The Financial System and the Economy

THE FINANCIAL SYSTEM AND THE ECONOMY PRINCIPLES OF MONEY AND BANKING

Éric Tymoigne

THE FINANCIAL SYSTEM AND THE ECONOMY PRINCIPLES OF MONEY AND BANKING

FIRST DRAFT

ÉRIC TYMOIGNE

© August 2016 by Eric Tymoigne. All rights reserved.

TABLE OF CONTENTS PREFACE ....................................................................................................................................................................... V CHAPTER 1: BALANCE-SHEET MECHANICS ......................................................................................................................................... 1 WHAT IS A BALANCE SHEET? ............................................................................................................................................. 2 BALANCE SHEET RULES..................................................................................................................................................... 4 CHANGES IN THE BALANCE SHEET ....................................................................................................................................... 6 Net cash flow ........................................................................................................................................................ 6 Net addition to assets and liabilities ..................................................................................................................... 7 Net income ............................................................................................................................................................ 8 Net capital gain ..................................................................................................................................................... 8 CHAPTER 2: CENTRAL-BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS................................................... 10 BALANCE SHEET OF THE FEDERAL RESERVE SYSTEM ............................................................................................................. 11 FOUR IMPORTANT POINTS .............................................................................................................................................. 12 Point 1: The Federal Reserve notes are a liability of the Fed. ............................................................................. 12 Point 2: The Fed does not earn any cash flow in USD ......................................................................................... 13 Point 3: The Fed does not lend reserves and does not rely on the taxpayers ..................................................... 14 Point 4: Banks cannot do anything with reserve balances unless they are dealing with other Fed account holders ................................................................................................................................................................ 16 CAN THE FED BE INSOLVENT OR ILLIQUID? ......................................................................................................................... 17 CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL-BANK BALANCE SHEET .................................................20 THE MONETARY BASE AND THE MONEY SUPPLY ................................................................................................................... 21 RESERVES: REQUIRED, EXCESS, FREE, BORROWED, NON‐BORROWED ...................................................................................... 23 HOW DOES THE MONETARY BASE CHANGE? ....................................................................................................................... 27 CAN THE FED ISSUE AN INFINITE QUANTITY OF MONETARY BASE? .......................................................................................... 29 CHAPTER 4: MONETARY-POLICY IMPLEMENTATION .............................................................................................................. 33 WHAT DOES THE FED DO IN TERMS OF MONETARY POLICY AND WHY? ..................................................................................... 34 TARGETING THE FFR PRIOR TO THE 2008 FINANCIAL CRISIS .................................................................................................. 37 A GRAPHICAL REPRESENTATION OF THE FEDERAL FUNDS MARKET ........................................................................................... 40 TARGETING FFR AFTER THE GREAT RECESSION ................................................................................................................... 41 CHAPTER 5: FAQS ABOUT CENTRAL BANKING.............................................................................................................................47 Q1: DOES THE FED TARGET/CONTROL/SET THE QUANTITY OF RESERVES AND THE QUANTITY OF MONEY? ...................................... 48 Q2: DID THE VOLCKER EXPERIMENT NOT SHOW THAT TARGETING RESERVES IS POSSIBLE? ........................................................... 49 Q3: IS TARGETING THE FFR INFLATIONARY? ...................................................................................................................... 51 Q4: WHAT ARE OTHER TOOLS AT THE DISPOSAL OF THE FED? ............................................................................................... 52 Q5: WHAT IS THE LINK BETWEEN QE AND ASSET PRICES?..................................................................................................... 53 Q6: HOW AND WHEN WILL THE LEVEL OF RESERVES GO BACK TO PRE‐CRISIS LEVEL? THE “NORMALIZATION” POLICY ....................... 54 Q7: IS THERE A ZERO LOWER BOUND? .............................................................................................................................. 55 Q8: WHAT ARE THE EFFECTS OF A NEGATIVE INTEREST‐RATE POLICY? ..................................................................................... 59 Q9: HOW DID CENTRAL BANKERS JUSTIFY USING NEGATIVE INTEREST RATES AND QE? ............................................................... 60 Q10: SHOULD THE FED FINE‐TUNE THE ECONOMY? ............................................................................................................ 60 Q11: IS THE FED A PRIVATE OR A PUBLIC INSTITUTION? ....................................................................................................... 62 Q12: WHAT ARE NO‐NO SENTENCES FOR WHAT THE FED DOES? (WILL GIVE YOU A ZERO ON MY ASSIGNMENTS) ............................ 63 CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS........................................................................................ 66 MONETARY POLICY AND THE U.S. TREASURY ..................................................................................................................... 67

