regional banks, which elects bank presidents who in turn serve on 4 seats of the FOMC). There is also equity in the form of whatever coupon payments or capital gains/loss the Fed receives from the assets.

    But the assets/liabilities distinction does have some real implications. The assets are valued at cost, at whatever cost happens to be on the open market. So, if on average the future asset cost equals the present cost, the Fed can destroy all of the monetary base by selling the assets. The Fed also takes money out of the economy when it receives coupons on its assets or the required bank investment. As long as the (fair market value of assets) > (bank reserves) + (currency in circulation), the Fed could in theory fight any sort of possible inflation given the will.

    If there is one of these helicopter sort of ideas, then liabilities would increase without an increase in assets. The Fed would have no legal ability to take money out of the economy at a certain point and the only way to get money back out is through taxation.

    Finally, every Fed policy to increase NGDP does seem to have some sort of economic allocation change. QE or dropping bundles of money in the South Bronx could both meet NGDP level targets. But the latter policy would certainly move more of the economy’s real production towards people in the South Bronx than QE. There’s also negative IOR and NGDP futures trading, but it’s extremely tough for me to think through how QE, IOR or NGDP futures would each have different economic allocation changes.

  12. Gravatar of Tom Brown Tom Brown
    13. March 2014 at 21:58

    Scott, you write:

    “Yes, if you set an interest rate target then the base becomes endogenous. But it’s equally true that if you set an inflation target then interest rates become endogenous.”

    Would it be fair to modify that sentence to read like this?:

    “Yes, if you set an interest rate target then the base becomes endogenous. But it’s equally true that if you set an inflation target then both the stock of base money and interest rates become endogenous.”

  13. Gravatar of Tom Brown Tom Brown
    13. March 2014 at 22:08

    Benjamin Cole, thanks, I thought that was you about the counterfeiters.

    If you read my comment, I too insisted on high quality counterfeiting. And just to be clear, Scott’s full response was:

    “Tom, It’s better to buy the bonds, counterfeiting makes the economy less efficent, as taxes must rise to cover the cost.”

    So putting aside the PC considerations for a moment, and taking him at his word, why do taxes have to rise to cover the cost? What cost? Does he mean that the Fed will accumulate negative equity when those counterfeits are sold back to the Fed, and thus taxes must be used to shore up this negative equity?

  14. Gravatar of Lorenzo from Oz Lorenzo from Oz
    13. March 2014 at 22:21

    I suppose it’s a fine explanation of monetary policy if you go for the interest rate approach to monetary economics, it’s just that I hate that approach.
    So, apparently, does Deidre McCloskey.
    http://www.deirdremccloskey.com/docs/pdf/Article_26.pdf

    But if you are interested in long run economic history, the interest rate approach is going to seem, well, very time period specific and so therefore less plausible.

  15. Gravatar of Tom Brown Tom Brown
    13. March 2014 at 22:47

    Matt, did the first round of QE in 2009 (or was it 2008?) amount to a bit of a helicopter drop in that the Fed was perhaps overpaying for some of the MBS type securities it was acquiring?

  16. Gravatar of Benjamin Cole Benjamin Cole
    13. March 2014 at 23:26

    Tom Brown:

    This is why I am a blind dog in a meathouse. I am not sure what Scott Sumner or Matt Waters is talking about.

    It may be an accounting convention. For some reason, the Fed cannot simply print money.

    For example when the Fed buys Treasury bonds, even if they hold the bonds to maturity, and even through they have paid for the bonds in cash, they are then obligated to “extinguish” the bonds and the proceeds from the Treasury upon maturity or sale.

    Of course, the Fed can just buy more bonds, so in sense they can create money through QE, permanently, but they have to maintain their bond portfolio.

    In you like forward guidance, then the Fed should tell everyone that is the plan, keep the QE hoard, and a permanent expansion of the monetary base. The Fed has not done this, leaving open the possibility of very contractionary policy in the future. This is not much talked about and I wish Scott Sumner would talk about it.

    Why counterfeiters raise legal taxes is beyond me, although they are tax on everyone. In other words, a counterfeiter gets a claim on production, but makes no contribution, and so they are a “tax” on everyone else.

    But if it is only accounting conventions that keep us from an effective monetary policy, then I say change the accounting conventions.

    It seems to me a nation has a sovereign right to print more money. It may abuse that right, but it may also use that right to do much good, just as the court system, police etc can be abused but are necessary.

    A nation that leaves monetary policy in the hands of someone else is really just a quasi-state.

  17. Gravatar of Matt Waters Matt Waters
    14. March 2014 at 03:28

    Tom, perhaps. MBS are complicated instruments even though they are backed by the government. I don’t know all the details of QE1, so I can’t say for sure.

    Benjamin, when a bond held by the Fed matures, then something odd happens with the Fed balance sheet. Before the bond matures, it is an asset and an equal amount of cash in circulation is a “liability.” Now that cash has come back to the Fed and the cash is both an asset and a liability. As long as you take the accounting fiction of cash as a Fed liability, you can just net out the asset and liability, and reduce the Fed balance sheet.

    The idea of cash as a liability is a hold-over from free banking days and the idea the Fed is somehow, itself, a bank. In the free banking days, the only currency was literal silver and gold specie but it was extremely inconvenient and risky to walk around with a bunch of silver and gold coins for transactions. Therefore, banks would issue bank notes, which were liabilities as much as deposits. If somebody showed up at the bank with a bank note, the bank needed to pay them with the currency held in the bank vault.

    Free banking ended some time in the 1870′s, IIRC, and the US issued national bank notes and there were the first national banks, versus only state charters. The idea remained though of the notes being some sort of liability until the Fed was created.

    If you were to say this all sounds like complete accounting fiction with monetary policy today, you would be correct. What really matters is the actual mechanics and goals of monetary policy, but those mechanics matter.

    With a simple example, let’s say the absolute, only thing the Fed could ever do is target the Fed funds rate at 0%. It could say “we are keeping the Fed funds rate at 0% until growth reaches 5% NGDP levels,” but without any more ammunition, I’m hard-pressed to say how it could actually reach those levels. If the market wants full-blown deflation, there’s little punishment for expecting full-blown deflation.

    Leaving bags of newly printed money on the street is the inflationary analog. So people would gladly spend the money they find, but what would happen if most of the cash in the monetary base is printed this way? Let’s say it gets to the point where the bonds are all “extinguished” and all cash anywhere (whether as cash or bank reserves) was printed as bags on the street?

    Well, if inflation threatens, the Fed has no legal authority to take the money back. The money has to be taken out through taxation.

    It is also theoretically possible for the assets on the Fed balance sheet to significantly depreciate to the point of assets being less than liabilities. Let’s say the Fed was committed to keeping inflation at 2%, but Obama shows his communist colors and starts running Zimbabwe-like fiscal deficits? The market would be absolutely flooded with new US debt and the Fed would actually add to it as it tried to destroy currency. Interest rates would go up significantly, depressing the open market value of the Fed’s bonds and the cash paid printed by the Fed would be more than the cash the Fed gets back. At some point, the Fed would have zero “assets” with cash still out there. With Zimbabwe-like fiscal deficits and no money printed, the Fed would continually have to find new buyers with the cash remaining. Velocity would need to keep going up to supporting it, but eventually the cash would be worthless.

    …Or I think that’s how it goes. Very abnormal fiscal policy, both third world deficit levels and, say, WWII deficit spending, can have a significant macro effect. For most developed countries though, the pressure to cut deficits or the expectation of deficit reduction with full employment will not have such a cycle develop. I say “expectation of deficit reduction” because that is somewhat key to the case of 200% debt/GDP Japan. If there was ever a legitimate scare of hyperinflation/default due to Japanese deficits despite the BOJ, Japan would do every bit of austerity necessary to make interest payments.

    Eh, I probably just confused everyone more with these hypotheticals. That’s the real interesting thing about monetary economics. There’s a lot of very possibly chaotic elements such as how the bankruptcy of Lehman brothers collapsed NGDP expectations in a couple of days, despite nothing different coming from the Fed’s rate targets or FOMC statements.

  18. Gravatar of Benjamin Cole Benjamin Cole
    14. March 2014 at 04:13

    Leaving bags of newly printed money on the street is the inflationary analog. So people would gladly spend the money they find, but what would happen if most of the cash in the monetary base is printed this way? Let’s say it gets to the point where the bonds are all “extinguished” and all cash anywhere (whether as cash or bank reserves) was printed as bags on the street?–Matt Water.

    If inflation occurred in this unlikely but fun to think about scenario, the Fed would start to sell bonds, and hoard the cash. Or the Treasury. Just sell a lot bonds and and hoard the cash, an you would cut off inflation.

    Which brings up the point—why is the Fed not part of the Treasury in the modern economy? The way the economy has evolved, and the monetary and fiscal impacts of the two organizations overlap….it is koo-koo to have the Fed suffocating the economy while the President is trying to revive it….or vice versa….

  19. Gravatar of J Mann J Mann
    14. March 2014 at 04:42

    Here’s my 2 cents.

