Fractional Reserve Banking: a myth?

[Hellestal]

@LinusK

To my understanding, MMT is to academic status what being in the marching band is to High School popularity. (Yes, I stole that from John Oliver.) So I’m not asking you to adopt it or anything. Just keep an open mind.

I’ve read several MMT explanations straight from the source before, including writings from UMKC professors.

All Post-Keynesians I’ve ever read (and that includes MMT theorists) go bad in basically the same way. If I had to sum up the flaw in one phrase, it would be: “Argument from identity.” They understand the identities just fine, and some of them explain those identities extremely lucidly and well. But identities are just definitions. There’s a sharp line where the accounting identities end and the crazy begins.

I’d guess most economists don’t read Marx, or Sraffa, or von Mises, or probably even Adam Smith. I do. I try to be more open-minded than the average tenure-hunting junkie. I read from a broad range of non-conventional opinion, but I can’t be the judge of how successful those endeavors actually are. I can only make arguments that seem good to me.

The proposal to keep interest rates indefinitely low is mine. So far as I know, it’s nothing that comes from MMT.

Fair enough.

@Frylock

Hallestal, what is the power the central bank yields when the interest rate is zero?

I would say: The same mechanism when the rate’s not zero.

(We’re getting into more controversial territory here. Endless qualification becomes tedious, so what follows will be presented without the usual hedging. Keep in mind, though, that some others disagree with parts of this. I think I’m right but that’s always the case for everyone.)

There’s circular causality here we need to unlock. Interest rates were extremely high in the 1980s. Interest rates go up because inflation is high. Makes perfect sense. If bond holders are expecting higher future inflation, then they will demand higher yields to compensate for that inflation. What this means is that an extended period of high interest rates is a sign that money has been very loose in the recent past. In order to fight this inflation, Volcker in the early 80s jacked up rates even higher than they had been before. High rates from inflation went higher from Fed pressure. The result was a brief but very sharp recession, the sharpest post-war recession until now with unemployment reaching 10%.

Construction companies shipped a two-by-four to the Volcker Fed as a symbolic protest against the high rates that were driving them out of business. Bernanke kept the prop in his office](Ben Bernanke says bold action key in Fed’s 100 years - The Boston Globe) as a sort of historical reminder of how that little committee has real world power.

When Volcker and his committee had thrown enough people out of a job, the economy stalled, and the inflation was finally tamed. Lower expected inflation meant bond-holders didn’t need to demand such high yields to compensate. Those high rates came back down because of lower inflation. Those rates came back down lower than they had been before the whole thing started. These relative low rates weren’t a sign that money was super-loose again, as it had been in the 1970s. The causation worked the other way: lower inflation was itself bringing the rates down.

So if we try to look at things through an interest-rate filter, we absolutely cannot say that any particular interest rate is a sign that money is tight or money is loose. An increase in rates might mean that money is getting tighter… or it might mean that rates have to increase because money was loose just before. A decrease in rates might mean money is getting looser… or it might mean that inflation is dropping fast and rates are dropping with them. The causation works in a circle.

This is why I HATE using interest rates as some sort of sign of how policy is doing.

An extended period of high rates means that money has been loose. Similarly, an extended period of very low interest rates (say, for example, right now) will be a sign that monetary policy has been far too tight. After all, if we had loose money, then inflation would be much higher. If inflation were much higher, rates would have lifted from zero long before now.

Nick Rowe came up with the analogy of an acrobat balancing a tall pole in the palm of your hand. The top of the pole is the inflation rate, and the bottom is the interest rate most directly controlled by the central bank. If you’re perfectly balanced but you want the top of the pole to move left, then you start by moving your hand right. Once it begins to topple, you bring the hand quickly back to the left. This is the relationship between the interest rate and inflation. But there are also other things going on in the economy, wind currents that will shift things around.

It takes constant effort just to keep the pole from falling over.

So that’s one way to try to bring some intuitive sense to what we see in interest rate influence, but in doing that, we should also realize that there’s something more going on. It’s not a one-to-one relationship, where high rates always mean tighter money and low rates always mean looser money. An extended period of low rates (like zero) means money has been tight.

So we’re getting closer to the answer of your question: In order to get some traction at zero, the Fed needs to loosen money. In order to loosen money, they need to print money. But we’re not finished yet.

Now we get to QE. The Fed has created more than three trillion new base dollars and nothing much has happened. Why is this? The problem is what I called in a previous post Chekhov’s conditional gun. To purchase assets today means pushing a button on a computer. The suck those assets back out means pushing another button, which the Fed could do at any time they wished. They’ve created three trillion+, sure, but under what conditions will the Fed pull the trigger? Under what conditions will the Fed make the money disappear again?

If you look at Fed press announcements from their regular meetings, you can see how much they’re itching to raise rates. They really want rates to go back up from zero, would like to do it by the end of the year. So what are they waiting for? Well, they’re waiting for a sign that the economy won’t tank if they do that. They’re looking for economic healthiness. They’re watching out for any surge in inflation that they can crush with higher rates. They’re itching to pull the trigger. So right there in Act One, the Fed shows everybody the gun that they have.

Banks know this. So what happens if all the banks lend money right now in a frenzy of speculation? The money moves, the economy heats up, and the Fed… pulls the trigger.

All those new loans that the foolish banks might have made in their frenzy are in trouble, for two different reasons. First: when the Fed pulls the trigger and starts sucking money out of the economy, economic activity is likely to be depressed. A weaker economy means a bigger chance that the loans won’t be paid back. The banks won’t receive as much interest bank on the loans, and maybe not even the principal. Trouble for bank balance sheets. Second: when the Fed pulls the trigger, banks’ cost of funding go up. They pay more in interest.

If they get shot by this conditional gun, they get screwed two ways: less interest coming in from loans and more interest going out to depositors and other sources. So banks are very careful. They don’t lend as much as they otherwise might. The money doesn’t move as fast as it should. The three trillion of new money from the Fed is conditional money only. It might vanish when the banks need it most.

And now to answer your question: What can the Fed do when rates are zero? They can make the money permanent, rather than temporary. They can publicly and ostentatiously change the conditions that are attached to that trigger. Paul Krugman calls this a “credible promise to be irresponsible” but I kinda hate that because it’s exactly the reverse. It should be a "credible promise to be responsible, to do what they ought to do rather than claiming that they’re out of ammunition.

The problem is that their cries of relative impotence are politically convenient. Back when rates were higher, the whole thing was basically a mindless machine. A monkey could’ve done the job. All the hard thinking was behind them. When rates hit zero, the monkey was stuck. This had never happened in the US before (and who pays attention to Japan anyway?) so without the interest rate as a communication tool, they didn’t have any ready way to credibly announce their intentions of creating new money and making it permanent. By the time they realized they had fucked up, it was too late.

To take proper action after realizing the error would mean an implicit admission that it was primarily their own fault. To do the right thing now is to admit that they weren’t quite doing the right thing up until now.

Bernanke knows this. He knows all of this. There’s not a thing that I can say on this topic that he doesn’t already know. (Not a terribly huge set of people, at this point in my life, but he is without question one of them.) But not everybody on that committee was Bernanke. He was the public face before Yellen but on the board he was actually just one vote among many. I’m not good with the politics of these sorts of things, but I’d guess he did what he could. All those new dollars is nothing to scoff at. But think of it this way: what would have happened if we’d gotten one trillion of permanent new base dollars instead of three trillion+ of conditional dollars? If you look at that short data set I posted previously, comparing monetary base to inflation, you can see the relationship. If we’d had an influx of permanent money, we would probably be looking at stronger aggregate demand (and somewhat higher inflation) even if those permanent dollars were at a smaller magnitude than the current QE.

Less base money but higher inflation, all because the purpose of the Fed is much different in that scenario. Chekhov’s conditional gun fires in a different manner, and that makes all the difference.

As I try to mathematize my thoughts for my own research, I’m getting better and better at explaining in English. I think this post today is pretty decent. But I still have some way to go before I’m properly convincing with more relevant data behind it.

[Measure_for_Measure]

I probably am somewhat more fiscalist than the typical economist…

@Hellestal

But you have to understand, this is a special case. The “liquidity trap”. In an era of more normal rates, there’s no point in Congress doing any stimulus because the Fed is the institution that steers the nominal economy.

MMT goes against that. They are fiscalists. They are hyperfiscalists. The OP wants the Fed to keep rates near zero perpetually, and then have Congress exclusively influence the business cycle.

…but wholly moley, if that’s an accurate characterization I don’t know what to say. I suppose I could defend it under vastly different political institutions… but my skim of their work doesn’t indicate such proposals. Ok, I concede you did say the OP and LinusK has disavowed speaking for MMT.

I stand slightly apart from the mainstream, in that I think the central bank maintains its mojo even when rates are zero. The “liquidity trap” is, in my view, purely a political effect. It’s an excuse for the Fed to dodge responsibility for their choices. This is, in fact, the primary reason I returned to grad school. I intend to gather evidence that can better show one way or the other.

Solid topic. Still open in my view.

But I want to emphasize, again, that the mainstream divide is not whether the Fed or Congress is the main power in steering the nominal economy in normal times. That discussion is over. Central banks won. The mainstream divide is whether the Fed remains the main power, even when rates are near zero. I say yes, but as I was writing earlier to Measure for Measure, the case is strong but not a complete lock. There is room for disagreement.

The odd thing is that we have pretty similar policy prescriptions. I would advocate nominal GDP targeting, because I see little downside. If it doesn’t work, we get just get extra stimulus. If inflation takes off and nominal GDP overshoots you -wait for it- raise rates. The Fed knows how to do that.

The Fed targeted M1, M2 and M3 in the early 1980s. It didn’t work. So they kept tracking the aggregates and drawing their forecast cones, but didn’t take them too seriously. Then they quietly dropped them, starting with M1. In practice the FOMC looks at a variety of metrics when setting policy. That’s a given. Tacking on a nominal GDP level target isn’t a huge deal. If no problems crop up, they can weigh that consideration more heavily over time. I should think harder about what “Nominal GDP targeting didn’t work” even means though.

[Ok, I’ve heard of one criticism of Nominal GDP targeting. I can’t remember whether I’ve mentioned it before. It goes like this. 1) Nominal GDP targeting is similar in practice to inflation targeting. [It isn’t though. a) There’s the targeting levels vs. rates issue and b) I can’t remember the 2nd reason. Oops.] 2) And targeting growth sounds a lot like the Fed is limiting US economic growth: it produces some challenges in national politics that inflation targeting does not. The Fed doesn’t like causing problems with the know-nothings, especially if the know-nothings have non-fringy Congressional representation. ]

A decrease in rates might mean money is getting looser… or it might mean that inflation is dropping fast and rates are dropping with them. The causation works in a circle.

This is why I HATE using interest rates as some sort of sign of how policy is doing.

So… use real rates. I-bonds have been around for a while. If you want a longer series, work with the Livingston Survey and related datasets.

Admittedly, that might not get you all the way there. My rough measure of Fed tightness is to take the fed funds rate and subtract out core inflation. Neutral policy is about 1.75%. During the 1990s is hovered around 3% for a while. -.25% is loose. From Dec 2008-(say) Dec 2014 it was, “Incredibly loose, but still not loose enough.”

Still, you look at all the data you have.

If you look at Fed press announcements from their regular meetings, you can see how much they’re itching to raise rates. They really want rates to go back up from zero, would like to do it by the end of the year. So what are they waiting for? Well, they’re waiting for a sign that the economy won’t tank if they do that. They’re looking for economic healthiness. They’re watching out for any surge in inflation that they can crush with higher rates. They’re itching to pull the trigger. So right there in Act One, the Fed shows everybody the gun that they have.

Banks know this. So what happens if all the banks lend money right now in a frenzy of speculation? The money moves, the economy heats up, and the Fed… pulls the trigger.

Is there a way of looking at the balance of risks that a bank CEO/CFO faces? Because that was the situation I gleaned from your hot money discussion. You can imagine a Japanese banker in 1995 feared that their downturn would last forever (which basically it did). Create the possibility and fear that they could bet wrongly by not lending enough and you might get some traction. Recall that the Fed is also a regulator, so if you’re sworn in you can potentially get access to some fantastic data. On old mainframe computer tape, muha ha ha ha…

But… if the policy works as sketched here, wouldn’t hard money types oppose it? And don’t hard money types have a pretty powerful megaphone? So… are you giving the politics of Fed policy short shrift here?

