More, more, more money endogeneity confusion

First of all, happy new year everyone! We are now in 2015, so keep your eyes open for Marty McFly on the 21^st of October.

Let’s start the year with one of my favourite topics: money endogeneity. I’ve covered the subject a number of times, but it keeps coming back. On Mises Canada, Bob Murphy wrote a good post on the differences in reserve management between individual banks and the banking system as a whole (and describes very well the first step of Yeager’s ‘hot potato’ effect, that is, the increase in goods’ nominal prices). Murphy was replying to Nick Freiling’s post, who accused him of making a common mistake. Bob is right and Nick is wrong. In another ‘banks create money out of thin air’ post, Lord Keynes comments on (and, surprisingly, likes) a rather weird new piece of research by Richard Werner.

First, this is Nick:

Banks might decide to increase lending, but not at the expense of losing interest on reserves at the Fed. In fact, banks would rather earn interest on both new loans and reserves at the Fed (which is possible because new loans don’t require an outflow of reserves). Ideally, Bob would write a check against his loaned funds account that is addressed to another customer of that bank. Then the bank sees no loss in reserves (and so earns the same interest on the reserves as before) plus an increase in loaned funds which, of course, earns interest.

This is a very subtle point, but has huge implications for predicting inflation and gauging the effects of QE and growth in the monetary base. For example, there is no threat of sky-high levels of reserves “turning into” loans funds and thereby launching us into hyperinflation. Sure, a higher level of reserves pushes banks further from being constrained by their reserve-requirement ratio, which means they can increase lending. But banks are normally not reserve-constrained, so the relationship between reserves and loans is not direct, and might be hardly related at all.

There are some confusions here. Reserves can be in excess as long as banks aren’t fully ‘loaned up’ to the maximum allowed by reserve requirements. For instance, if the banking system has an aggregate $1,000 of reserves, and assuming a 10% reserve requirement, total lending can be expanded to $10,000. If overnight, reserves increase to $1,500 but lending remains at $10,000, the system holds $1,000 of ‘required’ reserves and $500 of ‘excess’ reserves. The Fed has been paying interest on this ‘excess’ for several years now (which wasn’t the case before). What happens if banks decide to increase lending following this reserves injection? $1,500 in reserves allows banks to lend an extra £5000. When lending reaches $15,000, there are no reserves in ‘excess’ anymore. Reserves have all become ‘required’. This is what many people mean by ‘lending out’.

Murphy’s point was that, at the individual bank level, the risk-adjusted yield on the ‘excess’ portion of reserves is compared to the risk-adjusted yield that the bank can make by expanding its loan book. Sure, the Fed still pays interest on required reserves, but it’s the excess reserves portion that is a monetary policy tool. Moreover, it is highly likely that the expanding bank is going to be subject to adverse clearing, thereby losing reserves to a competitor during the interbank settlement process, and hence the associated interests on reserves. Consequently, extending credit often leads to reserve outflows. The lower the market share of the bank, the more likely it is to suffer outflows. The system as a whole, on the other hand, does not lose reserves (unless withdrawn by depositors), and the interests on reserves lost by the first bank are now earned by another one.

The second point is trickier. There was indeed no inflation over the past few years despite the huge increase in reserves. And doomsayers (including Bob) have been wrong in predicting hyperinflation in the short-term. However, as I have recently pointed out, US excess reserves also massively increased during the Great Depression and the money multiplier collapsed. It took between 30 to 40 years for the multiplier to increase again, and guess what, this happened just before inflation levels jumped in the US (in the 1970s and 1980s). Coincidence? Maybe.

The problem is that Nick relies on a flawed banking theoretical framework. He quotes economist Paul Sheard as saying:

This is possible, again, because loans do not “come from” excess reserves. As Sheard explains:

…banks do not need excess reserves to be able to lend. They need willing borrowers and enough capital – the central bank will always supply the necessary amount of reserves, given its monetary stance (policy rate and reserve requirements).

This is the ‘endogenous money’ view (or, to be more precise, the ‘endogenous outside money’ view, as the fractional reserve banking theory necessary implies an endogenous inside money framework), also adopted by MMT-proponents (as well as Frances Coppola, though she says she doesn’t believe in MMT). It’s a nice theoretical construction. Just wrong. I have extensively written about this (see here, here, here and here). To be brief, there is no way an individual bank could continuously extend credit through central bank funding. This bank would suffer from central bank funding stigma (see also this recent paper) and be violently punished by the financial markets, forcing the contraction of its loan book (and of the money supply) in the medium-term. I advise Paul Sheard, who works for the rating agency S&P, to spend some time with his bank analyst colleagues, and ask them how they view a bank that increasingly relies on central banks for funding and liquidity. He might be surprised. In reality, banks’ inside money is endogenous but constrained by exogenous limits defined by the outside money supply (i.e. reserves).