    1) Giving the money away has one big problem, which is that it’s hard to take the money back out of the economy if you want to reverse the process. Buying assets lets you sell assets when you want to reduce the effective money supply. I don’t recall the specifics, but if you grant that the Fed tripled the base money supply between 2008 and 2012, at some point you probably want to reduce it.

    You could argue that by putting money in the hands of people with a higher propensity to spend, you wouldn’t need to triple the supply, but sooner or later, that money ends up in the hands of someone with a propensity to hoard, so my guess is you don’t get a huge boost to velocity over the alternative of buying assets.

    2) One reason counterfeiting requires more taxation is opportunity cost. If the fed makes money (literally and figuratively) from increasing the money supply, that reduces the tax level required to support government operations. If counterfeiters make money, not.

    The other reason is the same as above – if the fed has to give up something of value to reduce the money supply as the economy takes off, and it didn’t receive something of value when the economy increased, I think that means the government loses, and taxes have to go up. But I’m bad at fed reserve accounting, so I’ll gladly accept corrections.

  20. Gravatar of ssumner ssumner
    14. March 2014 at 05:00

    Tom, Don’t confuse money and credit. Monetary policy has no important links with bank loans. That’s a separate industry. The Fed controls NGDP by influencing the supply and demand for base money.

    Thanks Nick.

    Danny, The Fed balance sheet is special because it’s liabilities are the medium of account.

    Matt Waters. It’s no surprise that the Fed’s balance sheet rose when interest rates were high. If you look around the world balance sheets usually rise fastest in countries with high interest rates. The only exception is that rates fall all the way to zero balance sheets also tend to rise.

    Tom Brown, I agree that Nick’s (and Ben’s) policy idea would work, it’s just that I think there are better options (and I’m sure Nick does as well.)

    I don’t understand your zero monetary base example, what is the medium of account in that case?

    Your proposed rewrite is accurate.

    Lorenzo, Yes, if you are interested in monetary history you very quickly need to go beyond interest rates, What would have happned to rates if the US adopted a bimetallic system? They would have risen, AFAIK.

  21. Gravatar of Ilya Ilya
    14. March 2014 at 06:35

    Scott,

    When the CB increases the base, what mechanism guarantees that it becomes cash? Money demand? After all, it can’t force people to get cash.

    Great post. I hope you continue discussing money and banking/finance. I have a hard time splitting the two up.

  22. Gravatar of Philo Philo
    14. March 2014 at 06:39

    “[R]eserves are just the name given to base money when held by banks, and cash is the name given to base money held by non-banks.” So currency held by banks counts as “reserves,” and when I go to the bank and withdraw an amount from my checking account, taking that amount in currency, reserves are reduced and cash increases by that very amount. (Just checking that I have understood your definitions.)

  23. Gravatar of Philo Philo
    14. March 2014 at 06:44

    @ Benjamin Cole:

    “[L]eaving grocery bags of cash on the streets of lower-income neighborhoods . . . [n]ot because low-incomers are virtuous but because they will spend it and I know that works . . . .” If you give currency to high-income people do you think they will stuff it in their mattresses?

  24. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 07:36

    @Philo, I think you got the definitions correct. Google “Money Supply”… I think the table and definitions there are accurate. Basically base money (electronic or currency) owned by a bank is said to be “reserves.” Nothing else qualifies as reserves.

  25. Gravatar of W. Peden W. Peden
    14. March 2014 at 07:38

    Ilya,

    If a bank has more base money than it wants to hold (the reserve ratio exceeds its desired reserve ratio) then it can expand its promises to pay base money i.e. expand its assets. I suppose, strictly speaking, a bank expanding its assets isn’t “forcing” anyone to do anything, but most people will accept money from a bank for some asset at some price.

    The Bank of England hasn’t had a good official monetary theory for at least a very long time (I don’t know much about pre-1950s UK monetary policy history) and this is reflected in the fact that our Great Moderation didn’t come until 1993, and our recovery from the Great Recession has been so stop-go. It has never taken base money seriously in the post Keynesian period, and hence our monetary policy has been markedly worse than US policy in all periods of the post-war period (so even when US monetary policy was very bad, as in the 1970s and early 1980s, ours was even worse).

  26. Gravatar of W. Peden W. Peden
    14. March 2014 at 07:39

    * ours.

  27. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 07:56

    Scott, you write:

    “I don’t understand your zero monetary base example, what is the medium of account in that case?”

    Shoot, I was hoping you could tell me! How about in part 2.? Is it clear the MOA is reserves in that case?

    Also, your response is different than Nick’s (I asked him the same question):

    “In your (interesting) hypothetical, what would the commercial bank promise to convert its demand deposits into? If there is no currency, and no reserves, I think that promise would become empty. The central bank disappears (its balance sheet has $0 on the liability side), and the one commercial bank is now the new (privately-owned) central bank.”

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/one-general-theory-of-money-creation-to-rule-them-all.html?cid=6a00d83451688169e201a3fcd48f2d970b#comment-6a00d83451688169e201a3fcd48f2d970b

    If the private bank is really acting like the central bank (as Nick says), then it’s deposits would be the MOA, right?

  28. Gravatar of Doug M Doug M
    14. March 2014 at 08:23

    You hate the word “modern”? Then what do you think of post-modern? The “modern era” means ~1920 – 1980.

    Regarding the BoE’s definition of Money, I can’t say that there is anything controversial there. The money supply is the total assets on bank balance sheets — that is a standard definition. Banking is special — also standard. Money is created when banks lend — check.

  29. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 08:27

    … plus I guess you could turn run my hypothetical in reverse: start with case 2. and go to case 1.: i.e. start with $X > $0 in reserves (then the MOA is reserves, no?). Then have the CB target $0 in base money (i.e. sell its $X worth of assets). What happens to P then? The simple answer says it moves by a factor of 0/X or that it goes to 0, but I don’t see why that would actually happen.

  30. Gravatar of Banking theory disguised as monetary theory? « Economics Info Banking theory disguised as monetary theory? « Economics Info
    14. March 2014 at 09:02

    […] Source […]

  31. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 09:32

    Scott, when you wrote this:

    “Tom, It’s better to buy the bonds, counterfeiting makes the economy less efficent, as taxes must rise to cover the cost.”

    What costs were you referring to? I asked Benjamin, but he didn’t know either.

  32. Gravatar of J Mann J Mann
    14. March 2014 at 10:29

    Tom, I took a shot at answering your questions above – what do you think?

  33. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 10:52

    J Mann, I like most of that. I’m a little iffy on the 1st paragraph of your 2. I don’t see how it reduces tax levels, permanently anyway, for the reason you give there. First of all the Fed doesn’t have to buy T-bonds. Second, even it it does, when the bond matures the Tsy still needs to pay the principal… and it may well get that money via taxation. The Fed does remit the bulk of interest payments back to Tsy, so it does reduce the debt burden in that sense. Plus, if the Fed was a guaranteed buyer that always bought and never sold again, then they would essentially be funding the government.

    I follow your 2nd paragraph under 2. much better. That was essentially my point too: if those counterfeit notes become worn out and are sold back to the Fed… at some point it’s going to come up empty handed (accumulate negative equity). Imagine the Fed for some reason buys back all of its reserve notes… it’ll notice that it started off w/ $X in reserve note liabilities but ended up buying back $Y > $X notes!. Its negative equity would be realized. Since I think the Tsy is ultimately responsible for the Fed, if some Senator were to complain (Rand Paul for example) and insist on an audit, they might be able to make political hay out of the fact the Fed was “insolvent” … perhaps even force the Tsy to “bail them out.” Of course it’s hard to believe that any negative equity wouldn’t soon be corrected … the Fed must bring in a lot of profits in general, having the monopoly they do. But even w/ negative equity it’s ridiculous to ever describe the Fed as insolvent. Except to a banking theorist like Mike Sproul. So “ridiculous” here on themoneyillusion anyway. :D

  34. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 12:15

    Just to enlarge on Scott’s main points and add a couple of my own.

    1) “Money Creation in the Modern Economy”

    There’s nothing particularly “modern” about the current system of money creation. In particular central banks have been doing QE for over 340 years.

    2) Banks don’t lend out reserves.

    This is about as useless a mantra as saying “consumers don’t deposit currency”, and equally true.

    3) Loans create deposits.

    When Krugman was asked if loans create deposits, or deposits create loans, his response was “yes”.

    As he noted, it’s a simultaneous system, and in fact when short term interest rates are at the zero lower bound, and central banks are creating base money in ad hoc amounts as with QE, empirically the process is almost always one way from deposits to loans. In particular, Granger causality tests show that it is this way in the US from 1933-41, the US from 2008 to present and the UK from 2009 to present.

    4) The money multiplier is dead.

    Every Econ 102 textbook I’ve ever seen teaches the money multiplier is a function of three variables. The currency ratio is always portrayed as the depositors’ choice, the reserve ratio (above required, if any) is always the lenders’ choice, and the total amount of currency and reserves (the monetary base) is the central bank’s choice (even if supplied through the discount window), and all are dependent on the conduct of monetary policy by the central bank.

