Ed Harrison and Endogenous Money

Oilfield Trash makes a good observation about how close Ed Harrison is to MR.

“Interesting post from Edward Harrison, seem like he would make a good addition to the MR team.”

We are friends with Edward over here at MR, and many of our views overlap. His most recent post on Endogenous Money and Fully Reserved Banking is excellent.

 ”One way some economists believe we can stop this kind of crisis from happening is to move to a fully reserved banking system.  In such a system, the full amount of liabilities are held in reserve as cash or highly liquid assets. The benefit of this kind of system is that it limits the number of banks that can fail from a lack of liquidity. Now clearly banks in a fully-reserved system could still fail because banks could still grant credit to enough borrowers that defaulted to cause a huge hole to open up in the bank’s balance sheet and precipitate a bank run. But, the thinking here is that bank runs would be more limited in nature since other banks would be fully reserved. The need for a lender of last resort would be diminished if banks were not at as great a risk of failure due to liquidity crises.”

I don’t know if I agree with the bank run part, but banks can certainly go bankrupt under a 100% reserve system. A bank run implies depositors might not be able to get their deposits out of the bank, which causes the mad dash to be first in line to withdraw money.

Under a 100% reserve system, no matter how much the banks loses on it’s portfolio of loans, the money is available to re-pay depositors. It’s just all of the banks equity is wiped out, and can even go into negative territory. Negative equity for a bank under 100% reserves is entirely possible, and is the sign of an insolvent bank.

It’s as though the deposits are in a lock box, and the bank makes up an equivalent amount of new money to lend out to borrowers. The bank can  make profits and losses on the newly created money, but can’t touch that money in the lock box. All the risk is on the bank shareholders, and none on the depositors.

Of course, this all depends on the legal setup allowed by the feds who charter these banks, but this is the way I envision 100% reserve banks working. Depositors get risk free deposits, banks compete on offering high rates for deposits and low rates for loans and collateral quality. Borrowers search for the best deals on their collateral.

This of course relies on having massive amounts of money/risk free collateral created by the feds through some program.

Comments
  • Ashwin November 15, 2012 at 8:13 am

    The way I look at the 100% reserve and similar ideas is that you can completely separate out the depository and lending components of the current banking system.

    Here’s my preferred idea:
    1. Provide a public deposit option where depositors can put money in a safe account where all the deposits are simply invested in T-bills. Essentially, this replicates the old Postal Savings system which died thanks to deposit insurance. Given the expected significant demand for this, Treasury should align their funding program to shorter duration T-bills to meet this demand. This is the depository component.

    2. Central bank provides an open access repo window where any “lending institution” with the requisite capital can submit eligible collateral for cash. This is pretty similar to the way the ECB already operates. Obviously, lending institutions can raise uninsured debt and originate loans that are not eligible collateral but this is nothing different from what many credit funds do anyway.

    • Michael Sankowski November 17, 2012 at 8:14 am

      Agreed on the separation of deposits and lending – it seems to me like they become completely unrelated under certain structures of 100% reserve banking.

  • Edward Harrison November 16, 2012 at 8:21 am

    Thanks for the comments, Mike.

    I want to address this comment here:

    “Under a 100% reserve system, no matter how much the banks loses on it’s portfolio of loans, the money is available to re-pay depositors. It’s just all of the banks equity is wiped out, and can even go into negative territory. Negative equity for a bank under 100% reserves is entirely possible, and is the sign of an insolvent bank.”

    On bank runs and susceptibility to them, there is ALWAYS the susceptibility to a bank run irrespective of whether a bank has deposits that are 100% backed by reserves.

    The essence of a bank run is that depositors fear that they will not be able to get their money back for whatever reason. In today’s system of fractional reserves, if enough people believe this and start to pull deposits, then the bank has to sell good and liquid assets to meet deposits. This is ALSO true in a fully reserved system. The run creates a self-fulfilling prophesy because the assets DECLINE in value as they are sold to meet deposit withdrawals. When they decline in value, capital is impaired and when capital is impaired, the bank becomes more risky and even more susceptible to a run – hence the self fulfilling nature of a bank run.

