Bank Reserves

Paul Krugman responds to a Cullen Roche post at Pragmatic Capitalism:

http://krugman.blogs.nytimes.com/2013/08/16/banks-and-the-monetary-base-wonkish/

The Krugman post is reproduced below.

Professor Krugman is a great writer and communicator of economics. Cullen Roche has raised an issue about the relationship between bank reserves and bank lending. And the professor has responded to that. He concludes with a take on “word games” that he feels may be at play here. We think there’s more to it than that.

Professor Krugman approaches this issue indirectly at first:

“Similarly, if we ask, “Is the volume of bank lending determined by the amount the public chooses to deposit in banks, or is the amount deposited in banks determined by the amount banks choose to lend?”, the answer is once again “Yes”; financial prices adjust to make those choices consistent.”

He refers to ISLM in analogous fashion, suggesting that in both cases: “The correct answer is “Yes” — it’s a simultaneous system.”

In the case of the view that “loans create deposits”, this is not necessarily a conflicting statement. A borrower in seeking a loan can obviously create a new deposit with the proceeds. The negotiation between a lender willing to lend and a borrower willing to borrow must be an agreement on that. So “loans create deposits” translates to a prospective borrower who is in a position to create or “issue” a liability to the bank, which is the bank’s loan asset, in exchange for a deposit asset. Indeed, the arrangement can be viewed as an asset swap – loan for deposit – according to mutually agreed pricing, in the sense of the Diamond/Dybvig liquidity transformation that the professor uses in his model.

But the simple observation “loans create deposits” reflects an origination flow of funds – lender to borrower – that is more directly informative as a contrast to the misguided money multiplier theory. In any case, the idea that loans and deposits appear simultaneously informs nothing beyond that which is conveyed by “loans create deposits”. Moreover, “it’s a simultaneous system” doesn’t directly deal with the fact that banks don’t lend reserves, which is the issue that Cullen has raised. In this sense, simultaneity is arguably a straw man point with reference to the relationship between broad money creation and central bank reserves and the validity of the money multiplier theory.

Another economist has embraced Professor Krugman’s “simultaneous system” point as a pat answer to those pesky commenters who keep raising this issue about lending and reserves:

http://www.themoneyillusion.com/?p=23072

It is a curious point. Any outcome which includes the joint appearance of a loan and a deposit requires a preceding “adjustment” to get to that point. That must be reflected in the path of corresponding accounting entries and the pricing associated with those. But this alone doesn’t say a lot about loans, deposits and reserves.

The more relevant paragraph in Professor Krugman’s post follows next as it pertains to Roche’s point:

“Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks’ portfolio — they’re holding fewer securities and more reserve — and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits. That’s all that I mean when I say that the banks lend out the newly created reserves; you may consider this shorthand way of describing the process misleading, but I at least am not confused about the nature of the adjustment.”

The professor has previously made the same point about using “lend reserves” as a type of “shorthand”. But shorthand for what exactly? That would make an interesting post. And why shorthand? For one thing, a more detailed alternative might not fit easily in the NYT column format. Let’s acknowledge the shorthand, but for purposes here, this will be a temporary pass.

That said, there may still be some potential confusion arising from that second quoted paragraph. That is the focus of the rest of this post.

Consider a simple model of a commercial bank:

There are two asset portfolios – liquid assets and non-liquid loans. On the other side of the balance sheet, we have deposits and capital.

Banks maintain liquid asset portfolios as part of the process of managing the reserve account at the central bank. This area is sometime referred to as the bank’s money market operations. It includes both liquid assets and short term short term wholesale liabilities. These are the portfolios that help the bank to adjust its reserve position each day.

It is instructive in this analysis to consider the difference between the pre-2008 Fed environment and the situation since then with the creation of massive excess reserves through quantitative easing (QE).

First we consider the pre-2008 environment. The bank’s money market operation takes into account daily Federal Reserve policy as expressed in the policy target interest rate and implemented as necessary through the Fed’s open market operations. All interbank transaction activity ends up being settled in the reserve account via the interbank payment and settlement system. This includes everything on behalf of customers who transact with customers of other banks. The bank wants to manage the volatility of the resulting net reserve position to the best economic result. Too much net inflow results in unwanted reserves earning an inadequate rate of interest (zero interest on a pre-2008 basis). Too little means borrowing from the Fed, which is not encouraged and is the reason for liquidity management in the first place. At the same time, management has the job of trying to anticipate Federal Reserve policy as it affects interest rates. The reserve management operation looks to optimize the cost effectiveness of the net interest margin effect and the liquidity volatility protection offered by its liquid asset portfolio, given everything else that’s going on within the bank and outside it.

The key point in all of this is that the main lending operation, which accounts for the balance sheet expansion most relevant to the Fed mandate, does not respond to Federal Reserve policy at the level of reserve operations. That distinction explains the nature of the dilemma that is inherent in Dr. Krugman’s model and perhaps in the academic papers that back it up.

Let’s return momentarily to the issue of “lending reserves”. Dr. Krugman’s simplification is arguably more digestible in the case of the bank’s money market operation than it is with respect to the main lending operations. Bank reserve managers do respond to changes in their reserve positions that might be induced by proactive Fed reserve activity. A reserve manager will take steps to acquire money market assets if his reserve balance is increased because of Fed activity. Conversely, bank lending officers in making their credit decisions pay absolutely no attention to the bank’s daily reserve operations.

The use of the shorthand of “lend reserves” may be comparatively harmless when applied to the money market operation (although this does not fully validate it), but it is misleading when transferred to the area which most matters for the discussion, which is the bank’s main lending portfolio. Bank lending officers do not operate even according to the professor’s simplification. And the lending portfolio, not the liquid asset portfolio, is where the relevant balance sheet expansion take place over time.

Lending managers make decisions on the basis of credit risk assessment and capital allocation. And when they lend, deposits are created as a result. This has nothing to do with the reserve management of the day.

Even in the case of money market operations, and even allowing for the “lend reserves” simplification, the meaning of the adjustment in question must be qualified and limited in a very strict way in order for reserve operations to be depicted correctly. The Federal Reserve adjusts the system reserve setting in conjunction with targeting the Federal Funds rate. The Fed sets the policy rate. That’s what they do. They have tools in achieving that policy rate target. They adjust reserve settings when necessary in order to hit their target rate. (Still pre-2008 here.) But the degree to which they have to make such adjustment is miniscule in its order of magnitude compared to the size of the US banking system and its aggregate loan and deposit portfolios. One merely need look at the statistics going back over decades, pre-2008, to see that excess reserve settings have been tiny in this framing (very low single digit $ billions), and very stable on average over time, even on a high frequency weekly time series basis. The explanation for this is that when reserves pay no interest, the Fed need supply or withdraw very little of them in order to get the interest rate response it’s looking for. The banks’ demand for uncompensated reserves (pre-2008) is so interest inelastic, that a small change in the system position can move the funds rate significantly. Bank reserve managers have to deal with this. And they do so by attempting to get rid of excess reserves and to cover reserve deficiencies through money market operations and to do it very quickly based on perceived and actual Fed actions.

Thus, the Fed’s activity in achieving its target rate (when the actual rate is off course) tends to be quick – because the bank response is quick. And over a longer time frame, the Fed’s activity tends to be divided between steering the trading rate for fed funds higher or steering it lower, depending on the direction of the deviation from target, in order to get the trading rate back on target. That’s how open market operations work when used by the Fed in managing the fed funds rate. And so what happens is that any excess reserve position that is similarly higher or lower than a normal level of excess reserves, as a result of the Fed’s course correcting action relative to an existing target rate, tends to revert back to the normal level in short order – and we’re talking here about a matter of several days. And the result of that is that the Fed’s excess reserve setting has been very low and stable on average over time (pre-2008). And that means in particular that excess reserves which exceed this low average level are short lived. And those short lived episodes in particular never reach the attention of bank lending officers. The lending officer works in the dark as far as reserves are concerned, because there’s no functional reason for him to be interested in that activity. He lends based on risk assessment and capital requirements – not based on the Fed’s manipulation of the excess reserve position. Those short lived bursts of Fed activity in managing excess reserve expansion or contraction have absolutely no bearing on the lending decision through the bank’s main credit portfolio. And it is in this sense that the second paragraph quoted from the professor’s post is potentially misleading.

Two more points warrant comment – regarding required reserves and banknotes.

It is a fact that required reserves are calculated after the deposits that give rise to them are created. This is well documented in various Federal Reserve publications. And the Fed immediately supplies these required reserves to the system at the point they come into effect. It must do this in order to control the fed funds rate relative to target. So, given that time sequence, there is no way that the Fed’s necessary supply of required reserves can influence bank balance sheet activity in any meaningful way beyond that. Everything relevant to this issue is done in the money markets at the margin by way of the daily excess reserve setting as described above.

Next, bank customers decide when they want to exchange bank deposits for banknotes. The Federal Reserve has no operational control over such a decision process. If customers want banknotes, and if the banks’ corresponding purchases of those notes from the Fed reduces the reserve balances available to the banks for interbank payment and settlement, then the Fed will replace those lost reserves with a new injection through open market operations or the like. Just as in the case of required reserves, this is necessary in order to control the fed funds rate relative to target. Again, the active Fed management of the system reserve setting is done at the margin of both required reserves and banknote issuance, by way of the strategy for the excess reserve setting as described above.

It is puzzling how some treat the aspect of banknote issuance. If the banking system and its deposit base grow over time, it seems natural that the private sector will increase its holdings of banknotes on trend and in conjunction with such expansion, as a matter of asset mix (between deposits and banknotes) and portfolio rebalancing. And interest rates including deposit rates may well influence a liquidity preference for banknotes relative to deposits. This doesn’t seem complicated. What is mysterious is why this aspect needs to play a central role in understanding how the reserve system operates. That approach seems to place the supply of banknotes at the epicenter of monetary transmission, dismissing the importance of a more detailed and separate understanding of bank reserve operations.

That should cover the necessary issues regarding Fed operations for the most part, pre-2008.

Returning to the Krugman model of banking, which combines portfolio equilibrium and liquidity services according to the academic papers he cites, this seems like a solid perspective on role of banking at a high level. But the referenced papers, as famous as they are, do not seem to account for the adjustment mechanism in question as it occurs in the modern system.

Now let’s go back to the issue of Dr. Krugman’s “lend reserves” shorthand. Having accommodated this temporarily, we must now say that this is wrong at a technical level, whether we are talking about money market operations or lending operations.

Banks do not lend reserves. More precisely, banks only lend reserves to other banks, which again is only a liquidity management operation, separate from the main lending portfolio. And loans do create deposits. This is a factual matter of double entry bookkeeping. Banks record new loans to non-bank customers, creating corresponding new deposit entries at loan origination. When a brand new deposit departs the lending bank, and traverses to a competing bank, the lending bank will literally pay for that transaction through its reserve account. That is not lending reserves. That’s using reserves as the medium of exchange to pay for an interbank transaction. That’s the functional role of reserves – to pay for interbank settlement. It’s got nothing to do with “lending reserves”.

And this point applies just as accurately to money market operations. When I noted earlier that it might be more right (less wrong) to use the shorthand of “lend reserves” in money markets operations, it was an observation relating to the reserve manager’s way of responding to an excess reserve position. But the manager does not respond by lending reserves in any technical way, unless he is lending them to another bank through a special market for reserves that is directly available only to the banks (i.e. the fed funds market). The reserve manager is acquiring liquid assets and using reserves to pay the bank whose customer sold the securities. The counterparty bank does not owe reserves back to the acquiring bank and certainly no non-bank customer owes reserves to anybody at any time.

It is understandable that Dr. Krugman has used this as shorthand. But it is dangerous in the final analysis to do so – because it misleads on the nature of bank balance sheet expansion, which after all is the main subject beyond this technical issue of reserves. A fundamental distinction in banking is violated by the idea of “lending reserves”. And that is the difference between liquidity management and capital management. Bank reserve managers are liquidity managers. Bank lenders are capital managers, in effect.

(Capital management is a centralized bank function. Lending operations need to pay for their capital funding as supplied by that central function. Lenders determine if a prospective loan is financially viable by plugging in their cost of capital to the relevant profit calculation. Reserves have nothing to do with it other than in the case of a relatively minor cost calculation associated with the net interest margin tax effect of required reserves on prospective deposit funding.)

Bank lending and associated deposit creation – the kind that matters over time – the kind that the Federal Reserve is interested in influencing through monetary policy – requires capital underpinning. Banks make lending decisions based on risk assessment and the cost of capital. This has virtually nothing to do with bank reserves (other than the marginal tax-like cost calculation noted above in the case of required reserves). The lending officer must be connected by policy and operations to the capital account manager – not the reserve account manager. Lending uses up credit and other risk capital. And this difference in connection is evident in the institutional structure that functionally separates money market operations from portfolio lending in banks. (In the case of very large loan commitments, the lending division may well advise the reserve management function on the actual timing of the expected funds drawdown. This information can be useful in the planning of that day’s reserve management operations.)

