Cullen has his latest post up, based on a stoush between Krugman and Keen. I’m guessing Steve Keen is pretty much on track, Krugman, as clueless as ever, and Cullen, well let’s look at Cullen’s contribution.
The recent crisis has been beneficial in at least one way – it has begun to shed light on some of the myths of our monetary system that have poisoned economics and politics for many decades. If I had to rank some of these myths I would almost certainly put the currency user vs. currency issuer myth at the top of the list.
I think just possibly he’s right on this point. While there are as many Keynesian’s as ever, and they have been joined by the MMT/MMR brigade, I also see far more Austrian economics, so possibly, something good will emerge.
But a close second is the myth of the money multiplier. Students are generally taught that our banking system works through some sort of “loanable funds” market or “money multiplier” whereby banks obtain deposits so they can then loan them out. There’s just one problem with these ideas – they’re not right.
The ‘money multiplier’ myth I agree is a myth in that it is a false theory, but it is no myth that such a theory actually exists: it is at the heart of Keynesian economics.
These ideas have all come to a head in recent weeks when Paul Krugman and Steve Keen got into a bit of a back and forth about the operational realities of the banking system.
The banking system, without doubt, creates more disinformation than any other in economics. Of course, the banking system walks hand-in-hand with the State, and almost by definition, becomes cloaked in lies and half-truths.
I won’t comment specifically on the ideas of either men, both of whom are fantastic economists, but I think this conversation exposes the degree to which most people continue to misinterpret modern banking and requires some brief discussion.
Let’s pass on by then.
The standard banking model says that banks are reserve constrained and that the amount of loans a given bank can make is a multiple of its reserves. But the recent crisis has shot king sized holes in this myth. The Fed has substantially expanded the amount of reserves in the banking system, but lending has flat-lined:
The ‘standard banking model’ according to who?
True, many do get confused here. A bank, can make loans on a multiple of it’s total deposit base, and that includes both demand deposits & time deposits. The ‘reserve’ is the fraction that is held as a ‘reserve’ of any new deposits received as liabilities, from which the remainder can create new loans.
So bank “A” receives $100 dollars as a new demand deposit. The bank under a 10% reserve ratio reserves $10 and can make $90 in new loans. Let’s say another customer of bank “A” requests a $90 loan from bank “A”.
Bank “A” makes the loan. The borrower ‘deposits’ the new loan into bank “A”. Bank “A” can now reserve $9 from that new deposit, and create a new loan of $81 to another customer. As you can see, on a 10% reserve ratio, you can ‘multiply’ the money by approximately 10X.
This is fractional reserve lending. It is legal, because the State deems it so, and more critically supports this abortion via a Central Bank, that, can print fiat currency in any amount so that if the ponzi scheme starts to unravel, the Central bank can provide ‘liquidity’ to the stricken banks. It is called, a bank run.
Reserve balances are determined by the Federal Reserve who acts as the monopoly supplier of reserves to the banking system. Banks can never “get rid” of reserves in the aggregate. They can shuffle them among each other, but only the Fed can destroy or create reserves through open market operations. The Fed oversees the payments system and in doing so must act to ensure that banks can obtain reserves in order to settle payments and meet reserve requirements as needed.
You see Cullen is only telling ‘part’ of the story. If the banks create more credit than the Central bank deem appropriate, then they start to drain currency through the ‘selling’ of Treasury paper, thus removing ‘liquidity’ from the system. If the opposite, and they want to add ‘liquidity’ they purchase securities from the banks. This is termed “Open market operations”.
But the Federal Reserve is not the only player in ‘liquidity’, so are you and I. In a normally functioning system, demand deposits & time deposits become ‘fiduciary media’ which means that they function as money, but, are not money in that they can always be redeemed at ‘par value’. In a bank run, depositors convert demand & time deposits, fiduciary media into ‘currency’ money through demanding liquidity. The entire edifice of pyramided loans based upon deposits, collapses, and the Central bank, must bail out banks, or have the money system collapse. This is precisely what we saw in 2008.
Bank lending is not reserve constrained (in fact, many countries don’t even have reserve requirements at all). This means that banks do not need reserves before they make loans. Instead, banks make loans first and obtain reserves in the overnight market (from other banks) or from the Fed after the fact (if needed). New loans result in a newly created deposit in the banking system.
Which simply means that the ‘multiplier’ has no limit. Instead of stopping at 10X, in this system you can go to 100X, or 1000X. When the crash comes, the multiple determines just how bad it’s going to get.
Banks are capital constrained. Banks can always find reserves from the central bank so banks do not check reserve balances before making loans. Instead, they will check the creditworthiness of the borrower and their own capital position to ensure that the loan is consistent with the goal of their business – earning a profit on the spread between their assets and liabilities.
But when banks know that their downside risk is covered by the taxpayer, they throw all risk management out of the window and lend as much and to whomever: witness the sub-prime debacle.
Banks attract deposits because they want to maintain the cheapest liabilities possible in order to maximize this spread on assets and liabilities. Banks are, after all, in the business of making a profit!
Only if they generate their loans from a deposit base. If they fund from the money markets, as did Northern Rock, they leverage to whatever, and damn the torpedoes.
You don’t need to understand balance sheet recessions or liquidity traps to know what’s going on there. You just need to understand how banking works. Yes, it’s true that the balance sheet recession has been a truly unique period in American history.
Incorrect.
Exactly the same mistakes have been made in every US financial crisis, courtesy of the Federal Reserve, courtesy of government inflation, which is driven through their insatiable thirst to hang onto power, thus necessitating the buying of votes and catering to cartels.
When the demand for credit collapsed the Fed was nearly helpless in reviving the credit markets.
Only because the banks were so scared of another run on their liquidity, that they refused to create new credit, hence, government stepped in to create the credit expansion via fiscal policies.
Despite a $1.6 trillion reserve injection the lending markets just didn’t budge. This might have appeared like an anomaly to some, but to those who understood banking this made perfect sense. More reserves were never going to result in more loans.
Of course not, but the reserves were necessary to allay public demand to convert deposits, or fiduciary media into currency.
This was not because it had temporarily become true, but because this is the way banking works. Not just inside a balance sheet recession or liquidity trap or whatever you want to call it, but always….
Again, never quite sure whether Cullen simply has no clue, or purposefully misleads his blog audience with half-truths, outright fabrications, etc.
ducati998 