The “liquidity trap” is, in my view, purely a political effect. It’s an excuse for the Fed to dodge responsibility for their choices.

Professor Bernanke accused the Japanese Central Bank of avoiding any policy that didn’t have a 100% guarantee that it would work. I think there’s a lot to that. Nobody wants egg on their face. But if nominal GDP targeting depends upon bankers doing that which makes them uncomfortable, then I would expect it might run into some resistance in practice, largely along the sort of hard money rhetoric that we are familiar with. Still worth trying though, in my view.
Apropos nothing, it’s 2015. I’d like to get around reading some of the reviews of QE1, QE2 and QE3.

[Measure_for_Measure]

Also… why does the Fed pay interest on excess reserves? As I understand it the reasons are,

a) eh, what difference does it make? It’s only 0.25%
and
b) we don’t want to screw over the money funds, who have had their expense ratios squeezed quite enough.

So if you want to loosen further, it will affect longer term rates. The 10 year rate is currently 2.47%. Assuming an optimistic long run inflation rate of 2%, implies that it has a real rate of 0.47%. Which is low-low-low.

…but if a big part of the story involves the quantity of money as opposed to the price of money, then such an analysis could seriously mislead.

[Hellestal]

@Measure_for_Measure

The odd thing is that we have pretty similar policy prescriptions.

I don’t think it’s odd.

Among the people I consider most well-informed, the differences are all subtle. I don’t think major fiscal projects will work for stimulus. At all. But at the same time, I’m not strongly opposed to them when rates are zero because I can’t be sure. The US has some infrastructure needs and they’re even more worthwhile now that rates are low and they’re relatively cheaper. There is basically a Bubble of Reasonableness around each person of what we consider “somewhat reasonable options” that we’d consider worth exploring. Our bubbles are centered in different places based on our different beliefs, but if we’re honest about our ignorance, then the areas where our Bubbles of Reasonableness overlap with each other is still pretty large.

[Ok, I’ve heard of one criticism of Nominal GDP targeting. I can’t remember whether I’ve mentioned it before. It goes like this. 1) Nominal GDP targeting is similar in practice to inflation targeting. [It isn’t though. a) There’s the targeting levels vs. rates issue

“Inflation targeting” has the exact same split.

Inflation targeting can be a rate target, or a level target (sometimes called a price level target) which means to compensate for past misses of any inflation rate to keep the long-term trend on the right path. Level targeting is superior, regardless of whether you’re targeting inflation or nominal income. A price level target would be vastly superior policy in the eurozone right now because it would force the ECB to compensate when it missed its target. Which is basically, “every year” at this point. They don’t have to own up to their own incompetence because they don’t have a level target.

(That’s not entirely fair because the political situation is much tougher in Europe. But still, if they give every impression of being a bunch of bumbling clowns then it seems okay to call them that, regardless of the deeper reasons for their clownsmanship.)

2. And targeting growth sounds a lot like the Fed is limiting US economic growth: it produces some challenges in national politics that inflation targeting does not. The Fed doesn’t like causing problems with the know-nothings, especially if the know-nothings have non-fringy Congressional representation. ]

NGDP targeting is vastly superior here.

Targeting inflation has much, much bigger political problems. The public hates “inflation”. FDR got re-elected three times when he successfully killed the deflation of the Great Contraction, because the new inflation brought with it many, many new jobs. The two things go together when there’s not enough demand. But you can’t use that as a policy argument because the public hates “inflation”. And really, an income target is more honest anyway. It’s the dead truth that we want to create more income in the country when there’s a depression, not higher prices. That’s why monetary policy is used: to increase the country’s nominal income, to put more people work. The price increases are just an unfortunate side effect.

In the other direction, though, it’s also honest to say that when things are too hot, the goal is to cool down inflation. Yes, total income will be contained, too, but the purpose of doing that is to keep a lid on inflation. An NGDP target is more honest in both directions. Even more important: it’s much easier to explain.

So… use real rates.

Several potential problems with real rates.

1. Real rates seesaw in a similar way that nominal rates do, just with much lower variance. Strong real economic activity tends to drive real rates up (there’s so much opportunity that the real rate rises, pushing away marginal projects), and a weak economy tends to drive real rates down. Fed influence will affect these things as well. You mitigate the problem, but don’t solve it, using real rates. There’s still a balancing act. Even the real rate, by itself, doesn’t tell you whether policy is inappropriately tight or loose because you’re never exactly sure what the real rate should be in order to maintain that balance. Maybe the real rate right now should be negative.

2. The next issue is political. When nominal rates hit zero, then even the real rate stops being an obvious mechanism. How do you drive the real rate lower when the nominal rate has zeroed out? Well, you could start charging a penalty on excess reserves rather than paying interest. In Denmark, commercial banks pay the penalty to the central bank, and then depositors pay interest to their commercial bank for holding deposit balances. Denmark’s not eurozone but they’re pegged to the euro and that peg requires some amazing controls. I have to admit, this sort of thing would work. But could you even implement it in the US?

3. The final problem is idiot-proofing the system. Krugman talks a lot about how great the IS-LM model can be and how it can clarify thoughts and yadda yadda yadda. He’s wrong. The reason it works for him is that he has a sort of meta-model in his head so he knows which parts of IS-LM to use and which parts to ignore. He knows how to make it work for him, but the average non-genius simply doesn’t have those tools. IS-LM is not idiot proof. If other people use the model, they will fuck it up. They will come to wrong conclusions. I have seen it. I believe interest rate thinking has the same trap (and part of IS-LM’s problem is its reliance on rates). Interest rates aren’t idiot proof. If you talk about real rates, and use real rates, and manipulate real rates, then somebody out there in a position of power is going to get stuck in nominal thinking and they will fuck something up confusing nominal for real.

So I say why bother with rates, real or nominal?

You should be able to change the conditional trigger on Chekhov’s conditional gun and get the same effect more easily. Just announce an NGDP target, target the forecast for more credibility, with level targeting for even more credibility to make up for past mistakes. Then make an ostentatious public display of attempting to hit the target. If that works (and I really really think it would) then you don’t have to worry about rates ever again, and best of all, an NGDP target with all the trimmings if it works (and I really really think it would) would be idiot proof. There’s just no way to mess it up, because it’s monetary policy with a focus on money, rather than the last three strange decades of monetary policy with a focus on the interest rate.

Still, you look at all the data you have. Is there a way of looking at the balance of risks that a bank CEO/CFO faces?

Yeeeeeeah?

At least theoretically, the answer is yes.

The problem is putting all the pieces together. That’s why I think it’s a major mistake to focus exclusively on any individual’s incentives while ignoring everyone else. The reason I tend to focus so much on banking is that a lot of other people look through the lens of bank lending, and their lens is (again) not idiot proof. It introduces predictable distortions.

There are many transmission mechanisms of monetary policy, and they all work together simultaneously so it’s basically impossible to determine which are most important at any given time. My point is that all these mechanisms work in the same direction: toward a higher velocity of base money. The incentives of bankers tend to complement the incentives of foreign exchange traders, which tend to complement the incentives of other large bond holders, which tend to complement the incentives corporations and their stockholders. Etc. NGDP targeting is a way to aggregate all those complementary incentives into one number. I try to argue the micro case, piece by piece, because it’s easier for people to understand but what I’m trying to do is to get people to look at the big picture, the net effect. All those micro cases should be pushing toward the same place, and when that’s true, the relative effect sizes matter much less.

But… if the policy works as sketched here, wouldn’t hard money types oppose it? And don’t hard money types have a pretty powerful megaphone?

Compared to what?

THE FED PRINTING MORE THAN THREE TRILLION DOLLARS AND HYPERINFLATION BEING RIGHT AROUND THE CORNER RIGHT NOW???

So… are you giving the politics of Fed policy short shrift here?

If one trillion of permanent money has a stronger effect than three three trillion+ of conditional money (and it would), then you haven’t introduced a new political problem. You’ve solve the current political problem.

[LinusK]

As sort of a preliminary, I simply don’t have time to parse every word in every sentence; and in any event - at least as far as you’re concerned - I think I lose either way: either I’m being “overly literal” or you jump down my throat for making a general statement that’s not true in every case. There’s no “winning”, and I’ve lost interest in the game. Plus, I don’t want to wind up sounding like an academic, anyway.

@Hellestal

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.

You have to accept that - while you’re certainly entitled to take any view you want of anyone’s behavior - you’re not the king of economics on the SDGD board. You can attack them if you want, ignore them if you want, but people will continue to say things you disagree with. And you can’t stop them. (Unless you ARE the king of SDGD, in which case I guess I’ll find out when I get banned.)

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.

That was exactly my point.

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.

True. It’s an identity, since you’re saying base money goes up when base money goes up.

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

I’m not sure what to make of these numbers. In the second group, which I take to be countries with modern economies, the GDP growth rate and inflation rate are all similar, with the exception of Cyprus, Malta and Singapore. (Why are they in there, anyway?)

In the others, MB growth doesn’t seem to have much effect the other numbers. Not sure what to make of it, honestly. I’d like to see more recent numbers, since these are 25 years out of date.

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.

I know this. That’s why I kept saying “all things held equal” over and over again.

***Very Strange. It says “the text is too long.”

I think what it means is your is too long, because I certainly haven’t written 25,000 characters.(!)

[LinusK]

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.

Well, the issue I was trying to address was “What is the effect of issuing Treasuries”. You seemed to be saying that it caused people to “sit on money”. I think that view is wrong, if that’s what you were saying. Issuing Treasuries tends to increase the velocity of money (as you yourself have already said). Of course all kinds of other things can can also affect the economy simultaneously. OPEC, natural disasters, stock market bubbles, strikes, new technologies and any number of other things, including, as you say - the Fed.

Hopefully, the Fed and work in coordination with each other. I think everybody would agree that having two different branches of the government working at cross purposes is not an ideal situation.

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.

If what you’re saying is there can be a slack between the introduction of new demand, and the ability of - say - manufacturers to meet it, I can’t help but agree. I would argue, though, that the slack is much less today than it was in the 30’s. There are a number of reasons, which I’m sure you already know. A couple of them would include greater efficiency in today’s economy, and less reliance on manufacturing.

The thing that I take from the Great Depression, more than anything else, is this: the government, under Roosevelt, tried to run deficits a couple of times. After the first attempt, the economy began to improve. Then political conservatives pointed at the deficit, claimed the sky was collapsing, the deficit came down, and the economy deteriorated. Finally, WWII came along and the deficits rose to unparalleled heights - more than 100% of GDP - something conservatives would never have allowed if the problem was merely poor people starving, rather than blowing up NAZIs. Unemployment fell to approximately 0.

Economists subsequently predicted economic catastrophe, because of the humongous Federal debt. Instead we had one of the longest periods of economic growth in our history.

Despite the very real-world example that Federal debt is not the economy-killing monster (some) economists thought it was, today political discourse is still ruled by the debt-is-evil philosophy that is simply false.

Take just the simple political canard, “We’re putting our grandchildren in debt.”

Really? How are they going to pay us back? Dig up our graves and heap cash on our corpses?

Or its cousin: “We’re borrowing from our grandchildren.” Again. Really?

If we are borrowing from our grandchildren, they’re going to get everything we have, when we’re dead. If that’s not enough to pay back the debt, I don’t know what is.

And the final question: How can we be borrowing from and indebting them simultaneously?

Yes, I know the answer, and so do you. But most people don’t, and as far as political discourse is concerned, this is a real issue. More important than unemployment. And inflation. (Which are real issues.) Debt. (Which is not, except to the exact extent it effects the other two.)

Anyway, as you said, there are probably few people reading this by now, so I’m just venting.

This is flatly wrong.

Ok, so I went back to see what I was flatly wrong about, and it was this: Quantitative easing - which is what is what happens when the Fed purchases bonds previously printed by the Treasury - reduces the number of Treasuries in the non-government sector, and replaces them with money. Considered by itself, QE has no effect on the wealth of the non-governmental sector. It simply exchanges Treasuries (by buying them) with money (by “printing” it).

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.

That is true. Balance sheets are static. They are records of assets and debts at a particular point in time. Since it’s what they are, that’s the right way to look to look at them

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.

Of course not. Whoever writes the balance sheet doesn’t even know what Treasuries will be two months from now. He couldn’t record that, even if he wanted to.

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.

It’s right if you’re looking at a particular asset transfer, at a particular point in time.