At least, the MMT view is nicely-constructed, on a relatively sound theoretical basis. This isn’t the case of Richard Werner’s latest paper, titled ‘Can banks individually create money out of nothing? – The theories and the empirical evidence’.

I really don’t know what to think of it. It accumulates so many mistakes and misunderstandings that it becomes hard to take seriously. Its author seems to identify three banking theories: the credit creation theory of banking, the fractional reserve banking theory (FRB) and the financial intermediation theory of banking. The first one implies that banks are not constrained by reserves to extend credit, but not MMT-style: according to the theory (Werner has been a long-time proponent), banks apparently never need reserves (whereas MMT/endogenous theory says that banks can just borrow them from the central bank without limit). The last theory of the list emanates from Tobin’s work ‘Commercial Banks as Creators of Money’, which Werner considers the most dominant theory of banking nowadays. He makes a curious distinction between this view and FRB, as if they were unrelated. But Tobin’s ‘new view’ is based on FRB and the distinctions remain relatively minor.

Nevertheless, Werner manages to make the following (amazing) claim (my emphasis):

Starting by analysing the liability side information, we find that customer deposits are considered part of the financial institution’s balance sheet. This contradicts the financial intermediation theory, which assumes that banks are not special and are virtually indistinguishable from non-bank financial institutions that have to keep customer deposits off balance sheet. In actual fact, a bank considers a customers’ deposits starkly differently from non-bank financial institutions, who record customer deposits off their balance sheet. Instead we find that the bank treats customer deposits as a loan to the bank, recorded under rubric ‘claims by customers’, who in turn receive as record of their loans to the bank (called ‘deposits’) what is known as their ‘account statement’. This can only be reconciled with the credit creation or fractional reserve theories of banking.

Wait… really? So you mean that most economists did not know that deposits were sitting on the liability side of banks’ balance sheet?… Or perhaps they did, and the author simply completely misunderstood the ‘financial intermediation’ theory.

Furthermore, Werner also misunderstands the FRB theory:

Since the fractional reserve hypothesis requires such an increase in deposits as a precondition for being able to grant the bank loan, i.e. it must precede the bank loan, it is difficult to reconcile this observation with the fractional reserve theory.

This is also wrong. The FRB theory never states that a bank needs to get hold of reserves before extending credit. Indeed, the FRB states that a monopoly bank can extend credit up to several times its reserve base, because it is not subject to adverse interbank clearing. In a competitive market however, banks are likely to suffer from reserve outflows at some point. This implies that an individual bank needs to find extra reserves before the outflow occurs (in case it doesn’t already have some in excess) in order not to default on its interbank settlement. But this also implies that the bank can extend credit before finding those reserves*.

This leads Werner’s empirical evidence to completely miss the point: of course the bank can extend credit out of nowhere. But in this case the bank also knows that no cash is going to leave its vaults as the result of the transaction (which the researchers agreed to repay on the following day)**. But here we go: the paper ‘rejects’ the FRB theory on the ground that (brace yourself) “there seems no evidence that reserves (cash and claims on other financial institutions) declined in an amount commensurate with the loan taken out.”

There is evidently no discussion whatsoever in the paper of adverse clearing or evidences in banking history. No, instead, the paper concludes that

it can now be said with confidence for the first time – possibly in the 5000 years’ history of banking – that it has been empirically demonstrated that each individual bank creates credit and money out of nothing, when it extends what is called a ‘bank loan’. The bank does not loan any existing money, but instead creates new money. The money supply is created as ‘fairy dust’ produced by the banks out of thin air. The implications are far-reaching.

Nothing less.

According to the paper, Keynes:

was perhaps even more dismissive of supporters of the credit creation theory, who he referred to as being part of the “Army of Heretics and Cranks, whose numbers and enthusiasm are extraordinary”, and who seem to believe in “magic” and some kind of “Utopia” (Keynes, 1930, vol. 2, p. 215)

I am no fan of Keynes. But it does seem he got that right.

Ironically, Lord Keynes (the blogger) found this paper ‘excellent’, and seems not to be able to spot the many differences between Werner’s theory and post-Keynesian’s (and ‘endogenous money’) views.

* For a single transaction, it may not even have to look for extra reserves if the funds are transferred to one of its own customers.

** There are also plenty of other reasons why this bank, a member of the German cooperative banking group, would not seek extra reserves. The operational arrangements of this group (and of the German savings banks group too) are very specific and relatively unique in the world. Werner’s whole experiment is thus flawed. His accounting analysis is also far from clear and seems to mix up reserves and money market claims on intragroup banks and other financial institutions.