There’s a clash of ideas in Richard Werner’s work and that of Monetary Realism’s. I’ve had a stack of papers on my desk here by Werner, a German economist, that I’ve been meaning to write posts about for weeks. But they’re so good that I don’t to do them injustice. But then today I am clicking through my FT links and I see this:
“There are different types of money. The first is legal tender paper money. This is mainly used by the public for petty transactions and amounts to only about 3 per cent of the total money supply. Another type of money also created by the central bank is solely for the use of its clients, the banks. This is reserve money. It stays in the banks’ accounts at the BoE to settle their claims against each other. If one bank reduces its reserves, this raises those of another bank, leaving the total amount of this closed-loop money unchanged. It normally also amounts to about 3 per cent of the money supply, but it never circulates in the economy and as such is not really money. So what about the money that is used for most transactions and accounts for the bulk of the actual money supply?
As Martin Wolf has pointed out, it is created by profit-oriented companies, the banks, when they do what is commonly referred to as “lending money”. But they don’t lend existing money. Instead, they newly invent the money that they lend…”
That’s perfect. MR describes the money types as outside money and inside money. That is, inside money is the money that’s created inside the private sector by banks (bank deposits). And outside money is the money created by the government outside the private sector. As Werner notes, the money that matters most is inside money. Outside money just facilitates the use of inside money (for instance, cash allows withdrawal of money for someone who has an inside money account and reserves or central bank money simply help settle interbank payments and smooth the efficiency of the payments system).
Anyhow, he has some other thoughts on having the government borrow directly from the banks, but that’s the policy side of things. Me, I am more interested in getting the operational description exactly right and Werner seems to really get it.
Good post Cullen,
I’ve always thought of the Fed’s reserves as akin to plastic chips in a poker game, that is, a mere miniscule mirror of the money that actually does operative things in the economy.
In special instances the Fed’s reserves can perform an important role in the economic process (e.g. it can tacitly finance budget deficits when open market purchases are coordinated with new bond issues as well as provide liquidity to financial firms). But its main use is to set interest rate policy (little more).
The qualifier ‘fractional reserve banking system’ is a bit of a misnomer today. After the early 1980s failed monetarist experiment the Fed all but dismantled reserve requirements with bank ‘innovation’ (e.g. sweep accounts) largely bypassing what remained. So the USA can be described as operating on a “fractional (as in miniscule)” fractional reserve banking system (as long as one remembers that reserves do add funding power to bank balance sheets).
Yes, this is the key quote:
“it never circulates in the economy and as such is not really money.”
It’s interesting to study American history and see why the Fed system even exists. When the banking panics were all happening in the late 1800′s & early 1900′s I think the bankers came to their senses realizing the tide was turning against them. So they compromised on being the controllers of money and teamed up with the govt to create a system that would “independently” oversee their actions. The reserve system essentially created one cohesive payment system that was overseen by the US govt. BUT, it left the power of money creation with the banks. So, not more monopolies for guys like JP, but they settled for a pretty powerful oligopoly instead.
Either way, it’s interesting to note how almost every single economic school in the world has some form of reserve centric model that they work from. The Fed is just a facilitator though. Confusing the Fed for the ruler of the monetary roost is like confusing your cane for your legs.
I thought I linked my typo correction to my first comment: “(as long as one remembers that reserves do [NOT] add funding power to bank balance sheets).
Reserves are used for clearing which is what I was getting at with the analogy to poker chips.
BF, thanks for the “poker chip” analogy
“it never circulates in the economy and as such is not really money.”
But reserves can be “spent” by banks as “Tom Brown”/”Joe in Accounting” has pointed out. So the question is, especially with excess reserves, and when banks are no longer capital constrained (maybe in the next year when Fed regulatory arm and Basel III implementation planning is completely clear), whether the Nick Rowe “hot potato” will develop within the financial sector and whether IOER can slow it down.
Let me clarify. First, the capital constraint will never go away, Basel III and Fed Regulations are meant to strengthen that capital constraint.
Second, if you look at the term “spent” by banks, it still falls within Cullen’s description that reserves never leave the banking system. Here’s my example, a bank has $100 of excess reserves (excess meaning more than they legally need based on reserve ratio requirements). On their balance sheet that shows up as $100 on their cash and due from banks asset. So let’s say they decide to spend that $100 on salaries. Now, regardless of whether their employees have accounts at this bank or not, the bank’s balance sheet changes by having $100 less in assets and $100 less in capital (as salaries are an expense that reduce equity).
