Tag Archive | MMT

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 21st 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.

Myths are slowly being debunked. Slowly…

A few institutions have recently raised voices to try to debunk some of the banking legends that had appeared and became conventional knowledge as a result of the crisis. Here’s an overview.

S&P, the rating agency, just published a note declaring that, surprise surprise, the UK’s ring fencing plans could have clear adverse consequences. Those include: possible downgrade to ‘junk’ status and lower ‘stability’ of the non-ring fenced entities, costs for customers could rise, credit supply could be squeezed, and, what I view as the most important problem of all, ring fencing rules “will undoubtedly further constrain fungibility.” According to the S&P analyst, as reported by Reuters:

“The sharing of resources (and brand, expertise, and economies of scale) means we view most banking groups as being more than the sum of their parts,” the report said.

It said disrupting these benefits could lead S&P to have a weaker view of the group as a whole and to lower its credit ratings on some parts of the banks.

S&P said the complexity of separating functions “represents a significant operational challenge” for banks at a time of multiple other regulations.

I cannot agree more. I have already written four long pieces explaining why intragroup liquidity and capital transfers were key in maintaining a banking group safe. Ring fencing does the exact opposite, putting those liquidity buffers and capital bases in silos from which they cannot be used elsewhere, potentially endangering the whole bank.


The BoE just reported that households could actually cope with raising interest rates. One of the Bank’s justification for not raising rates was that it would push many households towards default, so it is now kind of contradicting itself. And anyway, as I have described previously, lowering rates ceased to translate into lower borrowing rates due to margin compression. Patrick Honohan, Governor of the central bank of Ireland, reported that the exact same phenomenon occurred in Ireland:

Because of the impact on trackers, though, the lower ECB interest rates have not directly improved the banks’ profitability, because the average and marginal cost of bank funds does not fall as much. The banks’ drive to restore their profitability, combined with the lack of sufficient new competition, has meant that, far from lowering their standard variable rates over the past three years as ECB rates have fallen, they have (as is well known) actually increased the standard variable rates somewhat. […] These rates indicate that standard variable rate borrowers are still paying less than they were before the crisis, but not by much. A widening of mortgage interest rate spreads over policy rates also occurred in the UK and in many euro area countries after the crisis, but spreads have begun to narrow in the UK and elsewhere. Until very recently bank competition has been too weak in Ireland to result in any substantial inroads on rates.

Ireland mortgage rates

This chart exactly looks like what happened in the UK. Spread over BoE/ECB rates have increased, and increasing rates could actually translate into the same level of mortgage rates. This is because, as margin compression starts disappearing, competition can start driving down the spread over BoE/ECB. Households may have to remortgage to benefit from the same rates though.


In Germany, regulators said that the ECB’s negative deposit rates could incite more risk-taking and declared that:

Excess liquidity could even threaten the banking system if it is put to poor use

Regulators vs. ECB. This is getting interesting.


In FT Alphaville, David Keohane reports a few charts from Morgan Stanley. One of them clearly shows the Chinese Central Bank’s use of reserve requirements to manage lending growth. I’m sure my MMT and ‘endogenous money’ friends will appreciate.

Chinese monetary policy

More inside/outside money endogeneity confusion

I was surprised by a Twitter discussion yesterday that linked to this good post by David Beckworth. As you can guess, the topic once again involved the endogeneity of money. Beckworth’s answer to an interview question was:

My answer was that inside money creation–money created by banks and other financial firms–is endogenous, but the Fed shapes in an important way the macroeconomic environment in which money gets created.

David is right. But what I do find surprising is that his interviewer could ask such question as “do you believe that money is endogenously created?”

Let’s clarify something: the fractional reserve banking/money multiplier model necessarily implies endogenous creation of bank inside money. It describes how banks multiply the money supply from a small amount of externally-supplied reserves. If this isn’t endogenous creation, I have no idea what this is. I don’t think anybody who accepts that model ever denied that fact.

Endogenous money meme

The recent debate wasn’t about whether bank inside money was endogenously created but about whether or not the monetary base (i.e. outside money, or bank reserves) was also endogenously created. This is not at all the same thing and has very different implications altogether.

If the monetary base is endogenously created, the central bank cannot control the money supply, as MMTers and some post-Keynesians believe. I believe this is not the case, as highlighted in my various post (see here, here and here for examples).