    Every textbook that presents the simple model of multiple deposit creation follows this with a critique clearly stating its “serious deficiencies”. In Mishkin’s intermediate level textbook (I have the 7th edition), not only is there such a section, the chapter in which it is taught is followed by a whole other chapter that makes it abundantly clear that the currency and reserve ratios are variables.

    All models are wrong, some are useful. The simple model of multiple deposit creation is useful. And there isn’t a single textbook I have seen that doesn’t point out its serious deficiencies. If students pass a course unaware of the simple model of multiple deposit creation’s serious deficiencies, that is the fault of the instructor, not the textbook.

    So, in short, there is no such thing as “exogenous money” theory. (Where’s the Wikipedia page?) The believers in endogenous money have carefully constructed an exogenous money strawman, complete with a series of erroneous beliefs and nonexistent defective textbooks, so that they could have something to verbally abuse and physically beat up in socially binding demonstrations of rage.

    In the final analysis, if the money multiplier doesn’t exist, then why does so much Post Keynesian empirical research on the endogeneity of money use the money multiplier as a key variable? (e.g. Thomas Palley, Robert Pollin etc.) Saying the money multiplier is dead makes about as much sense as saying the sectoral sectoral balances is dead. It’s an accounting identity for heaven’s sake.

    5) Nick Rowe: “I’m sure they are not alone in having two theories: one for “normal times”; and one for QE, which is seen as needing a special theory only applicable in “abnormal times”. But it is rather peculiar having two different theories of the same thing.”

    What’s really peculiar is that the Fed, the BOJ and the BOE have all been in “abnormal times” now for over half a decade. How long before abnormal times becomes normal and normal times become abnormal? (Just wondering.)

    Maybe what we need is one general theory of money creation to rule them all.

    6) Nick’s post vaguely reminds me of another post he did five years ago:

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/03/the-return-of-monetarism.html

    “As interest rates approach zero, and central banks look at “unorthodox” monetary policies, the Neo-Wicksellian perspective on monetary policy has switched to a blank screen. We are witnessing the return of Monetarism.

    That’s the main reason why economists find it hard to think about unorthodox monetary policies. The dominant Neo-Wicksellian paradigm which fills our heads can say nothing about them. We are forced to return to older, half-forgotten ways of thinking. There is perhaps a “Dark Age” in thinking about monetary policy, just as much as in thinking about fiscal policy.

    The dominant paradigm for monetary policy over the last decade has been the Neo-Wicksellian perspective: monetary policy is the central bank setting a short-term nominal rate of interest…”

    “…So we need to revert to an older, earlier way of thinking. Monetary policy is about changing the stock of money. The objective of monetary policy, in a recession, is to create an excess supply of money. People accept money in exchange for whatever they sell to the central bank, because money by definition is a medium of exchange. But they don’t want to hold all that money. Or rather, the objective of the central bank is to buy so much stuff that people don’t want to hold the money they temporarily accept in exchange. An excess supply of money is a hot potato, passing from hand to hand. It does not disappear when it is spent. It spills over into other markets, creating an excess demand for goods and assets in those other markets, increasing quantities and prices in those other markets. And it goes on increasing quantities and prices until quantities and prices increase enough that people do want to hold the extra stock of money.

    That’s classic Monetarism…”

  35. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 12:31

    Tom Brown,
    “Matt, did the first round of QE in 2009 (or was it 2008?) amount to a bit of a helicopter drop in that the Fed was perhaps overpaying for some of the MBS type securities it was acquiring?”

    All Treasuries and Agencies are bought in the secondary markets, so how exactly does one overpay under those circumstances? This sounds like a rather questionable idea (“bag-o-dirt”) attributable to a certain blogger who shall remain unnamed.

  36. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 12:51

    Mark, that’s why I’m asking, not telling. Were there any cases in which the Fed ended up paying a non market rate for anything at all. Or one of it’s holding companies. I don’t know the answer… …again, it’s why I’m asking. What was Maiden Lane for example?

  37. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 12:57

    Mark, also I left a question on your post here:
    http://thefaintofheart.wordpress.com/2013/06/02/koos-wrongheaded-views-on-the-great-depression-as-an-example-of-a-balance-sheet-recession-a-guest-post-by-mark-sadowski/#comment-13276

  38. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 13:16

    Tom Brown:
    “Were there any cases in which the Fed ended up paying a non market rate for anything at all. Or one of it’s holding companies. I don’t know the answer… …again, it’s why I’m asking. What was Maiden Lane for example?”

    In the whole history of the Fed? Not really, at least not that I’m aware of.

    For example, what was the actual value of the Federal Reserve “bailouts” under the credit and liquidity programs?

    According to the 2011 audit of the Fed by the Government Accountability Office (GAO), there were $16.115 trillion in Fed loans issued under the credit and liquidity programs to banks and corporations around the world between the financial meltdown in 2008 and July 26, 2010.
    Page 131:

    http://www.gao.gov/new.items/d11696.pdf

    Now to see how silly the $16.115 trillion dollar figure is let’s focus on the largest component, the $8.951 trillion lent out under the Primary Dealer Credit Facility (PDCF). Those were overnight loans made over the period from March 17, 2008 through February 1, 2010. Thus the average amount of loans under the program on any given night was $13.1 billion.

    The peak amount of loans under PDCF was $130 billion (fourth page of the GAO audit) and occured in early October 2008. In fact nearly a third of all the loans (by amount) were made in October 2008. An Excel file containing details about the loans can be downloaded from here:

    http://www.federalreserve.gov/newsevents/reform_pdcf.htm

    The peak spread between the Libor rate:

    http://research.stlouisfed.org/fred2/data/USD3MTD156N.txt

    and the rate paid on a PDCF loan was 3.07% on October 10, 2008 when the PDCF rate was 1.75% and the Libor rate was 4.82%. Thus the value of the subsidy under PDCF was less that 3.07% of the average daily amount of $13.1 billion over 1.88 years or $756 million.

    Why is the subsidy on $8.951 trillion in loans so small? Because it’s a flow and not a stock.

    The peak stock amount under the emergency lending programs was $1,067 billion on December 18th, 2008:

    http://www.federalreserve.gov/releases/h41/20081218/

    A graph of the stock amounts is depicted on page 137 of the GAO Audit. The program with the largest stock amount was the Term Auction Facility (TAF) which peaked at $493 billion in early March 2009. At the time the interest rate paid on a TAF loan was 0.8%:

    http://publicintelligence.net/term-auction-facility/

    when the Libor rate was about 1.3%. The average amount of loans on any given day during the life of the program was $142 billion:

    http://research.stlouisfed.org/fred2/series/WTERAUC

    Thus the subsidy under TAF might have been about 0.5% (the spread) of $142 billion over 3.35 years or $2.38 billion.

    And in fact if one totals up the estimated subsidies for the $16.115 trillion loaned under the emergency lending programs it comes to about a measly $4 billion.

  39. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 13:35

    Tom Brown,
    I left you a response with multiple links to your first question. It will show up when Scott frees it from moderation.

    As for your question at Historinhas, I responded there but I shall respond here as well.

    Prior to November 1959 vault cash was not permitted to be used to satisfy reserve requirements. On average only about 73% of vault cash has been used that way since then.

  40. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 13:35

    J. Mann, towards the end of my comment should read:

    “Except to a backing theorist like Mike Sproul.”

    … not “banking”

  41. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 13:37

    Mark, thanks for the info. Appreciate it.

  42. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 14:07

    Scott,
    Off Topic.

    Paul De Grauwe shows that the German Consitutional Court does not understand EMH, LOLR and what a central bank is.

    http://www.voxeu.org/article/economic-flaws-german-court-decision

    “…The German constitutional court has declared the OMT program to be illegal according to EU-law. I have argued that this ruling is based on economic theories that should be rejected. The first one is the efficient market theory. This theory implies that there is no role for the central bank as a lender of last resort, not only in the government bond markets but also in the banking sector. Financial markets will do the job of providing liquidity to illiquid but solvent banks and sovereigns. Who believes this theory these days? Apparently, the judges from Karlsruhe do.

    The second theory is that central banks should have positive equity to be able to function. According to this view negative equity of the central bank implies that governments (taxpayers) will have to step in to save (recapitalise) the central bank. This view, on which the ruling of the judges of Karlsruhe is based, should be rejected. In a fiat money system central banks do not need equity. It makes no sense to claim that a central bank that cannot default should have a fiscal backing from governments that can default.”

    In a related note, Jeffrey Frankel says the ECB should buy Treasuries.

    http://www.project-syndicate.org/commentary/jeffrey-frankel-urges-the-ecb-to-buy-us-treasuries-to-expand-the-monetary-base

    “…What, then, should the ECB buy if it is to expand the monetary base? For several reasons, it should buy US treasury securities. In other words, it should go back to intervening in the foreign-exchange market.