You’re right that Fed purchases also affect prices of existing Treasuries, and I appreciate you pointing that out. (In fact, even slight variations of wording in Fed policy statements affect Treasury prices, among other things.)

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.

This is perfectly right, and I appreciate you pointing it out.

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.

Perfectly correct, as I said earlier.

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.

There are a huge number of variables that affect the economy. Nevertheless, it’s still perfectly correct to say that when the Fed purchases Treasuries, it’s swapping out one kind of asset (Treasuries) for another (dollars). It’s also correct to say that there are indirect and ancillary effects of anything the Fed does - as you’ve pointed out. And that includes buying (or selling) Treasuries.

***Stopping here for time and character limits.

[Hellestal]

@LinusK

Well, the issue I was trying to address was “What is the effect of issuing Treasuries”. You seemed to be saying that it caused people to “sit on money”. I think that view is wrong, if that’s what you were saying. Issuing Treasuries tends to increase the velocity of money (as you yourself have already said).

Emphasis added: I didn’t quite say that, and I don’t think I believe it. I’d have to consider it more carefully.

What I said was that I was willing to posit it as true. This was in order to ignore that point for the moment and drive at a deeper issue: that even if it’s true, it doesn’t matter if the Fed is going to yank back on the chain. The underlying issue that really matters is which institution is more powerful when driving nominal aggregates like the inflation rate.

More broadly: I was comparing two different methods of financing government spending. Those two methods are printing new base money or borrowing and issuing Treasuries. Financing with new base money is (ordinarily) going to be hotter than financing with Treasuries. People will sit on Treasuries (and I specified Treasuries, not “money”) a lot longer than they’ll sit on cash. Cash comes with a higher opportunity cost. Even if you think Treasuries can be a hot potato, cash is a much hotter potato. That was my point.

Hopefully, the Fed and work in coordination with each other. I think everybody would agree that having two different branches of the government working at cross purposes is not an ideal situation.

You’re right. It’s not ideal.

So if the monetary authority has all the nominal mojo, then obviously the fiscal authority should stop trying to dick around with stimulus. They won’t, though. Too politically popular.

The thing that I take from the Great Depression, more than anything else, is this: the government, under Roosevelt, tried to run deficits a couple of times. After the first attempt, the economy began to improve. Then political conservatives pointed at the deficit, claimed the sky was collapsing, the deficit came down, and the economy deteriorated.

Those deficits were created simultaneously with massive influxes of new money, most importantly starting with the abandonment of the gold peg in 1933. Congress did try to bring the debt under control later in 1937, simultaneous with a contraction of monetary policy. The tight fiscal policy was abandoned soon after, and again, this was simultaneous with another loosening of monetary policy as things improved again. The war of course required both a lot of new money and higher deficits.

You don’t have the natural experiment you’re looking for with your handy little narrative there. In order to understand which is more powerful, you have to make an attempt to separate the effects of new money from the effects of deficits.

Well, economists have tried to do that. Friedman and Schwartz argued that a closer look at the Great Depression seems to reveal the relatively greater importance of monetary policy. There are plenty of other examples. The 1970s and 1980s are illustrative. The oil shocks make things more difficult, but even given those shocks, we see a clear demonstration of loose money in the 1970s (especially from the Vietnam war and in the aftermath of the collapse of Bretton Woods) exploding inflation even given relatively tame deficits. Then in the 1980s, we see the debt exploding under the Reagan administration, and yet inflation coming down. Of course, we can keep going. The modern eurozone is another example. Japan in their own Lost Decade is another example. Japanese debt has gone over 200% of GDP in their many and varied efforts at fiscal stimulus, and it’s only now that the Bank of Japan is actively trying to hit a positive inflation target that they’ve finally escaped the deflation. Every governor before Kuroda was pulling back on the chain, pushing the country into deflation despite the largest debt in any advanced country. When they were threatened with a positive inflation rate, the BoJ raised rates. Conditional Chekhov’s gun, firing at the wrong time.

If you think the big deficits have more oomph than the central bank, then you simply haven’t looked at the data.

Maybe, maaaaaaaybe in our very strange present situation of near-zero interest rates, deficits will gain some traction. I doubt it, though. I was a bog-standard Keynesian before 2008, and it’s what I’ve seen since then that has changed my mind. I don’t think US deficits of 10% of GDP have had any appreciable effect, because other countries have had similar deficits with no appreciable effect. The difference in the US is the Fed. The difference in Japan right now is Prime Minister Abe giving the go-ahead to Governor Kuroda.

The countries that have been most successful in stimulating their economies have not been the ones pursuing big deficits. They’ve been the countries with the most “sensible” central bankers. It’s especially noteworthy that the ECB didn’t hit zero until relatively recently, and they tried (twice!) to raise rates only to see that stupidity backfire.

Despite the very real-world example that Federal debt is not the economy-killing monster (some) economists thought it was, today political discourse is still ruled by the debt-is-evil philosophy that is simply false.

Take just the simple political canard, “We’re putting our grandchildren in debt.”

Really? How are they going to pay us back? Dig up our graves and heap cash on our corpses?

Or its cousin: “We’re borrowing from our grandchildren.” Again. Really?

If we are borrowing from our grandchildren, they’re going to get everything we have, when we’re dead. If that’s not enough to pay back the debt, I don’t know what is.

And the final question: How can we be borrowing from and indebting them simultaneously?

The debt is not a burden for the naive reasons that many people seem to believe.

Yet it is still a burden for more complex reasons.

Yes, I know the answer, and so do you. But most people don’t, and as far as political discourse is concerned, this is a real issue. More important than unemployment. And inflation. (Which are real issues.) Debt. (Which is not, except to the exact extent it effects the other two.)

But if more and more debt isn’t the answer – as it has not been in apparently every historical case – then you’re stuck forcing the wrong medicine into the patient’s mouth.

This is the absolute biggest thing that the current crop of American left continually gets wrong. A lot of them think they should win precisely because their intentions are pure. They mean well. They focus on the big problems. And sure, they do. Big chunks of the current GOP are nothing more than raging id of hatred and sadism, barely concealed by the slimiest and thinnest of veneers. They don’t mean well and they’re loud and clear about it. The American left by and large does mean well. By my standards, anyway.

But that means nothing. Intentions are worthless. The road to hell is paved with that shit.

People fueled by their own good intentions are the most dangerous fuckers on the planet. Moral righteousness is not a substitute for calm, methodical, careful thinking and deep consideration of the available evidence. I’d rather have the competent surgeon in it for the paycheck than the naive fool who thinks their one magical elixir is the cure to cancer, hiccups, and the common cold.

You have correctly identified a serious problem with US policy. I share your concerns about this serious problem with US policy. Your heart’s in the right place.

And that just doesn’t matter a whit.

Anyway, as you said, there are probably few people reading this by now, so I’m just venting.

Pretty sure there were over a hundred views since my last post, maybe 120.

I tend to keep half an eye on that number in these sorts of threads. As I said in a previous GQ thread:

@Hellestal

I assume it’s not you refreshing dozens of times. I guess search engine bots would account for some of that, but the other possibility is that some of the people here are genuinely interested in the National Income and Product Accounts. One might think they had better things to do with their time. Like watching paint dry. Or finding what brand of mayonnaise tastes best with Doritos. Or giving serious consideration to what their hero name would be if they were a superpowered kitten that fights crime. (Mine is Avengakitty.) But they’re reading this. There’s something here that’s worthy of some attention.

And this thread’s topic is way more important than the NIPAs, which exist only in order to shed light on questions like these. This is the real deal.

Ok, so I went back to see what I was flatly wrong about, and it was this: Quantitative easing - which is what is what happens when the Fed purchases bonds previously printed by the Treasury - reduces the number of Treasuries in the non-government sector, and replaces them with money. Considered by itself, QE has no effect on the wealth of the non-governmental sector. It simply exchanges Treasuries (by buying them) with money (by “printing” it).

Yes. Flatly wrong.

You can’t get a wealth effect (which is a change in wealth) by looking at a static transaction or financial statement without time.

That is true. Balance sheets are static. They are records of assets and debts at a particular point in time. Since it’s what they are, that’s the right way to look to look at them

The problem, of course, is that you were using this static device as a metaphor in an attempt to describe an inherently dynamic process.

If you want to describe a wealth effect, which is all about changes in wealth over time, then it is beyond absurd to use an analogy that doesn’t incorporate change over time.

But you have now acknowledged that Fed announcements, including the very wording of their press releases, can have important effects on asset prices. I see that admission as directly contrary to your statement above which I called flatly wrong. That is a wealth effect. If you think your position has been entirely consistent, and there is no contradiction, then that’s fine, but in that case I would suggest a much different phrasing.

Whoever writes the balance sheet doesn’t even know what Treasuries will be two months from now. He couldn’t record that, even if he wanted to.

But they could record what the balance sheet looked like two weeks ago and compare it to today. Or they could compare what the balance sheet looked like before a Fed announcement vs after.

A lot of economic research goes into this. In order to get a dynamic look, you have to compare different times to look at the change in asset prices. And it would be even more accurate if we could do a sort of super-idealized always-mark-to-market for assets like Treasuries.

You have acknowledged the effect, so I don’t mean to beat this too much but I see this mistake all the time and it is a fundamental error. Nothing makes sense without realizing this. And we can take an even broader view. For another example: You think the government issuing Treasuries increases the financial wealth. People have more Treasuries and all that. There’s some justification for that belief, but in the super-idealized world of fictionally perfect balance sheets it might not be true. More Treasuries are new assets, but they also imply a new liability in the form of a higher future tax burden (whether through standard taxation or even inflation). There is a visible asset that was created, but there’s also an implicit liability that lies over the economy. There is no real-world balance sheet that records this liability (and for good reason) but it still exists. The actual net change in wealth – everything properly considered – might be positive as you think but it might be zero or might even be negative. But that is yet another difficult topic that would take another multi-page thread to work through.

You’re right that Fed purchases also affect prices of existing Treasuries, and I appreciate you pointing that out. (In fact, even slight variations of wording in Fed policy statements affect Treasury prices, among other things.)

Yes.

And this is why purpose is so important.

@LinusK

As sort of a preliminary, I simply don’t have time to parse every word in every sentence; and in any event - at least as far as you’re concerned - I think I lose either way: either I’m being “overly literal” or you jump down my throat for making a general statement that’s not true in every case. There’s no “winning”, and I’ve lost interest in the game. Plus, I don’t want to wind up sounding like an academic, anyway.

And yet on the first page of this thread, I pointed out several places where I basically agreed with what you were saying.

I only started nitpicking you when you unjustifiably starting nitpicking others. I would agree, you’re probably not going to win a nitpicking contest with me. (Which should tell you something, yes?) But there’s an easy solution to this.

You have to accept that - while you’re certainly entitled to take any view you want of anyone’s behavior - you’re not the king of economics on the SDGD board. You can attack them if you want, ignore them if you want, but people will continue to say things you disagree with. And you can’t stop them. (Unless you ARE the king of SDGD, in which case I guess I’ll find out when I get banned.)

Here is another thing I said on the first page:

@Hellestal

Ultimately, of course, arguments stand on their own terms. Reality doesn’t bend to any credential.

I don’t know how my arguments look to other people.

But I haven’t been claiming some shield of infallibility. I haven’t been waving a banner of authority to which all onlookers must kneel in awe. (Which would be especially ridiculous in economics, of all fields.) I have been making arguments. I have been citing evidence. I have been explaining theory. I haven’t just been saying WRONG WRONG WRONG. I have been giving the reasons why these things are errors.

I’m not sure what to make of these numbers.

…

Not sure what to make of it, honestly.

There is a relationship between monetary-base growth and the inflation rate, an especially strong relationship in high-inflation countries. In the low-inflation countries, the effect is still present (obviously) but less strong for the reasons I already explained.

I went through all this.

I’m not quite sure what’s so confusing about it, unless you’ve never actually looked at a data set before. I grabbed this one out of super convenience.

I’d like to see more recent numbers, since these are 25 years out of date.

Looking at numbers yourself would be an improvement.

Look at your Great Depression example. That was actually a huuuuge improvement over most of your posts because it was citing a real-world example. Most of your posts are just blue-sky imaginings, but in that moment, you actually reached toward reality and cited something that was true. It’s absolutely true that deficits were increasing under FDR when the economy was improving. It’s true that when they tried to cut the deficit, things got worse. It’s true that when deficits expanded, the economy improved again. This is all true stuff. Maybe it looks like X caused Y from this historical example.