Conversely, the nature of the money market operation is such that the related liquid assets tend to be high quality, low risk and short duration – meaning that the capital allocation for risk in liquidity management operations is typically not significant when compared to the main lending book. Thus, the money market operation is a relatively low user of risk capital and for good reason according to the nature of the liquidity management function.

The Fed’s monetary policy works through interest rate targeting. Fed reserve operations are a means of achieving the operational objectives of interest rate targeting. This principle holds for QE as well, notwithstanding the popular focus on the enormous level of excess reserves currently in the system. QE in its various forms is an extension of Fed interest rate targeting. The parabolic increase in excess reserves under QE is a byproduct of interest rate targeting of a wider scale.  In the initial credit easing phase, the Fed lent to certain non-bank entities, alleviating money market rate pressures, and creating bank reserves as a by-product in the process. In parallel, it provided reserves directly to banks in order to alleviate interest rate pressures in the inter-bank market. The funds rate would have skyrocketed under these conditions otherwise, without this extraordinary action by the Fed. The interbank lending system had seized up because credit risk had penetrated deeply into money market and interbank operations. The Fed injected reserves so that interbank settlement could take place at the target funds rate. Excess reserves were required to an extraordinary degree to alleviate extraordinary interest rate pressures. But this demand for reserves had nothing to do with banks’ desire to “lend reserves” to non-bank customers (i.e. outside of the fed funds market). And it had nothing to do with banks’ desire to stockpile reserves for future lending. It was about hoarding a risk free asset (bank reserves) in a market environment that had suddenly become very risky – i.e. hoarding the asset that is used for payment and settlement of transactions in a normal market. The Fed provided reserves to satisfy that demand in an attempt to restore normal interest rate conditions, and then started to pay interest on reserves to establish an interest rate floor (albeit an imperfect floor) once rates became better behaved and the outsized supply of excess reserves became redundant to its usual purpose of payment and settlement. In the subsequent stages of QE, with mortgage and Treasury bond purchases, the Fed created reserves again as a byproduct of its policy to extend its direct interest rate influence further out the yield curve. Again, the supply of reserves increased, not for the purpose of “lending reserves”, but this time as a byproduct of bond purchases, most of which were sourced from the portfolios of bank customers rather than the portfolios of the banks themselves. Given the banks’ normal role in servicing customer bond transactions, they received more excess reserves as a result of that activity, when non-bank bond sellers deposited their new money back into the banking system. These interest bearing excess reserves resemble treasury bills captured inside the banking system. There is no need for them for purposes of lending activity.

Cullen Roche was basically correct in saying:

“Banks don’t lend their reserves out so expanding the monetary base was never going to result in consumers getting “the money for deposits”.

Moreover, he would have been correct even if accommodating “lending reserves” as shorthand for actual operations, the way Dr. Krugman suggests. Because the relevant bank reaction function that both of them should be referring to (and which Cullen was referring to by implication) is the main lending portfolio. But the reaction function that Dr. Krugman actually describes is the money market operation and liquidity management function, on a pre-2008 basis for the most part. That is not the same as the bank reaction function that the Fed is interested in from the perspective of its mandate for economic expansion under price stability.

Regarding Dr. Krugman’s citing of several classic academic papers, surely it must be possible that such papers, being great works in economics, might be supplemented effectively by modern updates in some way. Is it possible that today’s monetary system works in such a way that these papers alone no longer offer an encompassing explanation? Specifically, the academic papers cited by the professor don’t seem to say much about bank capital. Portfolio decisions on risky lending require an allocation of capital – not an allocation of central bank reserves. The bank liquidity process described by the Diamond/Dybvig paper involves a risk transformation function that requires an allocation of capital across the organization’s asset portfolios as a necessary condition for the associated creation of liquid, low risk bank deposit liabilities. Virtually all bank liquidity crises start with some element of a perceived risk to bank capital, and capital adequacy plays a central role in the liquidity management framework for any banking institution. The Tobin and Brainard paper examines a range of banking system equilibria that include combinations of reserve requirements and fixed bank deposit rates. That doesn’t seem to model the modern system in which deposit rates float competitively, and where by analogy the only relevant fixed interest rate is the target fed funds rate, which is fixed in the sense of being administered by the Fed until the Fed wants to change it. But this is the anchor rate that propagates influence throughout the system as the basis for a galaxy of differentiated rates with different risk premiums and term structures, including the required return on bank equity capital. Rates of return are not determined by the public demand for banknotes, or by a model that assumes the Fed can determine that for them. The paper seems incomplete relative to an understanding of today’s system.

So there is a great difference between using “lend reserves” as convenient shorthand for operational dynamics in bank money market operations (which is relatively OK) and the material distortion of economic substance that this phrase conveys if entirely overlooked when applied more broadly to lending operations (which is not OK). And that is what deserves a bit more attention, given that this is not a minor issue in understanding the financial crisis and the response of the Federal Reserve to it.

These are not word games. It’s about how the internal institutional organization of banking interfaces with the Federal Reserve in functionally differentiated ways. This multi-layered institutional response provides clues as to how monetary policy actually affects banking. It is about clarifying distinctions between liquidity risk and credit risk and capital, and how banks make portfolio decisions based on these different risk factors and exactly where in the bank they make those decisions and how those decisions relate in their own different ways to Federal Reserve operations. And at the end of the day, the Fed transmission of monetary policy occurs through interest rates being set and not through reserves being provided. The excess reserve setting on a pre-2008 template was a tiny but fairly stable pool of special funds attached to an ocean of financial flows, a pool for the sole purpose of providing interbank settlement liquidity at the prevailing fed funds target rate. The QE reserve setting post-2008 has resulted in a larger lake of the same type of special funds, due to a Federal Reserve interest rate policy that has been extended to include credit risk premiums and the yield curve. These funds still have nothing directly to do with commercial bank lending operations in the main.

 

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http://krugman.blogs.nytimes.com/2013/08/16/banks-and-the-monetary-base-wonkish/

August 16, 2013, 11:39 am

Banks and the Monetary Base (Wonkish)

Cullen Roche is unhappy with the way I treat monetary expansion in my old Japan paper (pdf); or actually he’s unhappy with the way I talk about it. I’m actually kind of reluctant to even get into this, because any discussion of these issue brings out the people who believe that they have discovered the hidden secrets of the monetary universe, somehow missed by generations of economists. But here goes anyway.

When I think about the role of banks in the economy, I generally rely on two models, which are both partial pictures but add up to a reasonable overall approach. One is Diamond-Dybvig (pdf), which portrays banks as providers of liquidity services, and also shows how bank runs can happen. The other is Tobin-Brainard (pdf), which portrays the financial system in terms of a portfolio equilibrium, in which each sector — households, banks, firms, etc. — choose the mixes of assets and liabilities they want to hold, and asset prices adjust to make these choices consistent.

What I did in that old Brookings Paper was a quick-and-dirty merger of these two approaches, in which I got the monetary base into the story in the form of required reserves held by banks. That was a strategic simplification, and an unrealistic one — almost all of the monetary base is actually held in the form of currency, not bank reserves. But it was obvious to me that it didn’t really make any difference for the question at hand.

And how did I know that? Basically from Tobin-Brainard, who showed that whether banks hold monetary base in the form of reserves makes no fundamental difference to the monetary mechanism, as long as somebody wants to hold base money — and the public does, in the form of currency.

Actually, Tobin-Brainard is to many of the controversies that swirl around banks and money as IS-LM is to controversies about interest-rate determination. When we ask, “Are interest rates determined by the supply and demand of loanable funds, or are they determined by the tradeoff between liquidity and return?”, the correct answer is “Yes” — it’s a simultaneous system.

Similarly, if we ask, “Is the volume of bank lending determined by the amount the public chooses to deposit in banks, or is the amount deposited in banks determined by the amount banks choose to lend?”, the answer is once again “Yes”; financial prices adjust to make those choices consistent.

Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks’ portfolio — they’re holding fewer securities and more reserves — and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits. That’s all that I mean when I say that the banks lend out the newly created reserves; you may consider this shorthand way of describing the process misleading, but I at least am not confused about the nature of the adjustment.

And the crucial thing is that there are no puzzles or misunderstandings here. Tobin and Brainard got it all straight half a century ago, and anyone who thinks that there’s a big flaw in their reasoning is almost surely just getting caught up in his own word games.

 

Comments

  1. Anonymous says:

    JKH,

    Regarding this statement: “A reserve manager will take steps to acquire money market assets if his reserve balance is increased because of Fed activity. Conversely, bank lending officers in making their credit decisions pay absolutely no attention to the bank’s daily reserve operations.”

    I met a former treasurer of regional bank (branches in several states) and he said that he did try to get rid of excess reserves by acquiring money market assets AND by issuing more loans. Now this was pre-2008 and his decisions was based on a number of other factors (capital position of bank, credit risk of borrowers, risk-return tradeoffs, etc), but the point is his story contradicts what you are saying.

    Maybe his loan officers, as you note above, were not aware of how the loans got funded but from his big-picture perspective it was clear.

    • You raise an interesting point, so I’ll try and be reasonably thorough in addressing it.

      Treasurers have centralized jobs with an all-bank scope. But treasurers don’t normally have responsibility over the full lending function of a bank (note the last 3 words of the post). I suppose that would be possible in a small bank, although it would be an unusual organization structure. And I suppose it might have been the case with the fellow you spoke to. But it is certainly not the case in larger institutions. And it fair to say that my description of things may apply more accurately to larger institutions (especially the money center banks, which account for most of the $ trillions of the banking system balance sheet) than necessarily to the smaller ones.

      In the case of the treasurer you spoke with, it’s definitely the case that his responsibilities would reflect a “big-picture perspective”, which is in the nature of the job, but less certain that everything he was describing (as you describe it) correlated with activity that he was directly responsible for, unless the organization structure was quite unusual, as noted above.

      In any event, all that said, there is a distinction between the scope of a Treasurer’s responsibilities and the mode in which reserve account management is done on a daily basis, which is what I attempted to highlight in the post.

      Every cash flow that goes through the bank that goes to or comes from another bank goes through the reserve account, and reserve account management normally is a treasury responsibility. So the treasurer sees everything in that sense. But he doesn’t cause everything to happen that gets reflected in that reserve account. A big part of reserve account management is responding to stuff that’s been caused elsewhere in the bank. This is the difference between non-discretionary and discretionary cash flows, as defined from the perspective of what the reserve manager is seeing and doing. The reserve account manager has to execute his own proactive (discretionary) strategy to offset the net impact that’s otherwise being delivered to him (non-discretionary) from the rest of the bank. The idea is to balance the position as best as possible without being buried in excess reserves or getting caught having to go to the window (pre-2008).

      The issue is how the reserve account manager goes about executing his decisions on a daily basis. This can involve money market loans of short duration (i.e. which are loans of a type, to one of your points), in addition to securities, all under pre-approved credit limits. But treasurers don’t go out and make loans through external branches in order to respond to a given day’s increase in the reserve account. Rather the reserve manager sees effect of that activity as it originated from those lending units and as it flows through the reserve account, reacting to it by managing the net cash flow effect of those loan drawdowns along with everything else that’s going on in the bank, and using money market transactions as the balancing tool, in an effort to target the reserve position to best economic effect by the end of the day.

      “Maybe his loan officers, as you note above, were not aware of how the loans got funded but from his big-picture perspective it was clear.”

      That’s actually very consistent with the standard treasury function and with the message of the post, although I might have elaborated on that point. It sounds like the treasurer is referring to the internal funds transfer system, which shows him the entire asset-liability management profile of the bank and allows him to manage bank wide liquidity and interest rate risk exposure accordingly. That’s a big function with a direct connection to reserve management via the liquidity dial. For example, the treasurer can undertake interest rate swaps to manage the consolidated interest rate exposure that is delivered to him from the rest of the bank, a risk slice that is orthogonal to the bank’s liquidity position. And all of this involves reaction to decisions made and to transactions initiated from elsewhere in the bank and is consistent with the reserve account operation I described.

      Finally, bank treasurers sometimes have egos to go along with the big scope of their responsibilities. In any event, it would be quite easy to describe one’s job of Treasurer as if you seemed to be running the entire bank, or have it perceived that way (possibly as in “his loan officers”). Not saying this was the case, but it’s easy to hear it that way, because it’s one of the few jobs that has the entire scope of the bank in its view.

    • Anonymous,

      It is possible for a single bank to be like that. Imagine a bank which is growing fast in the sense that its market share of loans issued in total is increasing. It can find itself constrained by its funding. Perhaps its deposit raising ability is not as good as its capturing the loan market.

      Also while this bank’s market share is increasing, others’ is decreasing. In the aggregate lending is demand-led and on top of it also depends on bankers’ own animal spirits so in the whole (unless in crisis, banks as a whole aren’t reserve-constrained).