    NOTHING about fully reserving a banks deposits negates these effects. Full reserving only diminishes the effect in the same way deposit insurance does, by guaranteeing the depositor she will get her money.

    Moreover, bank runs occur at the nadir of a business cycle when malinvestment is all around and credit writedowns are proceeding at a heavy clip. In that environment, it is much easier for any institution, whether fully-reserved or not to fall short of capital and trigger an outflow of deposits – an outflow that could require selling assets and yet more writedowns.

    If a bank sells assets into a panic/bank run, other liquid assets of the same type on the bank’s balance sheet will decline in value to reflect the firesale price of the asset sold to pay for deposit withdrawals. BY DEFINITION that means the bank is no longer fully reserved and must sell other assets on its balance sheet to become fully reserved. The mere fact that the bank has to be fully reserved dictates that a firesale/panic in liquid assets will indeed create contagion into other asset classes because the bank must sell these other assets to maintain its reserves.

    Bottom line: There is no way around the lender of last resort to stop panics and bank runs. 100% reserves is a form of OVER-regulation that is designed to give confidence to depositors. Fully reserving does NOT fully remove the spectre of liquidity-induced bank failure from a bank run. Bank runs can still happen. And banks can still fail under a fully reserved system. In fact, the fully reserved nature of the system guarantees contagion if a panic in liquid assets were to occur.

    • JKH November 16, 2012 at 9:21 am

      The inherent assumption in a 100 per cent reserve system is that the reserve itself is a risk free asset – in terms of liquidity, interest rate, credit, foreign exchange and any other risks. This is the case for example with a system that is mandated to hold 100 per cent central bank reserve balances against reservable deposits. So there shouldn’t be any reason for a run from those deposits, if the depositor rationally understands the regulatory mandate for reserves against those deposits. There is no deposit risk under such a mandate. There is no need to sell assets to meet those deposit liabilities. It’s as if the reserve/reservable deposit section of the balance sheet is a separate, risk-free bank, entirely insulated from the rest of the bank.

      Where there IS an issue is in the case of non-deposit funding that supplements equity funding. There CAN be a run from that kind of funding to the degree it can be liquidated. And THOSE non-deposit funding agents can be subject to the bank’s solvency risk and risk of non-repayment of their funds because of that. That’s why they won’t renew their funding, which amounts to a “run”.

      In any event, all bank losses will end up being the account of the equity investors and the non-deposit funders. But the depositors will be protected at all times, according to the definition of the deposit base that is 100 per cent reservable with risk free reserves.

      The reserves and the deposits are effectively “ring-fenced” and in this sense, risk free.

      I’ll be posting something longer on this stuff in the context of the Chicago Plan and other things sometime in the next few weeks.

      BTW, very interesting post on endogenous money, Ed.

      Coincidentally, I’ll have quite a bit to say on that subject in my post.

      • Edward Harrison November 16, 2012 at 9:27 am

        That’s the assumption but I think that assumption is not valid because it assumes a level of risk-free assets that are neither available for the banking system nor wanted by banks because of their low return.

        As we saw during the last panic, what institutional investors including banks do in a low rate environment is load up on risk-free AA substitutes that enhance return for apparently little risk. That’s what investments in SPain over Germany were about in the euro zone for example. This is also why Chinese sovereign wealth funds invested in agency paper and were apoplectic when those companies failed and the possibility of default was real.

        What I believe would happen is that there would be a lot of “risk-free” paper with enhanced yield that banks would use as cash substitutes. This paper will be found to not be a good substitute for Treasuries or cash and the panic will cause their price to decline at the worst possible time.

        The alternative, of course, is to do the same in the non-cash portion of the bank asset portfolio as you have suggested and that is also likely.

        • JKH November 16, 2012 at 9:37 am

          Availability isn’t an issue. The CB just injects them by lending to the banks.