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Treasury’s involvement in monetary policy during the 2008 crisis ..................................................................... 69 Other examples of Treasury’s involvement in monetary policy .......................................................................... 72 FISCAL POLICY AND THE FED ........................................................................................................................................... 74 A NECESSARY COORDINATION OF TREASURY AND CENTRAL BANK ACTIVITIES ............................................................................ 76 TO GO FURTHER: CONSOLIDATION OR NO CONSOLIDATION? THAT IS THE QUESTION. ............................................................ 77 TO GO EVEN FURTHER: WHAT ARE THE RELEVANT QUESTIONS TO ASK FOR A MONETARILY SOVEREIGN GOVERNMENT? ............... 79 CHAPTER 7: LEVERAGE ..............................................................................................................................................................................84 WHAT IS LEVERAGE? .................................................................................................................................................... 85 WHAT ARE THE ADVANTAGES OF LEVERAGE? ..................................................................................................................... 86 WHAT ARE THE DISADVANTAGES OF LEVERAGE? ................................................................................................................. 86 Interest‐rate risk ................................................................................................................................................. 86 Higher sensitivity of capital to credit and market risks ....................................................................................... 87 Refinancing Risk and Margin Calls ...................................................................................................................... 87 Impact On mortgage debt ................................................................................................................................................ 87 Impact on security‐based debt: Margin call risk .............................................................................................................. 89

EMBEDDED LEVERAGE ................................................................................................................................................... 89 BALANCE‐SHEET LEVERAGE, SOME DATA ........................................................................................................................... 91 THE FINANCIALIZATION OF THE ECONOMY ......................................................................................................................... 92 CHAPTER 8: THE PRIVATE BANKING BUSINESS .......................................................................................................................... 96 THE BALANCE SHEET OF A BANK ....................................................................................................................................... 97 WHAT DO BANKS DO? ................................................................................................................................................. 100 WHAT MAKES A BANK PROFITABLE? ............................................................................................................................... 100 RISKS ON THE BANK BALANCE SHEET ............................................................................................................................... 103 BANKING ON THE FUTURE ............................................................................................................................................ 105 EVOLUTION OF BANKING SINCE THE 1980S ..................................................................................................................... 107 CHAPTER 9: BANKING REGULATION ................................................................................................................................................. 111 EXAMPLES OF BANK REGULATIONS ................................................................................................................................. 112 Reserve requirement ratios ............................................................................................................................... 112 Capital adequacy ratios .................................................................................................................................... 113 CAMELS rating .................................................................................................................................................. 114 Underwriting requirements ............................................................................................................................... 115 WHY ARE THERE STILL FREQUENT AND SIGNIFICANT FINANCIAL CRISES IF REGULATION IS SO TIGHT? ............................................. 115 Deregulation, competition and concentration ............................................................................................................... 115 Deenforcement and desupervision ................................................................................................................................ 118 Regulatory arbitrage....................................................................................................................................................... 119

THEORIES OF BANK CRISES AND BANKING REGULATION: TWO VIEWS ..................................................................................... 120 Laissez faire, laissez passer: Crises as Random events ...................................................................................... 120 Save capitalism from itself: Crises as internal contradictions ........................................................................... 122 CHAPTER 10: MONETARY CREATION BY BANKS ........................................................................................................................ 127 MONETARY CREATION BY BANKS: CREDIT AND PAYMENT SERVICES ....................................................................................... 128 WHAT CAN WE LEARN FROM THE EXAMPLE ABOVE? .......................................................................................................... 132 Point 1: The bank is not lending anything it has: when providing credit services, the bank swaps promissory notes with its clients ......................................................................................................................................... 132 Point 2: The bank does not need any reserves to provide credit services ......................................................... 132 Point 3: The bank is not using “other people’s money”: it is not a financial intermediary between savers and investors ............................................................................................................................................................ 133 point 4: The bank’s promissory note is in high demand .................................................................................... 134 HOW DOES A BANK MAKE A PROFIT? MONETARY DESTRUCTION .......................................................................................... 135