So basically all this about excess reserves is a non-issue. All these excess reserves give to banks is excess liquidity. This liquidity is having an effect on financial asset prices, and Cullen is right to question this policy as it has the potential to create another asset bubble in which market values aren’t supported by fundamentals. In my opinion, I just don’t see many banks doing that at this time
Agreed. I was thinking more about banks trading financial assets between them. The hot potato. Now whether this hot potato actually happens, I’m not an economist (esp. a monetarist), but usually the argument against reserves and the hot potato is reserves are trapped in the financial system so you won’t get a generalized hot potato, but that doesn’t exclude a hot potato confined to the banking system (assuming anyone has ever proven the hot potato effect in any market). BTW I wasn’t implying the capital constraint will go away, but short term uncertainty over capital *may* go away in the next year. Plus, one could argue that the greater the capital constraint the faster you want to trade assets to reduce the holding time, which may have a very procyclical momentum effect (trading increases with positive momentum and vice-versa). I’m thinking about the explosion in securitization and SPVs as an outgrowth of that.
Is the banking system both fractional reserve and fractional capital?
What’s interesting is John Carney’s point that loan proceeds can be used to fund capital (bank can always charge an loan origination fee, which will transfer % of loan to bank capital).
No more comments from me: “(as long as one remembers that reserves do add [NOT} funding power to bank balance sheets).
I’m still learning and trying to understand MR… What does this part mean exactly:
“…it is high time for leaders to realise that they need to kick-start the bank credit money supply, and can do so immediately by stopping the issuance of government bonds and instead funding the public sector borrowing requirement by having the Treasury enter into loan contracts with the money creators – the banks. “
Werner is alluding to the fact that almost all of the money in our system is issued by banks. So, if you really want the economy to kick up you need to see a rise in lending (loans create deposits). Contrary to popular opinion, the govt doesn’t actually create much money. The govt basically just recycles bank money through the system.
I believe what Werner is calling for is for the banks to lend money directly to the govt so the Treasury can just spend. So, what we do now is the govt sells a bond and redistributes someone’s bank money. In Werner’s proposal, the govt would just borrow from the bank like anyone else and credit the private sector with deposits. This would create bank deposits directly as opposed to what we do now by creating t-bonds. Not sure it would make as huge a difference as Werner seems to think, but that’s the gist of it.
I need to go back and read some of his old Japan commentaries to make sure. If I get around to it tonight I’ll get back to you.
“So, what we do now is the govt sells a bond and redistributes someone’s bank money.”
That can happen.
And, “In Werner’s proposal, the govt would just borrow from the bank like anyone else and credit the private sector with deposits. This would create bank deposits directly as opposed to what we do now by creating t-bonds.”
Can’t this happen now?
“So, if you really want the economy to kick up you need to see a rise in lending (loans create deposits).”
I don’t believe the solution to too much debt is more debt.
Cullen, I think your interpretation is correct, and Fed Up, I think it can. I don’t know why it doesn’t happen more often. I know Mosler has said it doesn’t.
This is the way the Marc Lavoie described deficit spending in his MMT critique. And this is also what has been debated here at MR – that that’s NOT the way most deficit spending is conducted, but rather redistributes deposits among the private sector (plus add of govt bond, which occurs in both cases).
Pretty crucial distinction though and it’s where I think MMT goes wrong. MMT will describe the reserve settlement via TGA as “destruction” and then “creation” of money. Ie, they imply that the system they want is the one we already have. But that totally ignores the actual flow of funds through the system. The actual flow shows that the govt can only settle in TGA after it has obtained bank deposits. And that bank deposit exists as a result of the creation of the loan. That loan doesn’t get “destroyed” when the govt taxes you. The govt necessarily spends the deposit back into the system.
When you view the world through the MMT lens you get the impression that the govt creates all of our money when the reality is that the govt is a mere redistributor of money. The money system is built around banks and the reserve system supports this system based around banks. As Werner says in this video, the money supply has been “outsourced” to the pvt sector.
http://www.youtube.com/watch?v=zIkk7AfYymg
Of course, Werner, (and all the MRists) understand that the MMT world is a very real option. But it would require a change in the system with the focus becoming the govt and not the banks.