      I think the PKE punchline “banks lend first and look for deposits later” is a bit of an overkill. In fact in the book Horizontalists and Verticalists Moore himself states that he does some overkill.

      I think here http://www.rba.gov.au/publications/fsr/2012/sep/html/contents.html or any one of the reports near that publication it states how Australian banks first look for deposits and then lend (my words not that of the RBA – something of that sort)

      Read it a while back but can’t find where so if you have the time and can find out let me know.

      So when a bank raises deposits it will see an inflow of central bank settlement balances or reserves. Perhaps the person you asked is more right talking about deposit inflow rather than reserves.

  2. An excellent post, as always.

    Given the banks’ normal role in servicing customer bond transactions, they received more excess reserves as a result of that activity, when non-bank bond sellers deposited their new money back into the banking system.

    Presumably, the increase in deposits and reserves arises on settlement of the bond sales. It doesn’t require bond sellers to subsequently deposit anything back into the banking system, does it? (Although, I guess it would if the bond sellers were paid in $ bills).

    • Thanks.

      I was a bit concerned about this one because it’s something I slapped together on a weekend, as a Sunday post to a Krugman drive-by the previous Friday. Not that I think there’s anything innately wrong with Krugman drive-by activities – they can be quite stimulating. And notwithstanding the title, it’s not a primer on bank reserves – it’s a post on bank reserves in the context of the first paragraph lead in. I left the title generic because I don’t want to misrepresent a fuller Krugman view on the subject. So this post presumes some pre-existing curiosity about the subject matter before hitting the title. In any event, the subject matter should be interesting for those who want to go deeper into how commercial banks actually respond to central bank policy, IMO, whether one agrees with my interpretation or not.

      On your question, it depends on the precise bank account arrangements. If JPM buys bonds from a pension fund and on-sells those bonds to the Fed, the pension fund will receive some form of payment from JPM, probably through an electronic credit to the pension fund’s bank account as per an instruction to that effect.

      The payment routing doesn’t matter so much. What matters is the consolidation of the balance sheets of the Fed, JPM, the pension fund, and the pension fund’s bank.

      Put that all together and you have bonds as a new Fed asset, new reserves as a Fed liability and an asset for the pension fund’s bank, and a new deposit as the latter’s liability and as an asset of the pension fund. Bonds, reserves, deposit – the system balance sheet has expanded in terms of banking intermediation.

      And JPM is flat relative to the entire transaction, taking whatever spread they’ve made as a dealer. My more general point on that is that the commercial banks and the bank owned investment dealers (such as JPM’s dealer) were not the original source of the QE bonds. That’s based on what I think is a reasonable counterfactual, in that the commercial banks have never held a lot of US Treasuries in their own portfolios.

      • Regarding the electronic credit to the pension fund’s bank account, you can alternatively visualize that as a cheque paid by JPM to the pension fund, which the fund then deposits in its bank account. And it may happen that way in some cases, depending on banking arrangements.

    • I think it is a bit of formal language usage by JKH. A bit FoF-ish.

      So we say: X received proceeds from a bond sale and deposited the proceeds in a bank. In this the “proceeds” is something more abstract than the deposit increase itself.

      One can similarly use “funds” instead.

      Is that right?

      • yes, a bit FoF-ish, always

        Its interesting how when the language risks ambiguity, the only sure solution is to refer directly to the accounting entries

        I tend to go FoF-ish as language that is attached in a standard way to that version of macro accounting

        Although ‘funding’ language is used regularly in banking as per my earlier post

        In this case, a seller could ‘deposit’ FoF ‘funds’ in the form of cheque

        • Yes, although going back to the line I quoted, presumably the banks would get the reserves when the Fed credited the reserve account of the primary dealer’s bank (or do primary dealers themselves hold reserve accounts?), not when bond seller deposited his check.

          • I’m slightly lost in the flow, but:

            A cheque that is deposited gets credited to the depositors account before the depositor’s bank’s reserve account is credited

            The corresponding reserve adjustment is part of the cheque clearing and settlement function, that from physical operations perspective happens overnight following the day the cheque is deposited (debits to payer’s deposit accounts may be backdated depending on technology)

      • I guess. It just sounds a bit odd to me. If my employer pays my salary direct into my account, I don’t think of it as me receiving it then depositing it. But I know what is meant.

        • you’re right

          I was thinking more about depositing a cheque when writing that rather than electronic transfer

        • Yeah but isn’t it like that from a flow of funds viewpoint. We say the income is the source of funds and depositing is the use of funds. And opposite for the other parties involved. Even though you don’t physically take it and deposit it in some sense.

          But the same is done in many other instances. For example even taxes on salary deducted at source is shown as first being received by the employee and then paid by him/her to the tax authority.

        • I’m clearly past my best before date on this particular point so I shall retire from it for now

        • Some simple Google search on depositing the proceeds got me this:

          ” Second, the Treasury could sell more bills and deposit the proceeds with the Federal Reserve.”

          http://www.federalreserve.gov/monetarypolicy/mpr_20090721_part3.htm

          and proceeds usually means “moneys collected” in legal language.

          I kinda like this because I am a bit interested in the legal aspects of money for reasons I don’t know.

  3. let us see if cullen’s “let me groom your beard you grizzled hunk” approach has any luck. finger crossed.

    • Cullen Roche says:

      I just generally try to be nice to people and respectful of them even if I think their ideas stink. Insulting a person is a sure fire way to turn someone off. But you can’t just win people over by being respectful. Ultimately, the ideas have to win them over. That’s how this will go down. So we’ll see.

      • Paul K isn’t even really off base with what he is saying. Yes, he’s relying on models which don’t reflect reality. But he’s clearly grokked the primary, major ideas of these (wrongheaded) models, and those models aren’t entirely worthless. It’s just those models are far more limited than they need to be. They are needlessly weak models.

        Something few people understand is the importance of fully understanding the technical details. In this case, the technical details preclude the models Paul K wants to use. The world cannot work like Paul K thinks it works, because the actual technical details do not allow it to work like the models.

        Even if these models can be coaxed to deliver results similar to what happens in the real world under certain circumstances, they are still dangerously wrong. The fact they do simulate some of the important features of banks make them more difficult to abandon, but doesn’t make them more correct.

        What JKH and Cullen are trying to do is point out these models are wrong, even if these wrong models give a pretty good understanding of what we see in the real world under some conditions. And this is holding back Paul K from better understanding what is going on in the economy.

        This isn’t simple to understand, and it’s entirely understandable that anyone makes this mistake.

        Here’s JKH:

        “Specifically, the academic papers cited by the professor don’t seem to say much about bank capital. Portfolio decisions on risky lending require an allocation of capital – not an allocation of central bank reserves. The bank liquidity process described by the Diamond/Dybvig paper involves a risk transformation function that requires an allocation of capital across the organization’s asset portfolios as a necessary condition for the associated creation of liquid, low risk bank deposit liabilities. Virtually all bank liquidity crises start with some element of a perceived risk to bank capital, and capital adequacy plays a central role in the liquidity management framework for any banking institution. The Tobin and Brainard paper examines a range of banking system equilibria that include combinations of reserve requirements and fixed bank deposit rates. That doesn’t seem to model the modern system in which deposit rates float competitively, and where by analogy the only relevant fixed interest rate is the target fed funds rate, which is fixed in the sense of being administered by the Fed until the Fed wants to change it. ”

        This is an incredibly polite and detailed way of saying “Hey look – those models are not good enough to use for the problems we’re facing today. Those models are almost certainly profoundly misleading in many cases. In our current situation, the models will be profoundly misleading. Here is why. ”

        Any honest timeline of 2008 would start with the questions of Lehman’s bank capital. The liquidity crisis spurred by Lehman happened when the street felt Lehman did not have enough capital. (Yes, it’s more detailed than that, but the point is the capital crisis happened before and caused the liquidity crisis for Lehman)

        • Yes, there’s a very fundamental connection between capital and liquidity risk.

          Capital is a form of long term funding that doesn’t need to be paid back – thinking about it in its purpose of being there to absorb unexpected losses. The more capital you have, the lower the liquidity risk is , other things equal, because with 100 per cent equity funding you essentially have no liquidity risk.

          Sometimes I think of the money multiplier theory as one where economics took a wrong turn, confusing liquidity and capital, in the sense that the only legitimate multiplier idea starts not with reserve ratios but with capital ratios – i.e. the inverse of the appropriate capital ratio becomes a multiplier from capital to balance sheet size (nominal or risk weighted depending on the ratio used).

          Required reserve ratios are ex post government ratios because the Fed supplies the required reserves after the fact.

          Capital ratios are ex ante private sector ratios – because banks need private capital to lend before the fact. You can’t cover losses with capital that you don’t yet have.

          So they need capital to lend (i.e. for risky lending).

          But they don’t need central bank reserves to lend.

        • Scott Sumner in the comments from his post that I linked to:

          “Monetary policy is all about the Fed’s control of the supply and demand for base money. It’s true that banks hold a lot of base money, but so do drug dealers. I don’t feel I need to be an expert on drug dealers to comment on monetary policy.”

          That’s not surprising – that is his position.

          But it does beg the question as to what definition of monetary policy various people are working with.

          • Sumner seems to make a distinction that the proceeds from lending is not money, it’s credit, and as such isn’t relevant to monetary policy.

            Beyond that a point worth drilling home is when the central bank creates reserves. Pre-2008 these reserves were created as a response to new lending by banks in order to hit the target rate, and as such was simply a response to endogenous lending activity. Post 2008 the central bank has been proactively increasing the monetary base. Pre-2008 was anyone even really paying attention to reserves like they do today as MMT, MR, PKE have grown in popularity and QE has dominated the scene? So as economists prognosticate about bank reserves in a QE world, they assume that proactive reserve creating central bank behavior is how its always been even though the Fed was mostly in the back seat until 2008.

            • SS (repeat):

              “Monetary policy is all about the Fed’s control of the supply and demand for base money.”

              I can see how the Fed controls the supply of base money in the sense that it is the issuer of base money. That’s sort of a definition of control in that context.

              It’s not clear to me what its supposed to mean for the Fed to control the demand for base money – unless that’s supposed to happen through interest rates – which means the Fed must control interest rates – which it does to the degree it controls the policy rate.

              Which seems redundant in terms of what is supposed to be the control lever.

              And I don’t see how that is supposed to work at the zero bound anyway, given that the Fed loses control of the policy rate in the sense that it has no effective option to move the policy rate negative (which maybe is why SS spent so much time on his negative IOR proposal).

  4. Isn’t it possible for banks to get rid of excess reserves by making more loans? The reserves don’t leave the banking system, but they stop being ‘excess’ and become ‘required’ instead.

    • I’d be careful about characterizing it as proactively “getting rid” of excess reserves on either a pre-2008 basis or on a QE era basis.

      As noted in the post, the average system level of excess reserves was actually pretty stable over many years prior to QE. This means that as the deposit base grew and as the required reserve level grew with it, that the Fed was ensuring that the level of excess reserves was maintained at the level required to ensure stability in being able to meet the Fed funds target – that the excess setting was always finely tuned in the context of an inelastic demand for reserve balances (as per the post). So even if you characterize it as “getting rid of” in the gross sense, it isn’t really the case in the net sense, pre-2008.

      In the current QE environment what you say is arguably a bit truer on a net basis, but I still wouldn’t characterize it as “getting rid” of excess reserves. That would suggest that lenders are motivate to “get rid” of excess reserves by turning them into required reserves, which is not the case. They’re motivated by return on capital, as covered in the post.

      Moreover, I recall doing a calculation several years back to simulate how long it would take to “get rid” of QE excess reserves in the fashion you suggest. I believe I came up with a number in the order of 100 years – and that was when excess reserves were lower than they are now.

      Nonetheless, I’ve seen this sort of argument made on leading monetarist blogs, back when I used to follow them a bit.

      • Thanks.

        You say that banks “don’t lend reserves”. So what do they lend?

        • Good question.

          I don’t think I can answer that precisely.

          But first, here’s how they don’t lend reserves:

          It’s always qualified that banks can lend reserves to other banks but not to non-banks.

          The transaction and the obligation between banks is clear – payment and repayment from one reserve account to another, using the fed funds market, which is the market for bank reserves.

          But a bank doesn’t lend reserves to a non-bank customer.

          The proof is in “loans create deposits”.

          The reserve account isn’t touched when a bank creates a deposit from a loan, simultaneously booked at the same bank.

          So what do they lend?

          Quite some time ago, I remember reference to a distinction between fed funds and clearinghouse funds. I don’t know whether clearinghouse funds is still the right technical terminology or whether it applies broadly in the sense of your question.

          Again, good question.

          IMO, this is a good example of where “money” becomes a useful generic description, because in the final analysis, the bookkeeping is more important than the classification of money.