However, if bank inside money is endogenously created and outside money exogenously created, this can only mean one thing: banks’ inside money creation ability is exogenously constrained by the amount of outside money in the system (though other factors also come into play).

This has always been the essence of the fractional reserve banking/money multiplier model. Model that has been severely misinterpreted recently, as Scott Sumner pointed out in a very recent post:

He [David Glasner] seems to believe multiplier proponents viewed it as a constant, which is clearly not true. Rather they argued the multiplier depends on the behavior of banks and the public, and varies with changes in nominal interest rates, banking instability, etc.

I can’t say how much I agree with Scott here, and this is exactly what I said in a recent post:

In their attempt to attack the money multiplier theory, they mistakenly say that the theory assumes a constant ratio of broad money to base money. There is nothing more wrong. What the money multiplier does is to demonstrate the maximum possible expansion of broad money on top of the monetary base. The theory does not state that banks will always, at all times, thrive to achieve this maximum expansion. I still find surreal that so many clever people cannot seem to understand the difference between ‘potentially can’ and ‘always does’.

A system in which there would be no money multiplier would effectively be a 100%-reserve banking system.

What’s interesting is that many proponents of the ‘uselessness’ of the money multiplier seem to have tone down their criticisms recently. Frances Coppola went from “the money multiplier is dead” to “it is improperly taught” (my paraphrasing)…

PS: when in my various posts I refer to (and say that I don’t believe in) the endogeneity of money, I refer to outside money/monetary base/high-powered money/reserves/whatever you want to call it, as I take inside money endogeneity for granted (with constraints, as already explained).

The BoE says that money is endo, exo… or something

The Bank of England just published an already very controversial paper, titled “Money creation in the modern economy”. Scott Sumner, Nick Rowe, Cullen Roche, Frances Coppola, JKH, and surely others have already commented on it. Some think the BoE is wrong, some, like Frances, think that this confirms that “the money multiplier is dead”. Some think that the BoE endorses an endogenous money point of view. Many are actually misreading the BoE paper.

To be fair, this might not even be an official BoE report, and might only reflect the views of some of its economists. That type of paper is published in many institutions.

I am unsure what to think about this piece… They seem to get some things right and some other things wrong, and even in contradiction to other things they say. Overall, it is hard to reconcile. What I read was a piece written by economists. Not by banks analysts or market participants. Therefore, some ‘ivory tower’ ideas were present, though in general the paper was surprisingly quite realistic.

I have also been left with a weird feeling. I might be wrong, but almost the whole ‘Limits on how much banks can lend’ section really seems to be paraphrasing my two relatively recent posts on the topic (here, where I criticise the MMT version of endogenous money theory, and here, where I respond to Scott Fullwiller). The paper does say that

The limits to money creation by the banking system were discussed in a paper by Nobel Prize winning economist James Tobin and this topic has recently been the subject of debate among a number of economic commentators and bloggers. (emphasis added)


Contrary to what some seem to believe, the BoE does not endorse a fully endogenous view of the monetary system, and certainly not an MMT-type endogenous money theory.

Let me address point by point what I think they got wrong or contradictory (I am not going to address the points in the QE section, which simply follow the mechanism described in the first section of the paper).

  • First, there seems to be an absolute obsession with differentiating the ‘modern’ from the ‘pre-modern’ banking and monetary system. The paper keeps repeating that

in reality, in the modern economy, commercial banks are the creators of deposit money. (page 2)

Well… You know what, guys? It was already the case in the pre-fiat money era… Banks also created broad money on top of gold reserves, thereby creating deposits, the exact same way they now do it on top of fiat money reserves. The only difference is the origins of the reserves/monetary base.