          The banks not wanting them is not an issue. They’re mandated – it’s a cost of doing business. And the CB can rate-adjust both the reserves and the loan to cover those costs at its option and allow competition.

          Mostly importantly, there’s no internal capital allocation for reserves – which means no ROE is required. Banks just need to recover operating costs, which the CB can accommodate as per above.

          Also, if all that doesn’t cover costs, the banks adjust their margins on loans funded by non-deposit funding.

          • Edward Harrison November 16, 2012 at 9:46 am

            The CB only supplies reserves in the form of deposits held at the CB. Most ideas of fully reserving do not just involve deposits held at the central bank but also involve holding “cash-like” instruments as “equivalent to” reserves. The devil being in the details, lobbyists will want to expand the definition of reserves to include these instruments.

            Moreover, a shift from fractional reserves to fully reserved involves a decline in ROE and ROA irrespective of whatever ring fencing you can do. In my view, the whole topic is moot because it won’t happen but it is clear to me that banks would never see it as a “no ROE is required” situation. Banks want to earn return on all their assets deployed as they have shareholders to satisfy.

            Lastly, another problem with full reserves is that it gives a distinct ROE advantage to banks that do not fund themselves through deposits and therefore makes the banking system more fragile as non-deposit funding was a crucial component of the last crisis. What any bank like JP Morgan Chase would do is move to a more wholesale or non-deposit funding scheme in order to boost returns by increasing their ROA given a specific capital base.

            • Edward Harrison November 16, 2012 at 9:48 am

              See here from Wikipedia on what people think of as fully resrved because I believe this is accurate:

              “Full-reserve banking, also known as 100% reserve banking, is a banking practice in which the full amount of each depositor’s funds are kept in reserve, as cash or other highly liquid assets. In other words, funds deposited are not lent out by the bank if the depositor has the legal right to immediately withdraw their funds.”

              http://en.wikipedia.org/wiki/Full-reserve_banking

              • Michael Sankowski November 17, 2012 at 8:18 am

                Yes, my assumption was similar to JKH’s on the quality of the reserves: 100% risk free in every way, which means some form of CB issued reserves. If other forms of reserves are used, the possibility of a bank run still exists – and I am not sure there is any benefit to having a 100% reserve system in that case.

                Gorton has a 100% reserve structure in one of his plans, I think.

              • Michael Sankowski November 17, 2012 at 8:23 am

                for some reason, 100% reserves remind me of this.

            • JKH November 16, 2012 at 9:57 am

              The Chicago Plan is CB reserves only. And I view this entire subject as an extension of the type of reserve requirement that exists today in most systems – which is reserves in the form of CB liabilities – like the 10 per cent US requirement for demand deposits. There’s no non-CB liability permissible.

              All bets are off if you extend that into reserves where there is any form of risk.

              There’s no ROE requirement in respect of a function that doesn’t attract an internal capital allocation in bank capital management systems – its impossible when you think about it. The issue is one of cost recovery.

              To the degree that deposit funding adds to bank margins today, 100 per cent reserves will force up asset pricing in a 100 per cent reserve system – i.e. loan rates will be higher, other things equal.

              • Edward Harrison November 16, 2012 at 10:01 am

                We’re on the same page then.

                My comment on the Chicago Plan is that it has no realistic chance of being implemented for two simple reasons. First, banks don’t want it because it lowers return on assets and turns their core business into a boring and low-return model. Second, banks will certainly engage in regulatory arbitrage by trying to move offshore in some capacity or diminishing their reliance on US domestic deposits. I don’t see any way banks would take this kind of plan lying down.

                • JKH November 16, 2012 at 10:07 am

                  I failed to mention that the Chicago plan is pretty close to being silly in my view – I’m interested in it mostly for the analysis and its intersection with some other ideas.

                  • JKH November 16, 2012 at 10:12 am

                    And I’m not looking at the politics of it’s likelihood at all – just the mechanics of such a system if it were imposed as a requirement for a banking licence. Purely hypothetical. And I’ve found some problems with that IMF paper in that regard.