          Best I can do right now.

          • The reserve account isn’t touched when a bank creates a deposit from a loan, simultaneously booked at the same bank.
            So what do they lend?…
            IMO, this is a good example of where “money” becomes a useful generic description, because in the final analysis, the bookkeeping is more important than the classification of money.

            Great piece, I like how you stressed the point that the important part of banking is— both for the individual bank and the sector as a whole– risk management of capital (gambling if you will) and not reserve management. Only you, Sheila Bair and Tay Zonday seem to get that.

            This is how money is created from air / Bank bailouts, federal budgets / Money isn’t really there –
            +It’s an I.O.U., remember dollars are a promise / When you borrow from a bank / It’s not from other depositors
            The money for your loan / Gets created on the spot
            Then they put it in your name / Gamble on your life and body -…..
            +In your life cash and credit /They are very different things / But your credit’s someone else’s cash / Once it leaves your name….

            “Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself”, Sheila Bair
            (OK, that’s not actually true).
            http://www.youtube.com/watch?v=37eqoYbj1QM

            • Thx beo

              Tay Zonday sings the ultimate test of paradigm’ness

              Plus he’s down on the importance of accounting

              Good stuff

        • It is a very good question.

          I think part of the problem is that a loan doesn’t necessarily have to be a loan “of something”.

          It’s better if you think of the making of a loan as being a particular type of exchange. Imagine that I gave you my car in exchange for an undertaking by you to return my car to me at some future point. I think we would all say that this is a loan of my car.

          Alternatively, your undertaking could merely be to return to me any car meeting certain criteria. Now you might call this a loan or you might not. It’s not obviously a loan of my car any more, but it is a sort of car loan. This is in fact the way that stock lending tends to work. (As an aside, I have found that people with a legal background from countries with Napoleonic code legal systems have more difficulty seeing this type of arrangement as a loan, than those from countries with English civil law systems).

          When a bank makes a loan, future obligations are exchanged both ways. The borrower delivers his IOU and the bank delivers its IOU. The difference of course is that the bank’s IOU can be easily transferred and is generally accepted as payment and therefore constitutes money. But it would be wrong to think that money had been lent in the same sense as my car had, because the money in question did not exist before the loan. In my view, I don’t think anything is being lent in that sense.

          And of course, none of this has anything to do with reserves.

          • PK, have you seen Steve Randy Waldman’s post about this:
            http://www.interfluidity.com/v2/3402.html What is a bank loan?

            “Because in fact, the seller would not accept my debt in exchange for the goods and services she supplies. If I wrote her a promise to perform for her some service of equal value in the future (which might include surrendering crisp dollar bills), she would not accept that promise as a means of payment. I circumvent her fear by writing to the bank precisely the promise that the vendor would not accept and having the bank “wrap” my promise beneath its own. The bank’s job is not to “lend” anything in any meaningful sense. The bank is just a bunch of assholes with spreadsheets, it has nothing real that anyone wants to borrow. The bank’s role is to transform questionable promises into sound promises. It is a kind of adapter of promises, or alternatively, a guarantor. [*]”

          • that’s excellent, Nick

            • Let’s imagine a system where the currency is gold coins, in which banks hold gold coins as their reserves.

              In this scenario, when a bank makes a loan, it creates a deposit. In other words the borrower gets a credit in his account at the bank. So “loans create deposits” in this system. No gold coins are physically placed into the borrower’s account, so in this sense the bank does not “lend out” its reserves. The coins stay in the bank’s vault, and the borrower receives a credit on the bank’s books. The borrower can then use this credit, or deposit, to pay for things without ever having to touch any gold coins.

              However, if the borrower decides to withdraw the amount he has borrowed, the bank will have to provide him with gold coins. And if the borrower immediately withdraws the gold coins once the loan has been granted, then we can say that the bank has in fact “lent out” its reserves.

              Now in this scenario it’s perfectly possible that the bank doesn’t even have any gold coins in its vault when it makes the loan and creates the deposit. So if the borrower asks to withdraw the coins, the bank might have to go and borrow coins from someone else, probably another bank.

              Nonetheless, it is clear that what is being lent here is gold coins. The deposit is simply a promise made by the bank to pay gold coins on demand. So the bank can create deposits put of thin air if it wants to, but those deposits are always promises to pay gold coins on demand. Even if the gold coins are never withdrawn and stay in the bank’s vault, and even if the bank doesn’t have any gold coins in its vault when it makes a loan and creates a deposit, what is being lent in each circumstance is gold coins. The deposit is simply a claim on gold coins.

              Now the only real difference between this scenario and the current system is that in the current system the currency is not limited in potential supply. The central bank can create an infinite quantity of it, if it wants to. It can supply any quantity at a given interest rate. This means that banks are not ‘reserve constrained’, in the sense that they can always borrow currency at a given interest rate. In this system “loans create deposits”, but a deposit is simply a promise made by a bank to pay currency on demand, either physical currency or electronic currency (reserve balances).

              • PK, I’d say the bank was lending a “promise” (aka money) not lending a gold coin if the vast vast bulk of transactions never involved any gold changing hands. I got the impression that (just as you describe) banking under gold standard times was broadly the same as it is today.

              • Non-banks can’t ask their banks to deliver reserves, so I think the better counterpart for your gold coins would be $ bills. So, if you think that what is going on in your example is that gold coins are being lent, I think you would say that in the current system $ bills are being lent even though, as you appreciate, $ bills are not transferred and the bank doesn’t even need to hold them to make the loan.

                One important difference between a bank loan and any other loan is what happens to the lender’s balance sheet. With a non-bank loan, the lender starts with an asset (monetary or otherwise), and in the making of the loan exchanges that asset for a different asset, being the rights against the borrower (ignoring accounting issues about whether de-recognition is appropriate). With a bank loan there does not need to be an asset to start with. When the bank debits its loan ledger, it can do so by crediting a liability (the deposit account), rather than having to credit another asset.

                Now, we could have a system whereby lending always involved reserve transfers. For example, we could imagine that borrowers were prohibited by regulation from holding accounts with their lending banks, so that loans always had to involve transfer to another bank. If all such transfers were then on real time gross settlement, then every loan would indeed involve the lender exchanging one asset (reserves) for another (rights against the borrower).

                In that scenario, I think there is a sense in which banks could be said to be lending reserves. However, there is a common understanding that when A lends something to B, that means that B has use of it for the period of the loan and not A. That perception may or may not right, but the problem is that if you say that banks lend reserves, many people think that implies that bank is giving the borrower use of some reserves for the period of the loan. That is not what is happening. The reserves are only used for settlement.
                If I lend you my car, you have use of my car and I don’t. Even if you lend it on to someone else, only one person can ever have use of it at one time. Stock-lending means that the total of all long positions in the stock can exceed the amount of stock in issue, but only one person receives the real dividend and gets to exercise the voting rights. There are no rights or benefits attaching to reserves that could accrue to a borrower during the term of loan that might suggest that the borrower has use of the reserves in that period.

                The problem with saying that banks lend reserves is that it suggests that the lender is faced with a choice of using the reserves itself or lending them out. This is clearly wrong. Banks need reserves to settle the loan payments; they don’t need them to support their outstanding loans. If a bank wanted to make some new loans, it would never have to consider calling some existing loans in order to get back the reserves to do so. The reserve function is as a flow, not a stock.

                • Excellent again, Nick.

                  If sometime you have a month to blow, you might be interested in working out an analogous interpretation for the position of central banks in a multi-central bank system feeding into a super-central bank, e.g. the TARGET2 system, which I thrashed around here:

                  http://monetaryrealism.com/target2-window-on-eurozone-risk/

                  • At least a month, I’d expect.

                  • “Non-banks can’t ask their banks to deliver reserves”

                    They can ask their bank to deliver reserves to someone else on their behalf. For example, you can instruct your bank to pay the Treasury with reserve balances on your behalf.

                    Reserve balances are basically currency in electronic form. Although only certain institutions can have electronic currency accounts (reserve accounts at the central bank), non-banks can still have access to electronic currency indirectly.

                    “I’d say the bank was lending a “promise”

                    The bank is making a promise; specifically it is going into debt to the depositor. I’m not sure it is “lending a promise” though. The underlying asset in the transaction is not the promise itself but the thing that the bank promises.

                    “With a bank loan there does not need to be an asset to start with.”

                    That’s not entirely true. You can’t start a bank with no money. You need a lot of capital, and liquid assets. A bank charter, access to the central bank, and FDIC insurance are other assets that provide a guarantee that the bank’s promises can be fulfilled. Plus banks do normally have some reserves (both currency and central bank deposits), as well as cash-equivalent assets like T-bills, so it’s not really true that they lend without having an asset to start with (even though they might not have the amount being lent sitting in reserves at the time a loan is made).

                    A bank deposit is basically a loan from the depositor to the bank. So essentially what’s happening when “loans create deposits”, is that the bank is lending money to the depositor, and the depositor is lending the money back to the bank. There’s no real magic in this. For example, imagine you lend some money to a friend, and he immediately lends it right back to you at a lower rate of interest. No money needs to change hands, you don’t even need any money in the first place, so long as the two loans initially cancel each other out. All you need to do is write “you owe me x, and I owe you x” on a piece of paper. In this case “loans create deposits”. Non-banks can do this too.

                    • Re whether a bank needs assets to start. I completely agree that as a business and practical matter, banks need assets first. I was simply trying to isolate the issue of what is being lent.

                      I also agree with what you say in your last paragraph. This type of arrangement can certainly be implemented between non-banks, although it has more limited use as non-bank IOUs are not as generally acceptable as payment for other things. What makes it much more prevalent with banks is that the bank IOU is effectively money, so although the arrangement is circular to begin with, that circle can easily be broken. But yes, there’s nothing special about banks that enables them to create debts without pre-existing assets.

                    • The Steve Randy Waldman post that ‘stone’ links to is very unrealistic. He’s describing an imaginary pure credit economy, not the monopoly currency system we actually have. He fails to mention the fact that behind the commercial banks stands the central bank, which issues the currency in which their debts are denominated.

                      In reality the only bank which is near to being just ” a bunch of guys with spreadsheets” is the central bank. Waldman’s assertion that commercial banks have “nothing real that anyone wants to borrow” is really quite ridiculous.

        • Is “what do they lend” the right question? W don’t want to confuse accounting entries with money thing as Chris Cook has observed. A loan (entry on the asset side) creates a deposit (entry on the liability side). The deposit as a bank liability is a promise to settle on demand for a demand account.

          No money thing is yet involved and none may be if netting is involved in settlement.

          The money thing is not the banks to create. It has to obtain the money thing if required for settlement, either rb as the settlement vehicle in the payments system for drafts on a demand account or cash demanded at the window (which the bank gets by exchanging rb).

        • you guys are all out of paradigm. this is why you cannot understand economists and why economists cannot understand you.

          according to SS and PK and every economic model banks lend out deposits.

          why do SS and PK think bank lend out deposit? It is not because model says so explicitly. Nobody sat down and asked themselves “what do bank really lend out, let us put that in model”. No. They have layman understand and write model about something completely diffierent and implement bank lending as driven by deposit or reserve or whatever they beleive. So this is not explicit element where you can discuss elasticity. This is implicit in constructed frame.

          I have never seen anyone successfully coaxed out of implicit frame their professional livelihood, respect, and identity are built on but maybe if Cullen is sufficiently enthusiastic with his servicing, PK might, in a moment of weakness, open himself to Cullens feverish pillow talk. I sound negative, but I really honestly wish this is what will happen.

          Diamond-Dybvig says bank borrow short and lend long. It is the lend out deposit. It is wrong and Austrian but it is common knowledge and built into paper. Note that model assume lending mechanism and then SHOW how it create bank run.

          Tobin-Brainard is exact same thing. Lenders put deposit in bank, which act as intermediary, and loan out deposit to borrower. Read paper.

          The reason Mosler & MMT phrase it as “loans create deposit” is because it is explicitly opposite to DD/TB/layman model where “deposit fund loan”.

          Cullen — you had prof ears and you failed to make a difference.

          • Cullen Roche says:

            You’re not actually contributing anything. So what’s the point of a comment like this? Why don’t you and the other MMT people who read this site cut it with the unproductive nonsense. There’s really no point. Your battle isn’t with MR stop instigating stuff here. Thanks.

            • Cullen — if you cannot see contribution it is your problem, not mine.

              you state your goal is to change economist mind. fine. you try with the bearded one. great. you fail — ok, let us see where and learn what we can.

              Look at actual form of dismissal (and it was dismissal, not rejection). he cite paper paper paper model model model. In particular Diamond-Dybvig (pdf) and Tobin-Brainard. At structural level this gives you first clue by MMT gain no traction and it is because it is outside cannon of models used and does not directly address models. You cannot gain traction by referral to reality, you can only get traction by referral to model if your goal is to change mind. If your goal is to change field then you need to change all reference model in a Night of Long Knives.

