The problem is that you’ve made these sorts of arguments before.
I responded to several of them in previous threads. I tried to walk you through a different way to think through some of these issues in previous threads. I pointed out what I perceived to be holes in your argument. You didn’t respond to the issues I raised, as I noticed in the last post of the first thread I just cited. You left with those issues almost entirely unacknowledged. Then later you started new threads and made the same mistaken assertions all over again.
I took a dim view of this behavior.
I’m willing to walk through these issues again. This stuff isn’t easy. You’re trying to argue a “balance sheet effect” (what you call a wealth effect). This balance sheet effect does not work as you believe. I’m willing to rephrase my previous arguments in a way that might make more sense this time around. But if I make a criticism against your argument that goes unacknowledged, if I see an error that’s not admitted, only to see the same argument or error resurface three months later in another thread, my current dim view is not likely to change. You should also know that my patience is much more limited past the first page of one of your threads. My expectations are low based on previous experience. If few other people are reading, as would often be the case past post 50, there’s less incentive for me to put extended effort into the explanations.
The point is that the total amount of base money stays identical when the government issues Treasuries. If the government were to issue new currency in order to finance its spending, then total base money would increase rather than staying the same.
Before the present “liquidity trap” conditions, there was an extremely strong relationship between increases in monetary base and the inflation rate. Robert Barro’s macro textbook lists part of these relationships.
Country MB growth RGDP growth Inflation Time period
Brazil 77.4% 5.6% 77.8% 1963-90
Argentina 72.8% 2.1% 76.0% 1952-90
Bolivia 49.0% 3.3% 48.0% 1950-89
Peru 49.7% 3.0% 47.6% 1960-89
Uruguay 42.4% 1.5% 43.1% 1960-89
Chile 47.3% 3.1% 42.2% 1960-90
Yugoslavia 38.7% 8.7% 31.7% 1961-89
Zaire 29.8% 2.4% 30.0% 1963-86
Israel 31.0% 6.7% 29.4% 1950-90
Sierra Leone 20.7% 3.1% 21.5% 1963-88
. . .
Canada 8.1% 4.2% 4.6% 1950-90
Austria 7.1% 3.9% 4.5% 1950-90
Cyprus 10.5% 5.2% 4.5% 1960-90
Netherlands 6.4% 3.7% 4.2% 1950-89
U.S. 5.7% 3.1% 4.2% 1950-90
Belgium 4.0% 3.3% 4.1% 1950-89
Malta 9.6% 6.2% 3.6% 1960-88
Singapore 10.8% 8.1% 3.6% 1963-89
Switzerland 4.6% 3.1% 3.2% 1950-90
W. Germany 7.0% 4.1% 3.0% 1953-90
The question is what’s likely to happen when the government finances with base money. The answer pops out of the data. There is a strong relationship between more base money and more inflation before the “liquidity trap” era.
There are a couple slightly more subtle things to notice here. First is that the relationship is stronger in high inflation countries. In the low-inflation group, the relationship isn’t as strong, because in low-inflation countries, “real” factors in the economy have a disproportionately strong effect on any price changes. This makes sense because price changes are so small, “real” factors are better positioned to push around nominal figures.
This relates to the reason why “liquidity trap” conditions can only happen in low-inflation countries, but that’s a more troublesome area.
Let’s posit that this is correct.
The federal government has a deficit. They issue Treasuries to finance the deficit. There’s a “wealth effect” (a balance sheet effect) that increases the velocity of base money, with total base money held constant. All else equal, as you said. This means expected NGDP has increased. There is more aggregate demand.
The problem here is that all else is never equal in macro.
The microeconomists can get away analyzing the effects of a price change on a single good and then flatten out the rest of their analysis by ignoring the rest of the world. Macro theorists, in stark contrast, must have a theory of general equilibrium (or cynically stated, a theory of general disequilibrium) where we try to come to terms not only with an effect but the rest of the economy’s reaction to that effect. Most important in this context, we have to consider what’s sometimes called the Fed reaction function.