  • They very often refer to Tobin’s ‘new view’. But they never mention Leland Yeager, who strongly criticised Tobin’s theory in his article ‘What are Banks?’ As a result, their view is one-sided.
  • The point that “saving does not by itself increase the deposits or ‘funds available’ for banks to lend” (page 2) is slightly misinterpreted. By not saving, and hence, consuming, customers are likely to maintain higher real cash balances, leading to a reserve drain. Moreover, even if no reserve drain occurs, banks end up with a much less stable funding structure, that does not make it easier to undertake maturity transformation. It is always easier to lend when you know that your depositors aren’t going to withdraw their money overnight. This is also in contradiction with their later point that

banks also need to manage the risks associated with making new loans. One way in which they do this is by making sure that they attract relatively stable deposits to match their new loans, that is, deposits that are unlikely or unable to be withdrawn in large amounts. This can act as an additional limit to how much banks can lend. (page 5)

  • In their attempt to attack the money multiplier theory, they mistakenly say that the theory assumes a constant ratio of broad money to base money (page 2). There is nothing more wrong. What the money multiplier does is to demonstrate the maximum possible expansion of broad money on top of the monetary base. The theory does not state that banks will always, at all times, thrive to achieve this maximum expansion. I still find surreal that so many clever people cannot seem to understand the difference between ‘potentially can’ and ‘always does’. Moreover, the BoE economists once again contradict themselves, when on pages 3 and 5 to 7 they essentially describe a pyramiding system akin to the money multiplier theory!
  • The paper also keeps mistakenly attacking the money multiplier theory and reserve requirements while entirely forgetting all the successful implementations of reserve requirement policies by central banks throughout the world (China, Turkey, Brazil…).
  • The ‘banks lend out their reserves’ misconception is itself misconceived. I strongly suggest those BoE economists to read my recent post on this very topic. Here again this is in opposition with their later point that individual banks can suffer reserve drains and withdrawals through overlending…
  • The ‘Limits on how much banks can lend’ section is very true (though I might be biased given how similar to my posts this section is), and I appreciate the differentiation between individual banks and the system as a whole, differentiation that I kept emphasizing in my various posts and that I believe is absolutely crucial in understanding the banking system. Nonetheless, while their description of the effects of over-expanding individual banks and what this implies for broad money growth is accurate, it is less so in regards to the system as a whole. Indeed, they seem to believe that all banks could expand simultaneously, resulting in each bank avoiding adverse clearing and loss of reserves. This situation cannot realistically occur. Each bank wishes to have a different risk/return profile. As a result, banks with different risk profile would not be expanding at the exact same time, resulting in the more aggressive ones losing reserves at the expense of the more conservative ones in the medium term, stopping their expansion. At this point, we get back to the case I (and they) made of what happens to over-expanding single banks.
  • Finally, despite describing a banking system in which lending is built up on top of reserves (pages 3 and 4)  and in which banks cannot over-expand due to reserve drains (pages 5 and 6), they still dare declaring that:

In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. (page 2) (emphasis added)

I just don’t know what to say…

What do we learn from this piece? For one thing, those BoE economists do not believe in the endogenous money theory. This is self-explanatory in the mechanism described in pages 5 and 6. They clearly know that an individual bank cannot expand broad money by itself. They seem to admit that the central bank does not have the ability to provide reserves on demand (despite saying a couple of times that the BoE supplies them on demand, another apparent contradiction). Their only qualification is that this can happen when all banks simultaneously expand their lending. This is theoretically true but impossible in practice as I said above.

Why would the central bank not have the ability to provide those reserves on demand? Actually, it can. It’s just that there is no (or low) demand for those reserves. This is due to the central bank funding stigma, an absolutely key factor that is not referred to even once in this BoE paper. As a result, their description seems to lack something: if individual banks lack reserves to expand further, why aren’t they simply borrowing them from the central bank? By overlooking the stigma, their mechanism lacks a coherent whole.

This is how things work (in the absence of innovations that economise on reserves): money supply expansion is endogenous in the short-term. But any endogenous expansion will also lead to an endogenous contraction in the short-term. In the long-term, only an increase in the monetary base can expand broad money. Only central bank injections free of any stigma, such as OMO, can sustainably expand the monetary base by swapping assets for reserves without touching at banks’ funding structure.

Banking expansion cycle

I have a minor qualification to add to this mechanism though. 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.

In the end, the few ‘ivory tower’ ideas that are present in this research paper make it look incoherent and internally inconsistent. Central banks are notorious for their intentional or unintentional twisting of economic reality and history (see this brand new article by George Selgin on the Fed misrepresenting its history and performance. Brilliant read), so we should always take everything they say with a pinch of salt.