It’s really a stock/flow error they’re making, which is richly ironic when you think about it.
The system is designed such that existing private sector money recycles through the TGA from taxing/borrowing to spending.
The TGA is a conduit for that recycling of private sector money.
So, other thing equal, this is essentially a stock equilibrium based process – an existing stock of private sector money that recyles.
Then, add to that trend growth over time in money supply and other economic dimensions. But the base case stock equilibrium in question still operates at a point in time apart from that trend economic growth.
The other way is a gross flow destruction/gross flow creation perspective – which is intriguing, but rather silly, in that it’s irrelevant, given the basic net stock stability of the system as it’s designed to function in the factual case as opposed to the counterfactual case.
The Fiebiger paper captures all this in a more sophisticated way.
It’s occurred to me that they make exactly the same error in the famous $ 27 trillion (or whatever that number is) they accuse of being the case in the Fed’s “bail-out” activities, whatever those are supposed to be. It’s a gross recurring flow exaggeration of what is in reality a much smaller net stock effect. Same idea, in this case obviously for ideological positioning.
Don’t say that. How in the world will we awake from our “Never Never Land” or the “Cartoon” world we’ve built here???
“Once you’ve painted yourself into the ideological corner of “I hate the JG so much that everything MMT says about state money must be wrong” the next logical step is to paint a cartoon door on the wall and step through it into never never land.”
http://www.blogger.com/comment.g?blogID=2761684730989137546&postID=2599419185473605548
Of course, I never said I “hated” the JG. I just didn’t like the “money monopoly” concept as a basis for it. I actually said I was in favor os starting a small JG, but didn’t like the basis for their argument or the gung ho “let’s hire 10-20MM people right now” approach. But let’s not let the truth get in the way of our dream world here where we attack other people and misrepresent their actual words so we can make ourselves feel better about what is really nothing more than a policy agenda sold to economic amateurs as “operational reality”.
And they still don’t seem to understand how it’s absurd to describe our system designed around private banking as a “money monopoly”. And that leads them to the absurd conclusion that money gets “destroyed” when taxes are paid.
Who’s living in a cartoon world Never Never Land? Only someone who is out to lunch could possibly describe the flow of bank funds through the reserve system as a “destruction” of money. Maybe we can just start calling t-bonds money and then we can dive a sequence lower in the MMT dream world.
Sorry, but at some point this whole repetitive conversation gets absurd. It’s time for the MMT people to stop spreading a blatant myth about how the money system works. You can understand MR and still be in favor of all the same policy conclusions that MMT would be in favor of. The difference is, you shed all the accounting manipulation and distortions about how money actually is created and destroyed.
wh10, I think it (the NEW gov’t bond/loan) can happen (be purchased) with a NEW demand deposit (MOA/MOE) or it can happen with EXISTING SAVED currency or demand deposits (MOA/MOE).
What does the scenario and/or accounting look like if the gov’t sells a new gov’t bond/loan in the amount of $100,000 for 1 year with an interest rate of 6% and sets up its budget so that both principal and interest are paid at the end of the 1 year (the bond/loan is paid off)?
Oops … assume a bank buys the gov’t bond/loan.
“Not sure it would make as huge a difference as Werner seems to think, but that’s the gist of it.”
Let’s assume the banks securitize 100% of the Federal lending; let’s call them FBS. Now, rather than $16T of Tsys (currently) we would have an additional $16T of money/deposits and $16T FBS. Sounds very expansionary.
If the banks securitized and created the “FBS” as you say, wouldn’t those “FBS” replace the bank deposits? The bank would issue a “FBS” and annul the bank deposits that the bank received as payment for the “FBS”. So it wouldn’t seem to be much different from current treasury funding in terms of “expansiveness”. Was there irony that I clumsily missed or am I in a muddle about this???
I used the FBS example for 2 reasons:
(1) it eliminated the question about how the banks would behave, re:ALM
(2) to compare to MBS (since we’re on a Real Estate Monetary standard, as Mike says)
Specifically for (2), it looks to me like there is no difference between MBS and FBS. Bank credit is created and “spent” in the private sector; only the borrower is different. At least that’s my superficial view, but I don’t know Werner’s proposal. Note, this contrasts with the current system.