                    • Edward Harrison November 16, 2012 at 10:16 am

                      Yes, this is purely hypothetical. Look forward to your thoughts on the IMF paper.

                    • beowulf November 16, 2012 at 6:49 pm

                      The IMF paper puts a spin on the old Chicago Plan, loans would be funded primarily by the discount window (in that sense it jibes with Mosler’s idea of replacing the overnight market with the discount window). Beyond that, I too await JKH to take the plan apart to point out all the moving parts.

                    • Michael Sankowski November 17, 2012 at 11:16 am

                      The CI approach wins again. It’s such a good framework. Anything is possible, until you define the system, any discussion is nearly doomed.

                      that should be a good write up. I need to dive into that Gorton paper on banking too.

                • Michael Sankowski November 17, 2012 at 8:21 am

                  Oh yeah – there is a 0% chance of 100% reserves.

                  Banks will not support this at all.

                  • Oilfield Trash November 20, 2012 at 10:37 am

                    Michael

                    I gues the question for me is why should the FED (aka Banking system) be granted rights of seignorage, by allowing them the ability of creating the unit of account at negligible cost.

            • JKH November 16, 2012 at 10:01 am

              Also, ROE is far more important than ROA – particularly in a risk adjusted capital allocation system. Equity investors won’t care a whole lot if there’s some gigantic risk free tree house on top of the bank that’s actually taking the risk.

              ROA will decline, but who cares if half the A is risk free?

      • beowulf November 18, 2012 at 12:03 am
  • Ramanan November 17, 2012 at 1:01 am

    JKH,

    “I failed to mention that the Chicago plan is pretty close to being silly in my view – I’m interested in it mostly for the analysis and its intersection with some other ideas.”

    Good to know this.

    In my view suppose the government dictates banks to reach this position – it will take ages for the transition. (The paper seems like the view of some people in the IMF staff, not of the IMF itself so not likely to be implemented in any case).

    Anyway what do you think of the following (view of mine): The banking system stabilizes the debt market and this transmits into equities. That is they would be more volatile otherwise. (The flip side however is that if banks themselves are in trouble, the financial system is in more trouble than other kinds of busts of bubbles in financial markets). The Chicago plan may make the loan rates more volatile and this will transmit into more volatility in the broader financial markets. Right?

    “I’ll be posting something longer on this stuff in the context of the Chicago Plan and other things sometime in the next few weeks.”

    Look forward to it.

    • JKH November 17, 2012 at 7:49 am

      R.,

      “The banking system stabilizes the debt market and this transmits into equities”

      Interesting idea – fairly big idea – I’ll ponder that.

      BTW – I was away recently when I think you provided a couple of links to Sinn et al.

      Couldn’t find those later – could you re-provide?

      thx

      • Ramanan November 19, 2012 at 5:06 pm

        JKH,

        (Hoping you don’t miss this and the above comment):

        Plus more … this time from Karl Whelan:

        http://www.forbes.com/sites/karlwhelan/2012/11/19/all-you-wanted-to-know-about-target2-but-were-afraid-to-ask/

        and the paper referred there:

        http://www.karlwhelan.com/Papers/T2Paper.pdf

        • JKH November 20, 2012 at 5:46 am

          Thanks, Ramanan!

          Have only now just skimmed all papers above and they look like good updates to respective views (also your post) – will plunge in a bit later.

          Whelan seems to have stolen and modified Sinn’s idea for annual settlement, without attribution, and despite rejecting it a year ago.

          Buiter likes to play with PV of seigniorage.

          Whelan:

          “Constructive criticism is welcome (angry ranting less so.)”

          There’s a good reason why he’s experienced ranting in the past.
          :)

          • Ramanan November 20, 2012 at 11:19 am

            Yes the inclusion of annual settlement was strange – given he rejected it a year ago.

            I think Sinn has improved. Earlier his mistakes were used by others to prove that his whole thesis is wrong.