Ah, but now I have stepped forward and pointed out the other argument. Maybe Z caused Y. Z and X were happening at the same time, so how do we know it was the one instead of the other? Maybe it was money that was the primary stimulus and not the deficits. In order to back up that argument, I cited other examples outside the Depression where X and Y don’t actually move together but Z and Y do. Huge 1980s deficits accompanied lower inflation.

I used to argue the Depression example exactly as you do. Now I don’t. This new argument won me over. I changed my mind.

No one’s asking you to do the same right now. You don’t have to conform like a robot. But at the same time, if you don’t have a new argument to explain the discrepancy between your beliefs and the apparent evidence, then just maybe there is some problem with what you believe. You are free to believe you can’t “win”. The “game” apparently isn’t fun against someone who offers data, historical example, and an understanding of modern theory.

But if the “game” is actually, you know, trying to figure out how the world works, then changing your mind is not actually losing, as you seem to believe. Changing your mind is actually winning if what’s fun is learning new things.

[LinusK]

(Continued.)

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.

I assume you mean by “real wealth effect”, you mean “real” in the sense that it “really” happens, not that the wealth itself is real: since it’s financial wealth, not real wealth.

I think that’s a fair assumption.

One of the reasons (though not the most important reason) why inflation is so muted even though the Fed has created more than three trillion new dollars is that the Fed has decided to pay a quarter point to banks on that cash if the banks keep any cash in excess of their legal reserve requirement. If the Fed stopped paying that quarter point, banks would have 0% cash on their books rather than 0.25% cash on their books. They’d be wondering if there were something more productive they could be doing with that money. The cash would be tempted to move.

There are too many quotes within quotes regarding the 0.25% interest rate the Fed is paying on excess reserves. Here’s the point I was trying to make: you say the “cash” (by which I assume you mean reserves) would be tempted to move.

Move where?

The only way for reserves to escape is to be exchanged for currency. The problem with currency, is that it also pays zero interest. It also takes up physical space, and requires protection (big steal vaults with giant wheels, or whatever).

They could purchase foreign assets, but the dollars wouldn’t disappear: they’re traded. And the dollars stay here.

Now there’s a way that you’re right: if banks collect zero on their excess reserves, they really have no incentive to hold customer deposits. They would start charging depositors. Depositors, in turn, would then prefer to hold cash, rather than pay to keep their money in the bank. I think that’s the real reason the Fed pays 0.25% on excess reserves. I don’t know that for a fact, of course, but in that case - if customers began holding money as currency, rather than in bank accounts, they would drain the reserves pretty quickly. I suspect the Fed doesn’t want that.

The banks themselves, however, are not in control of any of those things. For the most part, the total amount of reserves in banks is whatever the Fed decides it should be. Banks themselves, cannot loan out reserves. They can only loan out commercial bank money.

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.

Well, I was talking about the banking system as a whole. If you want to talk about a hypothetical individual bank, that’s fine. But that’s not what I was talking about.

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.

This is a very strange argument. You seem to be saying that the 0.25% interest keeps individual banks from making stupid decisions. I guess I’d say that if a quarter point of interest is enough to make a bank make bad loans, it shouldn’t be in business.

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”.

Yes. I was 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.

I’m not sure exactly what you’re saying here. We both agree that customers can always demand cash in exchange for bank checking/savings accounts. We agree that when that happens - holding everything else constant - that reduces the amount of reserves.

You mention “many factors” but the main one is going to be whether banks pay interest on deposits, let people deposit for free, or charge them for depositing money. If banks began charging for deposit accounts, you’d see more people holding more currency, because that’d be cheaper than keeping it in the bank. As I said before, I think that’s where the 0.25% comes into play. At minimum, it gives banks an incentive to take deposits, a perhaps even pay a tiny bit of interest on them.

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.

Banks could, in theory, choose to charge people for deposits. That would be dumb, as long as the Fed is paying .25% interest.

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.

Banks will do whatever is in their financial self-interest. Which, again, is why I think the Fed’s paying .25%. Why turn away free money, when you can get .25% interest?

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.

There was a run on banks in the US in the 30’s, and it’s because the Fed fucked up. I don’t think anyone believes they’d make the same mistake again. In fact, they proved that just a few years ago.

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.)

I’m interested in Greece. But Greece is different than the US: they don’t control their own currency.

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.

I would say that they don’t lend reserves. Rather, customers with deposits withdraw currency, which in turn drains reserves. (Since currency and reserves are interchangeable.) I suppose a bank could lend currency. A customer could come in for a loan, and the bank could hand them cash. They could do that, I’m just not aware that they do. In any event, what banks actually do is lend commercial bank money, not currency or reserves. (Again, I’m talking about the banking system as a whole, not individual banks. An individual bank always has to be prepared for the fact that a loan might get deposited at another bank, in which case it will need reserves to transfer to the second bank.)

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.

Banks can and do change the rates they pay for deposits. They are for-profit, profit-seeking entities, however, which compete with each other. Ultimately their decisions are going to be based on what’s profitable for them. Whether and how much interest they pay to attract cash back into the system is based on their cost of funds, and/or whether the Fed pays interest on excess reserves - both of which are controlled by the Fed.

I’ve run out of characters, and time, so I’ll have to stop here.

[Hellestal]

@LinusK

(Continued.)I assume you mean by “real wealth effect”, you mean “real” in the sense that it “really” happens, not that the wealth itself is real: since it’s financial wealth, not real wealth.

Yes.

I think that’s a fair assumption.

An empirical regularity, not an assumption.

Here’s a notable Jackson Hole paper (PDF) from who is quite possibly the most important monetary economist in the world. A main method of the paper is to look at instantaneous changes in financial markets that result solely from central bank announcements. These comparisons require change over time, with the specified time overlapping with the central bank policy announcement.

This is the same paper in which he advocated support for NGDP targeting. I’m pleased to say I beat him to it.

Here’s the point I was trying to make: you say the “cash” (by which I assume you mean reserves) would be tempted to move.

Move where?

The only way for reserves to escape is to be exchanged for currency. The problem with currency, is that it also pays zero interest. It also takes up physical space, and requires protection (big steal vaults with giant wheels, or whatever).

Did you never play a game of hot potato as a kid?

The potato can never leave the “system”. But the individual incentive is to get rid of the potato as fast as possible. Both things are true simultaneously. That one observation is 75% of monetary economics.

Cash reserves normally pay zero percent interest. Other kinds of financial assets can pay positive real interest. Holding cash instead of holding those other assets is painful. Holding cash instead of holding those other assets means pissing away the return you could have gotten if you’d tossed the cash to someone else. Opportunity cost. (And I’m saying “cash” here because this is as true for non-banks as it is for banks. Reserves are just “cash” held by banks.)

Base money is the hot potato. You pass it on as quickly as you can. If the “system” is the entire world economy, then the money never leaves the system, it only gets passed from person to person. But no individual wants to be the dumb fucker holding the potato. They’ll get burned so they pass it on as quickly as possible.

When the Fed pays interest on excess reserves, what they’re doing is cooling down that potato. It’s not as painful to hold it. Especially given how dangerous the rest of the world looks. Right now the banks are holding that cool potato because they don’t fear it. They’re even being given a small reward to hold it. Interest on excess reserves decreases base velocity. During the normal state of the world before 2008, banks held no excess reserves.

It does not matter if base money never leaves the system if the incentive of every individual within the system is to pass it on as quickly as possible.

They could purchase foreign assets, but the dollars wouldn’t disappear: they’re traded. And the dollars stay here.

I’m not sure why you believe that “the dollars stay here”.

Post 50:

@Hellestal

Since 2008, total physical currency in circulation (outside of bank vaults) has expanded by more than half a trillion dollars. A big chunk of this is owing to increased international demand for portraits of Benjamin.

Post 55:

@Hellestal

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.

There’s no good data on this (obviously) but I’ve seen estimates that at least 250 billion dollars in physical currency has been shipped abroad since 2008. The number could be higher than that.

The dollar is used internationally. Many dollars do not “stay here”.

Now there’s a way that you’re right: if banks collect zero on their excess reserves, they really have no incentive to hold customer deposits. They would start charging depositors. Depositors, in turn, would then prefer to hold cash, rather than pay to keep their money in the bank.

For the entire history of the Federal Reserve since its founding in 1913 until the financial crisis, banks received no interest on their excess reserves. But somehow, they nearly always managed to pay positive interest on their customer accounts in order to attract depositors.

They received no interested on their excess reserves, so they decided to keep no excess reserves. Hot potato. They never kept any base money in excess of their reserve requirement, until the Fed started rewarding them for holding cash in excess of their reserve requirement. These two things moved together.

That’s not perfect causation. There are other things going on here, some of them more important. But it is one element that is having its effect.

This is a very strange argument. You seem to be saying that the 0.25% interest keeps individual banks from making stupid decisions. I guess I’d say that if a quarter point of interest is enough to make a bank make bad loans, it shouldn’t be in business.

If the price of a new Ferrari dropped from 200k to 190k (or whatever), I would not buy one. But someone out there on the edge, on the margin, would be enticed into a purchase.

I have specifically said, more than once before this post, that interest on excess reserves is not the most important factor determining bank lending right now. But it is a factor. It is one boulder in the river, changing the flow of the current. A quarter point of risk-free return is nothing to sneeze at in this climate. It will change behavior on the margin, and yes, that will tend to be for the most vulnerable banks. Obviously.

There was a run on banks in the US in the 30’s, and it’s because the Fed fucked up. I don’t think anyone believes they’d make the same mistake again. In fact, they proved that just a few years ago.

The future goes a long way out. Times change. People change. Institutions change.

What’s true now does not have to be true forever.

I’m interested in Greece. But Greece is different than the US: they don’t control their own currency.

Yes.

Money is more powerful than deficits.

More nominal spending would genuinely help the Greeks if they could afford it. But the nominal income of the eurozone is decided in Frankfurt, not in Athens. The ECB has set up a true beggar-thy-neighbor situation. Unintentional. They meant well with their brave new currency.

Intentions mean jack shit. Road to hell.

I would say that they don’t lend reserves.

And would you still say the same thing if most other knowledgeable people phrase it differently?

I don’t have numbers on this particular phrase but I trust my instincts more than I trust yours. Yours is an infelicitous usage.

You have clambered your way up into a sort of understanding of this system. It took some effort, and you’re proud of where you’ve gotten. You genuinely do understand things that 99% of other people do not understand. I know the feeling. But you hiked up the mountain in an idiosyncratic way, which necessarily means you have different labels for all the landmarks on the way up. So if you’re in a conversation with other people, which language should you choose? The one you know? Or the one everybody else knows?

What’s the goal here? Do you want to communicate clearly with other people? Or are you a proselytizer out to convert the world into your manner of speaking?

There’s nothing wrong with having an internal language that helps you, personally, understand what’s going on. But you’re no longer working your lonely way up the mountain. You’re selling an idea, a monetary ideology. West German Chancellor Willy Brandt is quoted as saying: “If I am selling to you, I speak your language. If I am buying, dann müssen Sie Deutsch sprechen.” If you want people to buy what you’re selling, you must learn to speak their language.

[LinusK]

I’m never going to catch up at this rate, so I’ll make some general points, instead.

• The money multiplier: one way to test whether a theory is accurate is to see if its predictions are true. Currently, there’s approximately $4 trillion of base money in the US economy. That’s up from around $800 million in '08/09, or a five-fold increase (500%). The money multiplier equation (from the first post) is:

Total Money Created = Initial Deposit x (1 / Reserve Requirement)

We’ll assume a 10% reserve requirement (although it’s actually less than that).

If you insert the amount of new money ($3.2 trillion) into the equation, it’s:

$3.2 trillion x (1/.1) = $32 trillion. The actual amount of new money (M2) created since '08/09 is $4 trillion. That’s 1/8th of the amount predicted.

Another way of looking at it is, aside from the new money itself ($3.2 trillion) very little additional money was created ($0.8 trillion). The money multiplier theory predicts a multiple of the original amount. Instead, banks created a fraction.

People have suggested various explanations. It’s been called a “liquidity trap” for example. Calling it a liquidity trap doesn’t explain anything, however. It’s just a label.

Hellestal suggests that banks are unwilling to lend because of Chekhov’s gun: they fear the Fed will increase rates in the near future, and don’t want to be stuck with a lot of low-interest loans at a time when the cost of funding is about to go up.