              Next, look at dismissal from content perspective. Do you know Diamond-Dybvig is favorite model of Austrians because to them it shows inherent instability in banks and maturity mismatch in general? What does it tell you that academic economists and austrians, who shun each other, on topic of banking pick same model as touchstone?

              Now look at the wonderful Tobin-Brainard paper. You know why it was written? It tells you why very nicely: “Do shadow-banks, which do not have reserve requirement or interest rate ceiling, mean that monetary policy does not work?” Does this question even make sense? Look at what the existence of this very question assume must be true. And again, paper nicely tells you right away: it is exactly the same as Diamond-Dynvig model.

              But if you actually look at DD, it takes what banks do–what is meant by financial intermediary–as given and just model liquidity. So that means that DD itself is merely symptom, the core incorrect assumption is deeper but now I am bore. I also suspect that no such foundational paper exist. This live as folk wisdom.

              When JKH say “deposit fund loan” he mean something very different from when Krugman say “deposit fund loan”. It is mark of pedant to fixate on mere words what people say and not also think about what people mean by those words. So, when JKH say “deposit fund loan” he ir right, but when krugman say it he is wrong wrong wrong.

              So cullen, you try and attract fly but you become a fly yourself, buzzing around. Krugman dismiss you easily by reciting list of models that everyone knows are true — even though they are not. And if you still are buzzing, he will say “well there is no real difference, we’ve already thought of and incorporated all this stuff” and continue on his merry ways.

              Let us see if unlike fly you can learn and take better strategy in future.

              • Zanon,

                Tut, tut,

                As they say arrogance and ignorance go hand in hand.

                Tobin knew long back that loans make deposits (see my link above) – it is there in the title itself. The Brainard-Tobin paper describes a different function of the bank – to accommodate portfolio preferences of the non-bank sector.

                Tobin was also the discoverer of stock-flow consistency and had a supreme knowledge of how the monetary system works. Some of his approach was however neoclassical – such as marginal productivity theory.

                • Please read Tobin paper you link to beyond just the title. Again, JKH and Krugman can say same words and one will be right and other will be wrong.

                  Tobin paper opens by talking in sarcastic terms and dreadful state of academic understanding of money (383-384) (Cullen can now tell him how can be more influential) but all of this is setup to typical maturity-mismatch/Austrian style model (“Nature of Financial Intermediary”) but his twist is that monetary policy work by impacting real rate of return (“criterion of effective monetary control”).

                  This is intellectual underpinning which give you NGDP targetting as viable strategy which is nonsense.

                  So yes, Tobin poo poo state of Macro in this area, but he does not poo poo what is “intermediary”, he poo poo proposed mechanism of monetary policy and substitute a different one which is equally wrong.

                  • Ha – that Holier Than Thou attitude again.

                    Instead of merely asserting, find out about Tobin’s work.

                    Anyway you are simply taking some phrases out and making fun of it for no good reason.

                    Go and read the Tobin paper I quote – it clearly shows how loans create deposits!

                    “This is intellectual underpinning which give you NGDP targetting as viable strategy which is nonsense.”

                    Random non-sense.

                  • “intermediary”,

                    In national accounts the word intermediary is used because the main thing in the sequence of accounts is production.

                    Silly objection of the use of the word “intermediary”.

                    “but his twist is that monetary policy work by impacting real rate of return ”

                    Yes it does! Any reason why you object to that?

                    • Not silly. Pivotal. Please actually read what you accuse others of not reading. I have no problem with word, I have problem with meaning. Let us look at concepts in Tobin’s own words:

                      “…intermediation permits borrowers who wish to expand their investments in real assets to be accommodated at lower rates and easier terms than if they had to borrow directly from the lenders.”

                      Term “intermediary” conceptualizes bank entity as playing coordination role in between two agents: lender and borrower. In this concept, Tobin has bank as market maker between agent with different portfolio preference. Bank itself is not seen as lending agent (which shows how wrong concept is), it is “intermediary”.

                      Just to make sure everyone is clear on what he is saying he says:

                      “Without reserve requirements, expansion of credit and deposits by the commercial banking system would be limited by the availability of assets at yields sufficient to compensate banks for the costs of attracting and holding the corresponding deposits.”

                      Do you now see why he fundamental does not understand system? So OK, maybe he gets “loan create deposit” but he does not understand what implications are. So conceptually, he is really no better than those he began by mocking. It could just as easily be “deposit fund loan” in Krugman sense.

                      A nice end cap from Tobin — the very next line:

                      “In a regime of reserve requirements, the limit which they impose normally cuts the expansion short of this competitive equilibrium. When reserve requirements and deposit interest rate ceilings are effective, the marginal yield of bank loans and investments exceeds the marginal cost of deposits to the banking system. In these circumstances, additional reserves make it possible and profitable for banks to acquire additional earning assets.”

                      So he think reserves constrain on lending. He does not understand primary action of bank is credit decision. He does not understand how bank lending is capital constrain. He believe that additional reserve enable increase bank lending. In short, I cannot see any difference between Tobin and someone who thinks “deposits fund loans” because everything is just so conceptually wrong and backwards.

                    • You are adamant about the use of intermediaries to suit your purposes.

                      In national accounts the central thing is production activity and hence banks are intermediaries.

                      Silly adamance on the use of the phrase “intermediaries” in your comments.

                      “Do you now see why he fundamental does not understand system?”

                      You randomly pick some statements and are trying to prove you are Holier Than Thou. There is a specific historic context to all this.

                      A bank of course is limited in lending if it cannot attract deposits. The cost of deposits matters. Try opening a bank – why would anyone lend you at market rates. You need credibility in the markets. So of course for a single bank, there is a theoretical maximum. Even borrowing from the central bank is limited by the amount of collateral a bank can provide.

                      Around the time it was thought that interest ceilings would limit the amount of lending by banks. It took experiments by the Federal Reserve to see that this is not the case.

                      Plus – in the next page Tobin does say a bank can borrow reserves from the central bank and hence is not constrained by reserves and also that the textbook description is misleading.

                      Do you have any writing by MMTers in the 1970s? Were they born with an understanding of money?

                      If you are simply interested in “loans create deposits #enufsaid”, good luck!

                      Anyway better attitude here http://bilbo.economicoutlook.net/blog/?p=9574

                    • Again, I have no problem with word “intermediary”, I have problem with how Tobin use it because he use it to mean “coordinate between two agent — borrower and lender” which is misleading description of what bank do.

                      This is core conceptual confuse that mainstream economist run into. Whine and cry at me all you like, Paul Krugman still dismiss MR and you still buy into his frame by not pinning him to this point.

                      Tobin think bank match borrower and lender. They do not. Bank is own lending agent. Even when Tobin say bank can borrow reserve from central bank he say that in context of funding, not enabling, deposit. He say the marginal cost of reserve set marginal cost of loan.

                      “This cost [of reserve from Fed or other bank] the bank must compare with available yields on loans and investments.”

                      It is now up to you to do reading comprehension. You should also understand what economist mean by model, and what they look at. If an economist, in model, is looking at wrong margin, then either model is wrong, or interpretation is wrong, or whole thing is nonsense.

                      What would be good for you to think this is see how someone who understand how loan create deposit and horizontal balance sheet expansion can still get the whole thing wrong. You know why? Wrong paradigm. Why is paradigm wrong? Because it has bank as just lending enabler instead of lending agent. You know why economist not include banking sector in model? Because bank is not agent, it is just enabler which intermediates — intermediary. And then you have paul krugman say “for every borrower there is lender so at macro level the whole thing is a wash”, and then you have money being ignored entirely, because it does not matter and you get “money illusion”. Scott Sumner named his blog that for a reason because in his models there is no money and you do not need it.

                      Tobin paper was excellent. It clarify one element of what is wrong in thinking.

                    • zanon,

                      PK and Tobin are different personalities.

                      Apart from creating money via the lending process, one important function of a bank is to mediate the non-bank sector’s portfolio choice and it is closely connected to Tobin’s asset allocation model. Even PKEists use Tobin’s asset allocation model.

                      So there is another reason to use the phrase intermediary. I know the phrase intermediary is misleading in some sense because it sort of places banks at the same level as other lenders but there are good reasons for the phrase.

                      So two reasons – from a production viewpoint they are intermediaries and from a portfolio allocation viewpoint another.

                      This role of banks is majorly missed in the blogosphere and no wonder you take issue with it because it comes across as something foreign (and hence out of paradigm for you).

                      Now, this point is important in discussions which involve looking at the economy as a whole and Krugman confuses Tobin’s own work.

                      It is crystal clear that Tobin knows loans create deposits, so please get this out of paradigm nonsense out. There are more interesting things but if you are not open minded, you won’t see what is happening.

                    • Good comment Zanon, and I agree I think.

                      I say I think because I agree that all those things you say about banks not being simple intermediaries are true. They are indisputably true as far as I’ve learned from people like Mosler, Roche, JKH, Winterspeak, Ramanan etc etc and I agree that people like Krugman seem to talk as if banks do behave that way. Clearly monetarists are confused about banking and lending and they appear absolutely hopeless. I agree also that it appears form the statements you quoted that Tobin is more Krugmanesque than Mosleric. On a scale with Krugman 1 and Mosler 10 Tobin looks to be at best 2.5 or 3

                      One side comment about Sumner and his ilk. The more I hear him argue for loose money, NGDP targeting, unusual Fed policy and the sort the more I suspect that he is ready for the Fed to simply “promise” (and really really really mean it this time!!!) to just hyperinflate. Buy everything out there for whatever price it takes to hit the NGDP target. If they are ready to pay 1 mil for a previously 150,000$ house or 50,000$ for a bag of rocks whatever, he is simply ready to have our money transactions mean nothing to everyone . He thinks they already mean nothing as we are just living in a barter world anyway but he just wants everyone to share his illusion. He should never ever ever scream Zimbabwe or Weimar as they are examples of places that got it right. They finally unshackled themselves form their encumbering currency and just got down to what really mattered

                    • Ramanan,

                      PK and Tobin are different personalities but they are working in same intellectual tradition. Krugman cite Tobin-Brainard–my conflation is not emotinoal excite. It is description of who academic economics work. Paper build off paper. All that is new must be seen through lens of all that has gone before.

                      And also please read what Tobin say about asset allocation instead of reading what you want to beleive. To Tobin, asset allocation is decision for some people to borrow, and other people to deposit money:

                      “…the essential function of financial intermediaries, including commercial banks, is to satisfy simultaneously the portfolio preferences of two types of individuals or firms. On one side are borrowers, who wish to expland their holdings of real assets… On the other side are lenders who wish to hold part or all of their net worth in assets of stable money value with negligible risk of default.”

                      So his use of “intermediary” in asset allocation is exactly the same as his use for “intermediary” when talking about matching lenders and borrowers. For Tobin, an decision to lend or borrow is asset allocation decision. So this is not two different uses of word “intermediary” — it is one, and it is the same one Tobin always uses, and it is what Krugman etc. use, and it is conceptually wrong. Holding this concept in mind blocks ability to understand PK/MMT concept.

                      I am OK with having saving/borrowing decision to be consider asset allocation. I am also OK with having bank play role in this. I am not OK with having role described as “intermediary” in that bank is in middle (“inter”) busy coordinating (“mediating”) between the two sides. Because this is not reality.

                      So yes, we all agree that Tobin knows loans create deposits. But we also all can see that he does not know that banks are lending agents, how reservers work, how bank lending is capital constrained, and what margin to look at when considering credit expansion, or frankly anything else about financial system. So he has knowledge in one piece of puzzle, but completely misses what that implies for everything else and so continues to say wrong thing. You don’t like the word “paradigm” then fine — choose another word for this huge mess of interconnected assumptions and implications which keeps getting the wrong answer and blocks understanding of right answer.

                    • zanon,

                      When Moore wrote the book Horizontalists and Verticalists in 1988, there were a lot of questions left unanswered. Charles Goodhart wrote a paper “Has Moore become too Horizontalist” or something like that.

                      A lot of untied pieces of Moore can actually be answered using Tobin’s ideas. It is a supreme piece of work.

                      James Tobin – although placed in neoclassical economics – had a great knowledge of how economies work more or less. Now in the quotes you quote Tobin is worried about other things than loans creating deposits itself.

                      Morever, there is a function of the banking system which fits with his theory of asset allocation but you simply wouldn’t care because you seem to be interested in sloganism.

                      “I am not OK with having role described as “intermediary” in that bank is in middle (“inter”) busy coordinating (“mediating”) between the two sides. ”

                      Because while they are making loans they also do this mediating part. Which is different from the mediating role you have in mind. You have to look at the asset allocation theory to understand this. You won’t find it in the blogosphere.

                      To repeat again, it is also standard terminology in SNA because from a production viewpoint also, banks are intermediares.