          • Ramanan November 21, 2012 at 8:47 pm

            JKH,

            By the way what is all this discussion about bank notes in the Forbes blog?

            I think Whelan thinks that if Germany ends up as the sole user of the Euro, then the cash notes issued previously is profitable to Germany. But this should be the exact opposite.

            If Germany becomes the sole user of the Euro, then the cash notes are actually an extra liability (when it didn’t have previously) and this deteriorates the German net asset position.

            It is not as if the cash notes will be continued to be held by foreigners. They will exchange it for interest bearing German assets and then it is an outflow of interest payment from Germany to ROW.

            So there is no advantage Germany gets.

            • JKH November 22, 2012 at 5:03 am

              Haven’t thought about this enough yet, but first take:

              Buiter seems to have taken this at least partly into account as follows:

              “Assume that the value of the Bundesbank’s right to base money issuance would be equal to one third or one half of the value of the current Eurosystem’s NPV of seigniorage profits (rather than its 27.1% current capital share in the ECB). This would imply that the single-member Eurosystem (Bundesbank’s/ECB) base money issuance would be larger relative to the size of the German economy than it is for the 17 member Eurosystem and the euro area economy today.”

              So this seems to this assume (implicitly) redemption of a good part of the outstanding float of Euro notes. That redemption would occur across the exiting countries – because those that hold Euros now and redeem/convert them will end up getting new currency in exchange. (I think it works out ultimately through the NCBs who would redeem Euro notes in exchange for monetary base in their own currency – presumably the new market rate rather than the exit conversion rate – but I don’t know.

              Then the new NCBs will send those Euro banknotes stuff back to the Bundesbank, which will redeem it for Euro deposits. Maybe those NCBs have new FX reserves as a result; not sure here.

              But I don’t think all this necessarily cause upheaval in German NIIP interest margins:

              I think it all comes out in the wash, and the Buiter/Whelan future seigniorage assumptions implicitly assume a large redemption of outstanding Euro notes – because they downsize the book to fit Germany’s position rather than today’s larger Eurozone position.

              And the loss exposure to Germany of “inheriting” the full Euro book is all taken into account in Buiter’s calculations in particular, so the loss of interest margin from the liquidation of a good part of the banknote portfolio must be taken into account as well – according to the downsizing assumption for the future seigniorage benefit.

              Assume that everybody but Germany exits the Euro, and that Bundesbank takes over the entire Euro denominated Eurosystem balance sheet. Before considering all of the loss exposure to the Bundesbank, those new assets and liabilities don’t change Germany’s NIIP. Then consider losses. For example, Buiter I think calculates a number of about 800 billion for Germany in that scenario. So that’s the number he works with in terms of considering how future seigniorage can make that up. He also assumes downsizing of the monetary base – which means foreign redemption of Euro banknotes in exchange, effectively, for some of the gross asset value held by the Bundesbank. Again, NIIP doesn’t change because of that (although it will change in part due to the losses that have to be taken). And the NIIP interest isn’t affected to the degree that those other assets and liabilities weren’t in the German NIIP pre-breakup. Then what’s left is sorted out.

              That’s incredibly rough but mildly intuitive to me at this stage – could be right or wrong in parts.

              Make any sense?

              • JKH November 22, 2012 at 5:11 am

                Or, cut to the chase, foreign Euro note holders swap them for interest bearing Euro claims now held by the Bundesbank – with no direct effect on NIIP and with the interest margin/seigniorage effect already taken into account by Buiter et al.

                (But losses will affect NIIP – writedowns of claims on other countries will reduce German NIIP, other things equal).

              • Ramanan November 22, 2012 at 5:51 am

                Whenever Buiter starts to NPV into the infinite future, I get a bit put off :)

                Let’s assume 16 of the 17 EA nations leave the Euro Area and Germany is left with the ECB.

                I guess till now I was talking of the TARGET2 claims. Now Buiter also talks of the SMP holdings of the Eurosystem and makes some “tit-for-tat” assumption.