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INTERBANK PAYMENTS, WITHDRAWALS, RESERVE REQUIREMENTS, AND FEDERAL GOVERNMENT OPERATIONS: THE ROLE OF RESERVES ............................................................................................................................................................................... 138 WHAT LIMITS THE ABILITY OF A BANK TO PROVIDE CREDIT SERVICES? .................................................................................... 140 MOVING IN STEP ........................................................................................................................................................ 141 LIMITS TO MONETARY CREATION BY THE CENTRAL BANK AND PRIVATE BANKS .......................................................................... 142 TO GO FURTHER: A SIDE NOTE ON ALTERNATIVE VIEWS OF BANKING: THE MONEY MULTIPLIER THEORY AND FINANCIAL INTERMEDIATION. ....................................................................................................................................................... 142 CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM ................................................................................... 147 THE REAL EXCHANGE ECONOMY .................................................................................................................................... 148 Money supply is a veil ....................................................................................................................................... 148 Finance and the economy ................................................................................................................................. 149 Conclusions ....................................................................................................................................................... 151 THE MONETARY PRODUCTION ECONOMY ........................................................................................................................ 152 Money is everything .......................................................................................................................................... 152 Why monetary incentives matter? And what are other implications? ............................................................. 153 Finance and the economy ................................................................................................................................. 154 Beyond incentives: the role of macroeconomic forces ...................................................................................... 155 Conclusions ....................................................................................................................................................... 157 CONCLUSION ............................................................................................................................................................. 157 CHAPTER 12: INFLATION ......................................................................................................................................................................... 160 THE QUANTITY THEORY OF MONEY: MONETARY VIEW OF INFLATION ..................................................................................... 161 INCOME DISTRIBUTION AND INFLATION: A NON‐MONETARY VIEW OF INFLATION ..................................................................... 164 TO GO FURTHER: KALECKI EQUATION OF PROFIT, INTEREST RATE AND INFLATION ................................................................ 168 CHAPTER 13: BALANCE-SHEET INTERRELATIONS AND THE MACROECONOMY ....................................................... 171 A PRIMER ON CONSOLIDATION ...................................................................................................................................... 172 THE THREE SECTORS OF THE ECONOMY ........................................................................................................................... 173 SOME IMPORTANT IMPLICATIONS .................................................................................................................................. 175 point 1: The beginning of the economic process requires that someone goes into debt. ................................. 175 point 2: Not all sectors can record a surplus at the same time ......................................................................... 176 point 3: Public debt and domestic private net wealth ...................................................................................... 180 point 4: Business cycle and sectoral balances ................................................................................................... 182 CONCLUSION ............................................................................................................................................................. 184 TO GO FURTHER: SECTOR BALANCES FROM THE PERSPECTIVE OF THE NATIONAL INCOME AND PRODUCT ACCOUNTS ................. 184 TO GO EVEN FURTHER: NIPA AND FA DEFINITIONS OF SAVING ...................................................................................... 185 CHAPTER 14: FINANCIAL CRISES......................................................................................................................................................... 190 DEBT DEFLATION ........................................................................................................................................................ 191 Step 1: Overindebtedness and distress sales ..................................................................................................... 192 Step 2: Distress sales and deflation, the “Dollar Disease” ................................................................................ 192 Step 3: Deflation and debt liquidation; the “Debt Disease” .............................................................................. 192 Step 4: Prices and profit and net worth, the “Profit Disease” ........................................................................... 193 Step 5: the “Amplifier effect” ............................................................................................................................ 194 Step 6: Pessimism .............................................................................................................................................. 194 Step 7: Interest‐rate spread .............................................................................................................................. 195 Conclusion ......................................................................................................................................................... 196 ORIGINS OF DEBT DEFLATION ........................................................................................................................................ 197 Real exchange economy: Efficient markets and imperfections ......................................................................... 197 Monetary production economy: The financial instability hypothesis ............................................................... 198 Financial fragility ............................................................................................................................................................ 199

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The Financial instability hypothesis ................................................................................................................................ 200