While I understand what he’s saying, I think, there’s some problems with it. One is that banks could, if they wanted, simply lend at higher rates: if they think the cost of funds is going up to 2%, they could charge 6%,or 8%, or whatever number made them feel safe. Another is that banks, so far as I can tell, are eager to make loans, even at low rates. The current 30 year fixed rate mortgage is 4.15%, according to bankrates.com. Car rates are only slightly higher (4.38%). Banks are constantly soliciting me to refinance my home. (I know I’m just one data point, but I assume I’m not the only one.)

While I understand what he’s saying, I’d argue the problem is different: people (collectively) are trying to pay down debt, and creating financial savings. As long as that’s the case, banks are going to have a problem selling loans. It is of course, what people are told to do, and as an individual strategy, it’s great. But banks can only lend what people are willing to borrow.
*M0, M1, M2, etc.: I’d argue that the terminology now widely used to describe different kinds of money creates more confusion that it solves. A better way to understand money (I’d argue) is to simple describe in terms of where it comes from.

You can describe money as originating from two sources: the central bank (the Fed, in the US), or from commercial banks. You can further divide commercial bank money into two forms: reserves, and currency. That results in three kinds of money: commercial bank money - which is money in commercial bank accounts. And “government money” which is either reserves or currency. Currency and reserves are interchangeable, meaning if you have a claim on reserves, you can freely convert that claim into currency. Of course, that’s only my opinion, but it’s worked well for me, and eliminates a lot of confusion that otherwise results from trying to memorize and differentiate between the various M’s.

You can always differentiate between them, because commercial bank money is in commercial bank accounts. Government money is either currency, or reserves.
*Financial instability: I’d go on to argue that having sufficient government money is critical, because government money, unlike commercial bank money, is not subject to financial panics or bank runs.

Relying too heavily on commercial bank money (or exclusively on commercial bank money) creates a problem: commercial banks create money by making loans. The loans always require the borrower to pay back more than the principal. (Otherwise, there’d be no reason to make the loan.) What that means is that the public (the non-banking sector) always owes more to banks than the amount of money banks have created.

If the economy grows, and banks are lend more (in order to supply the economy the money it needs to grow) the gap between what people owe to banks, and the amount of money needed to repay banks, also grows. This looks good to individual bankers, because it means their balance sheets are healthy: their assets (loans) are worth more than their liabilities (deposits). For the public, it also looks good, at least for a while. So long the public (collectively) can roll its loans over, or obtain new loans, and the economy and the amount of money are growing, business is good. People are employed, and businesses are profitable.

Then, eventually, something happens. It could be a stock bubble collapsing. Or a drought, that destroys crops farmers were depending on to make mortgage payments. Or systematic fraud within the financial sector. Or rumors of insolvency of some number of banks. Then the problem’s exposed: there’s not enough money in the banking system to pay the debts the banking system itself created. People withdraw their money; but most of the money is circulating outside the banking sector: only a fraction of the money is actually at the banks. Then it’s first come, first serve, and the rest are out of luck. (In fact, if the bank issues bank notes - as was the case in 19th century - everybody who holds the bank’s notes is out of luck, if the bank goes bankrupt.)

Blame gets assigned: bankers were recklessly making loans; or deadbeats failed to make timely payments, or defaulted; or investors were recklessly purchasing securities, without doing due diligence.

But the deeper fault is in the system itself. So long as commercial banks extend less credit (money) than what they demand in return - which they must do, in order to remain solvent, a financial crisis or panic is inevitable.

Finally, the money supply must grow, if the economy grows. If the economy grows, and the money supply is stagnant, the result is deflation.

The solution is for the central bank to supply a substantial part of the money supply itself. Not just after a crisis has started, but consistently. And it should do so - I would argue - by purchasing government debt.

[LinusK]

Hellestal: I’m going to respond to as many of your points as I have time to, which may turn out to be not very many.

I want to say, first, that you’ve gone a long way toward convincing me of the Fed’s power. I don’t think I ever thought it was not powerful, but you’ve introduced some things I haven’t thought of previously.

My main argument is that the Treasury should print bonds, and the Fed should buy them. I’ve also argued that the bonds themselves - in the absence of the Fed “pulling back the chain”, as you say - provide a service, or actually a number of services. I won’t go through them now, in the interest of time, and because I’ve stated them previously.

If you say the Fed is more powerful than the Treasury, I’ll take your word on that. I don’t have time now to look at all the historical data you suggest I look at. I will say again though, that the Fed and the Treasury should be working together, not at cross-purposes.

During the normal state of the world before 2008, banks held no excess reserves.

I’m aware of that. Banks’ reserves are what the Fed provides for them. I think providing the bare minimum is probably a mistake. It leaves banks vulnerable to the kind of financial crisis that precipitated the most recent recession.

I think I understand what you’re saying about the “hot potato”. If excess reserves pay no interest, individual banks will pass them off to other banks, as quickly as they can. They will do that, presumably, by making loans - at low interest rates, if that’s what’s necessary to induce customers to borrow. That will, in turn, increase the amount of commercial bank money, until the excess reserves are gone. The additional commercial bank money won’t solve the commercial bank instability problem - in fact, it will increase it. It will also increase demand, and if production is not able to keep up with it, inflation.

Yet commercial banks are offering low-interest loans now, and customers aren’t buying. I’d argue the reason is that people are generally more interested in paying down debt, and obtaining financial savings, rather than accumulating more debt.

Either way, I’d argue that offering interest on excess reserves, or increasing reserve requirements, or some other measure that increases the ratio between central bank money and commercial bank money, is a good thing, that would lead to greater financial stability in the future. The money supply must grow in order for the economy to grow, and relying only on commercial banks to provide the additional money is inherently dangerous.

I’m not sure why you believe that “the dollars stay here”.

Ordinarily in order to purchase a foreign asset, you must obtain foreign currency. To do that you trade your dollars on the FX market. You buy foreign currency - usually in the form of an account at a foreign bank - and the buyer of your dollars gets the dollars - usually dollars at a US bank.

You could take your dollars abroad, in the form of currency, and perhaps find someone abroad who wanted dollars, instead of the currency of his own country. I just don’t think that’s generally what banks do.

Of course, lots of US currency winds up in foreign countries. There’s nothing wrong with that, so long as the Fed is willing to make up it, in terms of the drain on currency circulating here. To put it differently, if all our currency wound up in foreign countries, that would be a bad thing. Some amount of currency is needed here, and only the Fed can provide it.

For the entire history of the Federal Reserve since its founding in 1913 until the financial crisis, banks received no interest on their excess reserves. But somehow, they nearly always managed to pay positive interest on their customer accounts in order to attract depositors.

They received no interested on their excess reserves, so they decided to keep no excess reserves. Hot potato. They never kept any base money in excess of their reserve requirement, until the Fed started rewarding them for holding cash in excess of their reserve requirement. These two things moved together.

That’s not perfect causation. There are other things going on here, some of them more important. But it is one element that is having its effect.

In order to get rid of reserves, banks make loans. The loans result in deposits, somewhere in the banking system. The reserve requirement applies to deposits, so when deposits increase, they eventually bump up against the reserve requirement. To put it differently, banks “get rid of excess reserves” not by reducing the amount of reserves, but by increasing the amount of deposits. The excess reserves then become required reserves.

I’m interested in Greece. But Greece is different than the US: they don’t control their own currency.

Yes.

Money is more powerful than deficits.

More nominal spending would genuinely help the Greeks if they could afford it. But the nominal income of the eurozone is decided in Frankfurt, not in Athens. The ECB has set up a true beggar-thy-neighbor situation. Unintentional. They meant well with their brave new currency.

Intentions mean jack shit. Road to hell.

I’m interested in Greece, but I don’t know much about it. My perhaps naive take is that Greece needs its own currency, so that it can print whatever money is necessary to reduce unemployment (which, I think is 50% among young people). The new Greek currency would obviously fall in value relative to other currencies, but that would be a good thing. It would create demand for Greek products internationally, increase employment in Greece, and allow Greece to pay its debt in real terms - by exporting goods and services to other countries, instead of consuming them in Greece. Along the way, young people would be learning trades and professions and honing skills, and Greece would be increasing its real wealth - the productivity of its people. The downside, for the Greeks, would be a sudden increase in the cost of imported products. Perhaps that would be disastrous. I don’t know enough about the Greek economy, one way or another. But if Greece has a debt, and if they’re going to pay it off, they must consume fewer products from abroad, and produce more products at home, and sell those products internationally.

The other alternative - draining Greece of money to the point where nobody is willing to spend anything - seems like national economic suicide (for the Greeks).

And would you still say the same thing if most other knowledgeable people phrase it differently?

I don’t have numbers on this particular phrase but I trust my instincts more than I trust yours. Yours is an infelicitous usage.

You have clambered your way up into a sort of understanding of this system. It took some effort, and you’re proud of where you’ve gotten. You genuinely do understand things that 99% of other people do not understand. I know the feeling. But you hiked up the mountain in an idiosyncratic way, which necessarily means you have different labels for all the landmarks on the way up. So if you’re in a conversation with other people, which language should you choose? The one you know? Or the one everybody else knows?

What’s the goal here? Do you want to communicate clearly with other people? Or are you a proselytizer out to convert the world into your manner of speaking?

There’s nothing wrong with having an internal language that helps you, personally, understand what’s going on. But you’re no longer working your lonely way up the mountain. You’re selling an idea, a monetary ideology. West German Chancellor Willy Brandt is quoted as saying: “If I am selling to you, I speak your language. If I am buying, dann müssen Sie Deutsch sprechen.” If you want people to buy what you’re selling, you must learn to speak their language.

I’m not sure what to make of this paragraph.

I guess I’ll tell a story. I read - at least once, and probably more than once - popular economic articles asking why banks aren’t lending their reserves.

The answer seemed obvious to me: commercial banks don’t lend reserves. They lend commercial bank money. The Fed decides how much reserves there are, and collectively there’s little commercial banks can do about it.

The phrase “banks lend reserves” to me, at least, seems misleading. If you believed that - that banks lend reserves - you might wonder why the amount of reserves isn’t falling, as banks lend them out.

Simply understanding that banks create and destroy commercial bank money, and the Fed creates and destroys reserves, made something clear to me that would otherwise be confusing.

What I’m saying is, that understanding there are two kinds of money - commercial bank money and central bank money - was an important insight, for me, that helped me understand the nature of modern financial systems. If I were to say “banks lend reserves” I’d feel like I was erasing the distinction, and adding to confusion, rather than reducing it.

[Hellestal]

@LinusK

Hellestal suggests that banks are unwilling to lend because of Chekhov’s gun: they fear the Fed will increase rates in the near future, and don’t want to be stuck with a lot of low-interest loans at a time when the cost of funding is about to go up.

While I understand what he’s saying, I think, there’s some problems with it. One is that banks could, if they wanted, simply lend at higher rates: if they think the cost of funds is going up to 2%, they could charge 6%,or 8%, or whatever number made them feel safe.

Supply and demand. Not one individually but both together.

If you’ve got a project that would be profitable at 8% then be sure to let the world know now because you could make a killing at current financing rates.

If you can even manage to get financed. The rate only tells the price of successful transactions. There are times when rates are “low” for banks to other banks but no one else can tap into the funds.

While I understand what he’s saying, I’d argue the problem is different: people (collectively) are trying to pay down debt, and creating financial savings. As long as that’s the case, banks are going to have a problem selling loans. It is of course, what people are told to do, and as an individual strategy, it’s great. But banks can only lend what people are willing to borrow.

People are absolutely trying to rebuild their financial wealth. That’s exactly right.

This manifests in many ways, and one of the most problematic is in our stronger demand for “savings”, which results in a stronger demand to hold on to our cash (base money) rather than spend it during times of crisis, slowing the velocity of money and dropping total spending in the economy. But by making cash hotter, the monetary authority forces higher velocity. Hot potato. That higher velocity forces the creation of the very new assets people are demanding.

The mistake is in seeing the government itself as the only possible provider of the safe assets that people are demanding. Another recent example: Iceland. When the Icelandic banking system imploded, deficits necessarily skyrocketed but they also used their independent currency to increase demand. The currency depreciated on international markets. In the wake of the disasters, the Icelanders didn’t deliberately push for higher deficits from what they inherited from the crisis. They pushed in the other direction. The Icelanders have balanced their budget, while at the same time having a stronger recovery than countries stuck in the eurozone. Since the trough, Icelandic “austerity” can be viewed as sharper than almost anywhere in the eurozone, but their recovery has been better. Greece is only running a primary surplus, but Iceland is running a pure surplus. Yet recovery.