                      “how bank lending is capital constrained”

                      Btw, this is misleading actually! It is certainly true in credit crunch scenarios but at a macro level, it is far from being a constraint in some sense of the word constraint. Again this is too complicated for discussion here as it is a digression.

                      “But we also all can see that he does not know that banks are lending agents,”

                      General torturing with words.

                      Anyway, you won’t change your mind. I was presenting a case for looking at Tobin with his ideas of asset allocation theory in mind – one of the most wonderful things in monetary economics. It fits perfectly well with money endogeneity.

                      Krugman is an idiot I agree.

                    • You may be interested in a more balanced view by Nathan Tankus here:

                      http://www.nakedcapitalism.com/2013/08/james-tobin-versus-paul-krugman.html

                    • well, you now send me to link which says 1963 Tobin is wrong, so I will take that as admission of defeat, as that was my whole point.

                      “Intermediary” and “asset allocation” may have dozens of definition, but Tobin was very clear about what he mean in that paper and what he mean is wrong.

                      More importantly, and this is where you should pay attention instead of becoming hysterical, is that he is wrong in way which illuminates why Krugman and buddies dismiss MMT/PK in so easy manner now.

                      So, according to your link, Tobin himself change mind. Great. But Paul refer to 1963 Tobin so that is where field’s head is at. You need to attack assumption built in 1963 Tobin and I show you where it is.

                      I am sure Tobin is wonderful and smart man. Anyone who writes an opening as sarcastic I have soft spot. I would love to learn more about the asset allocation theory you mean. But his bank model, in 1963, is still wrong, and that seem to remain functional model today.

                    • zanon,

                      “well, you now send me to link which says 1963 Tobin is wrong, so I will take that as admission of defeat, as that was my whole point”

                      No – just pointing to a more balanced view and some respect on the part of Tankus. Not necessarily agreeing to all that Tankus says.

                      “I would love to learn more about the asset allocation theory you mean. But his bank model, in 1963, is still wrong, and that seem to remain functional model today.”

                      Yes please go and read! The 1963 paper is one part of his ideas on looking at the whole economy from a stock-flow consistent viewpoint.

                    • Zanon, you are misrepresenting Tobin in the paper Ramanan linked to. For one thing Tobin is right that banking leads to lower lending rates than if no banking existed, so you disagree with this?

                      Tobin explicitly states that the idea that “the practical banker who is so sure that he ‘lends only the money depositors entrust to him'” is a “naive fallacy of composition”.

                      He also gives an example of banks making loans as loan agents.

                      “The banking system can expand its assets either (a) by purchasing ,or lending against, existing assets; or (b) by lending to finance new private investment in inventories or capital goods, or buing government securities financiing new public deficits”.

                      As far as reserves go, he goes on for several paragraphs talking about how bank lending is not reserve constrained. In the section you quoted he is making the different and correct point that required reserves are a constraint on lending because they are a cost to the bank.

                      I’m curious to know what you think the reason is that banks take in any deposits?

                    • I will spend time with both Tobin paper, thank you. Can you please highlight which concept in particular you like so much. Terms like “asset allocation” are used in multiple ways so if you can guide me I would be oblige.

                      AH, please I do not misrepresent Tobin. I highlight what he actually say very clear, not what people want him to say. I use quote that are very fair and representative. if you say I misrepresent you need to actually find proof not just assert. You will find none.

                      Whether or not banking leads to lower rates is besides point. Question is not whether rate is too low or too high, question is whether rate is right for risk. But I reject the entire frame because it puts banking as a “facilitator” matching “borrowers” and “lenders” and reducing “frictional cost” along the way. Entire model is bogus and is like loanable funds concept.

                      So it is good Tobin realize that bank can act as loan agent. It is bad he does not realize that people who want to park money in checking account are not would-be investors.

                      His section on reserves is laughable. I agree with 1980s Tobin that 1960s Tobin got this wrong and have moved on. Please join us.

                      I think bank take on deposit for all of the excellent reason JKH and others are written about many times. Also, when JKH say “deposit fund loan” he is correct, but when most other people say it they are wrong because they mean something different with those word

  5. I’m of the impression that the majority of confusion surrounding “lending reserves” is a by-product of a poor understanding of accounting standards and specifically double-entry bookkeeping. To Krugman and others, deposits on the liability side of a bank’s balance sheet and reserves on the asset side are one and the same. Viewed on a micro scale, a loan made to a non-deposit customer sees reserves exit the bank, ergo the bank has lent out its reserves. If this transaction was preceded by a client making a deposit that sees the bank receive reserves it further validates the line of thinking that deposits create loans. The technical book-keeping aspect appear not to matter to those without a background in accounting. Someone like Krugman likely did a bachelor’s, master’s and Phd in economics and never went through an accounting course the entire trip. Conversely a business student exposed to economics will have a much easier time understanding the nuances of this argument because they’ve gone through the T-Account, balanced 3 separate accounting statements, connected the transaction dots and generally understand that every transaction has a corresponding offsetting transaction. However, these offsets are not always booked to the same ledger account and ultimately that matters.

    I believe you’ve actually tackled this related topic before JKH, but I also wrote about it on my blog about the use of the nomenclature of “funding” a loan. To those who don’t view the financial world form the perspective of a balance sheet the whole discussion looks very different than for those who do – http://dismalecon.blogspot.ca/2013/06/if-loans-create-deposits-why-do-banks.html

    • That’s an excellent post – very clearly written.

      What you’re describing there is how banks conduct active asset-liability management, beyond the “loans create deposits” phase.

      As you noted, it was what I was getting at, in part, with this post:

      http://monetaryrealism.com/loans-create-deposits-in-context/

      The other part of it is that even without the ALM fine tuning of liquidity and interest rate risk, banks compete for funding right at the outset of the “loans create deposits” phase.

      “Loans create deposits” creates instantaneous liquidity risk in a competitive system, in that the deposit may leave the bank as soon as it is created.

      So the bank may need new funding of some type to balance its balance sheet wrt to the loan that was just created.

      And it pursues ALM techniques on an ongoing basis because of this type of risk.

  6. I have been seeking more detailed clarification on what banks “can do” with reserves, particularly with respect to money market operations and broader types of securities. This line of questioning is separate from “why” or “how a bank would decide” to do any of these transactions. I’d just like to know if the mechanics are possible.

    So I know reserves can be used for the following:

    1) Lending to other banks in the interbank funds market
    2) Swapping them for banknotes/cash with the Fed
    3) Settling payments for fed funds loans
    4) Settling payments between banks due to customer activity
    5) Swapping them for govt securities with the Fed
    [6) Meeting reserve requirements]

    But building off of (5), can reserves be used to purchase securities from private sector entities? I think you said “yes” in this post, but I’d like to confirm. For example, can a bank purchase a govt bond from another private sector entity *using* its reserves, in a transaction such as the following:

    Purchasing Bank: Reserves (-), Govt bond (+).
    Private Sector Entity: Govt Bond (-), Deposits (+).
    Private Sector Entity’s Bank: Reserves (+). Deposits (+). (recognizing purchasing bank could be same as entity’s bank)

    And for that matter, could that type of transaction with the private sector apply more broadly to any type of money market instrument?

    Theoretically, could that type of transaction also apply to a broader range of private sector debt and equity instruments (e.g., corporate stocks and bonds)? If so, I’d imagine the riskier the assets get, the more that risk assessment and capital allocation decisions would have to come into play. It doesn’t seem that banks do this.

    I’m going to throw out another hypothetical. Say a bank raises funds, such that: Bank Assets: Cash (+). Bank Equity: (+). Say the bank wants to build a new branch with that cash. Could the cash be deposited at the Fed, to acquire reserves (Bank Assets: Cash (-), Reserves (+)), and then spent on building construction (Bank Assets: Reserves (-), Building (+))? If so, this seems like an odd use of reserves, something not typically discussed. If not, how do banks make these types of transactions? Do they keep their cash as vault cash? When they spend it, do they transfer it in Brinks trucks to the customer’s bank (assuming it’s a different bank)?

    • “Can reserves be used to purchase securities from private sector entities?”

      Not directly.

      If the purchasing bank is different than the seller’s bank, the purchasing bank pays the seller by cheque, or instructs a credit to the seller’s bank account. Reserves are then used to pay the seller’s bank but not the seller.

      Banks allocate capital to all risks as they are identified and measured.

      Your final example:

      Banks wouldn’t raise equity capital and be paid in the form of banknotes, which is what you seem to be exploring. Typically the reserve account will increase in respect of most of the equity issue, which will be bought by customers of the other banks. The reserve account increases when the bank issuing the equity gets paid with cheques and clears those cheques back to the buyers’ banks for payment through their reserve accounts. The reserve manager would push those reserves out into the rest of the system by acquiring money market assets. As funds are required for construction outlays, the reserve manager would start liquidating those assets to attract reserves and the bank would write a cheque for the construction outlays and the construction company’s bank would clear that check back to first bank whose reserve account would be debited.

      Something like that, as an example.

      • Thanks.

        “If the purchasing bank is different than the seller’s bank, the purchasing bank pays the seller by cheque, or instructs a credit to the seller’s bank account. Reserves are then used to pay the seller’s bank but not the seller.”

        I believe my book-keeping entries capture this. I suppose you say “not directly” because the seller does not receive “reserves,” but ultimately, the only way the seller gets money in his deposit account is if his bank receives reserves from the purchasing bank.

        Another way of looking at it, even though it’s not done this way, theoretically the purchasing bank could hand the seller cash. That doesn’t violate any laws of accounting. In that hypothetical, the bank would be using a form of base money to acquire the security quite directly (but don’t worry, I’m doing any monetarism here).

        • (In any case, I’m not trying to get into a debate with you on ‘directly’ vs ‘indirectly.’ Unimportant. In this instance, this seems mostly to be an issue of semantics.)

        • Your bookkeeping is fine.

          Just clarifying who’s paying whom with what.

          • And you’re correct, as usual.

            Planning on writing a more interesting response here, to explore the paragraph Krugman wrote that starts with “Now, think about what happens when the Fed makes an open-market purchase of securities from banks…” If Krugman wants to prove he understands the “nature of the adjustment” being discussed, that paragraph needs to seriously be unpacked.

  7. JKH, re:”lending of reserves” or “money market liquidity management” …
    Out of curiosity, what kinds of “investments” would bank treasurers use for short-term, and which are a better deal than Fed Funds? Typically, secured lending (i.e. repo) which has no capital charge, trades at rates below Fed Funds, so from strictly a financial perspective there doesn’t seem to be an incentive to “lend reserves”.

    Also, “The parabolic increase in excess reserves under QE is a byproduct of interest rate targeting of a wider scale.”. Bang on. Monetarists seemed to forget that during the GFC, new aspects appeared: e.g.
    (1) emergency regulation: TALF, emergency federal guarantee on money markets, deposits etc., FX swaps
    (2) emergency securities lending
    And these were interesting because: (1) excess reserves was a natural *outcome* and a “accounting entry” not a “hot potato” phenomena. (2) or had *nothing* to do with base money. It was all about private liability management with public liability.

    • I think its very tough to generalize on this because its extremely organization dependent – but things like treasury bills, short term bonds, bankers’ acceptances, high grade commercial paper, repos, etc. That would be the starting point anyway.

  8. So how do the new excess reserves affect the Feds ability to control the Fed Funds rate when they decide to tighten?

    It seems to me that the actual level of reserves, excess or required, is irrelevant. Theoretically, the Fed can always buy and sell just the right amount of bonds in open market operations to hit the rate it wants. The level of reserves is just a residual left over from previous interventions. The interest on reserves does matter to banks, but only in the case when IOR is greater than the federal funds rate will it affect the ability of the Fed to hit its target. When IOR is below the federal funds rate ALL reserves in the system act like a tax on banks, which is why banks work hard to keep them at a minimum. But this is not central to the actual practice of open market operations.(Doesn’t the bank of Canada work with a zero reserve requirement.)

    Is this right?

    • In writing this post, it was reinforced on me how difficult it is to tackle the kinds of issues raised by Krugman’s view of things, because of the huge difference between pre-2008 and QE monetary conditions. Most of the post is written to pre-2008 specs, because Krugman’s arguments coincide with that assumption. Back then, there was no interest on reserves – or more precisely, IOR was 0 per cent, which was far away from the fed funds target most of the time. So the excess reserve level was critical to the trading rate for fed funds. That’s what is meant in referring to interest rate inelasticity of the demand for reserves. It was a matter of trial and error to find the right amount of excess reserves so that supply and demand for funds by the banks ended up pricing actual fed funds at the target rate.

      QE with non-zero IOR is completely different. Apart from technical glitches, there’s no reason for the fed funds trading rate to be substantially different than the IOR rate. And that will be the case when the Fed wants to increase the target rate. And that will be the case until the Fed eventually (presumably or maybe) exits the QE condition entirely and goes back to the previous IOR = 0 setting. (Steve Waldman doesn’t think they’ll ever do that. He may be right, although that’s what they’ve expressed as their intention in Fed minutes.)