    CommentsView/Create comment on this paragraphFor starters, there would be no legal obstacles. Operations in the foreign-exchange market are well within the ECB’s remit. Moreover, they do not pose moral-hazard issues (unless one thinks of the long-term moral hazard that the “exorbitant privilege” of printing the world’s international currency creates for US fiscal policy). Finally, ECB purchases of dollars would help push down the euro’s exchange rate against the dollar.

    CommentsView/Create comment on this paragraphSuch foreign-exchange operations among G-7 central banks have fallen into disuse in recent years, partly owing to the theory that they do not affect exchange rates except when they change money supplies. But in this case we are talking about an ECB purchase of dollars that would change the euro money supply. The increase in the supply of euros would naturally lower their price. Monetary expansion that depreciates the currency is more effective than monetary expansion that does not, especially when, as is the case now, there is very little scope for pushing short-term interest rates much lower…”

  43. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 14:13

    Scott,
    Off Topic.

    The CFR has interesting graphic comparing unemployment and inflation right, now using four measures each, to what they were in the four previous rate hike episodes.

    http://blogs.cfr.org/geographics/2014/03/13/stillinflation/#cid=soc-twitter-at-blogs-its_still_the_inflation_stupid-031314

  44. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 14:19

    Mark, at that Historinhas post, you use this formula:

    M=(1+c)/(r+c)*MB

    I’m comparing that with this article:
    http://en.wikipedia.org/wiki/Money_multiplier

    You call r the “reserve ratio” but from reading the wiki article it’s not clear to me what they mean. They use the following:

    RR = “reserve requirement”
    Here:
    http://en.wikipedia.org/wiki/Money_multiplier#Formula

    But they also use the term “reserve ratio requirement” to express this:
    R/M >= RR

    The also have
    m = (1+CurrencyDrainRatio)/(CurrencyDrainRatio+DesiredReserveRatio)

    Where
    DesiredReserveRatio = the sum of the Required Reserve Ratio and the Excess Reserve Ratio

    The also say that
    DesiredReserveRatio = alpha + beta where
    alpha = the legal reserve ratio (on (0,1))
    beta = the excess reserves ratio (on (0,1)

    Also, there’s a bit towards the bottom with a similar formula using D, R, and C… but I’m failing to match it up precisely with the rest.

    1. Why are alpha and beta limited to (0,1)?

    2. Does what you mean by “r” match any of the various things the Wiki article seems to use? The legal reserve requirement ratio? alpha+beta?

    Thanks.

  45. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 14:27

    Mark, your “non-market” answer came through. Lot of good info there, thanks!

  46. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 14:53

    Tom Brown,
    Let’s answer these in reverse order.

    “2. Does what you mean by “r” match any of the various things the Wiki article seems to use? The legal reserve requirement ratio? alpha+beta?”

    What I call “r” they call the “desired reserve ratio” or “alpha+beta”.

    “1. Why are alpha and beta limited to (0,1)?”

    Because required and excess reserves can’t be less than zero and they cannot be more than deposits.

    Incidentally, to be picky this is wrong in a couple of respects. It’s more correct to say alpha+beta is limited to [0,1] because the *sum* of required and excess reserves cannot exceed deposits, and furthermore, at least in theory, they can be exactly equal to zero or exactly equal to deposits.

  47. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 15:16

    Thanks Mark, but why can’t they exceed deposits? Couldn’t we raise RR to 150% right now if we wanted? Or are you just saying for the formulas to be true then alpha+beta must lie on [0,1]? Actually they mention gamma is on (0,1) too, and it’s added in in places… so is it really the case that alpha+beta+gamma must be on [0,1]?

  48. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 15:48

    Tom Brown,
    If reserves exceeded deposits that would imply banks hold more assets than liabilities. If this only applied to one kind of deposit (e.g. checkable) I suppose this might be possible, but it would be portrayed as burdensome by banks and I can’t imagine such a thing ever occuring. Furthermore the highest reserve requirement I’ve ever seen in practice (temporarily IIRC in Angola, Kuwait and Serbia) or in theory (the Chicago Plan) is for 100% reserves. (Also, and not the most satisfactory answer, this is the typical requirement found in textbooks.)

    “Or are you just saying for the formulas to be true then alpha+beta must lie on [0,1]?”

    No, I think the formula would still work anyway

    “Actually they mention gamma is on (0,1) too, and it’s added in in places… so is it really the case that alpha+beta+gamma must be on [0,1]?”

    No, the currency ratio is totally separate from the reserve ratio. If is 0 then no currency is held. The upper limit of 1 is obviously a mistake, since there is no reason why the amount of currency cannot exceed the amount of deposits.

  49. Gravatar of benjamin cole benjamin cole
    14. March 2014 at 16:18

    Philo—
    Because rich people will put the money in the bank and I think there is some amount of disintermediation going on…perhaps due to IOER….but I only believe that if Mark Sadowski assents…

  50. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 16:18

    Mark, thanks again. Yes, I’m pretty sure that reserve requirements (RR) in the US just apply to checkable deposits. Recall I asked both you and Scott about raising the RR to 167% a couple of weeks back. In light of the fact that we have IOR, you brought up the “belt and suspenders” comment. In fact I specified 167% because you gave me a figure of $2.5T in reserves and only $1.5T in “deposits” (by which I think you meant checkable deposits) as the current aggregates. I think it was you anyway!

    What is this variable r wrt? Is it wrt checkable deposits? If so then if we consider the current situation to be “desirable” (suppose for the sake of argument that it is) then r > 1 right now, correct?

    Plus it’s easy to construct a case for which reserves exceed deposits, regardless of the kind of deposit. Say there’s just one commercial bank, w/ a blank BS. Now the CB buys a $1 of assets from non-banks, and the bank sells $1 of stock to non-banks. Deposits = $0, but reserves = $1.

  51. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 16:32

    Benjamin Cole,
    “Because rich people will put the money in the bank and I think there is some amount of disintermediation going on…perhaps due to IOER….but I only believe that if Mark Sadowski assents…”

    IOER is contractionary because it increases the demand for base money. (That’s my story and I’m sticking to it.)

    But if somebody wants to leave me a grocery bag full of money I’ll be happy to do my part to boost NGDP. :)

  52. Gravatar of ssumner ssumner
    14. March 2014 at 16:35

    Ilya, That’s up to the public. The Fed can influence reserve demand through reserve requirements and IOR. They have no influence on cash demand.

    Philo, That’s right.

    Tom, When there is no medium of account there is no price level. Once you introduce a MOA, a price level gets established.

    Doug, I was complaining that they treated the base and reserves as being synonymous.

    Tom, Taxes must rise to service the interest on the bonds that the Fed did not buy.

    Mark, I agree that purchasing T-bonds would be a reasonable action by the ECB.

    And those two cfr graphs are quite revealing.

  53. Gravatar of Morgan Warstler Morgan Warstler
    14. March 2014 at 16:37

    Mark / Tom,

    It seems pretty straight forward to me that the Fed never pays “market rate” it pays market rate +1.

    Because you can say if they didn’t buy it for same price, someone else would, but not prove it, it’s just as feasible to say someone else would have paid less.

    And more to the point, “lender of last resort” artificially shifts prices up. No ifs and or buts, there.

    And now that we know Fed does affect price level, we ought / should consider if there are more moral ways for it to achieve its ends.

  54. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 16:47

    Mark, for the the first money multiplier formula they introduce in the Wikipedia article for the “maximum commercial bank money/central bank money,” I can prove that the formula is only valid (mathematically) for RR on (0,2) and probably practically for RR only on (0,1].

    Say we start with B base money deposited at a bank, and a legal reserve requirement of RR. Then the bank can loan out D*(1-RR), which might be re-deposited and then D*(1-RR)^2 can be loaned out, etc. So if done an infinite number of times, we have the infinite summation:

    M = D*(1 + (1-RR) + (1-RR)^2 + (1-RR)^3 + … )

    Obviously this only converges for |1-RR| < 1. Mathematically, this forces RR to be on (0,2), but in fact it may not make sense for it to be anywhere but (0,1] (since it might give M < 0 otherwise). The infinite sum is thus

    M = D/RR, and the multiplier is thus 1/RR. But again the region of convergence is not the real line.

    The formula breaks down at RR = 0, but that's still a valid choice. I'll check the region of convergence for the other infinite summations (I believe they all are infinite summations).

  55. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 16:50

    B = D above.

  56. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 16:58

    Tom Brown,
    “Yes, I’m pretty sure that reserve requirements (RR) in the US just apply to checkable deposits.”

    That’s correct, although it varies by the amount of checkable deposits the bank has. (Very small banks have no requirement at all.)

    “Recall I asked both you and Scott about raising the RR to 167% a couple of weeks back. In light of the fact that we have IOR, you brought up the “belt and suspenders” comment. In fact I specified 167% because you gave me a figure of $2.5T in reserves and only $1.5T in “deposits” (by which I think you meant checkable deposits) as the current aggregates. I think it was you anyway!”

    Yes, I remember the conversation very well. At the time I didn’t bring up the fact that anything over 100% is highly unrealistic because we were just talking hypotheticals anyway.