The central bank funding stigma

Yesterday the Federal Reserve Bank of New York published a brand new study about the stigma associated with banks borrowing from the central bank’s discount window. That was a nice coincidence following my response to Scott Fullwiler on the MMT and endogenous money theory, which seems to ignore this stigma (or at least to downplay its impact) and to consider that banks freely borrow from the central bank, providing a perfectly elastic high-powered money (reserves) supply. On the contrary, in my view, the stigma is one of the fundamental reasons that undermine the endogenous money theory.


Essentially, the NY Fed does not see much reason for this stigma to exist, but acknowledges that it does exist… I think they entirely forgot the possible impacts on a bank and its stakeholders of being considered illiquid, which I described in my previous post. Nonetheless, they made some good points (see below). A key point in my opinion is that banks are willing to pay more for other sources of funding than use the cheaper discount window.

The four main hypotheses they tested were very US-centric but interesting nonetheless. They found that:

  • Banks inside the New York District were 14% less likely to experience the stigma than banks outside of the district (admittedly not that much difference)
  • Foreign banks were 28% more likely to experience the stigma than similar US peers
  • The largest the financial markets disruption, the higher the stigma
  • The stigma does not decline when more banks utilise the discount window


Photo: MoneyAware

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.

The problems with the MMT-derived banking theory

(Update: Following Scott Fullwiler’s comment, I published an update here, in which I provide extra clarifications and introduce what I see as the fallacy of composition of the endogenous money theory (I moved this update to the top of my post following a few questions I received).)

Today will be a little long and technical… Many people have heard of the classic textbook story of the banking money multiplier, a characteristic of fractional reserve banking systems. Banks obtain reserves (i.e. central bank-issued high-powered money – HPM, which forms the monetary base) as customers deposit their money in, then lend out a fraction of those deposits that gets redeposited at another bank, effectively creating money in the process, and so on. In fine, reserve requirements at central banks prevent banks from expanding lending (and hence money supply) beyond a certain point. This led to the view that banks’ expansion is reserve-constrained.

But proponents of Modern Monetary Theory (MMT), and others who have no idea what MMT is, but who have been convinced by the argument, have been shouting out for a while now that this view is wrong. Banks do not lend out reserves they assert. Banks aren’t reserve-constrained but capital-constrained. Therefore, lending is endogenous, the supply of bank loans is almost perfectly elastic and the quantity supplied only driven by demand. Scott Fullwiler described the process on Warren Mosler’s (aka current MMT Guru) website. Cullen Roche has also been a strong proponent of this view (see here and here for example).

I managed to find a relatively good detailed summary of this view here:

[…] we had discussed the orthodox belief that the government controls the money supply through control over bank reserves. This position is rejected by Post Keynesians, who argue that banks expand the money supply endogenously. How is this possible in nations with a legally required reserve ratio? Banks, like other firms, take positions in assets by issuing liabilities on the expectation of making profits. Much bank activity can be analyzed as a “leveraging” of HPM–because banks issue liabilities that can be exchanged on demand for HPM on the expectation that they can obtain HPM as necessary to meet withdrawals–but many other firms engage in similar activity. For our purposes, however, the main difference between banks and other types of firms involves the nature of the liabilities. Banks “make loans” by purchasing IOUs of “borrowers”; this results in a bank liability–usually a demand deposit, at least initially–that shows up as an asset (“money”) of the borrower. Thus, the “creditors” of a bank are created simultaneously with the “debtors” to the bank. The creditors will almost immediately exercise their right to use the created demand deposit as a medium of exchange.

Indeed, bank liabilities are the primary “money” used by non-banks. The government accepts some bank liabilities in payment of taxes, and it guarantees that many bank liabilities are redeemable at par against HPM. In turn, reserves are the “money” used as means of payment (or inter-bank settlement) among banks and for payments made to the central bank; as bank “creditors” draw down demand deposits, this causes a clearing drain for the individual bank. The bank may then operate either on its asset side (selling an asset) or on its liability side (borrowing reserves) to cover the loss of reserves. In the aggregate, however, such activities only shift reserves from bank-to-bank. Aggregate excesses or deficiencies of reserves have to be rectified by the central bank. Ultimately, then, reserves are not discretionary in the short run; the central bank can determine the price of reserves–admittedly, within some constraints–but then must provide reserves more-or-less on demand to hit its “price” target (the fed funds rate in the US, or the bank rate in the UK). This is because excess or deficient reserves would cause the fed funds rate (or bank rate) to move away from the target immediately.