      BTW, when the Fed sells the “right amount of bonds”, that translates to a specific excess reserve level on a pre-2008 basis. Those two things are the same. But under QE conditions, they wouldn’t need to sell anything to get rates up. They’ll just hike IOR.

      • ” exits the QE condition entirely and goes back to the previous IOR = 0 setting.”

        Oh I thought they are thinking about moving to a corridor system (instead of the floor system) where IOR still exists – something like NZ, Australia, UK, Canada …

        • so still non-zero IOR?

          maybe that’s correct; not sure

          still QE exit though, right?

          does that mean they’ll have minimal XR but be sloppy about it?

          • yeah QE exit via letting bonds expire and not rolling over and continuing to pay interest on reserves while still in the floor system (and raising interest on reserves for interest rate hikes) and when the level of reserves goes back to pre 2008 type of levels, move to a corridor system. That seems to be the direction as of now once “taper” starts to happen – if it happens.

            • also remove reserve requirements from 10% to 0% – here:

              Footnote 9:
              http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm#fn9

              “The authority to pay interest on reserves is likely to be an important component of the future operating framework for monetary policy. For example, one approach is for the Federal Reserve to bracket its target for the federal funds rate with the discount rate above and the interest rate on excess reserves below. Under this so-called corridor system, the ability of banks to borrow at the discount rate would tend to limit upward spikes in the federal funds rate, and the ability of banks to earn interest at the excess reserves rate would tend to contain downward movements. Other approaches are also possible. Given the very high level of reserve balances currently in the banking system, the Federal Reserve has ample time to consider the best long-run framework for policy implementation. The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system”

        • But even now open market operations are effective right?

          Say the Fed wanted to raised the feds fund rate above the IOR rate, couldn’t they just do open market operations like before? And if so why raise IOR to tighen instead of just the federal funds rate?

          There is an interesting trade-off between the two. Raising IOR is basically giving the banks subsidy to lend at a certain rate, but open market operations to raise rates would also probably lead to losses on the Feds portfolio.

          • “Raising IOR is basically giving the banks subsidy to lend at a certain rate, but open market operations to raise rates would also probably lead to losses on the Feds portfolio.”

            I don’t know if the Fed will ever raise rates, not without some rather dramatic and unlikely economic reforms first. Look at the trendline of 30 year mortgage rates over, well, the past 30 years.
            http://research.stlouisfed.org/fredgraph.png?g=lDb
            [update: replaced with latest 30 yr chart, added U3 rate and set it to begin with Paul Volcker choking out the US economy in the octagon.]

            A point that Mike has made that explains an awful lot is that we are on a real estate based monetary system. Lower interests mean more expensive real estate since families budget how much they can spend on a monthly mortgage payment and then find out how much house that will buy. The patron saint of mortgage brokers, as everybody knows, is Karl Marx (quoted here by Michael Hudson).
            “The forming of a fictitious capital is called capitalising. Every periodically repeated income is capitalised by calculating it on the average rate of interest, as an income which would be realised by a capital at this rate of interest.” Thus, Marx concluded: “If the rate of interest falls from 5% to 2½%, then the same security [paying 50 pounds and hitherto worth a 1000 pounds] will represent a capital of 2000 pounds sterling. Its value is always but its capitalised income, that is, its income calculated on a fictitious capital of so many pounds sterling at the prevailing rate of interest.”

            Look at that 30 year mortgage chart again, the increased real estate values created by the lower interest rates has been THE driver of household net wealth and consumer spending and retirement planning for three decades . We’re at the zero bound, interest rates aren’t going any lower and I’m skeptical rates can go up very much without tanking the already crippled real estate market.

            • I’ve wondered whether the 1980 onwards phenomenon of using falling interest rates to raise asset prices has also had a massive impact on global distribution of wealth and income. The asset price inflation concocted via the secular drop in long term interest rates attracted in capital flows from the developing world to the developed world. That ensured that the developed world could purchase all of the global supply of commodities and manufactured goods.
              http://directeconomicdemocracy.wordpress.com/2013/05/09/isnt-a-financialized-economy-the-goose-that-lays-our-golden-eggs/

            • “Look at that 30 year mortgage chart again, the increased real estate values created by the lower interest rates has been THE driver of household net wealth and consumer spending and retirement planning for three decades.”

              Agree totally.

              That’s why I’ve always been puzzled by Mosler’s claim that the reverse doesn’t work – i.e. that the deficit expansion effect of higher rates on the debt dominates the effect you describe (in reverse).

              I think it’s very clear that tightening interest rates has a net effect just as easing has had the effect you describe. But WM stirs the pot with natural gas deregulation in the 80’s as the paradigm determinant.

              Also agree that there is a “new normal” with respect to the size of the ABSOLUTE rate increase that will bite next time around – because of the change in the relatives.

              It’s going to be very difficult.

              Which is also why deficits and debt could arguably be Japan-like, given the lower absolute dollar risk to nominal interest rate cost on the debt.

          • By selling off their holdings of bonds, would the Fed even be capable of reducing the excess reserves enough to induce a positive real interest rate without IOR ? As they sold off the long term securities, the price they got for them would drop. So they would fail to gather back enough of the monetary base. They could sell off all of their securities and still be left with the situation where the banks still had excess reserves and so still be left with the situation where, without IOR, the short term rate was zero.
            In a big sell off to try and reverse QE, the fed could potentially only receive say $60 for a security that it bought for $120 during QE. The whole point of QE was to elevate the price/reduce the yield of long term assets after-all.
            Would reverse repos be able to create positive rates without IOR in a way that simply selling off the fed’s holdings of securities couldn’t?

            • They’ll need to pay IOR at least as long as reserves are in super-excess.

              They also have a term deposit facility now, which they’ve tested with dealers.

              That may end up being useful as a choice over selling bonds right away, if they’re inclined to sell bonds. Term deposits lock in both the rate and the liquidity of excess reserves – if they’re concerned about either of those things. That avoids or defers marked to market losses on bonds sales. They’ll have more flexibility on the timing of bond sales, other things equal. The accounting for bonds still on the books remains accrual, which results in better optics on Fed profits compared to sudden M to M losses on bond sales.

          • “Say the Fed wanted to raised the feds fund rate above the IOR rate, couldn’t they just do open market operations like before? And if so why raise IOR to tighten instead of just the federal funds rate?”

            That won’t work. They can’t do that unless they completely drain the entire $ 1.8 trillion in excess reserves back to pre-2008 levels, which was about $ 2 billion.

            Otherwise, actual fed funds would trade down to the previous/current IOR rate, notwithstanding any announcement to the contrary.

            I.e. there would be no announcement of a higher funds target unless IOR was increased in conjunction with that, so long as super-excess reserves are outstanding.

            So excess reserves will force the actual trading rate down to IOR, regardless of any higher announced fed funds target.

            • So what would happen if Fed did a bunch of reverse Q.E. right now, say sold off a bunch of T-bills? The T-bill rate would go up but the Feds fund rate would stay the same? This seems unlikely to me but I haven’t got my head around the specifics yet.

              • To be honest, I don’t pay a lot of attention to the T-bill, funds rate, LIBOR rate spread stuff. I know it’s important and interesting for what it says about risk, and that it’s important to traders, but I just don’t follow it closely these days. Just as I don’t pay a lot of attention to 25 bp IOR, fed funds, bill spreads at the zero lower bound.

                But if the Fed sold bills to drain reserves, it would probably affect some of those spreads, presumably in the direction you would expect – i.e. relative marginal upward pressure on bill rates. But I don’t see this as big deal in terms of the important trends for Fed interest rate policy.

                The important point here is that if the Fed wants a higher target funds rate, and it still has material excess reserves in the system, it has to increase IOR in order to achieve that higher target funds rate.

                If the Fed did have enough treasury bills to drain nearly all excess reserves (it doesn’t), then excess reserves would be drained and the Fed could achieve a higher target funds rate without necessarily increasing IOR or even setting IOR at zero. In that hypothetical, treasury bills rates would move up on trend with a higher target funds rate (through arbitrage) but the bill/funds rate spread would probably move around a fair bit, the way it sometimes did in pre-2008.

                • So the will the fed be doing open market operations going forward?

                  “If the Fed did have enough treasury bills to drain nearly all excess reserves (it doesn’t),”

                  The Fed could just issue its own bonds, though this would probably require legislative changes. This happens in lots of developing countries that have shallow government bond markets. For example, central bank bills have made up the majority of government bonds in China over the past decade.

                  • They don’t have enough bills; they do have enough bonds.

                    And to your good point on liability management, they do now have the capability of issuing term deposits, which they’ve tested in trial runs, and which could assist with the exit strategy over time.

                  • A H,

                    They can use reverse repos and the Fed also has the power to offer time deposits. Also it can ask the Treasury to issue bills to drain reserves.

                    Actually during the GFC, the Treasury was selling more bonds than it needed to help the Fed drain reserves created by the huge rescue operations of the Fed

  9. JKH, I commend you (and the other MMR guys here) for continuing to engage in this debate/discussion with Krugman/mainstream economists. Every now and then, even those of them who finally seem to get it, still get lost, and go back to their confused understanding. I guess it all boils down to environment. If you’re an academic economist who’s always surrounded by like minded and like experienced economists, and have never spent even a few months working in an actual bank, it’s easy to slide back to previous errors. It takes practitioners who care enough to take the discussion back to reality. One day, maybe given enough cases of real world validation, all economists will adopt this reality based view of banking and money creation.

    • thx

      Intriguing that Krugman has done a few posts where he opines that the blogosphere has had a very constructive influence on the development of academic economics – in the sense that poor academic work (in his view) gets called out.

      He tends to exclude himself from those that are exposed in this way, but that’s human nature I guess.

      Still, interesting use of leverage on his part.

  10. beowulf

    Look at that 30 year mortgage chart again, the increased real estate values created by the lower interest rates has been THE driver of household net wealth and consumer spending and retirement planning for three decades .

    Also agree on this, at least as far as the UK goes, and I’d expect the US. Real estate value plays a crucial role in my UK macro model.(http://monetaryreflections.blogspot.co.uk/2013/08/macro-model-update_20.html)

  11. PK
    The Steve Randy Waldman post that ‘stone’ links to is very unrealistic. He’s describing an imaginary pure credit economy, not the monopoly currency system we actually have. He fails to mention the fact that behind the commercial banks stands the central bank, which issues the currency in which their debts are denominated.
    In reality the only bank which is near to being just ” a bunch of guys with spreadsheets” is the central bank. Waldman’s assertion that commercial banks have “nothing real that anyone wants to borrow” is really quite ridiculous.

    PK, my impression is that you might be misunderstanding what SRW is meaning. Don’t you agree that very little in the way of bank reserves (or dollar bills) need be used when loans are made and that money is used. Isn’t that much of the “magic” of banking?

  12. Greg:

    I agree with you. I think zanon is actually right on this point, and I think I might write a post on it.

    I’ve said it before and I’ll say it again, fiscal policy is the last refuge of the monetarist. If the Fed buys your time for $1M per second, how is that not, effectively, fiscal policy?

    • Cullen Roche says:

      Hey WS,

      I’ve already engaged Sumner and the MM guys on this point. I accused Sumner of being a fiscalist which he really loved!

      They’ll tell you you’re wrong and that the Fed doesn’t even need to print anything. That they just need to be firm in their commitment to set expectations. The old Chuck Norris thing. I always say that’s wrong. As Bruce Lee said, “saying is not enough, you must do”. The MM guys don’t know that Chuck Norris got his ass kicked and his chest hair ripped out (literally) by Bruce Lee way back in the day.

      :-)

      • Well it comes down to the debate you were having with JP Koning. In certain contexts, the Chuck Norris effect does work well – e.g., when the Fed announces a new FFR target, it is often argued that it usually doesn’t really need to “do anything” to move the FFR other than say “the new FFR is x%.” That works because the underlying architecture of the reserve system makes it clear that the Fed has ultimate control over the FFR, so it’s commitment is credible to the market, and the market does the work for the Fed. MM’ers implicitly think some underlying mechanism exists for NGDPT, so it’s reasonable for them to invoke “Chuck Norris” to some extent. I personally still don’t understand what that mechanism is, and I found your debate with JP Koning to be very interesting (maybe the most productive conversation between two people on somewhat opposite sides of the NGDPT coin). I too agree that perhaps bags of dirt may work, but I also agree that’s better classified as ‘fiscal policy’ and not a lever that would be conventionally viewed as available to the Central Bank. JP mentioned some other stuff, but I haven’t looked into it.