So the bank creates a loan to the government and a deposit that the government spends. The recipient of the government spending then uses that bank deposit to buy the loan off the bank in the form of your FBS. The net result is no overall change in the amount of bank deposits but a new FBS.
Is this supposed to be radically different from our current system where the government spends and the recipient of the government spending then uses that bank deposit to buy a treasury bond such that the overall change is a new treasury bond?
The Bank of England was started as a private bank that chose to specialize entirely in lending to the King. Is this just a re-assertion of that?
Jt26
Specifically for (2), it looks to me like there is no difference between MBS and FBS
What Hypothecated collateral is the Gov offering the banks for the loan to create the FBS. The MBS has a assets attached to it.
MBS: first lien is the borrowers’ income stream; second lien is the real estate collateral
FBS: first lien is the borrowers’ income stream; second lien is the White House ;-}
What’s the collateral on sovereign bonds (excluding special renegotiated debt like Brady bonds)?
JT26
MBS: first lien is the borrowers’ income stream; second lien is the real estate collateral
FBS: first lien is the borrowers’ income stream; second lien is the White House ;-}
What’s the collateral on sovereign bonds (excluding special renegotiated debt like Brady bonds)?
Yeah I see the point, but one other issue comes to mind.
Sale of sovereign bonds to me are much like a bullet loan, which have no monthly payments and at the end of the term the full amount of principal is due.
Seems this would give banks alot of interest rate risk.
“Sale of sovereign bonds to me are much like a bullet loan, which have no monthly payments and at the end of the term the full amount of principal is due.”
That’s how zero coupon bonds/notes (and all T-bills) work.
I think the best way is to describe the 3 types of medium of exchange (MOE). They are currency, central bank reserves (the demand deposits of the central bank), and demand deposits. I believe currency and demand deposits serve as both medium of account (MOA) and MOE and circulate in the real economy. Central bank reserves only circulate in the banking system covered by the central bank and help with setting the risk free overnight rate and how many demand deposits could be defaultable. I’m also thinking they could affect how many assets the commercial banks can hold.
I’m trying to get my head around what the function difference would be of Werners, “true QE”. Under current QE, an insurance company say uses a bank to sell treasury bonds to the central bank. That leaves the insurance company with bank deposits in place of the treasuries and the bank with new bank reserves. The treasury then PERHAPS ends up paying less interest to the non-government because now the interest on the treasury bonds goes to the central bank and gets given back to the treasury BUT instead it may be paid as interest on reserves and so goes to the banks. If interest on reserves is paid, then the overall effect is to have the banks being the beneficiaries of the “welfare” of interest on reserves rather than the insurance company getting that “welfare” as treasury interest. The insurance company also gets bank deposits instead of bonds; it might behave differently as a result (eg blow a bubble with the money).
Under Werners “true QE” the treasury bonds are never issued in the first place. Instead the government borrows directly from the bank so the bank gets an enlarged loan book and receives interest from the government whilst the recipients of government spending get bank deposits. If the government spending ultimately ended up leaving bank deposits in the hands of the same people who have currently made use of QE to offload treasuries, then the end result of who owned what seems much the same.
Is the whole point that the prices paid and interest rates would all be different? Current QE provides a bonanza for people who had pre-existing holdings of long dated treasury bonds. They have recently sold them for 25% more than they paid when the treasury issued them. There might be none of that under Werner’s QE. Under Werner’s QE the banks would presumably not have had the ballooning amount of reserves so the whole interest on reserves floor system might not have been needed but would that actually make much difference? I think in the UK we had the interest on reserves system even back in 2006 before the crisis (I might be wrong though).
Although Werner is German he lives in the UK and is at the University of Southampton so I guess he is looking more at the Bank of England than the Fed but I guess UK, USA and Japan (where Werner used to live) are all much the same (except Japan has no interest on reserves so a zero rate floor).
Our UK government is fond of “public private partnerships” where the government enters into binding deals to pay on an ongoing basis for hospitals, trains etc that the private sector finances and builds. I always saw it as pure cronyism and simply a way that the government could ensure that future governments were on the hook for 8% per year repayments for something that a bond issuance could have funded at 2%. Are “public private partnerships” in effect much the same as Werners “true QE”?
“Under Werners “true QE” the treasury bonds are never issued in the first place. Instead the government borrows directly from the bank so the bank gets an enlarged loan book and receives interest from the government whilst the recipients of government spending get bank deposits.”