It’s absolutely true that people want to rebuild their paper wealth, but that does not mean that government deficits are a sufficient step, or even a necessary step, in accomplishing that.

The next section is a big long explanation but the following is really the only assertion that matters. It is the core of the argument.

But the deeper fault is in the system itself. So long as commercial banks extend less credit (money) than what they demand in return - which they must do, in order to remain solvent, a financial crisis or panic is inevitable.

This is simply false. It is a basic mathematical mistake.

It sounds good from a narrow static perspective. It looks like it makes sense. Banks lend X dollars which creates X commercial bank money (if you ignore the fact that it might not, as so often you like to do). But banks also want to be paid interest. In order to pay back the loan, banks need to be paid back more than the original loan: X plus interest. They need to be paid back “more” commercial bank money than was created originally by the loan. To someone who looks at this whole thing like it’s a static problem, it looks like there’s “not enough money” to pay back the loan and the interest together. (I now know why he wrongly on saying the “banking system doesn’t loan out reserves”. That statement is built directly on top of this mathematical error.) As with so many other points raised in this thread, I have tried to explain this mistake in previous threads. I tried to use bank accounting in order to explain it: debits and credits.

The problem was that you didn’t know what a debit or a credit was. The issue was double-entry bookkeeping, and at that time you didn’t know the two names of the two entries. Autodidacts sometimes have these problems.

If at all possible, I’d like to avoid the formality of accounting definitions, and just say the solution is obvious once you think in terms of the flow of money rather than any particular stocks. The human body has about five liters of blood. That’s the stock. But that does not mean that the flow of blood through the body is limited to five liters for any given time period. Five liters of blood can be pumped through the body again and again and again. The amount of blood pumped through the aorta can be more than five liters in a single minute.

A total loan balance of X in the economy, including the accompanying interest payments, can easily be sustained by a total stock of money that remains strictly less than X in the steady state. This is true even in a free banking system with no central bank. (A key technical point to realize is that bank expenses and bank dividends paid to owners will also expand “commercial bank money”.) In order to service the loan and pay back principal plus interest, you don’t need a strictly increasing stock of money. You just need the total money that “exists” to be pumped through the system in the right way.

If the financial system is prone to instability (and I absolutely believe that it is) your given explanation cannot be the reason because it is not mathematically coherent. It fundamentally confuses stocks and flows. A stock of money that is strictly less than any amount of debt can still service that debt.

Money is a stock. NGDP is a flow. One of the key reasons that I advocate strictly increasing nominal income every year is in order to service previous debt. (The other key reason is the labor markets, which is another complicated topic.)

@LinusK

Hellestal: I’m going to respond to as many of your points as I have time to, which may turn out to be not very many.

I want to say, first, that you’ve gone a long way toward convincing me of the Fed’s power.

That’s about the limit of what I can argue. I’m not in a position yet to make an airtight case that deficits are useless for aggregate demand.

But if you go around the world, it sure as hell looks like it. More and more evidence every year. The Icelandic austerity+growth is a particularly striking recent example. Balancing their budget hasn’t seemed to hold them back.

I’m not sure what to make of this paragraph.

I guess I’ll tell a story. I read - at least once, and probably more than once - popular economic articles asking why banks aren’t lending their reserves.

The answer seemed obvious to me: commercial banks don’t lend reserves. They lend commercial bank money. The Fed decides how much reserves there are, and collectively there’s little commercial banks can do about it.

This is still a horrible fucking way to describe things.

Horrible.

The phrase “banks lend reserves” to me, at least, seems misleading. If you believed that - that banks lend reserves - you might wonder why the amount of reserves isn’t falling, as banks lend them out.

And people might wonder why there’s still a hot potato in the game if little Sally threw it to somebody else. Didn’t she get rid of it? Why is there still a potato being tossed around if Sally got rid of it?

Confusion on this point is not a sign that the “standard explanation” of hot potato is flawed.

Children pass the potato. The fact that the potato is still in play after being passed does not mean that children are not passing the potato.

75% of monetary economics in a children’s game: the individual micro incentive is to pass the hot potato, but the hard macro fact is that the potato must end up in somebody else’s hands. The receiver’s micro incentive is (again) to pass it quickly but it must (again) end up in somebody else’s hands. If elementary school children can figure this out, then it’s not very confusing. Lots of things about money are confusing. This is not one of them.

Simply understanding that banks create and destroy commercial bank money, and the Fed creates and destroys reserves, made something clear to me that would otherwise be confusing.

What I’m saying is, that understanding there are two kinds of money - commercial bank money and central bank money - was an important insight, for me, that helped me understand the nature of modern financial systems. If I were to say “banks lend reserves” I’d feel like I was erasing the distinction, and adding to confusion, rather than reducing it.

For every good description of money I’ve ever seen, there have been a thousand bad descriptions. When you say that the “banks don’t lend reserves” that is also extremely confusing. First and most obviously, because it’s false. Even if you were careful enough to specify the “banking system” (and normally, you are not), I could still quibble with that as I previously did. It wasn’t clear what you meant by that sentence until you explained in more detail.

You’re using your own internal instincts to decide what sounds confusing and what’s not.

Obviously I’m doing the same with my own internal guidance. The difference is that there’s more than a decent chance that I have read more people from a broader ideological spectrum with more varied styles and a higher variety of conclusions than you have. When I come to a decision about what’s confusing or not in an economic explanation, I am (probably) approaching that question with more experience and more examples backing me up.

You are relying on your gut for this stuff, and your gut cannot be trusted.

There is no such thing as “communicating clearly” on this topic. Not yet, anyway. But if you want to communicate more clearly – if you want to push in the right direction – then you should, at minimum, adapt a style that at least acknowledges the more conventional phrasings as legitimate and potentially helpful and not a mistake* even if you thenceforth bring out your own idiosyncratic language.

*I exclude from this the theoretical explanation of how money is multiplied, which is conventional and a mistake and useless. Off the top of my head, though, that might be the only thing I would terminate with extreme prejudice from an intro/intermediate book.

[LinusK]

@Frylock

Confusing thread is confusing. I thought you two were basically agreeing at the top of the thread, but now there are curses being thrown and strong disagreement is happening. Somewhere in the middle MMT was brought up, and I thought Hallestal was speaking sympathetically about it, but now it appears he is vociferously and angrily agin’ it? I don’t know.

Money is hard.

Money is not that hard. A couple of things to remember about money.

1.) All money is directly and indirectly someone else’s debt.

2.) There are two kinds of money: (a) commercial bank money, which is deposits at commercial banks. And (b) “government money”, which is either currency, or reserves at Federal Reserve banks.

As to #1: money is directly debt, in the sense that commercial bank money (deposits) is money commercial banks owe you. It’s indirectly debt in the sense that it’s created when banks make loans. In order to create the money (the deposit) in the first place, some bank, somewhere, had to make a loan: in other words, they had to create a debt.

Government money, on the other hand, is a liability on the Fed. But it’s very different from commercial bank money, because while commercial banks have to - if they’re pressed - come up with government money to pay off depositors, the Fed cannot be forced to pay off its liabilities with anything other than dollars. Furthermore, the debt the Fed holds is mostly Treasury debt. It’s money created by the government (the Fed) lending to itself (the Treasury).

[LinusK]

@Hellestal

Supply and demand. Not one individually but both together.

If you’ve got a project that would be profitable at 8% then be sure to let the world know now because you could make a killing at current financing rates.

If you can even manage to get financed. The rate only tells the price of successful transactions. There are times when rates are “low” for banks to other banks but no one else can tap into the funds.

No doubt. Banks are willing to make loans, though, even at some pretty low interest rates. People just aren’t buying.

People are absolutely trying to rebuild their financial wealth. That’s exactly right.

This manifests in many ways, and one of the most problematic is in our stronger demand for “savings”, which results in a stronger demand to hold on to our cash (base money) rather than spend it during times of crisis, slowing the velocity of money and dropping total spending in the economy. But by making cash hotter, the monetary authority forces higher velocity. Hot potato. That higher velocity forces the creation of the very new assets people are demanding.

The mistake is in seeing the government itself as the only possible provider of the safe assets that people are demanding. Another recent example: Iceland. When the Icelandic banking system imploded, deficits necessarily skyrocketed but they also used their independent currency to increase demand. The currency depreciated on international markets. In the wake of the disasters, the Icelanders didn’t deliberately push for higher deficits from what they inherited from the crisis. They pushed in the other direction. The Icelanders have balanced their budget, while at the same time having a stronger recovery than countries stuck in the eurozone. Since the trough, Icelandic “austerity” can be viewed as sharper than almost anywhere in the eurozone, but their recovery has been better. Greece is only running a primary surplus, but Iceland is running a pure surplus. Yet recovery.

Interesting. I know almost nothing about Iceland since their commercial banking system imploded. One of the few things I remember is their currency fell dramatically, essentially putting everything “Iceland” on sale.

It’s absolutely true that people want to rebuild their paper wealth, but that does not mean that government deficits are a sufficient step, or even a necessary step, in accomplishing that.

Financial wealth can come from a number of sources. And there is, of course the definitional question of what is “financial wealth,” exactly. From a household point of view, people tend to look at bank accounts, cash (if they hoard it, like some people do), home equity, and stocks and bonds. No one has direct control over the stock market, and it tends to run exactly in the wrong direction, as far as economic stability is concerned: in other words, it tends to shoot up, when things are going well, and declines at exactly the time you don’t want it to - when things are looking down.

Home equity is (usually) less volatile, but does the same thing, in general.

As far as bank accounts go, one person’s deposit is another’s debt. People - collectively - can’t both decrease debt and increase balances in bank accounts simultaneously.

Attempting to do so only leads to less spending, which leads to less income, which leads to less employment, which leads to even less spending, etc. Individually, some households may be able to pay down debt and increase balances, but only at the cost of reducing balances and/or increasing debt somewhere else. Looking at those three financial assets - bank deposits, stocks, and home equity - what you see are ingredients for financial instability. When stocks and/or home values rise, people spend. When people spend the economy expands. When it expands, banks lend.

If - or when - something happens, stocks and/or home values fall, people cut back on spending, and the economy slows or contracts. Banks lend less, and people try to cut debt and “save” money (increase balances). Less spending means less income, which leads to more unemployment, and the economy declines further.

Treasuries are not the only savings vehicle, but they are different from other savings vehicles in that the government can, and does, provide them when the private sector can’t.

**** Continued.

The next section is a big long explanation but the following is really the only assertion that matters. It is the core of the argument.

This is simply false. It is a basic mathematical mistake.

It sounds good from a narrow static perspective. It looks like it makes sense. Banks lend X dollars which creates X commercial bank money (if you ignore the fact that it might not, as so often you like to do). But banks also want to be paid interest. In order to pay back the loan, banks need to be paid back more than the original loan: X plus interest. They need to be paid back “more” commercial bank money than was created originally by the loan. To someone who looks at this whole thing like it’s a static problem, it looks like there’s “not enough money” to pay back the loan and the interest together. (I now know why he wrongly on saying the “banking system doesn’t loan out reserves”. That statement is built directly on top of this mathematical error.) As with so many other points raised in this thread, I have tried to explain this mistake in previous threads. I tried to use bank accounting in order to explain it: debits and credits.

The problem was that you didn’t know what a debit or a credit was. The issue was double-entry bookkeeping, and at that time you didn’t know the two names of the two entries. Autodidacts sometimes have these problems.

If at all possible, I’d like to avoid the formality of accounting definitions, and just say the solution is obvious once you think in terms of the flow of money rather than any particular stocks. The human body has about five liters of blood. That’s the stock. But that does not mean that the flow of blood through the body is limited to five liters for any given time period. Five liters of blood can be pumped through the body again and again and again. The amount of blood pumped through the aorta can be more than five liters in a single minute.

A total loan balance of X in the economy, including the accompanying interest payments, can easily be sustained by a total stock of money that remains strictly less than X in the steady state. This is true even in a free banking system with no central bank. (A key technical point to realize is that bank expenses and bank dividends paid to owners will also expand “commercial bank money”.) In order to service the loan and pay back principal plus interest, you don’t need a strictly increasing stock of money. You just need the total money that “exists” to be pumped through the system in the right way.

