A response to Scott Fullwiler on MMT banking theory

Following my post about the problems with the MMT and endogenous money banking theory, Scott Fullwiler, one of its proponents, briefly (and very nicely) commented on it, suggesting that I was not criticising the theory and that we were in fact in agreement. I beg to differ.

Another commenter, JH, also left a link to a much more comprehensive article describing the theory, written by Scott (you can find it here). I recommend this article to everyone. It is a very interesting piece about banking, and Scott clearly demonstrates in it that his knowledge of the banking system is superior to most of his fellow economists.

I had started to write a fairly long post criticising the (few, but in my view, important) errors in Scott’s paper, but decided against it eventually, and deleted most of it to get directly to the main point. I could probably write a whole academic article about the topic but I have no idea how to get it published so won’t do it! (any advice appreciated though!)

Overall, I agree that Scott’s description of the lending process is largely accurate. However, I believe that the conclusions that seem to ‘naturally’ follow fall into a fallacy of composition. The endogenous money theory correctly assumes that the lending decision regarding a single loan is independent of the reserve status of the bank. However, the theory incorrectly assumes that this description also applies to lending as a whole.

The endogenous money theory correctly describes one-off borrowings from banks that temporarily lack reserves for some technical reasons. But this lack of reserves is only temporary as they have the necessary liquid holdings to generate new primary reserves. If banks can lend independently of their reserve status, it is because they have beforehand secured enough liquidity (= claims on primary reserves) to face settlements.

The fallacy of composition involves applying this reasoning to a bank’s aggregate lending. What happens as a one-off event cannot happen continuously, as it would progressively deplete the bank’s secondary reserves until it ends up only relying on interbank or central bank funding for marginal lending, assuming funding costs were maintained at a stable level. But they are not. The more secondary reserves fall, the more the bank’s ratings are cut, its cost of funding increases and its share price falls. At some point, not only the marginal increase in lending is not profitable anymore, but also the bank might have endangered its very existence by becoming borderline liquid resulting in all market actors getting hesitant to provide it with any fund.

Therefore, Scott is right when he says that we agree that banks are pricing-constrained. Indeed. But we disagree on the backstop mechanism. The endogenous view considers central bank funding (and pricing) as the backstop mechanism, against which banks are going to benchmark their new lending to assess its profitability (the interest rate spread) if other sources of funds are unavailable. As Scott says:

Borrowings and reserve balances can always be had at some rate of interest; the question is whether or not this rate of interest is one at which the bank can make a profit that provides a sufficient return on equity.

Scott here mainly refers to the lender of last resort, the central bank. This implies that the supply of reserve by the central bank is perfectly elastic at a given interest rate, and therefore entirely driven by demand. But he does not take into account the impact for a bank of being able to raise funds only from a central bank. Sure, a bank that cannot seem to find any reserve anywhere else can still usually borrow from the central bank. Nonetheless, this bank, is, well… screwed. It just committed suicide.

By overexpanding, it depleted its liquidity position (through adverse clearing) to such an extent that no market actor was willing to lend to it anymore. By admitting its new reliance on central bank funding for survival, it admits its failure. As I have already said in my previous post, this is why banks are doing their best to avoid using central banks’ facilities. Nonetheless, this bank has the possibility to regain market confidence: it can reduce its lending in order to generate new liquidity. This shows the limit of the endogenous money theory: in the medium-term, lending is indirectly reserve-constrained.

We can see that the benchmark against which banks assess the profitability of new lending isn’t the central bank’s rate. It is the various market rates. Even without the central bank changing its target rate, an overexpanding bank will inevitably be forced to contract its lending by market forces, and consequently, the money supply.

Endogenous money theorists could respond that financial markets act irrationally: there is no point in punishing banks that could actually obtain funding from the central bank, making liquidity risk irrelevant (at least as long as they are only illiquid and not insolvent).  But investors have very good reasons: illiquid banks are usually either bailed-out or left to fail, with in either case serious consequences for shareholders, bondholders, and sometimes depositors. Think about Northern Rock and Bear Stearns. Those two banks were notoriously illiquid (rather than insolvent). You know what happened next.

Regarding the treatment of reserve requirements, I am not going to come back to the evidence from countries that actively use them as a policy tool. Nonetheless, the endogenous theory concludes that reserves are basically useless, except for interbank settlements and to comply with reserve requirements when needed (even cash withdrawals by customers are downplayed). I disagree; reserves are the most liquid asset banks can hold. When uncertainty increases in the markets and when even liquid securities suddenly become illiquid, banks increase their reserves holdings, which become precautionary reserves. Banks thus sacrifice some yield for liquidity. This does not mean that banks would not invest those reserves in loans or in securities should the economic conditions be normal.

I am going to stop here for today. There are a few other points I could have covered but as I said at the beginning of this post, this would require a 20-page article… Some of those include an overexpanding banking system as a whole (not just a single bank), the fact that, unlike what is implied in Scott’s article, banks are not maximising leverage, that leverage does seriously impact banks’ ratings, that deposits aren’t always the cheapest funding source, and even some details about banks’ regulatory capital calculations. Those are less important (or even very minor) points.