        • Cullen Roche says:

          I don’t totally agree with that view though. The power is in the doing in my view. The Fed has the only gun in the room, but if the Fed’s hostages know they won’t use it then it’s not a real weapon. The power is still in doing. Even with interest rates the Fed still has the SOMA desk to some of the dirty work. Every once in a while you have to shoot a bond trader in the knee and remind everyone else who has the gun. The power of the gun is not only in having the gun, but proving that you will use it. If the Fed just said it wanted 5% NGDP and then did nothing does anyone really think NGDP would just go there? Well, yeah, Scott Sumner thinks that, but I think Scott Sumner is living in lala land.

          • Chuck Norris vs Bruce Lee (think Cullen linked it on Twitter -that’s how I found it. )

            http://www.youtube.com/watch?v=FUfuZJI9LK4

          • You’re saying that if the Fed does actually have to act with any frequency to back up it’s credibility, then we classify the power as “ultimately in the doing.” That makes sense to me, but I see that more as a semantic argument over what the term “ultimate” means.

            I’m just saying I’m okay with using the concept of “Chuck Norris” if, say, 90% of the time the Fed doesn’t have to do anything. It illustrates that the Fed’s commitments are credible 90% of the time without it having to do anything.

            Maybe Sumner really believes, with respect to NGDPT, that the Fed would have to act (doing whatever he thinks it can do to back up its commitment) literally 0% of the time. Really? I’d imagine there’s gotta be some percent of the time he’d think they’d have to act in reality. .01%? .05%? .1%?

            Anyways, the more interesting debate is ultimately over what the Fed would have to do in those instances.

  13. “Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks’ portfolio — they’re holding fewer securities and more reserves — and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits. That’s all that I mean when I say that the banks lend out the newly created reserves; you may consider this shorthand way of describing the process misleading, but I at least am not confused about the nature of the adjustment.”

    What exactly is Krugman trying to say here?

    • In the context of my post, he is saying that the mechanism for bank balance sheet expansion is the response of the money market operation to Fed open market operations.

      As described in the post, that is not correct, at least as the core explanation.

      What he describes is typically a temporary liquidity management response. The opposite direction response (as occurs in in Fed withdrawal of excess reserves) can have the opposite effect. So in that sense these effects can cancel out over time as the Fed tries to provide the right level of reserves in either direction to target the prevailing funds rate over time.

      The driver of balance sheet expansion is the activity of those areas of the bank that use capital to take risk, not the activity of the liquidity management area, which doesn’t use much capital. Required reserves are added later in respect of the deposits created by this balance sheet expansion. But the expansion does not depend on excess reserves added earlier on occasion.

      • Is balance sheet expansion the right word here? If the QE buys assets from non bank entities, when these entites use the proceeds to make deposits it will expand a banks balance sheet right? or maybe I don’t understand the term.

        What it won’t effect is the amount of loans a bank makes, because the marginal effect of new deposits on a banks risk calculus of a new deposit goes down the higher the level of deposits, and under QE the level of deposits is very high.

        • Most of my post refers to pre-2008 monetary conditions, including the point being made above. That is also the implied context of Krugman’s post and his point made above.

          Your point on QE is quite correct but separate. The “proceeds” from QE are deposits and reserves.

          A commercial bank quite separately from that can make a loan and create a deposit. But under QE conditions of $ 1.8 trillion in excess reserves, it is very unlikely that Krugman’s example of marginal reserve injection through OMO will be applicable.

          • “The “proceeds” from QE are deposits and reserves.”

            Along those same lines, is this what happens when I deposit $100,000 in currency into a commercial bank (A)?

            Assets A: $100,000 in currency
            Liabilities A: $100,000 in demand deposits (DD) [also my asset]

            Next, A swaps the $100,000 in currency for $100,000 in central bank reserves at the central bank.

            Assets A: $100,000 in central bank reserves
            Liabilities A: $100,000 in DD [also my asset]

    • Fed Up,

      I think Krugman confuses portfolio rebalance happening at the non-bank level and assumes some portfolio rebalance at the bank level.

    • Let’s assume J P Morgan (JPM) is both my bank and a primary dealer.

      The fed buys a bond from JPM. JPM buys a bond from me.

      1) That is what Krugman is describing, right?

      2) I can’t be sure, but I think Krugman would not correctly describe the process of JPM buying the bond from me. Thoughts?

  14. “Next, bank customers decide when they want to exchange bank deposits for banknotes.”

    By banknote, do you mean currency? If so, I think you should use currency. It is too easy for people to confuse bank deposit with banknote.

  15. Is Krugman trying to say a bank receives $100 in commercial bank deposits, it then holds $10 of commercial bank deposits in “reserve” and sends them to the fed, and it now has $90 of commercial bank deposits to “lend”.

  16. SqueekyWheel says:

    JKH
    A cheque that is deposited gets credited to the depositors account before the depositor’s bank’s reserve account is credited

    For what it’s worth, in Singapore for cheques the order is: 1) debit payer’s account, 2) debit payer’s bank’s account with settlement firm, 3) credit payee’s bank’s account with settlement firm, 4) credit payee’s account, 5) progressively net banks’ accounts, 6) send net accounts at settlement firm to gross settlement system which does settlement of reserve accounts at the central bank. Items 1-4 are atomic (all or nothing) – so they are logically simultaneous hence why 5 can come after.

    I believe in the US that the Fed is involved in cheque clearing & settlement (I don’t know the details). In Singapore a subsidiary of one of the major banks does cheque clearing and settlement (I know the details) and sends the daily net to the gross settlement system.

    • thanks – although I don’t understand

      what happens when you present a cheque in a Singapore bank branch for deposit to your account?

      do you not get credit for that right away?

      if so, how is that not the first element in the process by which value is transferred from the writer of the cheque to the depositor of the cheque?

      • SqueekyWheel says:

        A moment of background – I’m a software guy, so I’m speaking from how /when the software actually makes adjustments to the digital account records. If I say ‘technically’ I mean that it the software sense, not the accounting sense.

        “do you not get credit for that right away?”

        No, you don’t get credit right away. You get credit in one to three days after the cheque clears and settles. Something I missed earlier, though the credit is unavailable, it begins collecting interest on the day it is presented.

        In my ordering I make a distinction between ‘payment request messages’ and adjusting balances in accounts. Technically there is a major difference. To make the writing easier – let’s assume you present the cheque to Citibank Singapore (C for credit) written by me against DBS (D for debit). The cheque is converted to a payment request message (ISO20022) which is sent to the low-value clearing/settlement system (ACH) – there are two cut off times per day. After the cut off, in batch, the ACH sends a debit request to DBS with relevant fields (account number, amount, etc). Assuming all is in order, DBS debits my (payer’s) account and credits the internal DBS account. DBS then replies to ACH that the payment is authorized (note: in the cheque system no news is good news and the success message is assumed while in the electronic payment system the success message should be explicitly presented). Again assuming a positive message, before the next cut-off window (again, everything done in batch mode), ACH will adjust DBS’s net position and Citibank’s net position. Citibank can then credit your account – typically done the next day. For cheques the final net positions are sent twice a day to the gross settlement system at the central bank for settling of reserves. The banks typically have until the end of the day to fund their reserve position to cover settlement (so yes, reserve management is explicitly *after* lending/payment/transfer/etc)

        So two notes – 1) from a software perspective we can distinguish between modifying a balance and the messages indicated the request/intention to modify a balance. This is a huge deal to making everything actually work, but mostly irrelevant to the accounting as long as it does work. 2) the messages allow the adjustments to be done ‘atomically’ – either both balances are adjusted or both are returned to their original values (I’ll skip how that happens; it’s needlessly geeky). Thus from a logical perspective, we could think of the adjustments to the balances, the accounting, as happening simultaneously – there is no state of the world in which one balance is changed and the other isn’t. This is good as it conforms to the intention of double-entry accounting.

        That’s a long winded way of saying that JKH’s article is correct all the way down to the code that implements the system.

        • Thanks.

          Payment systems are complicated and precise.

          Important in managing inter-bank credit risk.

          “No, you don’t get credit right away. You get credit in one to three days after the cheque clears and settles.”

          Does that mean you can’t present a cheque and get currency in exchange right away? You have to come back to the bank later?

          • SqueekyWheel says:

            “Important in managing inter-bank credit risk.”

            Yes. There are a couple of things in the clearing/settlement that explicitly deal with the possibility of a bank failing in the middle of this process, though I don’t recall the details.

            “Does that mean you can’t present a cheque and get currency in exchange right away? You have to come back to the bank later?”

            Yes (unless the cheque is from the same bank). Assuming all goes well, currency should be available by the end of the next day.

            I’ll note that cheque volumes are decreasing in Singapore. Purely electronic payments are growing rapidly. Singapore is very interested in getting real time (<1min) low-value payment systems. Once that happens it should be possible to present a payment and take currency roughly immediately.

            • Very interesting on Singapore, thanks.

              If economists in general had been better schooled in the distinction between the operational guts of payments systems and the financial balance sheets of commercial banks, and how those two things connect, they might have grasped the idea more quickly that banks don’t lend reserves to their non-bank customers.

              • SqueekyWheel says:

                One of the most interesting things (to me) about Singapore banking is that there is no interest rate policy – interest rates are endogenous. Instead the central bank manages the exchange rate.

                For me (probably as a software geek) the whole issue of loans create deposits and the non-lending of reserves clicked when I thought about how I’d build a bank. The first thing is that all accounts will exist as database records. Then it’s easy to have loans create deposits – simple database update. The most obvious way to do interbank exchange is to transfer funds between accounts at some 3rd trusted bank – the central bank. Under this model (which is the real model minus the regulations), a bank can only lend to its own customers. Since I’m not a customer of the central bank, I can’t get fed funds loans. duh. Another way of looking at this is that every bank has it’s own ‘currency’. For practical reasons, and due to deposit insurance, commercial banks and the Fed can maintain a 1:1 peg of their various ‘currencies’. Cyprus was a good indication of this – for a brief period Cypriot bank euros were different than German bank euros.

                As for the Bitcoin question I’ve thought and written about that a fair bit (pun intended). Bitcoin is a clever solution to the “double spending problem”. The problem roughly is that for any payment system, there must be a way to validate that all payments are legit and not replayed. This is normally handled by a trusted party (central bank, commercial bank, paypal, telco, etc). The problem Satoshi solved was how to deal with the double spending problem with no single trusted entity. If you *are* a trusted entity – a central bank – Bitcoin is needlessly inefficient, you can just flip the database bits. One possible use of Bitcoin (or other ‘crypto-currency'; Ripple is cool) would be to do interbank payments without a central bank. No single bank would be able to subvert the system. This could make sense in a region with no functional government or for payments between banks in antagonistic countries.

                Overall I think Bitcoin is a fascinating experiment with a lot of brilliant features. All future crypto-currencies will draw heavily from it.

            • I’ve been thinking that it would be possible for a central bank to implement a crytpo-currency system like bitcoin in order to handle interbank payments. The system is fast, and would be secure enough if it was run by the central authorties. The CB could control reserves by changing the payouts on mining. Miners could charge to verify transactions in order to keep an incentive for miners.

              It would also be funny to Bit Coin bugs heads explode when a hated central bank made use of their favoirte currency.

              • That’s pretty creative.

                What do you think of bitcoin generally?

                • Bitcoin is a clever secure transaction system, hiding behind a very silly monetary theory. The general trends in the Bitcoin economy are for more concentratoin in Bitcoin mining and exchanges, which means that they will also be regulated more heavily.

                  The main problem with a bitcoin monetary system is that if it is used as the unit of exchange, deposits would need to come before loans in any purely Bitcoin based banking system. And Bankers wouldn’t like this limitation, so there would be lots of disruption by “financial innovatoin” in any Bitcoin based system.

                  The thing is that the amount of “coins” created at anytime in a bitcoin like cryptocurrency system is completly arbitary. Bitcoin just happens to use an algoritm that creats bitcoins by giving a certain amount of new coins to miners. This isn’t essential to the system. I think the future for Bitcoin like systems will be those that focus on the essential secure transactions protocol, instead of trying to create a new monetary unit.

              • On Fedcoin.

                I like this post and your subsequent one, JKH. I find Krugman’s posts on this subject to be too short to properly decode, to the point that I feel he’s trying to hide his lack of understanding about the subject behind terse prose. It would be nice if he wrote something long form like yours so we could actually grasp exactly what he is saying.

                • Thanks.

                  I actually had my first ever post on ISLM in the works before this latest flurry on money came up. And the motivation was Krugman again. And I thought exactly the same thing in that case as you’ve pointed out here.

                  He’s done enough incremental reverse engineering of ISLM (or at least revealed his interpretation of it as if it were a process of reverse engineering) that I think it would be a good idea and helpful to all interested in it if he were to publish something more complete on it in one place.

                  • Yes, maybe bloggers should from time to time recapitulate their last year or two’s worth of thinking in a long-form pdf. A super-blog post. In the interim, we can always trust Krugman to write short imprecise posts that get the blogosphere in a tizzy.