                My question is that the ECB and the Bundesbank hold claims on other central banks and government bonds of some of the EA countries.

                But what do they owe the others? What is the “tit-for-tat”?

                (Guess something to do with cash notes)

                In addition, the ECB+Bundesbank will see an appearance of additional liabilities – which is the bank notes which were in the liabilities of the (other) 16 NCBs.

                Also some of these papers seem to assume that the cash notes is fixed by the central bank instead of assuming it is determined by the public – isn’t it?

                Basically I do not see any seigniorage benefit except for a brief period. Sooner or later the amount of Euro notes will be reduced to amounts already held by the German private sector.

                • JKH November 22, 2012 at 6:33 am

                  Germany has 700 billion or so in a TARGET2 asset claim and 200 billion in a banknote adjustment liability on which it pays interest to the Eurozone. So on that piece, the idea is that when the EZ defaults on Germany’s TARGET2, Germany defaults on its banknote interest. Net result is as if Germany’s net TARGET2 claim “all-in” is effectively 500, and the loss is calculated as that plus some other peripheral stuff.

                  Another 2-way piece is that Germany stops sharing Bundesbank profit with the rest of the system, and vice versa, but Germany in addition loses its loss sharing backstop with the rest of the system.

                  The additional banknote liabilities appear but as I said above I assume much of those will be redeemed by foreigners – in effect for offsetting Bundesbank assets.

                  The end result will be some carry forward note portfolio, after foreign redemptions, and which should be compared in size with Germany’s current 27 per cent formula share of Eurosystem structure. Buiter argues it will be somewhat higher than that due to international demand for Germany’s currency in the future. So there will be some redemption of the Eurozone legacy banknote portfolio, but not all the way down to a “normal” German level, because the new German Euro will become internationalized to some degree.

                  And all of that is the basis for what is really the issue for Buiter and Whelan, which is long term growth in the monetary base (mostly currency) and where that future growth in the base corresponds to future seigniorage profit that doesn’t currently exist, but that is projected and then transported back to the present through PV analysis – and then used to offset the transitional loss on that basis. You can account for that on either a PV basis or a future accrual basis – the fact is that the transitional loss is manifested in a shortfall of future interest revenue, and that’s how the accounting really works – not through PV.

                  • JKH November 22, 2012 at 6:35 am

                    That last sentence was also my point to Whelan.

                  • JKH November 22, 2012 at 6:57 am

                    P.S.

                    P.V. is – IN PART – a trader’s disease and in part an economists’ disease.

                    The world must eventually come to terms with accruals.

                    (which is the stuff of income at the macro level)
                    :)

                    • Greg November 22, 2012 at 8:08 am

                      “P.V. is – IN PART – a trader’s disease and in part an economists’ disease.

                      The world must eventually come to terms with accruals.”

                      Would like to see you expand on this a little more. Especially the part about accruals being the “stuff of income at macro level”

                    • Ramanan November 22, 2012 at 8:19 am

                      Yeah disease!

                      Good explanations, thanks.

                      Ok I get it now. I was missing that 200bn part. I guess I forgot how it works altogether and will go back and think about it before putting forward more questions if any.

                      There is some underplay element to Whelan’s approach given he has changed his views somewhat. He calculates interest and shows it is small like a few billion per year. But the loss is actually the big number such as 500bn (although I think it is higher since a panic will result in massive shift of funds into Germany). Just because someone holds $x in cash and is likely to hold at least that doesn’t mean one just calculates losses (if he loses $x of cash) by the interest accumulated in the future. The loss is $x not 0. For example central banks hold gold which doesn’t earn interest. If I were to believe him, gold disappearing is not a loss.

                    • JKH November 22, 2012 at 8:53 am

                      Ramanan,

                      Yeah, that’s right.