How does the Fed react to more bond issuance? Might they raise interest rates? Might they pull back on the chain? For an example of this idea, here are some PDF notes from former Treasurer of Australia Wayne Swan:
The question is not whether the issuance of more Treasuries might lead to more demand all else equal. The question is whether more Treasuries will lead to more demand all else not equal, if the central bank intends to offset any fiscal operations. If the monetary authority has a firm nominal target of a macroeconomic variable, then the fiscal multiplier will be approximately zero.
Yes.
But inflation can also result when there is still slack in production. Inflation was positive from 1934 to 1937 during the early New Deal, even when the unemployment rate was still over 10%. Unemployment was coming down after the inauguration of FDR and the abandonment of the previous gold peg, but it was still double-digit. There was high unemployment and rising prices.
The difference between the two time periods, 1929-1933 and 1934-1937, was that NGDP was plummeting during the Great Contraction, while NGDP was rising during the early New Deal. Prices can rise even when there is still productive slack in the economy, as long as total spending is on its way up. When there is no more productive slack and demand keeps increasing, then that’s when inflation really spikes. When there is slack in the economy, any increase in demand will be felt predominantly with more real production. Predominantly, but not exclusively. Some of the extra demand will be felt in price increases.
This is flatly wrong.
This is by far the most important mistake that I was pointing out previously. This is one of the issues that I was pressing the most.
You’re looking at a balance sheet like it’s a static device. As if the numbers recorded in the balance sheet are carved in stone. Asset for asset, one value exchange for an equivalent value at a given point in time.
This is the burden of accountants as they record transactions and draw up the financial statement. Any particular balance sheet is created at a single moment in time. It is a snapshot. Or to look at a specific ledger entry, any purchase of an asset is going to record the price of the asset at the time of the purchase. If a bank sells some Treasuries to the Fed, they will record something like:
DEBIT Cash reserves 1000k
CREDIT Treasuries 1000k
But that entry exists in a static point in time. It does not register what price the Treasuries were last week. It does not record what price Treasuries will be two months from now. If you want to think about the balance sheet effects (the “wealth” effects) from Fed asset purchases, you absolutely cannot look at that single moment and say that like was exchanged for like, and that no financial wealth was created or destroyed. That is completely wrong.
Suppose bonds were trading at 95 last week when the Fed announces a new round of asset purchases. Bond prices rise to 98 when the Fed makes its purchase. Saying that the Fed purchased a bond priced at 98 on the day of purchase tells us nothing about the net effect on the balance sheet, because the important price movement happened before the purchase when they originally announced their intention to buy stuff. That right there is a “wealth effect”, caused by the extra liquidity increasing demand in that particular market.
But Fed purchases can have more than one effect. Suppose bonds were priced at 99 last week, and the Fed made an announcement that it would be targeting a higher inflation rate. Some economists are recommending a target inflation rate of 4%, so there is no more danger of hitting zero when a recession strikes. Maybe the Fed listens to them and raises the inflation target. Then the Fed promises to make a lot of purchases to increase the amount of monetary base in the system for the specific purpose of increasing inflation. The price of bonds might actually fall to 96. The Fed is a new purchaser, yes, but the increase in inflation expectations means that the long bond prices will fall when the Fed announces its new target. (Long bonds are more vulnerable to inflation since it takes longer to mature.) If we look at the very moment of the transaction, it looks like bonds priced at 96 were sold at market value. If we look at the dynamic situation, we see that everybody holding Treasuries took a hit the moment the Fed made its announcement. The wealth effect happened before the purchase.
You cannot cannot cannot look at a static event of a single purchase and say there was no “wealth effect”. You cannot even look at the Treasury market alone, and ignore other markets, because expectations of a better economy will increase the value of companies because those companies will be expected to be more profitable. A superficial read of static financial statements won’t pick up on this dynamic real wealth effect.
Then you are mistaken.
This is plain fact. It’s not up for debate.