HOW TO DEAL WITH FINANCIAL CRISES ............................................................................................................................ 202 TO GO FURTHER: PONZI FINANCE AND THE BALANCE SHEET ............................................................................................ 203 TO GO EVEN FURTHER: MINSKY AND INCOME VS. CASH INFLOW .................................................................................... 204 CHAPTER 15: MONETARY SYSTEMS ................................................................................................................................................... 207 FINANCIAL INSTRUMENTS ............................................................................................................................................. 208 A SPECIFIC FINANCIAL INSTRUMENT: MONETARY INSTRUMENTS ........................................................................................... 209 AT WHAT PRICE SHOULD A FINANCIAL INSTRUMENT CIRCULATE AMONG BEARERS? .................................................................. 210 FAIR VALUE AND PURCHASING POWER ............................................................................................................................ 212 ACCEPTANCE OF MONETARY INSTRUMENTS ..................................................................................................................... 214 TRUST AND MONETARY SYSTEM: TRUST IN THE ISSUER VS. SOCIETAL TRUST ............................................................................ 216 WHY ARE MONETARY INSTRUMENTS USED? THE MONETARY FUNCTIONS ............................................................................... 218 CHAPTER 16: FAQS ABOUT MONETARY SYSTEMS ...................................................................................................................... 222 Q1: CAN A COMMODITY BE A MONETARY INSTRUMENT? OR, DOES MONEY GROW ON TREES? .................................................. 223 Q2: CAN A MONETARY INSTRUMENT BECOME A COMMODITY? ........................................................................................... 224 Q3: IS MONEY WHAT MONEY DOES? .............................................................................................................................. 225 Q4: ARE CONTEMPORARY GOVERNMENT MONETARY INSTRUMENTS IRREDEEMABLE? OR, IS THE FAIR VALUE OF CONTEMPORARY GOVERNMENT MONETARY INSTRUMENTS ZERO? ............................................................................................................... 227 Q5: IS MONETARY LOGIC CIRCULAR? .............................................................................................................................. 228 Q6: DO ISSUERS OF MONETARY INSTRUMENTS PROMISE A STABLE PURCHASING POWER? ......................................................... 228 Q7: ARE MONETARY INSTRUMENTS NECESSARILY FINANCIAL IN NATURE? .............................................................................. 229 Q8: ARE CREDIT CARDS MONETARY INSTRUMENTS? WHAT ABOUT PIZZA COUPONS? WHAT ABOUT PRETEND‐PLAY BANKNOTES AND COINS? WHAT ABOUT BITCOINS? .................................................................................................................................. 229 Q9: WHAT WERE SOME ERRORS MADE IN PAST MONETARY SYSTEMS? .................................................................................. 230 Q10: DO LEGAL TENDER LAWS DEFINE MONETARY INSTRUMENTS? WHAT ABOUT FIXED PRICE? ................................................. 232 Q11: IS IT UP TO PEOPLE TO DECIDE WHAT A MONETARY INSTRUMENT IS? WHO DECIDES WHEN SOMETHING IS DEMONETIZED? ...... 232 Q12: CAN ANYBODY CREATE A MONETARY INSTRUMENT? .................................................................................................. 232 CHAPTER 17: HISTORY OF MONETARY SYSTEMS ....................................................................................................................... 235 MASSACHUSETTS BAY COLONIES: ANCHORING OF EXPECTATIONS AND INAPPROPRIATE REFLUX MECHANISM ................................. 236 MEDIEVAL GOLD COINS: FRAUD, DEBASEMENT, CRYING OUT, AND MARKET VALUE OF PRECIOUS METAL ...................................... 237 TOBACCO LEAFS IN THE AMERICAN COLONIES: LEGAL TENDER LAWS AND SCARCITY OF MONETARY INSTRUMENTS .......................... 239 SOMALIAN SHILLING: THE DOWNFALL OF THE ISSUER AND CONTINUED CIRCULATION OF ITS MONETARY INSTRUMENT ..................... 240 GLOSSARY ................................................................................................................................................................. 242 ABOUT THE AUTHOR ................................................................................................................................................... 248

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PREFACE This text is the preliminary draft for a textbook that is the result of an extensive revision of posts published on the blog neweconomicperspectives.org. Why write a new money and banking text when there are already so many available? There are three main reasons. First, texts usually do not have a coherent theme that runs through them and that ties together all the chapters. Second, the monetary and banking chapters usually leave a lot to be desired because they present outdated views or are too limited in their presentation of the topic. Three, the macroeconomic sections usually do not use what was presented in the previous chapters, leave aside important debates in academia, and only briefly deal with balance sheet interrelationships to analyze macroeconomic issues. This preliminary text deals with these three issues. Throughout the text, the concept of balance sheet is central and used to analyze all the topics presented. Not only are balance sheets relevant to understand financial mechanics, but also they force an inquirer to fit a logical argument into double‐entry accounting rules. This is crucial because if that cannot be done there is an error in the logical argument. The monetary and banking aspects and their relation to the macroeconomy are analyzed extensively in this text by relying on the literature that has been available for decades in non‐mainstream journals, but that has been mostly ignored until recently. Gone is the money multiplier theory, gone in the financial intermediary theory of banks, gone is the idea that central bank control monetary aggregates, gone is the idea that finance is neutral in any range of time, and gone is the idea that nominal values are irrelevant. Preoccupations about monetary gains, solvency and liquidity are central to the dynamics of capitalism, and finance is not constrained by the amount of saving. The chapters dealing with monetary systems are also much more developed than a typical textbook. As such, the “money” chapter, usually first in M&B texts, only comes much later in the form of three chapters, once balance‐sheet mechanics and financial concepts, such as present value, have been well understood. In addition, the link between macroeconomic topics and banking theory is fully established to analyze issue of inflation, economic growth, financial crisis, and financial interlinkages. Of course, all this is still work in progress. There are many chapters missing for a full text and some of the chapters will need to be rewritten to account for comments by my students and others. Below is a list of missing Chapters that will be added between January and June 2017 (some of this is already included in the book but is underdeveloped): 1. Overview of the financial system (how financial companies differ because of different balance sheets) 2. Financial state of different macroeconomic sectors, flow of funds analysis (who is a net creditor? Etc.) 3. Federal Reserve System institutional analysis 4. Interest rate and interest rate structure 5. Pricing of securities 6. Securitization 7. Derivatives 8. Monetary policy in action (issues surrounding interest‐rate rules, transmission channels, etc.) v