Update: See this post on the central bank funding stigma.

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27 responses to “A response to Scott Fullwiler on MMT banking theory”

  1. stanislaus2 says :

    This seems to be a slippery slope argument. But that can be fallacious if we are not inevitably going to go beyond the critical point where you cannot prevent
    further falling.

    I think banks do not draw upon reserves or other bank customers’ deposits in order to lend. That ended when the dollar went off the gold standard or backing.
    When on gold, the bank had to draw upon the gold, backing its deposits ,in
    making loans. Otherwise it was not lending genuine money. But it was at risk
    of the borrower’s not paying back the loan. Hence the need for fractional reserves kept on hand.

    So, once the dollar no longer was backed by anything but the full faith and credit
    of the United States, what limited the bank’s lending? Well, the bank was still
    run as if it was on a gold standard, so it abided by the fractional reserve requirement post hoc, looking to other banks for loans to restore their reserves
    to the required levels. And the bank has to come up with money to pay back the loan on its reserves. It can’t borrow from itself to serve its profits or interests.
    Even the Fed can’t do that. And the Fed can be the lender of last resort. And regardless of whether or not the Fed creates the money out of thin air, it lends it to the bank, meaning the bank has to pay it back or be in default which is very serious.

    So, I think there can be additional constraints on banks that will constrain their
    unlimited lending. I think the author of the blog has laid out some of those quite
    well.

    • Julien Noizet says :

      Stanislaus, yes you are right that when the Fed lends to a bank, it needs to be paid back at some point. The Fed just doesn’t provide the reserves for free or against nothing.
      This is why any Fed borrowing will appear as funding on the balance sheet of the bank. And that borrowing cannot expand indefinitely.
      However, the Fed can increase the amount of high powered money in the economy through OMO. Those newly-injected reserves don’t have to be paid back. And banks don’t seek extra reserves through this mechanism.

      • stanislaus2 says :

        But the Fed is buying IOU’s for a loan of the banks to the govt. That should extinguish the loan of the govt to the banks. In extinguishing the loan, the Fed’s money created out of thin air should also
        be extinguished, as any loan paid off to a bank is paid with money that gets extinguished, reducing the money supply.

      • stanislaus2 says :

        The purchase by the Fed of US securities from private and foreign investors takes money that already existed in reserve accounts at the Fed. Those dollars can be spent into circulation and if conditions are favorable, cause inflation. That should not be true of buying securities from banks on loans to Tsy for deficit spending. The inflationary potential already existed when the Treasury deficit spent dollars received from bank loans on purchases of Tsy US securities by banks.

  2. pilkingtonphil says :

    I think this article is a bit confused. This is the crux of the issue.

    “But he does not take into account the impact for a bank of being able to raise funds only from a central bank. Sure, a bank that cannot seem to find any reserve anywhere else can still usually borrow from the central bank. Nonetheless, this bank, is, well… screwed. It just committed suicide.”

    That’s not the argument. The argument goes like this:

    If banks start lending heavily they will borrow from each other. The “velocity” of interbank lending will rise. This will put upward pressure on the overnight rate. The central bank will then intervene in the interbank market with repos or whatever to PREVENT having banks screw themselves by borrowing at the discount window. The system works automatically and lending is endogenous. Very simple. All the guys I know at the Fed and Treasury confirm this view.

    • Julien Noizet says :

      Phil,
      You’re relying on a very unrealistic scenario here, scenario that I actually also address: that banks would all start extending credit at the exact same pace, in the same volume, for the same maturities and to the same sort of borrowers from a credit risk perspective.
      This is the only way adverse clearing through interbank settlement can cancel out and allow unlimited credit expansion.
      But this never happens in practice as banks have different risk appetites, and the more conservative ones gains reserves at the expense of the less risk-averse ones.

      • jake says :

        @Julien Noizet,

        https://spontaneousfinance.com/2014/03/15/the-boe-says-that-money-is-endo-exo-or-something/ you explain in this flow chart example that while individuual banks may need to slow down on lending,retain funding and restore ratios.During a boom this contraction may not happen at all as money markets are more liquid and percieved risks lower.

        ” The endogenous contraction does not necessarily always occur around the same time. A period of economic euphoria could well lead to lower risk expectations, allowing banks to reshape their funding structure and the liquidity of their balance sheet in a riskier way than usual before the natural contractionary process kicks in.”

        So the banking system as a whole/in aggregate can expand lending;with the constraints on continued balance sheet expansion decreasing; until a sudden reversal in the money markets caused by massive aggregate loan failure(securitised or not).

        I guess the CB then comes back in to restore liquidity to the money markets.

      • Julien Noizet says :

        Yes I don’t deny that market expectations of what a ‘safe’ reserve ratio is may change when the economy is booming (we also need to take into account how the economy can boom in the first place, rather than growing in a sustainable way).
        But in the medium to long run the money supply remains constrained by reserves nevertheless.

    • jake says :

      @pilkingtonphil but didnt that not happen during the gfc,there was a shortage of tsy,and a run on the repo market,and then an asset fire sale,and a seizure in the credit markets.

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