This means that central banks cannot control the money supply.

I am going to argue here that this view is at best inexact. And that, if the textbook description is outdated, it is still mostly right.

Scott Sumner argued on his blog that lending was effectively endogenous in the short-run but not in the long-run. I only partially agree, as even in the short-run in-built markets limits are in place.

Banks raise funding to obtain reserves

My arguments come both from my theoretical knowledge and from my practical experience of analysing banks all day long and meeting banks’ management, including treasurers/ALM managers. On a side note, the MMT story is wrong in a commodity-backed currency environment. But its proponents reply that it is only valid in our modern fiat money-based banking systems. Fair enough.

The reality is… banks do obtain funding (hence reserves) before lending in most cases. The opposite would be suicidal. Equity funding is obvious: a bank issues equity liabilities in exchange for cash that it then invests/lends. Non-equity funding, by far the largest component of banks’ funding structure (around 95% of funding), mainly comes from two sources: customer deposits and wholesale funding. Banks primarily rely on deposits to fund their lending activities. They try to attract depositors as they provide banks with more funds to lend. Of course they don’t lend out the deposits but the increase in reserves that comes along an increase in deposits allows the bank to lend more without risking a depletion of its reserve base.

Banks at the same time try to minimise the interest rate they pay on deposits in order to minimise their funding costs and maximise their net interest margin (basically the margin between the rate at which banks lend and the rate at which they borrow from depositors and other creditors). They also try to attract sticky saving and term deposits, rather than more volatile (but cheaper) demand deposits.

When banks want to lend more than what their deposit base allows them to lend, they need to turn to wholesale funding. Wholesale funding roughly comprises senior and subordinated liabilities (bonds) issued on the markets as well as interbank borrowings and repurchase agreements. Bond issues are quite simple: the bank issues its liabilities on the financial markets in exchange for cash. Cash that will then complement its existing cash reserves, and that the bank consequently lends out at a margin (unless of course the purpose of the issue was to refinance existing bonds). Interbank borrowings and repos are usually minimally used by banks as a source of funding, as they are very often short-term and unstable (i.e. can be withdrawn by other banks or not rolled over). Interbank funding (and borrowing from central banks) is the cheapest source of funds (although continuously rolling over this type of funding makes it expensive in the end). Deposits and other wholesale issues are more expensive.

What do banks do with the cash/reserves/HPM that they acquire through their various funding sources? Well, as you guessed, they lend. But not only. Banks invest. In order to maintain an adequately liquid balance sheet at all times to face withdrawals and settlements, banks mostly 1. keep some cash in hands and at the central bank, which represents their official reserves (as specified by reserve requirements), 2. invest the remaining of their cash in liquid securities, often sovereign bonds or highly-rated firms’ debt securities, which represent their ‘secondary reserves’, and 3. place some cash at other banks (interbank lending mainly).

In the end, all banks hold a liquidity buffer that represents between around 10% and 25% of their assets (and between 10 and 40% of their deposit base), under the form of both primary and secondary reserves. Why not keeping all as cash? Because of the opportunity cost of holding cash. To maximise their margins, banks prefer to invest that cash in liquid, easily marketable, interest-bearing securities. Why even keeping reserves in the first place? To minimise the probability of a liquidity crisis (i.e. not being able to face deposit withdrawals, interbank settlements or other liability maturity). If liquidity were not a constraint and banks’ only goal was to maximise profits independently of liquidity risk, they would simply avoid investing in low-yielding securities and lend at a higher margin instead. In order to maintain their net interest margin, it also happens that banks try to slow the pace of deposit inflows by lowering their rates on saving accounts, if they don’t have enough lending opportunities.

Are you starting to see the differences with the MMT/endogenous lending story?

Let’s take a real life example (figures at end-2012): Wells Fargo (a large bank that does not have oversized investment banking activities that distort its balance sheet,  which makes it similar to smaller-sized banks as a result). What does its funding structure (liability side of the balance sheet) look like? Unsurprisingly, 83% of its non-equity funding comes from customer deposits. Long-term senior and wholesale funding represents 9% of its funding structure. What about short-term wholesale and interbank funding? 6% only of its total funding. Clearly, Wells Fargo does not fund its lending by borrowing from other banks. Its loans/deposits ratio is 84%. It gets its reserves from other sources.