9. International monetary arrangements and exchange rates 10. Modeling (theory of the circuit, including the money supply in models, stock‐flow coherency, portfolio constraints, capital gains, using models, etc.) In the second draft, the first five Chapters above will be Chapters 2, 3, 4, 5 and 6 respectively; Chapter 1 will still be about balance sheet mechanics and will be expanded. The Chapter 2 in the text below will be included in Chapter 3 above. Securitization and derivative will be included after studying banks in details (i.e. after Chapter 10 below). International arrangement will come toward the end of the book. In order to use this preliminary edition, it is recommended that institutional analysis be done first by the instructor. Any text will do for that purpose but the lecturer can emphasize how the structure of balance sheets differs between financial companies in order to explain what each financial company does. I wish to thank all the readers of the posts that form the basis of this preliminary text. Their comments were very helpful to improve clarity of the text and correct some mistakes. Many thanks to Stavros N. Karageorgis for carefully reading and editing the draft.

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CHAPTER 1: After reading this chapter you should understand: What a balance sheet is Why a balance sheet changes How a balance sheet changes

CHAPTER 1: BALANCE‐SHEET MECHANICS The U.S. financial system is extremely complicated. Figure 1.1 provides an overview of that system that consists of three main categories; financial markets, financial companies and regulatory and supervisory institutions. While most parts of that system will be at least mentioned in this draft, the draft focuses mostly on the Federal Reserve System and depository institutions. International Financial Markets (Foreign Exchange Markets, Eurocurrencies, Eurobonds, Foreign Bonds) Capital Markets: Securities with a maturity superior to one year (Stocks, Bonds, Asset-Backed Securities) Financial Markets

Money Markets: Securities with a maturity of one year or less (BAs, CDs, CPs, Federal funds loans, RPs, bills)

Primary Market Organized Exchanges Secondary Market OTC Markets

Insurance Markets (Forwards, Futures, Options, Swaps) Organized Exchanges (CBOT, CBOE, NASDAQ, NYSE) Financial-Market Companies Security Firms (Investment Banks, Brokerage Firms) Commercial Banks Depository Institutions Thrift Institutions (Credit Unions, Savings Banks, Savings and Loan Associations) Financial Sector

Financial Companies Financial Investment Companies (Hedge Funds, Pension Funds, Mutual Funds, Real Estate Investment Trusts) Insurance Companies (Life Insurance Companies, Property and Casualty Insurance Companies, Monolines) Finance Companies (Business Finance Companies, Consumer Finance Companies, Sales Finance Companies, SPEs) Government Financial Agencies

Government-Sponsored Enterprises (FAMC, FCS, FHLBS, FHMLC, FNMA, SLMA) Government Loan Guarantee Programs and Government Loan Programs (ExIm Bank, FHA, FCA, GNMA, SBA, VA, DLP) Federal Reserve System (Fedwire, Discount Window, Open Market Trading Desk)