I don’t get this. It seems to me that a gov’t/treasury bond and an enlarged loan book are the same thing.
Based on what JKH wrote in his “loans creates deposits” post, wouldn’t the private banks themselves try and cover funding of the “true QE” loans to the government with bank issued debt securities/time deposits that in effect would replicate treasury bonds? So the banks would undo “true QE”.
That’s a very, very good question IMO (as was your comment just before it).
These types of proposals tend to lack specificity in answering just this type of question as an integral part of an internally consistent plan for a revised monetary framework. The recent IMF Chicago Plan was quite poor in this regard, as I suggested in my piece on that. What these kinds of plans typically fail to consider is the comprehensive effect on the banking system balance sheet and the implications for bank liability management more generally. And the fact that advances from the banks to the government contain no credit risk barely begins to answer this type of question. It is important to specify exactly how the advances will be priced and what the expectation is for how the banking system will respond to that in the management of its overall asset-liability profile – i.e. including funding. The fact that the liability profile is delivered initially by a double entry bookkeeping mechanism doesn’t mean the banks individually won’t elect to change it as a funding profile. It may be that the government specifies and enforces a non-discretionary liability profile for the banking system, in which case it really has nationalized an entire section of the banking system balance sheet. But if that is not the case, what is the expectation for how the banking system’s management of its’ entire deposit base will be affected as a function of competitive behavior – now that the system has had the size of its deposit base expanded so dramatically in total? The fact is that the current banking system wasn’t designed to accommodate these kinds of massive structural shifts. Such proposals should be comprehensive and top down – not lazy, partial adjustments to a system that already exists and that has its own internal consistency as such. And it is impossible to know Werner’s answers to such questions – if he has answers – from a couple of lines in an FT article. Maybe his actual plan specifies it – but where’s that? Without that (and possibly even with it), we simply don’t know the answer to your question.
JKH, one day, I’d like to hear your detailed thoughts on why you think these new arrangements would be so difficult to accommodate.
For example, if the deficits were financed via banks, this would be a reserve drain once the Treasury draws down on their deposits. To accommodate this in a pre-IOR or even IOR world, the Fed could just purchase the bonds / loan contracts held on the banks books for reserves, if more reserves were needed.
I realize I am looking at this very simplistically, but I’d like to understand why this makes it that much more difficult for banks to manage their liabilities.
(Though, the more interesting question to me is the policy one – i.e., why financing deficits this way would make a difference.)
“this would be a reserve drain once the Treasury draws down on their deposits”
What would Tsy be spending on that wouldn’t simply transfer reserves (whether to entitlement beneficiaries, federal contractors or redeemed bondholders)?
Yeah, Werner is partners with some of the Positive Money people in the UK. I think they have similar ideas. It’s not all that comprehensive as you mention. But Werner seems to have the nuts and bolts of the monetary design down at least in terms of how banks “rule the monetary roost” and the reserve system facilitates.
Cullen your push (and the work of others) has been a great service to the understanding of (quite literally) monetary reality.
Thanks. I think a lot of people thought we had malicious intent when we were starting MR, but it’s always been about obtaining a better understanding of the system. MMT is so good on so many things, but I thought that the “money monopolist” point and several others were just unbalanced views of the way things actually work.
I think when you step back and view the world of banking and money through the MR lens that you end up with a much clearer and more realistic view of the way things actually work.
All these ideas to kick start the economy such as negative interest on reserves, QE or Werner’s “true QE” seem to miss the core issue IMO. My guess is that all such tinkerings will be futile so long as it is possible in some way or other to transport purchasing power through time without providing a future real world capacity to meet that financial claim. IMO our problems will only get sorted out if the ONLY way available to transport purchasing power through time is to ensure an ongoing capacity to provide real stuff.
I doubt they’ll look in this thread soooo…. I just sent emails to metro editors at Chicago Tribune and Chicago Sun-Times.
subj: Like Howard Cosell, this youth hockey coach never played the game (but won division)
I just came across this cute story about a Chicagoland dad (who blogged about it) who’s never coached or even played hockey before.
In his first season, he coaches his son’s youth league team to a division championship.
Kind of gives hope to non-athlete dads or moms who are asked to coach.
http://monetaryrealism.com/op-huskies-gold-mites-division-champs