    “What is this variable r wrt? Is it wrt checkable deposits? If so then if we consider the current situation to be “desirable” (suppose for the sake of argument that it is) then r > 1 right now, correct?”

    There is a *different money multiplier* for every measure of the money supply. That’s why I don’t usually bother with separating required from excess reserves. Nothing is really gained by doing that unless you really want to know those individual ratios.

    Consequently there is a *different reserve ratio* for each money multiplier. The value of “r” is the ratio of reserve balances to whatever amount of deposits there is in M1, M2 or MZM (for the US of course). Note that in my blog post I was working with the Friedman and Schwartz M2 measure of money supply.

    “Plus it’s easy to construct a case for which reserves exceed deposits, regardless of the kind of deposit. Say there’s just one commercial bank, w/ a blank BS. Now the CB buys a $1 of assets from non-banks, and the bank sells $1 of stock to non-banks. Deposits = $0, but reserves = $1.”

    Well, that’s your thing (and Nick Rowe’s), not mine. I prefer to stay on the empirical side of the street and observe the theoreticians playing with their wildly implausible money models involving cows and chickens or whatever from a distance.

  57. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 17:04

    … actually it never gives M < 0, but RR on (1,2) makes individual "loans" in the sequence less than zero, which doesn't make sense.

  58. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 17:23

    Tom Brown,
    Applying geometric expansion when the reserve ratio is one or greater doesn’t make sense since the first bank is unable to issue any loans. This is another reason why the upper bound for the reserve ratio is one.

  59. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 18:02

    Tom Brown,
    The Wikipedia table of the process of money multiplication is unusual in that it includes the currency ratio (gamma). Typically when teaching the simple model of multiple deposit creation this is not done, because it is needlessly complicating for something that is just a bridge to more realistic ways of looking at the money creation process.

    Because they have done it though, this means that the sum of the reserve ratio and the currency ratio must be less than one. However, note that this is not how the boundaries on the values is stated in the article. This must be where the erroneous upper limit on the currency ratio of “1″ is coming from.

    I can see why the author(s) wanted it done this way. They were determined to make the money multiplier process produce the actual money multiplier formula. But it is not necessary to go through a series expansion to derive the formula. The section above the table shows the derivation and that’s all you really need.

    If I were to write this I would do it totally differently. This looks like it was written by an Austrian hell bent on hammering round pegs into square holes. :)

  60. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 18:12

    Mark,

    “Applying geometric expansion when the reserve ratio is one or greater doesn’t make sense since the first bank is unable to issue any loans.”

    But if we take the reserve ratio r to be the legal ratio, and we start off with reserves in excess of r*(checkable deposits), which is quite possible, we can always make some loan.

    Starting off with reserves equal to r*(checkable deposits) prevents the 1st loan, regardless of what r is.

  61. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 18:15

    “If I were to write this I would do it totally differently. This looks like it was written by an Austrian hell bent on hammering round pegs into square holes. ”

    Interesting… and funny! :D

  62. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 18:22

    Tom Brown,
    The table in Wikipedia starts out with a deposit at a bank. If the desired reserve ratio is greater than one then the bank will not make a loan and instead will seek to increase its reserves.

  63. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 18:30

    Mark, agreed. But it doesn’t have to start that way, as our present circumstances demonstrate.

  64. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 18:38

    Tom Brown,
    All you really need to know as far as the money multiplier is concerned is the following:

    MB = (r + c)*D

    M = (1 + c)*D

    Thus m = M/MB = (1 + c)/(r + c)

    That’s it.

  65. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 19:00

    So you know r ahead of time, more or less, and then you solve for c to match reality?

  66. Gravatar of Mark A. Sadowski Mark A. Sadowski
    14. March 2014 at 19:22

    Tom Brown,
    It’s an accounting identity. You already know all of the values.

    c = currency/deposits

    r = reserves/deposits

    m = money supply/monetary base

  67. Gravatar of Tom Brown Tom Brown
    14. March 2014 at 20:03

    Ah, OK.

  68. Gravatar of Benjamin Cole Benjamin Cole
    14. March 2014 at 21:21

    Mark-

    I am glad you assent–but it also could be described (I think) as IOER causes a degree of disintermediation.

    I think I can safely say that Mark and I will be glad to test out the hypothesis, and take grocery bags full of cash and put some in the bank and spend most of it.

    The we can construct a model about whether the banked money ever entered the economy….

  69. Gravatar of Saturos Saturos
    15. March 2014 at 00:54

    I’m so glad to hear this.

    http://www.reuters.com/article/2014/03/13/us-ecb-policy-coeure-idUSBREA2C0HT20140313

  70. Gravatar of TravisV TravisV
    15. March 2014 at 05:43

    Noah Smith wrote a new post:

    http://noahpinionblog.blogspot.com/2014/03/the-finance-macro-canon.html

    See his recommendations at the very end? Why on earth does he recommend MMT and Stephen Williamson rather than Market Monetarism?

  71. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 07:47

    Mark, thinking about this some more, the geometric series way to visualize the maximum constraint is OK, but overly complicated IMO and leads to those artificial constraints on RR. It’s an equally valid simple model to assume the banking sector starts off with some investment capital (the reserves) and in one step loans the maximum amount. To do that, it’s easiest to image a single bank comprises the system. So if RR = 0.1, and the banking system starts w/ $1 reserves, in one step it can build loans and deposits of $10. Likewise if RR = 10, then in one step it could loan $0.10. No region of convergence or infinite series to worry about, and no limits on RR, other than RR >= 0. One step, and you’re done in all cases. The only special case is RR = 0. They should teach it like that… it’s much easier IMO. The infinite series approach leads one to believe it’s just setting an upper bound that could never be obtained because it would require an infinite series of loans and an infinite amount of time, when that’s not the case at all: one loan can get you to the limit right away.

    As for the formula with r and c, yes that is just an identity like you stated early on. You write:

    “…a whole other chapter that makes it abundantly clear that the currency and reserve ratios are variables.”

    Could you elaborate a bit on that? It seems to me they could be modeled as functions themselves of other variables.

  72. Gravatar of Philo Philo
    15. March 2014 at 07:54

    @ Benjamin Cole:

    Maybe your low-income (or poor) person will use his windfall to buy something from a merchant, who will put the money *in a bank*. On the other hand, a high-income (or rich) person would have bought stocks and bonds, by-passing banks.

    By the way, I fear that Mark Sadowski, as an authority, may be biased. Is he a rich person or a poor person?

  73. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 08:12

    Scott,

    OK, let’s start with your own example #7 from this post:
    http://www.themoneyillusion.com/?p=23314

    “7. Now let’s assume a cashless economy where the MOA is 100% reserves.”

    You’ve clearly identified the MOA there: reserves. Banking doesn’t matter, so why not assume a single commercial bank? And my other assumptions: no taxes, gov spending, foreign trade, etc.

    So if initially the CB buys $X in assets, this gives us an initial $X in reserves, which you’ve identified as MOA.
    Since we have an MOA, we will reach a steady state price level, P, right?

    Now what if the CB sells 1-epsilon of its assets? The new eventual price level should be:

    new steady state price level = P*(epsilon*X/X) = P*epsilon

    So as epsilon approaches zero, the new steady state price level should approach zero too??

  74. Gravatar of JN JN
    15. March 2014 at 08:27

    This BoE paper is really weird…
    It’s internally inconsistent, sometimes right, sometimes wrong.
    Completely agree with Scott on the term ‘modern’.

    I was also surprised that a whole section seemed to be paraphrasing my own blog posts on the topic…

    I just wrote a quick analysis on my own blog:
    http://spontaneousfinance.com/2014/03/15/the-boe-says-that-money-is-endo-exo-or-something/

  75. Gravatar of Mark A. Sadowski Mark A. Sadowski
    15. March 2014 at 08:30

    Philo,
    “By the way, I fear that Mark Sadowski, as an authority, may be biased. Is he a rich person or a poor person?”

    Mark A. Sadowski is an extraordinarily illiquid person.

  76. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 08:35

    Scott, of course the reserve requirement = 0% too.

  77. Gravatar of Mark A. Sadowski Mark A. Sadowski
    15. March 2014 at 09:10

    Tom Brown,
    The simple model of multiple deposit creation is found in almost every Econ 102 textbook. I know its been around at least as far back as Samuelson in 1948.

    I see it as a pedagogical tool. For whatever reason students seem to totally lose themselves in it. (It puts them in a mathematical reverie.) And teachers like it because it gives them an opportunity to impose some mathematical discipline on their students. (“Get down and give me ten iterations of multiple deposit creation!”) But on the other hand, in my opinion, it could probably be dispensed with entirely and nothing substantial would be lost.

    “Could you elaborate a bit on that? It seems to me they could be modeled as functions themselves of other variables.”

    Chapter 16 of the 7th edition of Mishkin is on the determinants of the money supply. The money multiplier is derived and the intuition is explained. The effect of changing the various ratios (currency, excess reserves, required reserves) on the money multiplier is explained.