                      I think the substance of your point all along has been – in effect – that when Buiter and Whelan do their analyses of the future seigniorage effect, and when they come up with numbers that suggest the central bank doesn’t need to worry about having negative equity, they fail to make the more fundamental point – which is your point I think – that the CB and the country is worse off by the amount of the loss when comparing that outcome to the counterfactual where there is no such loss. In other words, by being clever about the offsetting benefit available from the future seigniorage power of the central bank, they are submerging the issue of what is clearly a bad outcome relative to the counterfactual. Another way of saying that – and looking at it – is that the future seigniorage value for the CB is a benefit that is/will be available WHATEVER the ex post outcome in terms of current losses. So its really poor logic to argue that losses “don’t matter” simply because they can be covered or “self-insured” by future seigniorage. It’s a survival argument but not a quality of life argument for the CB.

                    • JKH November 22, 2012 at 9:07 am

                      Greg,

                      Income at the macro level equals GDP output (closed economy for simplicity).

                      Asset value fluctuations are not DIRECTLY part of that – at the macro level.

                      E.g. capital gains are not income at the macro level – because capital gains do not map directly to new output, the way income does.

                      Regarding present value – the present value of income that is expected beyond the current period is not income in the current period.

                      Present informs asset values, but it does not inform current period income.

                    • JKH November 22, 2012 at 9:13 am

                      P.S.

                      “The world must eventually come to terms with accruals”

                      meaning you have to wait to see future income materialize before its actual income – i.e. the expected future income that in some cases may be discounted from the expected future back to the present in the form of present value

                      re: traders

                      e.g. traders like to try and concoct compensation schemes based on present valuing of future income (which is different than trading marked to market securities) – bad idea from a governance perspective, and no small contributor to financial crisis froth in the CDO machine

                    • Ramanan November 22, 2012 at 9:58 am

                      ” It’s a survival argument but not a quality of life argument for the CB.”

                      He he – nice line.

                      I will take some time to relook this “Claims related to the allocation of euro banknotes within the Eurosystem”

                      But I tend to think that two things not considered earlier – this one – positive for Germany and the appearance of new liabilities for Buba (which acts negative) produce a net negative for Germany. Whelan however seems to write as if these two things together is a net positive.

                    • JKH November 22, 2012 at 10:23 am

                      R.,

                      re banknotes:

                      Appendix 2 here may be of interest, including links:

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

                    • JKH November 22, 2012 at 10:27 am

                      R.,

                      BTW, I was quite reminded of my own paper above when I started reading Whelan’s – there is some similarity in structure. Both Buiter and Whelan have gone into much more detail on break up scenarios, which I tackled earlier at a more heuristic level.

                    • Ramanan November 22, 2012 at 11:01 am

                      JKH,

                      Reading the post – I remember you had it there.

                      Yes, saw the approach which is different than earlier – probably they read your post. I think even Sinn did because in the new article he brings in your arguments about interest flows. Probably all of them read your post at length!

                    • Ramanan November 23, 2012 at 3:52 am

                      Okay now I understand this.

                      It is true that Germany could do a tit-for-tat and not settle the €200bn (?) arising out of adjustments for bank-notes but the total liability due to cash notes in circulation of the Eurosystem is €888bn!

                      There’s a bit of carefulness one should do in counting banknotes which suddenly appear as liabilities of the German monetary authority in the scenario but all this should net add to the already high TARGET2 losses. (I am a bit less enthusiastic to get all the data).

                      So my claim is that the scenario losses are huge than previously thought (with the straightforward but slightly tricky calculation).

                      Buiter and Whelan get away by saying that the liability is “not really a liability” and so on! In the end they get a net advantage whereas it’s a loss.

                      Actually in the spirit “not really a liability” (which I don’t really like), there shouldn’t be any advantage at all – I think.

                      Do you know what I mean?

                      i.e., normally the interest income of the central bank leads to its profits. In this case it is partly interest income from German government bonds and partly from claims on banks.

                      But this is given the terminology seigniorage from issue of cash notes. But that is true because it is the reflection of income on assets which expanded because liabilities rose.