Private: National Associations (SIFMA, FINRA, NBA, NFA), Organized Exchanges, Clearing Systems (OC Corp., CHIPS), Credit-Rating Agencies Regulatory and Supervisory Institutions Government: Department of Housing and Urban Development (FHFA), Department of Labor, Department of Treasury (OCC, OTS), Independent Federal Agencies (CFTC, FCA, FDIC, Federal Reserve Board, Reserve Banks, Fedwire, FTC, NCUA, SEC, CFPB), Interfederal agencies (FFIEC, FSOC), State Banking and Insurance Commissioners CBOE: Chicago Board Options Exchange, CBOT: Chicago Board of Trade, CFPB: Consumer Financial Protection Bureau, CFTC: Commodity Futures Trading Commission, DLP: Direct Loan Program, Ex-Im Bank: Export-Import Bank, FAMC: Federal Agricultural Mortgage Corporation (“Farmer Mac”), FCA: Farm Credit Administration, FCS: Farm Credit System, FDIC: Federal Deposit Insurance Corporation, FFIEC: Federal Financial Institution Examination Council, CHIPS: Clearing House Interbank Payment System, FHA: Federal Housing Administration, FHFA: Federal Housing Finance Agency, FHLBS: Federal Home Loan Banks System, FHMLC: Federal Home Loan Mortgage Corporation (“Freddie Mac”), FNMA: Federal National Mortgage Association (“Fannie Mae”), FSA: Farm Service Agency, FSOC: Financial Stability Oversight Council, FTC: Federal Trade Commission, GNMA: Government National Mortgage Association (“Ginnie Mae”), FINRA: Financial Industry Regulatory Authority, NASDAQ: National Association of Securities Dealers Automated Quotation System, NBA: National Bankers Association, NCUA: National Credit Union Administration, NFA: National Futures Association, NYSE: New York Stock Exchange, OC Corp.: Option Clearing Corporation, OCC: Office of the Comptroller of the Currency, OTC: Over-the-Counter, OTS: Office of Thrift Supervision, SBA: Small Business Administration, SEC: Securities and Exchange Commission, SIFMA: Securities Industry and Financial Markets Association, SLMA: Student Loan Marketing Association (“Sallie Mae”), SPE: Special Purpose Entity, VA: Department of Veteran Affairs.

Figure 1.1. The U.S. financial sector The core of the financial system consists of financial documents and among them are balance sheets. Balance sheets provide the foundation upon which most of an M&B course can be taught: monetary creation by banks and the central bank, nature of money, financial crises, securitization, financial interdependencies, you name it, it has to do with one or several balance sheet(s). As Hyman P. Minsky used to note, if you cannot put your reasoning in terms of a balance sheet there is a problem in your logic.

WHAT IS A BALANCE SHEET? It is an accounting document that records what an economic unit owns (its “assets”) and owes (its “liabilities”). The difference between its assets and liabilities is called net worth, or equity, or capital (Figure 1.2).

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CHAPTER 1: BALANCE‐SHEET MECHANICS

Figure 1.2 A balance sheet

There are many different ways to classify assets and liabilities. For our purposes, a balance sheet can be detailed a bit according to Figure 1.3. Financial assets are claims on other economic units; non‐financial assets (aka real assets) may be reduced to physical things (cars, buildings, machines, pens, desks, inventories, etc.) but may also include intangible things (goodwill among others). Demand liabilities are liabilities that are due at the request of creditors (cash can be withdrawn from bank accounts at will by account holders); contingent liabilities are due when a specific event occurs (life insurance payments to a widow); dated liabilities are due at specific periods of time (interest and principal mortgage payments are due every month).

Figure 1.3 A simple balance sheet

Balance sheets can be constructed for any economic unit. That unit can be a person, a firm, a sector of the economy, a country, anybody or anything with assets and liabilities. Table 1.1 shows the balance sheet of all U.S. households (and non‐profit organizations) in the United States. In 2014, U.S. households owned $98.3 trillion worth of assets and owed $14.2 trillion worth of liabilities, making net worth equal to $84.1 trillion (98.3 – 14.2). Households held $29.2 trillion of non‐financial assets and $69.1 trillion of financial assets. Their two main liabilities were mortgages ($9.4 trillion) and consumer credit (credit card debts, student debts, healthcare debts, etc.) ($3.3 trillion).

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Table 1.1 Balance sheet of households and NPOs. Source: Financial Accounts of the United States

BALANCE SHEET RULES A balance sheet follows double‐entry accounting rules so a balance sheet must always balance, that is, the following must always be true: Assets = Liabilities + Net Worth The practical, and central, implication is that a change in one item on the balance sheet must be offset by at least one change somewhere else so that a balance sheet stays balanced. 4

CHAPTER 1: BALANCE‐SHEET MECHANICS Start with a very simple balance sheet. The only asset is a house worth $100k that was purchased by putting down 20k and asking for $80k from a bank (Figure 1.4).

Figure 1.4 A simple balance sheet

What is the impact of a bank forgiving $40k of principal on the mortgage? The value of mortgage went down by 40k and the value of net worth went up by 40k so that the accounting equality is preserved (Figure 1.5)

Figure 1.5 Effect of forgiving some of the mortgage principal Going back to the first balance sheet, what is the impact of the value of the house going up by $20k? The asset value went up by $20k and the net worth went up by $20 and here again the accounting equality is preserved. (Figure 1.6).