    It’s noted that the excess reserve ratio is inversely related to interest rates and is positively related to expected deposit outflows. There is a graph showing the inverse relationship between interest rates and the excess reserve ratio from 1960 to 2005.

    There is also a nice application on the Great Depression that inspired part of my blog post on Koo and the Great Depression. (And this in turn comes directly from Friedman and Schwartz.) There is a graph of the currency and excess reserve ratio from 1929 to 1933.

    So not only does the student come away with a clear understanding that the various ratios and the money multiplier are all variables, the student also is exposed to the factors which may affect the ratios, and by extension, the money multiplier.

  78. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 09:20

    Mark, thanks a bunch. What is the currency ratio (c) a function of?

  79. Gravatar of Mark A. Sadowski Mark A. Sadowski
    15. March 2014 at 09:35

    Tom Brown,
    “What is the currency ratio (c) a function of?”

    Well, during the Great Depression, it was a function of bank failures. Allow me to quote myself:

    http://thefaintofheart.wordpress.com/2013/06/02/koos-wrongheaded-views-on-the-great-depression-as-an-example-of-a-balance-sheet-recession-a-guest-post-by-mark-sadowski/

    “…Between October 1929 and April 1933, the sum of commercial bank deposits and currency held by the public, which is the definition of M2 money supply used by Milton Friedman and Anna J. Schwartz in “A Monetary History of the United States, 1867-1960,” declined by 38.2%. This occurred despite the fact that the monetary base, as measured by St. Louis Source Base increased by 14.9%.

    In other words the money multiplier declined sharply. Friedman and Schwartz describe in detail how this came about through the series of bank panics that started in October 1930 and which largely came to a conclusion in March 1933 with the inauguration of Franklin Delano Roosevelt. During this time about 4000 banks failed, or approximately one fifth of all banks. Bank failures had a direct effect on money supply of course when they rendered their deposits worthless. But they also had an indirect effect in that worried depositors began to withdraw their accounts causing the ratio of currency held by the public to deposits to rise…”

    “…The currency held by the public ratio rose from 8.6% in October 1929 to 21.2% in April 1933, after peaking at 22.5% the previous month. The reserve ratio rose from 5.4% to 8.5%. A simple exercise in arithmetic reveals that the increase in the currency ratio accounts for 86.9% of the decline in the monetary multiplier, with the increase in the reserve ratio of course accounting for the remainder. According to “Banking and Monetary Statistics 1914-1941” excess reserves rose from 1.8% to 18.2% of all reserves during this period. The increase was symptomatic of a banking industry fearful of runs on deposits, but it accounts for less than half of the increase in the reserve ratio. Inspection of the data reveals that the currency ratio was fairly constant until the bank panics began…”

    “…Bank vault cash was more or less stable during this time period except for a temporary surge in March 1933 that coincided with a one month surge in the monetary base. Despite the increase in the reserve ratio the quantity of reserves actually fell from October 1929 to April 1933. But currency held by the public rose from $3.594 billion in October 1930, the month that the bank panics started, to $5.588 billion in February 1933, or by 55.7%…”

  80. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    15. March 2014 at 09:37

    Since ‘Banking Theory’ is in the post title, I see that Charles Calomiris will be on C-Span 2 this afternoon at 4:15PM (Eastern) to discuss his, and Stephen Haber’s, book (which I am currently enjoying) ‘Fragile By Design: The Political Origins of Banking Crises and Scarce Credit’.

    http://www.amazon.com/Fragile-Design-Political-Princeton-Economic/dp/0691155240

    As a public service, if you’re a Housing Cause Denialist with blood pressure concerns, avoid this discussion at all costs. Or, if you’re Paul Volcker (from p. 279);

    ‘In an eerie reminder of Carter Glass’s role in financial reform in 1933, the former Fed chairman Paul Volcker–who, as an unofficial advisor to President Obama, was given a pedestal from which to shape the financial reform agenda–made securities trading the central focus of his proposed reforms. In 1933, despite the fact that the banking collapse was unrelated to securities-market entanglements of banks, Glass used the reform opportunity to pursue his own pet project–the separation of commercial and investment banking. Like Glass in 1933, rather than focusing his reform advice on the real-estate markets that had crippled the financial system, Volcker waged a campaign against one of his longstanding pet peeves–proprietary trading. He even succeeded in convincing Congress to add the “Volcker Rule”–which prohibits proprietary trading by banks–to the Dodd-Frank Act, even though there is not much evidence to suggest that proprietary trading contributed to the subprime crisis.’

  81. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    15. March 2014 at 09:42

    Correction, the Calomiris interview is at 7:15PM Eastern on C-Span2.

  82. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 09:53

    Scott, O/T: regarding the following quote from David Glasner:

    “Contractionary monetary policy reduces total spending and income. Debts are fixed in nominal terms. Contracting nominal income implies that fewer debts fixed in nominal terms will be repaid.”

    http://uneasymoney.com/2014/02/28/exposed-irrational-inflation-phobia-at-the-fed-caused-the-panic-of-2008/#comment-52932

    1. Do you agree?

    2. I could swear I saw you write something similar one time, but I can’t find it… anything you’d want to add to that quote or change about it?

  83. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 10:00

    Mark, OK great… I did read that yesterday, but I thought perhaps there was a more general answer.

  84. Gravatar of Mark A. Sadowski Mark A. Sadowski
    15. March 2014 at 10:09

    Tom Brown,
    Neither Mishkin nor I have have a more general answer, although I agree it is worth thinking about. I’ve found some interesting correlations between the currency to GDP ratio but I’ve never looked into the currency ratio itself. I’ll have to take a look and see what I can find.

  85. Gravatar of ssumner ssumner
    15. March 2014 at 12:28

    Tom, Yes, as the level of reserves go to zero, so does the price level.

    And yes, I agree with David Glasner.

  86. Gravatar of ssumner ssumner
    15. March 2014 at 12:30

    Saturos, Good, but what are they waiting for?

  87. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 17:02

    Mark, you write:

    “Every Econ 102 textbook I’ve ever seen teaches the money multiplier is a function of three variables. The currency ratio is always portrayed as the depositors’ choice, the reserve ratio (above required, if any) is always the lenders’ choice, and the total amount of currency and reserves (the monetary base) is the central bank’s choice (even if supplied through the discount window), and all are dependent on the conduct of monetary policy by the central bank.”

    Are the three variables you mention?:

    1. currency ratio (borrowers’ choice)
    2. reserve ratio (lenders’ choice)
    3. total of currency + reserves (central bank’s choice)

    Let’s analyze a simplified example. Say required reserves are 0% of deposits. And say Cash is outlawed. Now our formula reduces to:

    M = MB/r = (excess reserves)/((excess reserves)/deposits) = deposits.

    So the CB chooses excess reserves and the lenders’ choose the ratio (excess reserves)/deposits. The borrower’s choice has been eliminated. But who chooses deposits?

  88. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 17:08

    … let’s do a simple numerical example:

    CB chooses excess reserves to be $1
    lenders choose r to be 10.

    Thus deposits are $10. But what if there are no loans for sale? Don’t the borrowers have a say here?

  89. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 17:09

    … sorry, lenders choose r to be 0.1 not 10!

  90. Gravatar of Mark A. Sadowski Mark A. Sadowski
    15. March 2014 at 17:16

    Tom Brown,
    In your example, deposits are a result of the choice of MB by the central bank and the choice of reserve ratio by the commercial banks.

    P.S. Why are you always so eager to totally eliminate the one thing that depositors control from your hypothetical examples? (i.e. currency)

  91. Gravatar of Mark A. Sadowski Mark A. Sadowski
    15. March 2014 at 17:23

    Tom Brown,
    “But what if there are no loans for sale? Don’t the borrowers have a say here?”

    I’m not sure I follow you. Are you asking why lender’s control the reserve ratio? The reserve ratio is the lender’s choice because they can make the terms on the loans as attractive or as unattractive to borrowers as they desire.

  92. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 17:49

    Mark,

    “Why are you always so eager to totally eliminate the one thing that depositors control from your hypothetical examples? (i.e. currency)”

    Simplifying things makes them clearer to me in many cases, this one not excepted.

    “The reserve ratio is the lender’s choice because they can make the terms on the loans as attractive or as unattractive to borrowers as they desire.”

    What if interest rates are as low as possible for the banks to break even (keep paying their electric bill, etc) should they reach their desired level of lending consistent with their choice for r, yet they still don’t attract enough loan sellers (borrowers) to realize their choice for r?

    I guess in that case, the lenders give up on that choice for r and pick a bigger one, right? They keep adjusting their choice for r upwards until supply meets demand I guess. It seems like borrowers have a role in that.

  93. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 17:59

    … another way to say that is that lenders (who buy loans from borrowers) chose r so as to maximize their profits. But isn’t the set of available r for them to chose determined by both the CB and the borrowers (the loan sellers) who control the supply curve for loans?

  94. Gravatar of Mark A. Sadowski Mark A. Sadowski
    15. March 2014 at 18:10

    “another way to say that is that lenders (who buy loans from borrowers) chose r so as to maximize their profits.”