                      But in this case, the asset appeared by capitalization by the German government. It’s not that the German government (after receiving central bank profits) is gaining out of the notes which suddenly appear. It is not gaining anything at all from those extra notes which have become its liability.

                      Maybe I am not making sense or misinterpreting/misrepresenting Whelan/Buiter.

                    • JKH November 23, 2012 at 5:42 am

                      R.,

                      From earlier:

                      “And all of that is the basis for what is really the issue for Buiter and Whelan, which is long term growth in the monetary base (mostly currency) and where that future growth in the base corresponds to future seigniorage profit that doesn’t currently exist, but that is projected and then transported back to the present through PV analysis – and then used to offset the transitional loss on that basis.”

                      I think that you are correct, roughly speaking – in the sense that the starting balance sheet of the new system isn’t the direct source of the seigniorage benefit, and I don’t think that’s what they’re talking about. The benefit comes from future growth in the monetary base that can be expected to occur following from that starting point. E.g. if the monetary base (currency presumably) grows by 5 per cent nominal per year, that’s a new section of the balance sheet that will starting generating a new addition to positive interest margin as it gets added. And so on into the future. My point about accrual versus present value above is that you can envisage that benefit as a staircase of staggered future interest margins (I think I’ll patent that phrase!), which is the projection of an accrual expression, or you can envisage it as the present value today of all those future additions to interest margins. That’s where the seigniorage is going to come from in order to offset today’s exit losses experience by the Bundesbank. The further supporting argument is that today’s starting point will be a larger monetary base than in a counterfactual, because arguably there is room for internationalization of the “new” Euro now exclusively issued by Germany. But as you argue, that piece up front won’t necessarily be a direct benefit today – but it will be a factor in that the future compound growth of the monetary base will be starting from a higher level, which means greater future seigniorage interest margins.

                      I think the important point is that you have to think of the relevant seigniorage profit as coming from the future expansion of the Bundesbank balance sheet – not from the starting balance sheet, which is the time point where I think your intuition is roughly correct.

                      P.S.

                      I’m very much with you on the issue of liability classification – I don’t like the exceptionalism that the academic community has invoked in this area regarding the monetary base. I have a fairly large section on something closely related to this in my upcoming Chicago post (hoping to get that up around December 2nd).

                    • Ramanan November 23, 2012 at 10:53 am

                      JKH,

                      “hoping to get that up around December 2nd”

                      So few IMF authors have 10 days lesser than all of us!

                      Yes you should patent the phrase.

                      The Whelan/Buiter discussion of monetary base is strange. They tend to assume that the cash notes issued is exogenous and can be fixed by the central bank.

            • Greg November 22, 2012 at 8:03 am

              If Germany becomes the sole user of the Euro is it any different than reissuing the Mark?

              • JKH November 22, 2012 at 9:17 am

                “If Germany becomes the sole user of the Euro is it any different than reissuing the Mark?”

                I can’t really answer that – I suspect the correct answer is horrendously complicated, given issues of dealing with the legacy EZ Euro portfolio as separate from the new German Euro. Intuitively, it would seem the Mark might be simpler in that sense, but that could be wrong too.

    • beowulf November 17, 2012 at 11:59 pm

      “The Chicago plan may make the loan rates more volatile and this will transmit into more volatility in the broader financial markets. Right?”

      Not sure if Chicago Plan would make financial markets more or less volatile but RSJ made the point a couple months ago that we should pay more attention to volatility in the real economy than in financial markets. (h/t Mike)

      “Which eras are those of moderation, and which are those of excess volatility? What did the central bank succeed in stabilizing as a result of relying on interest rate adjustments rather than income flow adjustments?”
      http://windyanabasis.wordpress.com/2012/08/06/the-great-unravelling/

  • Fed Up November 17, 2012 at 8:52 pm

    I’m seeing comments at different places that medium of account (MOA) and medium of exchange (MOE) are monetary base (currency plus central bank reserves).

    I think MOA/MOE are currency plus demand deposits.

    Which is it?