Figure 1.6 Effect of higher house price Sometimes, to get to the point more quickly and to highlight the changes, economists prefer to use so‐called “T‐accounts” (because the shape of the table looks like a T) that record only the changes in the balance sheet (Δ means “change in”). The offsetting accounting entry is shown more clearly. It comes from opposite changes in two items on the right side of the balance sheet (Figure 1.7), and a change in asset and net worth by the same amount (Figure 1.8). Of course, these are not the only 5

CHAPTER 1: BALANCE‐SHEET MECHANICS two ways the offsetting is done to preserve the accounting equality. We will encounter other cases as we move forward. The point is that one must change at least two things in a balance sheet to make sure that the equality A = L + NW is preserved. One must always ask: what is (are) the offsetting entry change(s)? This has practical implications when studying how banks and central bank operate. Household ΔLiabilities and Net Worth Mortgage: ‐$40 Net worth: +$40 Figure 1.7 T‐account that records the decline of the mortgage principal ΔAssets

Household ΔAssets ΔLiabilities and Net Worth House: +$20 Net worth: +$20 Figure 1.8 T‐account that records the higher house value

CHANGES IN THE BALANCE SHEET One can classify factors that change a balance sheet in four categories: ‐

Cash inflows and outflows: net cash flow.

‐

Purchases and sales of assets, issuance and repayment of debts: Net acquisition of assets and liabilities.

‐

Incomes and expenses: net income.

‐

Capital gains and capital losses: net change in the market value of assets and liabilities.

The last three categories are recorded more carefully in other accounting documents than the balance sheet, but this section focuses on their relation to the balance sheet.

NET CASH FLOW Cash inflows and cash outflows lead to a change in the outstanding value of monetary balances held by an economic unit, that is, a change in the quantity of physical currency or funds in a bank account held on the asset side. Some assets lead to cash inflows while some liabilities and capital (dividend payments) lead to cash outflows. If the cash inflows are greater than the cash outflows, monetary assets held by an economic unit go up. The economic unit can use them to buy assets or pledge them to leverage its balance sheet (see Chapter 7). If net cash flow is negative, then monetary‐asset holdings fall and the economic unit may have to go further into debt to pay some of its expenses (Figure 1.9).

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Figure 1.9 Balance sheet and cash flow

Going back to the balance sheet of Figure 1.4, assume that a salary of $40k is earned and that part of the salary is used to service a 30‐year fixed‐rate 10 % mortgage. Assuming linear repayment of principal to simplify (actual mortgage servicing is calculated differently), Figure 1.10 shows what the cash flow structure looks like.

Figure 1.10 Balance sheet and cash flows, an example

The balance sheet at the beginning of the following year is shown in Figure 1.11 (assuming all cash flows involve actual cash transfer instead of electronic payments). Quite a few things have changed in the balance sheet. There is a net inflow of cash of $29.3k, the principal of the mortgage fell by the amount of principal repaid, and the change in net worth accounts for these two changes.

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Figure 1.11 Balance sheet after the cash‐flow impacts

NET ADDITION TO ASSETS AND LIABILITIES Net cash flow records the net addition of monetary balances but there are many other assets on the balance sheets. Overtime, assets loss value via depreciation, or destruction, or repayment of principal; some assets are sold while others assets are purchased. The net change in the monetary value of assets (acquisitions minus loss of value and sales) impacts the balance sheet. Depreciation is counted as an expense and so impacts net income. Similarly, liabilities on the balance sheet are progressively repaid (principal repayment) or reduced in other ways, while new liabilities are issued by an economic unit. The net issuance of liabilities (new liabilities – principal reductions) also impacts the balance sheet of their issuers. They also impact the balance sheet of the creditors given that the liabilities of someone are the financial assets of someone else. Current net worth = Previous net worth + Net addition to assets and liabilities of the period Figures 1.4 shows the impact of acquiring non‐financial assets (the house) and incurring new liabilities (the mortgage). Figure 1.5 shows the impact of a decline in the principal amount of the mortgage.

NET INCOME Net income leads to a change in net worth: Current net worth = Previous net worth + Net addition to assets and liabilities of the period + Net income of the period Net income can be positive or negative so net worth may rise or fall depending on what the value of net income is. In the previous example (Figures 1.10 and 1.11), net cash flow and net income are the same thing; however, not all incomes necessarily lead to cash inflows (see Chapter 4 and Chapter 10). There is a debate about whether one should record capital gains and losses in the income statement. For the purpose of this section, the two are clearly separated.