We’ve already seen this isn’t true. It is wrong on multiple levels. You are, once again, repeating previous flawed arguments rather than directly engaging the criticisms against those arguments.
This will be the last time I correct this.
First and most important, and previously mentioned quite clearly in this thread, a bank must have reserves on hand in order to make a loan. The majority of loan checks are going to be deposited at a different bank. Without the available reserves to lend out, a bank simply cannot make a loan. It will be insolvent.
You cannot look at the total reserve balances of the banking system as a whole and say that everything is swell, because individual banks will be loaning based on their individual liquidity situations. From the perspective of an individual bank, they must have the reserves on hand if they’re going to make a loan. Those reserves might stay in the banking system (maybe) but that does not mean that those “same reserves” will come back to the same bank ever again in the future. The individual bank might fail based on poor decisions. The flow of reserves out of the bank to the public and to other banks might perpetually exceed the flow of reserves back in (at a price that the bank can afford to pay). That’s why the interest on excess reserves is an important effect for bank lending, though not the most important effect. If an individual bank is earning 0.25% on excess reserves, that’s a slightly better return than 0%. They’re making a little bit of money doing nothing with the reserves.
This is not about the banking system. It is about the profitability of a single bank.
If the Fed stopped paying interest to banks for excess reserves, that would decrease profitability for each individual bank holding those excess reserves. A single bank would look at that situation and maybe decide it was worth the risk to make a loan with its excess reserves instead of holding the 0% asset of cash. They might make loans.
A certain percentage of those loans would expand the supply of commercial deposits of the system as a whole. But that doesn’t matter to the individual bank. The individual bank is interested in its individual profitability, and the bank will fail if it can’t attract enough reserves back in a cheap manner to balance the reserves that get leached away.
Bottom line is that it is flat fucking wrong to say that banks don’t lend reserves.
Now there is one possible way you might believe can salvage that sentence. You can start talking about the “banking system”. The banking system, you might say, cannot loan out reserves. You avoid the literal error just above if you express yourself that way, but then you just introduce another error. When the banking system expand deposits with loans, the holders of those deposits will decide to take a certain amount in cash. The exact amount is going to depend on many factors, but it’s not at issue that the public at large has a certain demand for physical currency compared to deposits, and an increase in total deposits from a spike of lending will change the ratio of deposits to currency, which will tend to encourage more cash withdrawals at the margin.
The net result is that any increase in bank lending from the banking system as a whole will mean a certain chunk of the loan kept as deposits, and a certain chunk of the loan converted into currency. (The relative sizes of the chunks will fluctuate.) And at this point, you’re trying to make the argument that, golly gee, it’s the public’s decision to withdraw cash, and not the banking system’s. If the public takes cash, that’s their choice. The banking system can only make a loan by increasing commercial bank money.
Your claim here: “The banks themselves, however, are not in control of any of those things.” That’s still not true.
Your statement is not true no matter how charitable I try to be. The public doesn’t just randomly choose how much cash it wants. It depends on a lot of factors, but one of those factors is how much banks offer in interest to their depositors. This is part of the bank’s cost of funding. If banks think more liquidity from the Fed is coming for cheap, then they won’t give a shit about offering good rates for deposits, and the public will subsequently tend to withdraw more cash from the system than otherwise. It’s the banks’ decision whether to provide an incentive for the public to keep more of their liquid assets in deposit accounts instead of cash.
Another factor of the public’s money demand is the perceived stability of the financial system as a whole. The entire public make try to demand cash all at once, a gigantic bank run. Don’t say that the Fed will always in every case stop this from happening. The Fed didn’t stop the bank runs of the 1930s. Deposits are federally insured today, but only to a certain point and only in commercial banks. What we saw from 2008 was a run on the shadow banking system: everybody wanting their cash at once, which was causing stress in the system. Something similar might happen in Greece if they exit the euro. (Though the Greek people have been preparing for this for a long time. They’ve had an extended bank walk for some years, rather than a quick bank run. The ECB has been propping up the system, and that might just bite them in the ass soon, which would be entertaining watch in a depressing sort of way.)