If the financial system is prone to instability (and I absolutely believe that it is) your given explanation cannot be the reason because it is not mathematically coherent. It fundamentally confuses stocks and flows. A stock of money that is strictly less than any amount of debt can still service that debt.

Money is a stock. NGDP is a flow. One of the key reasons that I advocate strictly increasing nominal income every year is in order to service previous debt. (The other key reason is the labor markets, which is another complicated topic.)

That’s about the limit of what I can argue. I’m not in a position yet to make an airtight case that deficits are useless for aggregate demand.

But if you go around the world, it sure as hell looks like it. More and more evidence every year. The Icelandic austerity+growth is a particularly striking recent example. Balancing their budget hasn’t seemed to hold them back.

This is still a horrible fucking way to describe things.

Horrible.

And people might wonder why there’s still a hot potato in the game if little Sally threw it to somebody else. Didn’t she get rid of it? Why is there still a potato being tossed around if Sally got rid of it?

Confusion on this point is not a sign that the “standard explanation” of hot potato is flawed.

Children pass the potato. The fact that the potato is still in play after being passed does not mean that children are not passing the potato.

75% of monetary economics in a children’s game: the individual micro incentive is to pass the hot potato, but the hard macro fact is that the potato must end up in somebody else’s hands. The receiver’s micro incentive is (again) to pass it quickly but it must (again) end up in somebody else’s hands. If elementary school children can figure this out, then it’s not very confusing. Lots of things about money are confusing. This is not one of them.
For every good description of money I’ve ever seen, there have been a thousand bad descriptions. When you say that the “banks don’t lend reserves” that is also extremely confusing. First and most obviously, because it’s false. Even if you were careful enough to specify the “banking system” (and normally, you are not), I could still quibble with that as I previously did. It wasn’t clear what you meant by that sentence until you explained in more detail.

You’re using your own internal instincts to decide what sounds confusing and what’s not.

Obviously I’m doing the same with my own internal guidance. The difference is that there’s more than a decent chance that I have read more people from a broader ideological spectrum with more varied styles and a higher variety of conclusions than you have. When I come to a decision about what’s confusing or not in an economic explanation, I am (probably) approaching that question with more experience and more examples backing me up.

You are relying on your gut for this stuff, and your gut cannot be trusted.

There is no such thing as “communicating clearly” on this topic. Not yet, anyway. But if you want to communicate more clearly – if you want to push in the right direction – then you should, at minimum, adapt a style that at least acknowledges the more conventional phrasings as legitimate and potentially helpful and not a mistake* even if you thenceforth bring out your own idiosyncratic language.

*I exclude from this the theoretical explanation of how money is multiplied, which is conventional and a mistake and useless. Off the top of my head, though, that might be the only thing I would terminate with extreme prejudice from an intro/intermediate book.
[/QUOTE]

[Hellestal]

I literally laughed out loud at this. I have to wonder if there’s a single reader of this thread who would agree with it:

@LinusK

Money is not that hard.

An analogy:

I can imagine someone out there saying that standard bookkeeping is “not that hard”. I mean, legal technicalities, but beyond that? I’ve seen a soon-to-be professional accountant on the boards claim that it might be automated easily enough in the coming decades. Maybe that’s true.

But I’m telling you right now that from a certain broad perspective, accounting is extremely hard. The elementary structure of the idea is simple and not too tough to pick up, but it’s still hard because of what it represents. Here is an example of a difficulty I saw from a previous thread. (Link removed because it’s not really important here.)

I don’t know about this specific example, but I certainly know some where accountants create negative value.

My daughter worked for a small (she was employee #8) publisher that worked out of a rented house in Brooklyn. They published scientific lab manuals in looseleaf form that were upgraded quarterly and made a tidy profit. The owner sold out to a major publisher. When the lease expired, the moved the whole operation into their Manhattan building. I guess everybody moved over a bit to make room. So the costs of this imprint went down. But suddenly the imprint went from being profitable to losing money. Because the accountants attributed the cost of rented space in Manhattan to them and rental space in Manhattan is much more expensive than in Brooklyn. Fortunately, they didn’t close them down, although she no longer works there.

The belief is that the accountants didn’t add value. This is a tempting belief but it’s wrong. Assuming the rent expense was divided fairly, the accountants were on the side of the angels when they showed the imprint wasn’t profitable in Manhattan.

On the surface, this might seem to make no sense. The company as a whole is definitely more profitable if it’s earning the same revenue from the same imprint without having to pay the additional rent. Just squeeze everybody in, and you have both revenue streams without the burden of extra unnecessary office space. If revenues are the same, and no efficiency is lost after the consolidation, the company is absolutely better off paying one rent instead of two rents. But that doesn’t mean that the consolidation was the best decision possible.

New information came to light. The books after the consolidation were more accurate than the books before consolidation.

Apparently there was enough room to consolidate the imprint into the Manhattan headquarters… but then what the hell were they doing with that space before? Why were they using so much expensive Manhattan space to no purpose? In the most profitable ideal scenario, a better option was available. Instead of consolidating the offices, they should’ve been using significantly less Manhattan space in the first place, at significantly less cost. In a perfect world, that would have been even better than consolidation.

They were using more than they needed, and that waste was being hidden by how successful the main business was.

If they had enough space for the imprint, then they should never have been renting such a large area. At Manhattan rates, the savings they should have made from using smaller quarters would have more than made up for the bit of extra non-Manhattan rent from using two locations. One location can be cheaper than two stupidly inefficient locations, but two svelte operations is better yet. What happened with the “unprofitable” imprint is that the accounting became much more precise with the new information they had available. When the imprint was assigned its fair share of the rent cost, the reality of the old inefficient situation emerged. The new information was that they had way more room than they originally needed. The business learned they had been blowing cash on expensive space they didn’t actually need. (Hopefully, management already knew that, but the accounting didn’t adequately reflect that reality before the consolidation.)

That waste was always present, and the consolidation – although it definitely made the company better off than before – also revealed that there were potentially even better options available.

The mistake in that quote above is the assumption that the books were adequate before the consolidation, after which they suddenly became inaccurate. That’s not the case. The books were inadequate in expressing the underlying inefficiency until the consolidation was made. This does not mean the consolidation was a bad idea. Even after accountants unearthed the new information, management might have been fully justified in their decision because the best option of two svelte operations was still unavailable (maybe they were locked into the Manhattan arrangement, and the costs of moving or downsizing the Manhattan space would have been less than the cost of consolidation, or maybe a dozen other things we haven’t considered).

An inept manager who can’t read beneath the surface is not going to make good decisions. The books don’t show ultimate reality, they just show a slice of information that must be interpreted.

This hidden realm of philosophical accounting even exists for more straightforward cases. You might start a new company with a cool G of your own cash and a 10k loan from the bank, and use that loan to buy equipment. Your assets are the cash and the equipment, totaling 11k. Your liabilities are the loan at 10k. The equity is the difference. Simple. Easy to record. So far a mindless machine could do it. But there’s still more going on.

What’s recorded is 10k of equipment, but why did you buy those assets? Why take out the loan? The very existence of the new business is dependent on the belief that what was recorded in those books is wrong. The business exists on the belief that the equipment is actually worth more than the 10k it was purchased for, else the purchase would never have been made in the first place. Smart owners don’t actually “believe” their books. Not literally. The equipment is definitely not worth 10k. If the hopes of the owners are correct, it’s actually worth more than 10k (justifying the purchase), and if their hopes are wrong, then that equipment is worth much less than 10k, as they will find out later as they go bankrupt and sell everything for scrap.

The problem is that we don’t know the future. We don’t know whether Manhattan space is being used efficiently. We don’t know whether the assets on the balance sheet will lead to a profitable future or not. We don’t know what the idealized balance sheet actually would look like in the perfect world. So the accountants look at the purchase price of the equipment, and record that particular number. That number isn’t right. It’s not correct. But it’s the number they have. For a long-established business, the number is much more likely to be true than for a newer concern, but even then, the world changes. Countless businesses have been buried by their failure to adapt.

Honest accounting is Bayesian, with the priors chosen from purchase values and then continually updated as more information is obtained. It’s just not explicitly Bayesian partly because the Venetian method of bookkeeping predates modern probability theory and mostly because drawing up the numbers in the legal way is complex enough on its own without needing any more mathematical bells and whistles.

But an idealized balance sheet should have multiple branchings representing different possible futures, with each possible future properly weighted by the best-guess probability of that future being actualized. Of course, that’s not what accountants traditionally do. They just look at the receipt and record the number, then later draw up the standard statements. It’s only after the future has become the present, and new knowledge is added from new receipts, that we learn profits and losses and the balance sheet gets updated. There’s nothing wrong with doing things that way. It just strikes a different balance between honest updating and ease of reading. Probably the right balance, too. I sometimes imagine a world with Probability-Distribution-Balance-Sheets, but I have that luxury because I don’t have to deal with the damn things myself.

So is accounting easy or is it not?

No. No, it isn’t. It’s a mistake to get so caught up with the surface impression of How Things Work that we lose track of the underlying purpose, the inherent Why all this stuff exists. I’m sure there are plenty of accountants who debit and credit according to the rigid rules in their head and aren’t paid to give any thought to deeper concerns. But that does not mean that those deeper concerns do not exist. Management might not know every legal requirement, but ideally they should have something more than that: a deeper understanding of the Why.

Complexities hide beneath the surface of things that might seem to you “not that hard”.

No one has direct control over the stock market, and it tends to run exactly in the wrong direction, as far as economic stability is concerned: in other words, it tends to shoot up, when things are going well, and declines at exactly the time you don’t want it to - when things are looking down.

Home equity is (usually) less volatile, but does the same thing, in general.

The tendency doesn’t tell us the causality. It doesn’t tell us what causes what to happen.

Is the collapse of housing prices causing the economy to go sour and monetary conditions to become “tight”? Or is tight money itself the primary cause of the collapse of housing prices and the drop in home equity? What would housing prices look like across most of the country if NGDP hadn’t collapsed in 2008?

As far as bank accounts go, one person’s deposit is another’s debt. People - collectively - can’t both decrease debt and increase balances in bank accounts simultaneously.

Attempting to do so only leads to less spending, which leads to less income, which leads to less employment, which leads to even less spending, etc. Individually, some households may be able to pay down debt and increase balances, but only at the cost of reducing balances and/or increasing debt somewhere else.

You’re in full Storyteller mode right now.

I certainly think things can happen this way, but that doesn’t mean they must or even normally happen this way.

Looking at those three financial assets - bank deposits, stocks, and home equity - what you see are ingredients for financial instability. When stocks and/or home values rise, people spend. When people spend the economy expands. When it expands, banks lend.

More narrative. You’re just asserting causation without exploring it.

Is it rising prices that are causing people to spend? Or is it spending that causes rising prices?

Does the expansion of the economy cause banks to lend? Or does bank lending itself cause the expansion of the economy? There are times when there’s an extremely strong correlation between private debt levels and GDP. Is one causing the other? Or is there a third thing causing them both?

I have some complaints with how mathematics is used in modern economic thought, but it’s exactly in this case that math clarifies what we’re trying to say. For one thing, it forces a clean model in our heads of what is causing what to happen. X to Y, or Y to X, or Z to both Y and X? But even more than that, a bit of mathematical training gives us at least some small tool to look at circular (non-linear) systems, where both X causes Y and also Y causes X. It’s very easy to have incoherent thoughts papered over by English sentences and stories (Like “colorless green ideas” but more superficially attractive.) Just because we can write a story about one cause leading to another effect does not mean the story is coherent. That story might not work consistently as we add more and more puzzle pieces.

High stock prices will lead some people to spend more. But high spending itself is going to lead to high stock prices. Same with housing. And generally, I’d argue that the main thrust of causation is going to be exactly the reverse of what you argue here, in the majority of cases. But like the federal budget and the burden of taxation and debt, that is yet another multi-page thread.

If - or when - something happens, stocks and/or home values fall, people cut back on spending, and the economy slows or contracts. Banks lend less, and people try to cut debt and “save” money (increase balances). Less spending means less income, which leads to more unemployment, and the economy declines further.

Treasuries are not the only savings vehicle, but they are different from other savings vehicles in that the government can, and does, provide them when the private sector can’t.

More storytelling. I’d guess that’s all you have at this point. Saying “I know almost nothing about Iceland” is at least honest, but it also relates directly to the problem about real data that I was hammering at before and will no doubt hammer at again.