    Exactly.

    “But isn’t the set of available r for them to chose determined by both the CB and the borrowers (the loan sellers) who control the supply curve for loans?”

    Well, it’s kind of a simultaneous system with multiple markets each with a set of supply and demand curves and multiple agents each maximizing their utility. But in a very real sense the CB is running the whole show even if they can’t force the other agents to act in a certain way.

  95. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 18:18

    Mark,

    “But in a very real sense the CB is running the whole show even if they can’t force the other agents to act in a certain way.”

    I have to take that assertion on faith at this point, because I don’t see the logic of it. But thanks for your feedback… it’s really been helpful to me!

  96. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 18:49

    Mark, do you agree with Scott’s response to me here:

    http://www.themoneyillusion.com/?p=26355&cpage=2#comment-323611

    About my variant of one of his examples:

    http://www.themoneyillusion.com/?p=26355&cpage=2#comment-323558

  97. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 18:59

    … note that I clarify to Scott that reserve requirements = 0% a couple of comments down from my original question.

  98. Gravatar of Mark A. Sadowski Mark A. Sadowski
    15. March 2014 at 19:24

    Tom Brown,
    I agree with Scott. However, any example that doesn’t include currency is excluding what has been the most important part of the monetary base historically. In short it is extremely unrealistic.

  99. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 19:34

    Mark, thanks for the reply. You write:

    “However, any example that doesn’t include currency is excluding what has been the most important part of the monetary base historically. In short it is extremely unrealistic.”

    But it was Scott who introduced the “cashless society” concept in his example, not me! However I’m glad he did, because any monetary theory ought to work in all cases, especially simplified ones. And Scott has said that he expects we’ll be cashless at some point in the future. So think of it as me examining issues that Scott thinks will arise in the future. :D

  100. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 19:38

    … sorry for being a smart-ass there… I really do appreciate you taking the time to respond, especially since you consider it to be an unrealistic case.

  101. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 19:42

    … but the reason I keep bringing that up is I really do want to understand the theory, and removing cash does simplify things tremendously for me. Once I nail that down, I can add cash back in. I like to digest one thing at a time.

  102. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 19:45

    … plus it’s not that inconceivable that cash will disappear one day. On that I agree with Scott. And personally, I hate scraps of paper and bits of metal, so I try to avoid using it as much as possible, and I largely succeed. I suppose I’m assuming there’s going to be more and more people out there like me in the future.

  103. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 19:48

    … maybe the distant future, but still…

  104. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 20:20

    Do you think the MM theoretical model is not a good approximation when cash is eliminated? I got the impression from Scott that eliminating cash wasn’t a problem in that regard.

  105. Gravatar of Mark A. Sadowski Mark A. Sadowski
    15. March 2014 at 20:36

    Tom Brown,
    I’m an empiricist. I find all the theoretical noodling fascinating but I don’t attach much importance to it. The problem with theoretical models is you can create one that supports any given conclusion.

    I know a lot of people that think currency is going to vanish from use. Most of these people are trend followers who think we’re currently living in a unique age in terms of the rate of technological development. Personally I think this is all a load of horse manure.

    I confidently predict a century from now currency will still be over 5% of GDP.

  106. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 20:57

    Mark, I understand. And thanks again for humoring me and delving into the theoretical even though that’s “not your thing.” In my profession I often work with or develop mathematical models that are hoped or purported to approximate reality in some limited way, over some limited set of operating conditions, … at least enough to get the job done. Of course the ultimate test is empirical: does the hardware and software actually work in the real world as anticipated. But long before we get there, I do a lot of gut checks: what happens if this variable goes to zero or if it goes to the extreme of its valid range? What about this one? Etc. Especially for a job which is purely a simulation, that is standard operating procedure, and it can help you catch obvious problems before you spend more resources in simulation or actual product development. So naturally I’m drawn to the same process here, especially since I have basically zero skills as an empiricist in economics. And the cashless cases are the ones which cause me the most trouble in terms of gut checks. Bank-less cases seem to pass my gut check easier, which is why I don’t dwell on them as much.

    And also, I can completely understand if a model breaks down outside of the nominal operating point it’s intended to be valid under. But again, I didn’t get the impression that was a problem here.

  107. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 21:10

    … I should add that I pretty much have zero skills in economics altogether, empirical or otherwise. I’m an amateur trying to get a better feel for how this all works: and trying to resolve in my own mind what sometimes seem like incompatible explanations. For example, Nick’s response to the same question didn’t seem to match what you or Scott said at all. That puts me ill at ease and I’d love to resolve it ASAP.

  108. Gravatar of Tom Brown Tom Brown
    15. March 2014 at 21:29

    “Personally I think this is all a load of horse manure.”

    Lol… well you very well be right, but I hope you’re not. I’m not a “paper person”… I still have the same yellow note pad I was issued nine years ago at my present job. I just don’t have a use for the stuff, and I wish it would go away ASAP.

  109. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 07:02

    Scott & Mark, actually, looking at the title of this post:

    “A slightly off-center perspective on monetary problems.
    Banking theory disguised as monetary theory?”

    “Monetary theory” seems to be on-topic for once! :D

    BTW, Nick explained his different take: he first said that in my example there was no demand for reserves, so essentially the commercial bank would take on the role of the CB. Reviewing it later, when I asked him if he could explain why his answer was different than Scott’s (I gave him a link to the exact question I asked here), he said this:

    “Tom: you really do need to distinguish between the *demand* for reserves going to zero and the *supply* of reserves going to zero. (And *both* supply and demand going to zero.) I read you one way, and Scott read you the other. It’s supply AND demand.’”

    So my follow up to him is: “So no change in steady state prices then?”

    I feel like I’ve peeled off all the complicating and obscuring layers and am getting down to the core of this HPE theory thing. Nick, as he did with my last hypothetical (the CB merging w/ the banks), introduced the concept of *demand* changing too… shoot, I never would have thought of that! So he’s saying I’ve got to keep my eye on demand, not just supply! Interesting…

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/one-general-theory-of-money-creation-to-rule-them-all.html?cid=6a00d83451688169e201a5118689d2970c#comment-6a00d83451688169e201a5118689d2970c

  110. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 14:21

    Scott,

    Nick Rowe and JKH converge on Godley & Lavoie’s explanation? Lol

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/the-sense-in-which-the-stock-of-money-is-supply-determined.html?cid=6a00d83451688169e201a3fcd7204c970b#comment-6a00d83451688169e201a3fcd7204c970b

  111. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 15:28

    … JKH tones down the overlap a bit (comment below)

  112. Gravatar of ssumner ssumner
    16. March 2014 at 16:28

    Tom, I do believe cash as we understand it today will disappear. There may be some sort of electronic cash, say interest bearing cards with “cash” added to them. Those would be part of the base if produced by the Fed, and not (necessarily) part of the base if produced by the commercial banks.

  113. Gravatar of Mark A. Sadowski Mark A. Sadowski
    16. March 2014 at 17:11

    Tom Brown,
    “Nick, as he did with my last hypothetical (the CB merging w/ the banks), introduced the concept of *demand* changing too… shoot, I never would have thought of that! So he’s saying I’ve got to keep my eye on demand, not just supply! Interesting…”

    Money always involves both supply and demand. You’re obviously going to get different answers to your question if you phrase it in different ways, implying different assumptions.

    “Nick Rowe and JKH converge on Godley & Lavoie’s explanation? Lol”

    Personally, I don’t see anything that’s really new in Nick’s latest model. I don’t know Godley and Lavoie well enough (I have a copy) to comment on JKH’s point, but in Nick’s model the supply of money determines the quantity demanded, even with a perfectly interest-elastic supply function at an exogenously fixed rate of interest.

    I thought one of the main points that many of the endogenous money enthusiasts have been hammering on, over and over again, is that the quantity of money is purely demand determined. (Recall Pilkington’s tirade about this in comments yesterday?). So I’m surprised (astonished?) that JKH thinks that Nick’s latest model looks like Godley and Lavoie.

  114. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 17:27

    Mark,

    “You’re obviously going to get different answers to your question if you phrase it in different ways, implying different assumptions.”

    I gave him a link to the question I asked Scott.

    re: JKH & Nick: JKH pointed out that Nick’s model there is very restricted, so the overlap isn’t as much as I was thinking it might have been. But Nick does say his position on it cuts across “party lines.” He says Steve Keen and Bill Woolsey would probably agree with him while Glasner and Mike Sproul wouldn’t.

  115. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 17:31

    Mark,

    Here’s Nick:

    “In this economy, the (change in) the stock of money is determined by the supply (function) of money (i.e. the rate of interest set by the central bank), and by the demand for loans.”

    By “demand for loans” he really means the supply of loans (I think he makes that clear in the comments there or in the comments in the preceeding post). I asked him who determines that. He wrote:

    “Tom: “Who determines the demand for loans?” My “model” isn’t specified fully enough to say, other than “the people who want to borrow”.”

  116. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 17:32

    … i.e., the “supply of loans” as determined by the borrowers I think.