Let’s pick another similar bank that has a 126% loans/deposits ratio, UK-based Lloyds Banking Group. In this case, deposits could obviously not fund all lending. Did the bank fund its additional lending through interbank borrowing? No. Interbank borrowing only represents 2% of its funding structure. Adding other short-term wholesale funding makes it 10%.

A few points directly stand out:

  • Why would banks try to attract depositors, or even bother issuing expensive debt on the bond markets, if all they have to do to fund their lending is an accounting entry followed by some interbank or central bank borrowing?
  • Why would banks bother attracting expensive stable funding sources if all they have to do is to continuously increase (or roll over) short-term interbank or central bank borrowings?
  • Why are banks even keeping such amounts of primary and secondary reserves if, once again, reserves are not a constraint and all they have to do is to go ask fellow banks or central banks for reserves, which they have to provide to stick to their monetary policy?

From all those points, MMTers could reach the conclusion that bankers don’t seem to know what they’re doing.

There is a relatively straightforward answer to those questions: reserves still matter. Reserves are not directly lent out. They are indirectly lent out. When a bank credits the account of a customer out of thin air following a loan agreement, it exposes itself to a flight of reserves whose amount is equal to the loan, as correctly described by MMTers. Therefore, banks need to maintain an adequate level of reserves, as represented by their primary and secondary reserve buffers. If their primary reserves are low, banks can sell some of their secondary reserves to get hold of new cash for settlements. No need to borrow from the interbank market. However, there is a limit to this process: at some point, secondary reserves will also be exhausted. This is extremely unlikely though. Such a fall in balance sheet liquidity would be punished by financial markets (see below), incentivising banks to retain enough liquidity.

Moreover, banks usually try to avoid borrowing more than a limited amount on the interbank/money market. Why?

  1. Because this is a suicidal way of funding banking activities. A bank that would only rely on short-term and volatile interbank borrowing to fund its lending would expose itself to market actors’ furore: banks would start reducing their exposures to it, rating agencies would downgrade it, its share price would fall, and its cost of borrowing on the interbank market (or anywhere else) would rise.
  2. Because borrowing at very short-notice on wholesale markets would expose the bank to penalty interest rates. Most central banks also apply penalty rates to banks short of reserves.

But, the central bank has a target rate and needs to stick to it, MMTers are going to reply, thereby providing all the required reserves to this bank. What are the implications of such a claim?

Implications for a single bank

A bank that would have single-handedly increased its lending, and hence its liabilities, without securing reserves in the first place, is at risk of experiencing adverse interbank clearing and losing some of its reserves. At some point, its reserves could fall below the required amount. However, as we have seen above, the bank holds secondary reserves that it can deplete before running out of primary reserves. What the MMT story overlooks is market reactions to a bank losing its liquidity. I know no investor or no banker that would provide funds to a bank running out of liquid reserves, unless at increasingly high interest rates, even if they know that the bank could obtain reserves from the central bank. As a result, a bank single-handedly expanding beyond what its reserve would normally allow it to is going to experience a quickly rising marginal cost of funding as a response to the loss of its liquid holdings, pressurising its net interest margin and stopping its expansion.

If the bank reaches the point at which it has to borrow directly from the central bank as it has no other choice, it is already too late: markets are aware of its lack of primary or secondary reserves and won’t deal with it anymore. As a result, central banks’ overnight lending in such conditions is self-defeating. Banks, which is an industry based on trust and reputation, will do everything they can to prevent this situation from occurring in order to avoid the stigma associated with it, as we’ve seen many times during the crisis (see also a Fed study here, as well as this one). However, a bank in good financial health could well borrow from the central bank’s discount window from time to time to optimise its liability structure and cost of funding. In the end, a single bank might not technically be reserve-constrained, but it becomes reserve-constrained through market discipline! Of course, in good times, market participants can become more tolerant towards less-liquid balance sheet structures, but the principle still applies.

We could apply the same line of reasoning to asset quality. As a bank expands, the marginal return on lending diminishes and it has to lend to increasingly less creditworthy borrowers. The resulting pressure on its asset quality starts worrying market actors, impacting its cost of funding and slowing its expansion.