The point of all this is that the banking system has a great deal of influence on how much of the average new loan is withdrawn in cash, and how much stays as deposits. They obviously don’t have total control. But this isn’t a binary situation. You can’t honestly claim they are “not in control” with an absolutist statement, while ignoring how banks can nudge things at the margin. Banks can lure reserves back from the public if they want to pay the price for doing that. They’re not omnipotent in this, but they can nudge. Bottom line is that banks lend reserves. Even the banking system as a whole lends reserves, based on the incentives that the system provides to customers to maintain deposits rather than withdraw cash.
It’s a primitive theory that assigns to banks only one decision while ignoring important others dimension that they influence. Banks can attract more reserves by paying higher rates, and so slow the leaching of reserves out of the system. This power doesn’t have to be absolute in order to exist in some form.
One last time for emphasis: a bank can decide to decrease the incentive of its customers to maintain deposits by cutting the rate they pay on deposits.
It’s hardly any wonder that more than half a trillion in physical cash has leached from the banking system since the beginning of 2008. US banks have continually cut rates and now they’re paying almost nothing. There’s no incentive for them to pay for deposits when they can get reserves cheap from other sources. That, in turn, means there’s relatively more incentive for the public to keep cash. The opportunity cost of cash is very low in a time of low rates and low inflation. In this case, the “public” tends to be more international but the argument is the same. More foreigners would be keeping their cash in US institutions if those institutions were paying higher rates.
That’s a dumb argument. The purpose is essentially everything.
The purpose is 99% of what makes the entire system work.
If inflation suddenly jumped up to 6% under the Fed’s current purpose, they would be yanking back on the chain. They’d be collapsing their balance sheet, sucking liquidity out of the system, raising interest rates, throwing up the big red stop sign, and ending the party. If you ever read their regular policy announcements from their scheduled meetings, a big chunk of the minutes details the worries from the FOMC members and the hope that they can start yanking back the chain sooner rather than later.
They want to normalize rates. They want it bad. They say it every chance they can get. They are itching to raise rates this year.
And every single banker out there knows it. Every single banker out there has seen Chekov’s conditional gun ostentatiously displayed in the first act. They can feel it in their ulcers that if they start lending at 2% today, they might suffer big-time if rates jump to 3%. In that case, they’d be losing money. They’d be in trouble. So every loan decision that a bank currently makes is with at least half a mind thinking about the future, about the conditional pistol that might fire at them if they’re not careful, and how screwed they would be if they overexpose themselves. All of this is because the primary purpose of the Fed is to think about inflation and the broad economic situation, and not about the government’s financing needs.
The base money that the Fed has created is conditional. It’s not permanent. The base money that’s been created is totally dependent on the broad macroeconomic situation, and the government’s budget deficits are irrelevant to that. If US debt was low and there weren’t many Treasuries, then the Fed would be making essentially the same size purchases, they’d just be doing what the Swiss National Bank does and buying up more international assets.
This is all-important stuff. Chekhov’s conditional gun guides their actions. When we look at interest rates and wonder when rates will start to rise, we’re looking exclusively at the broad economic situation. We don’t give a shit about the budget deficit directly. Banks making loan decisions don’t give a shit about the deficit directly. They care about expected inflation. They care about the conditions that will cause the Fed to pull that trigger. The purpose is controlling inflation. QE is conditional, not permanent, because it would be reversed if inflation started ticking up quickly. The deficits are simply not a relevant factor. (Obvious deficits would become more relevant to monetary policy if US debt were in a more precarious position, but that’s not the case at present.)
If the Fed’s purpose were different – if there were a different condition to pulling that trigger – then bank behavior would be vastly different. If the Fed shredded half the assets on its balance sheet, so that it no longer had enough things to sell to suck all the cash out of the system, then QE would be effectively permanent. You’d better believe monetary velocity would explode in that case. The Fed might have to sell every remaining financial asset it had to keep things under control.
Purpose is so important that almost nothing else matters.