  117. Gravatar of Mark A. Sadowski Mark A. Sadowski
    16. March 2014 at 17:53

    Tom Brown,
    My interpretation of Nick’s model is that the quantity of loans supplied/demanded is a negative function of the interest rate.

    Nick:
    “The supply of money determines the quantity demanded, and not vice versa.”

  118. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 17:54

    Mark,

    “I thought one of the main points that many of the endogenous money enthusiasts have been hammering on, over and over again, is that the quantity of money is purely demand determined. (Recall Pilkington’s tirade about this in comments yesterday?).”

    I don’t think all PKers or “endogenous money enthusiasts” are the same on this stuff. And yes, I do recall your interchange with Philip.

    Personally, I don’t generally try and go around spreading propaganda of any sort… since I’m pretty far down on the totem pole of expertise. I come here (and other blogs) mostly to learn. But I was a little surprised by Nick’s statements there at first, so I thought I’d share.

    And long ago when I read Nick’s post “The Supply of Money is Demand Determined” in which he slowly peels off the layers saying first something to the effect that it made him sick just to type the title… and then going through a process of saying things like

    “The title of this post is not even not even wrong.” Ha!

    So.. then he incrementally moved it to “not even wrong” and then just “wrong.” etc.

    I got his point! Even though he admitted his final position by the time he got to “right” was “extreme” and that very few others would agree with him there. I quizzed him about that a lot (I read it long after he wrote it, so I’d ambush him w/ questions here and there)… it wasn’t until later that he told me his position was “extreme” on that post (at least at the end).

    I think he might be headed back into that boundary crossing “extremist” territory again… but I need to re-read this new post. Personally it didn’t seem that extreme to me, but what do I know?

  119. Gravatar of Mark A. Sadowski Mark A. Sadowski
    16. March 2014 at 18:10

    Tom Brown,
    Note also that in Nick’s model there are no commercial banks, no deposits and only currency. Thus the money multiplier is one, the currency ratio is infinity, and the reserve ratio doesn’t exist.

    Thus commercial banks don’t have a choice since they don’t even exist, and consumers don’t have a choice since there is no alternative to holding currency. Only the CB has a choice of the amount of monetary base/money, and it determines that by setting the interest rate.

  120. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 18:23

    Mark,

    You quote Nick:

    “The supply of money determines the quantity demanded, and not vice versa.”

    The quantity of what? Money I think. It looks to me like Nick is distinguishing between the “demand for money” and the “demand for loans” (again, really the supply of loans for that latter concept).

    Here’s his exchange with Dustin in the comments to the previous post:

    —– First Dustin —–
    Quick clarification – you said: “it is the supply curve of the thing that the bank is buying that interacts with the bank’s supply curve of money”

    Is that a typo, or are we really talking about 2 supply curves? I’ve never considered this type of thing.

    —– Now Nick —–
    Dustin: that was not a typo. See my new post, for an example of what I mean. (In that new post, the central bank is buying non-monetary IOUs in exchange for money, which means that people are supplying non-monetary IOUs to the central bank, and their supply of non-monetary IOUs, in normal language, is their demand for loans. So it is the central bank’s supply of money, plus the demand for loans [i.e. supply of loans provided determined by borrowers], that determines the stock of money. If the bank were buying apples, it would be the supply of apples [loans], plus the supply of money, that determine the stock of money.)

    I added the bit in [square brackets].

    Nick Rowe | March 16, 2014 at 03:48 PM
    (links don’t work onto the second page of comments)

  121. Gravatar of Mark A. Sadowski Mark A. Sadowski
    16. March 2014 at 18:36

    Tom Brown,
    “The quantity of what? Money I think. It looks to me like Nick is distinguishing between the “demand for money” and the “demand for loans” (again, really the supply of loans for that latter concept).”

    Well yes, of course.

    The key points in Nick’s post are in bold:

    “The supply (function) of money, and the demand for loans, together determine the quantity of money created, and that quantity created (eventually) determines the quantity of money demanded.”

    So the supply of money determines the quantity *of money* demanded, and not vice versa. This is not a conclusion that Philip Pilkington, or that most endogenous money enthusiasts would agree with.

  122. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 18:36

    Mark, you write:

    “Only the CB has a choice of the amount of monetary base/money, and it determines that by setting the interest rate.”

    and the interest rate works in conjunction with the supply curve for loans (supply determined by borrowers, right?) to determine the quantity of money.

    Here’s Nick again:

    “Cutting the rate of interest would not work. But we know it will work, provided the quantity of loans demanded depends on the rate of interest.”

    So the quantity of loans demanded depends on the rate of interest… but the demand curve which determines a quantity of loans demanded for each interest rate in turn depends on what? It still seems to me like Nick is saying (at least in part) the it depends on the “the people who want to borrow,” i.e. the people putting loans up for sale to the central bank.

    I asked Nick for clarification, so we’ll see what he says.

  123. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 18:46

    Re: Philip, I know almost nothing about him, so I can’t speak to that. You may be absolutely correct! I’m just trying to figure out what Nick said.

    You keep leaving out the “and the demand for loans” part when you restate what Nick wrote. Lol. But yes, I do agree with what you wrote… it just leave off the other thing, the two of which “together” do the job.

  124. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 18:50

    … at least that’s the way I’m reading him! Again, hopefully he’ll clarify. Thanks!

  125. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 19:12

    Well, nothing is easy, I kind of wish he’d just said “True” or “False”, but he said this:

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/the-sense-in-which-the-stock-of-money-is-supply-determined.html?cid=6a00d83451688169e201a73d9238b1970d#comment-6a00d83451688169e201a73d9238b1970d

    “In conjunction.”

    Which I think means “True.” :D

  126. Gravatar of Mark A. Sadowski Mark A. Sadowski
    16. March 2014 at 19:30

    Tom Brown,
    I think it still means that the supply of money determines the quantity of money demanded, and not vice versa. :)

  127. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 19:38

    Mark, I agree!! Definitely NOT vice versa. Are you just messing with me at this point. Lol.

    … but “in conjunction” with the supply of loans/AKA demand for loans.

    Well, I’ve asked Nick to just stick to true of false now… if he’s not totally sick of me he might answer.

  128. Gravatar of Tom Brown Tom Brown
    16. March 2014 at 20:27

    OK, Mr. smiley face, let’s-mess-with-poor-old-Tom’s-brain. Lol…

    Nick finally coughed up “True” to this:
    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/the-sense-in-which-the-stock-of-money-is-supply-determined.html?cid=6a00d83451688169e201a73d923656970d#comment-6a00d83451688169e201a73d923656970d

    Although he still scolded me for mixing “supply” up with “quantity supplied” (which I’ll have to track down), and he also seems to think I’m a Philip Pilkington fan I guess. (Philip, if you’re reading this, I have no opinion: I hardly know you)

  129. Gravatar of Tom Brown Tom Brown
    28. March 2014 at 09:36

    Mark, isn’t it true that when the Fed accepts a payment it either:

    1. Accepts paper notes and coins
    2. Debits a Fed deposit

    So if the Fed sells a security to a bank or a non-bank, then unless it’s receiving paper notes and coins in return, then a Fed deposit somewhere is being debited. No?

  130. Gravatar of Kristjan Kristjan
    31. March 2014 at 03:44

    I am a little late I guess.

    “I recall that Paul Krugman was once criticized for saying banks can “lend out” reserves.”

    No actually Krugman said this: “First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand.”

    http://krugman.blogs.nytimes.com/2012/03/30/banking-mysticism-continued/

    I sure hope that Bank of England sent Krugman a copy too, because B of A writes in this paper:”Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out.”

    Krugman didn’t know that. I don’t have his contacts, I would send him this paper.

  131. Gravatar of Tom Brown Tom Brown
    31. March 2014 at 05:46

    Kristjan,

    I recently criticized those same bits from Krugman here:
    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/alpha-banks-beta-banks-fixed-exchange-rates-market-shares-and-the-money-multiplier/comments/page/1/#comment-6a00d83451688169e201a73d9ae024970d

    Nick Rowe comments on my comment (a few lines down):
    “Tom: I tend to agree. Given the amount of miscommunication over the “loans create deposits!” issue, it really needed a very carefully written piece.”

    … and Philippe adds some critiques of my critique in between

  132. Gravatar of Kristjan Kristjan
    31. March 2014 at 15:06

    Tom Brown, I like your comment. Philippes line of talk is misleading about the deposit creation IMO. He says: “Deposits are bank debts, i.e. bank borrowings, and they are also considered to be a form of money as far as everyone else is concerned. So banks create money simply by going into debt to depositors.” This is true in a way but doesn’t give you the whole picture. Both parties “borrow” from each other and both parties “lend” to each other. Both parties are going into debt. I think it is best to talk that bank loan creates a deposit. He is not wrong really.

    I once asked in my blog: who is the borrower and who is lender here since both parties issue liabilities. :) That’s why finance is tricky :)

  133. Gravatar of Tom Brown Tom Brown
    31. March 2014 at 15:37

    Kristian, thanks.

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