Moreover, the interbank lending rate need not rise if a single bank is having difficulties to fund itself. Other banks could actually see their borrowing cost fall as they see massive money market deposit inflows, keeping the aggregate rate stable. Second, central banks clearly cannot completely control the rate: it jumps way above target from time to time.

Implications for the system as a whole

There seems to be an inherent implication to the MMT/endogenous lending story: all banks have a natural incentive to expand as they can freely borrow reserves from the central bank. By literally following their description, it seems that most, if not all banks are fully loaned up as there is no risk of becoming illiquid. Although in such a case, there is no way they can borrow and lend from the interbank market: none of them has excess reserves. The only thing they can do is borrow from the central bank, which cannot refuse if it wants its target interest rate to remain on target. Consequently, the central bank cannot control the money supply as demand for commercial loans is out of its control.

There are a couple of contradictions here. If all banks are short of reserves, there is no interbank market anymore. Nonetheless, it is true that money markets can still exist with money market funds and other non-bank financial institutions and businesses supplying short-term cash to banks. However, this situation is unlikely to happen: as described above, increasing marginal cost of funding for all the banks trying to expand beyond reasonable will slow and eventually stop the process. Only a simultaneous increase in lending by all banks could lead to all banks expanding beyond the limit. In such a case, interbank settlements would cancel out, leaving the reserve positions of each bank unaffected, with no need to borrow for settlements. In practice, banks never expand at the exact same time: some banks are aggressive, some banks are conservative.

What about empirical evidence?

The evident conclusion that MMTers reach is that reserve requirements are ineffective in reducing loan growth. Is there any empirical evidence to confirm this claim? There is. But it doesn’t exactly reach the same conclusion. A few central banks actively use reserve requirements as a monetary policy tool, such as China’s, Russia’s, Brazil’s and Turkey’s. Take a look at the charts from this recent Gavyn Davies article in the FT on China:

China RR

China RR2China RR3

From those charts, we can see that every time reserve requirements are cut (mid-2008, early 2012), loan growth surges temporarily while the newly-available reserves are released. When reserve requirements are increased (early 2010, early 2011), loan growth slightly falls relative to trend. Granted, those charts do not show us the whole picture: other factors may well impact loan growth.

Another FT blog post summarised the trend, although the chart stops in 2010:

China RR4

A BIS study on Chinese reserve requirements also found a link:

China RR5

I don’t have data for Turkey and Russia, but this study found that increases in reserve requirements led to a contraction in domestic credit in Brazil.

What about interbank lending rate? It is pretty well reported that banks in worse financial health have to pay more for reserves on the interbank market (or on any other market). This should not be a surprise to financial markets actors: everyone knows that illiquid and/or insolvent banks have wider credit spreads. Does it necessarily mean that, as soon as a bank has to pay more than the target rate, it should instead borrow from the central bank? Obviously not. And we have already mentioned the stigma associated to this.

Finally, what about the moral hazard associated with unrestricted supply of reserves? If this were true, surely this is a very bad way of designing and managing a banking system?

This leaves us with the good’ol money multiplier textbook explanation. As I said at the beginning of this (long) post, it is quite outdated, but it remains essentially right, albeit in an indirect way. Nowadays, banks engage in what they call ALM (asset/liability management) through specific departments that identify and manage mismatches between the maturities of assets and liabilities and their respective cash inflows and outflows. As a result of this dynamic and active management, banks try to economise on reserves and take slightly more funding and liquidity risks than 19th century “collect and lend”-type banks. Nonetheless, reserves still matter and ALM bankers and treasurers also set up contingency liquidity plans, which would not make sense if they could freely access interbank or central bank funding without repercussions.

There are probably other things I could say about the MMT/endogenous money story. I may follow-up later, but for now this post is long enough… I just thought that some reality had to be reintroduced into the story, which sounds theoretically as pleasant as a fairy tale but doesn’t seem to stand its ground when you dig a little deeper.

Update: I initially quoted Frances Coppola in this post as her view seemed to be pretty similar to the quoted MMT story. She told me it wasn’t the case, and I updated the post as a result. There are still several things she said that I don’t agree with though.


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