You need to actually look at the world if you want to have any idea whether your story fits with reality.

I tell stories, too. I have a grand narrative that I’m exploring. The difference is that when I hit some real-world example that doesn’t seem to fit my narrative, I don’t just repeat the narrative from the beginning as if repetition will make it more true. I have actually changed my mind since 2008 because the story I used to tell didn’t seem to fit what I was seeing. It’s possible that my mind has finally found a rut that it doesn’t care to move from, but at the very least, my habits seem to be clean. I can’t say for certain that my ideas are right but I don’t just tell my same favorite story over and over again. I look at the world every once in a while to see if the narrative fits the facts on the ground.

There’s no reference to the real world anywhere in your post. It’s all Storytelling. Do you think that’s a clean habit for coming to conclusions?

Do you think anyone else reading this would think it’s a clean habit for coming to conclusions?

[LinusK]

@Hellestal

The next section is a big long explanation but the following is really the only assertion that matters. It is the core of the argument.

But the deeper fault is in the system itself. So long as commercial banks extend less credit (money) than what they demand in return - which they must do, in order to remain solvent, a financial crisis or panic is inevitable.

This is simply false. It is a basic mathematical mistake.

It sounds good from a narrow static perspective. It looks like it makes sense. Banks lend X dollars which creates X commercial bank money (if you ignore the fact that it might not, as so often you like to do). But banks also want to be paid interest. In order to pay back the loan, banks need to be paid back more than the original loan: X plus interest. They need to be paid back “more” commercial bank money than was created originally by the loan. To someone who looks at this whole thing like it’s a static problem, it looks like there’s “not enough money” to pay back the loan and the interest together. (I now know why he wrongly on saying the “banking system doesn’t loan out reserves”. That statement is built directly on top of this mathematical error.) As with so many other points raised in this thread, I have tried to explain this mistake in previous threads. I tried to use bank accounting in order to explain it: debits and credits.

The problem was that you didn’t know what a debit or a credit was. The issue was double-entry bookkeeping, and at that time you didn’t know the two names of the two entries. Autodidacts sometimes have these problems.

If at all possible, I’d like to avoid the formality of accounting definitions, and just say the solution is obvious once you think in terms of the flow of money rather than any particular stocks. The human body has about five liters of blood. That’s the stock. But that does not mean that the flow of blood through the body is limited to five liters for any given time period. Five liters of blood can be pumped through the body again and again and again. The amount of blood pumped through the aorta can be more than five liters in a single minute.

A total loan balance of X in the economy, including the accompanying interest payments, can easily be sustained by a total stock of money that remains strictly less than X in the steady state. This is true even in a free banking system with no central bank. (A key technical point to realize is that bank expenses and bank dividends paid to owners will also expand “commercial bank money”.) In order to service the loan and pay back principal plus interest, you don’t need a strictly increasing stock of money. You just need the total money that “exists” to be pumped through the system in the right way.

I understand this. I’m sorry if I gave the impression that I don’t.

I’m not arguing that “there’s not enough money” in the case that everybody demands their deposits at once. I understand that rarely happens. What I’m arguing is that the greater the debt is, in relationship to the amount of money, the greater the danger of financial instability.

To steal your analogy, so long as there’s enough “blood” pumping through the system, the system works ok. But if the amount of blood is inadequate it leads to low blood pressure (I assume, I’m not a doctor). If the deficiency grows large enough, for whatever reasons, the health implications become more and more serious.

To to repeat myself: I understand that X amount of money can (and does) service Y amount of debt, even if X is smaller than Y (which, I understand, is usually the case.

I’m merely arguing that if the difference between X (the amount of money) and Y (the amount of debt) becomes too large, it leads to economic consequences. Which can range from mild to catastrophic.

If the financial system is prone to instability (and I absolutely believe that it is)

I read the link. The first half of which, at least, sounded like something I might write.

I liked it so much, particularly the bolded parts, I’m going to quote it here.

I can give one interpretation of the Financial Instability Hypothesis, but with the caveat that I’ve only read indirectly about it from various sources, not directly from the man himself, so I’m likely to be coloring the original with my own thoughts. But here is how I would describe it:

We start by noting that most of the modern money supply is not currency, not the little pieces of paper or the jingling coins that we carry around in our pockets. Most of the stock of money that exists is debt. Money is debt. (In an accounting sense, even those little pieces of paper in our wallets are debt, too, since they represent liabilities of the central bank.) But it goes even beyond that. Not only is the majority of money debt, but the majority of money is private debt.

I have bank accounts: savings, checking. I think of these accounts as if they’re “cash”, but really, they’re not. They’re just numbers that exist in my banks’ ledgers. Specifically, they’re numbers that exist in the LIABILITIES column of the bank. My bank account balances aren’t really cash, but rather a promise by the bank (a debt) to pay me cash whenever I show up to claim that cash. I might write a check to my landlord, when my landlord uses exactly the same bank that I do. My landlord will deposit the check, but what happens in an accounting sense? No actually currency changes hands. What the bank does is look at my deposit balance and say, “Sure enough, we owe Hellestal money. But Hellestal wants to give that cash to his landlord. So let’s decrease the amount of money that we owe to Hellestal (debit his account) and increase the amount of money that we owe to the landlord (credit his account).” Everyone is satisfied with this arrangement. My account balance is lower, and my landlord’s account balance is higher, and the bank still owes exactly the same amount of debt… it just owes the debt to a different person.

The real world obviously has many different banks, but in a certain sense, we can look at the whole banking system as a whole in the same way. When I swipe my check card, it’s not always necessary for any government money to change hands. The whole series of transactions can be changes in private debt only. We think of it as “real money”, when in fact, the only changes that are made might be in the financial statements of private banks.

This means debt is vitally important to the money supply. Money is a kind of debt, so new loans can create new money. When a bank issues a new loan, the very act of creating the loan will create new money in the system. If I want to buy a house, I’m not going to get into debt directly with the contractor. The contractor isn’t in the business of knowing who is credit worthy, and who not, so the bank bridges the gap between us. I get into debt with the bank, in the form of a 30-year mortgage. Simultaneously, the bank gets into debt with the contractor by creating a brand new account and crediting that account for the purchase price of the house. The bank is an intermediary, both a borrower and a lender simultaneously. The bank owes money (the new deposit account created), and the bank is owed money (the amount of the loan). Profit comes from the difference in interest rates. The banks “earn a spread”. This has nothing to do with impressing a date, but refers to the interest-rate spread between what the bank is paying in interest to its deposits and what it is receiving in interest from its mortgages and other loans.

I personally would not say “money is debt” because it’s a simplification: a useful and helpful simplification, in my opinion, but one that would draw more criticism than it was worth.

your given explanation cannot be the reason because it is not mathematically coherent. It fundamentally confuses stocks and flows. A stock of money that is strictly less than any amount of debt can still service that debt.

Money is a stock. NGDP is a flow. One of the key reasons that I advocate strictly increasing nominal income every year is in order to service previous debt. (The other key reason is the labor markets, which is another complicated topic.)

I understand the difference between stocks and flows. I’m sorry if I gave the impression I didn’t.

I’m curious about this sentence, though: “One of the key reasons that I advocate strictly increasing nominal income every year is in order to service previous debt.”

By “nominal income,” are you referring to income per person, national income, or something else?

That’s about the limit of what I can argue. I’m not in a position yet to make an airtight case that deficits are useless for aggregate demand.

But if you go around the world, it sure as hell looks like it. More and more evidence every year. The Icelandic austerity+growth is a particularly striking recent example. Balancing their budget hasn’t seemed to hold them back.

I guess I’ll tell a story. I read - at least once, and probably more than once - popular economic articles asking why banks aren’t lending their reserves.

The answer seemed obvious to me: commercial banks don’t lend reserves. They lend commercial bank money. The Fed decides how much reserves there are, and collectively there’s little commercial banks can do about it.

This is still a horrible fucking way to describe things.

Horrible.

You’ve used strong language to describe how horrible it is, but you haven’t said what’s horrible about it. I agree people use the statement, “banks lend out reserves”.

Maybe at least some of the people - when they say that - realize banks (mostly) don’t lend reserves: they create new commercial bank deposits.

I certainly wasn’t one of those people. I thought the statement “banks lend out reserves” meant that “banks lend out reserves”. As long as I believed that, it was a stumbling block in terms of understanding how the banking system really works. YMMV.

I’m just saying that if you’re not part of the club that understands “banks lend out reserves” doesn’t mean “banks lend out reserves,” it creates confusion.

And people might wonder why there’s still a hot potato in the game if little Sally threw it to somebody else. Didn’t she get rid of it? Why is there still a potato being tossed around if Sally got rid of it?

Confusion on this point is not a sign that the “standard explanation” of hot potato is flawed.

Children pass the potato. The fact that the potato is still in play after being passed does not mean that children are not passing the potato.

I don’t understand the reference to the potato at this point. I understand the “potato” is money, and that increasing the rate at which it gets “passed around” is an increase in the velocity of money.

I don’t understand why “banks lend out reserves” is better than “banks create new deposits when they make loans.” To me, the second is clear and helpful. The first is confusing and misleading.

75% of monetary economics in a children’s game: the individual micro incentive is to pass the hot potato, but the hard macro fact is that the potato must end up in somebody else’s hands. The receiver’s micro incentive is (again) to pass it quickly but it must (again) end up in somebody else’s hands. If elementary school children can figure this out, then it’s not very confusing. Lots of things about money are confusing. This is not one of them.

Again, I understand anything that increases the velocity of money has real effects on the economy. I just don’t understand why that makes “banks lend out reserves” a better way of describing how the process actually works.

For every good description of money I’ve ever seen, there have been a thousand bad descriptions. When you say that the “banks don’t lend reserves” that is also extremely confusing. First and most obviously, because it’s false. Even if you were careful enough to specify the “banking system” (and normally, you are not), I could still quibble with that as I previously did. It wasn’t clear what you meant by that sentence until you explained in more detail.

If you understand it now, there’s no reason to go over it again. But to be sure, when I say “banks don’t lend out reserves” what I mean is that (with the exception of a bank, for example, making cash loans) a commercial bank loan either stays at the bank (in which case is becomes a new commercial bank deposit) or it goes to another bank (in which case it becomes a new commercial bank deposit - at the second bank). Regardless, with the exception of banks making loans in cash, the loan becomes a deposit somewhere in the commercial bank system.

More importantly, no amount of commercial bank loans directly effect the amount of reserves held by commercial banks. There may be an indirect effect. For example, if the total size of commercial bank deposits grows to the point where banks are no longer able to obtain reserves within the Fed’s target rate, the Fed must either create more reserves, or increase its target rate.

You’re using your own internal instincts to decide what sounds confusing and what’s not.

Obviously I’m doing the same with my own internal guidance. The difference is that there’s more than a decent chance that I have read more people from a broader ideological spectrum with more varied styles and a higher variety of conclusions than you have. When I come to a decision about what’s confusing or not in an economic explanation, I am (probably) approaching that question with more experience and more examples backing me up.

You are relying on your gut for this stuff, and your gut cannot be trusted.

There is no such thing as “communicating clearly” on this topic. Not yet, anyway. But if you want to communicate more clearly – if you want to push in the right direction – then you should, at minimum, adapt a style that at least acknowledges the more conventional phrasings as legitimate and potentially helpful and not a mistake* even if you thenceforth bring out your own idiosyncratic language.

*I exclude from this the theoretical explanation of how money is multiplied, which is conventional and a mistake and useless. Off the top of my head, though, that might be the only thing I would terminate with extreme prejudice from an intro/intermediate book.

I’m always open to suggestions. Maybe you’re referring to something, or some other things, besides “banks don’t lend reserves”.

However, it that is what you’re referring to, I admit to being unconvinced.

I still think banks don’t lend reserves. What they lend is commercial bank money, which in turn winds up as commercial bank deposits, somewhere within the banking system.

It is true, that when commercial bank money moves from one bank to another, reserves also move.

But I still don’t see “banks lend reserves” as a true or helpful way of describing what happens when commercial banks make loans.

Reserves stay where they are (in Federal Reserve accounts). They don’t become deposits at commercial banks. Commercial bank loans (in general) don’t directly affect the amount of money in reserve accounts. I’m curious if you disagree with me (about the statements in the previous three sentences) of if it’s just the phrasing that bothers you.