NET CAPITAL GAIN The value of assets and liabilities change merely because of changes in their market prices even though their quantities has not changed (no net addition). If accounting is done on a “mark‐to‐ 8

CHAPTER 1: BALANCE‐SHEET MECHANICS market” basis, i.e. by valuing balance‐sheet items on the basis of their current market value, these changes are accounted in the balance sheet. Some assets see their prices go up (capital gains) while other see their prices go down (capital losses) and the difference between capital gains and capital losses (net capital gains) affects the net worth accordingly: Current net worth = Previous net worth + Net addition to assets and liabilities of the period + Net income of the period + Net acquisition of assets and liabilities of the period + Net capital gains of the period The example of Figure 1.3 is a simple illustration of the impact of capital gains. The effect of a change in the market prices of assets and liabilities may not be recorded in the balance sheet if they are valued on a cost basis. For financial assets, there are three options to record their value. Level 1‐valuation uses the available market price. Level‐2 valuation, for assets that do not have an active market, uses a proxy market as a point of reference. Level‐3 valuation, also called mark‐to‐model (or more cynically “mark‐to‐myth”), uses an in‐house model to give a dollar value to the asset. During the 2008 crisis, major financial institutions argued that the market prices of some assets did not reflect their true value because of a panic in markets. The Securities and Exchange Commission allowed them to move to level‐2 or level‐3 valuation to avoid recording capital losses on their assets. Many analysts have been critical of that decision and considered it to be a convenient way to hide major losses of net worth by financial institutions. Summary of Major Points 1‐ A balance sheet is one of the important financial documents used to record the financial state of an economic unit 2‐ Assets represent what is owned and liabilities represent what is owed by an economic unit 3‐ Net worth or capital or equity is the difference between the monetary value of assets and liabilities 4‐ A balance sheet must balance, i.e. at all time the following must be true: Assets = Liabilities + Net Worth 5‐ A balance sheet follows double‐entry accounting rules: a change somewhere leads to at least one offsetting change somewhere else to ensure that the balance sheet stays balanced. Keywords Balance sheet, non‐financial assets, financial assets, demand liability, time liability, contingent liability, net worth, capital, net income, net cash flow, net capital gain, net acquisition of assets and liabilities, level‐1 valuation, level‐2 valuation, level‐3 valuation Review Questions Q1: What does a balance sheet do? Q2: If the value of assets goes up and the value of liabilities goes down, what happens to net worth? Q3: If the value of assets and liabilities changes by the same amount, what happens to net worth? Q4: If outstanding assets depreciate faster than the acquisition of new assets, what happens to the value of assets? To the value of net worth? Q5: If an economic unit takes on new debt faster than it repays outstanding principal, what happens to the level of liabilities? Of net worth? 9

CHAPTER 2:

After reading this Chapter you should understand: What the main components of a central‐bank balance sheet are How a central bank provides reserves That a central bank does not rely on taxpayers That a central bank does not lend reserves That a central bank does not use any domestic monetary instruments That a central bank does not earn any cash flow in the domestic currency That banks cannot buy anything with reserve balances from the public

CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS The Federal Reserve System (the Fed) is a typical central bank. It provides the currency of the nation, it is the depository and fiscal agent of the Treasury, it provides advances of funds to banks, and it intervenes in financial markets. In order to understand how all this is done, it is important to understand the balance sheet of the Fed. This Chapter applies the insights of Chapter 1 to study the balance sheet mechanics of the Fed.

BALANCE SHEET OF THE FEDERAL RESERVE SYSTEM Table 2.1 shows the actual balance sheet of the Federal Reserve System. It sums the assets, liabilities, and capital of all twelve Federal Reserve banks and consolidates them (i.e. removes what Fed banks owe to each other). The main asset is Treasury securities that amounted to about $718 billion in January 2005.

Table 2.1 Actual balance sheet of the Federal Reserve System Source: Board of Governors of the Federal Reserve System (Series H.4.1)

The main liability is outstanding Federal Reserve notes (FRNs) issued—that is, held outside the twelve Federal Reserve banks’ vaults—that amounted to $718 billion in January 2005. This line in the balance sheet includes all FRNs issued regardless who owns them. A distant second liability was reserve balances (“deposits of depository institutions”) that amounted to $31 billion.

11

CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS Capital consists mostly of the annual net income of the Fed (“surplus” line) and the shares that banks must buy when becoming members of the Federal Reserve System (the “capital paid in” line). These shares are not tradable, cannot be pledged (banks cannot use them as collateral and they cannot be discounted), do not provide a voting right to banks, and pay an annual dividend representing 6% of net income of the Fed. Any left‐over net income is transferred to the U.S. Treasury and the Secretary of the Treasury can use the funds only for two purposes: to increase Treasury’s gold stock or to reduce outstanding amount of Treasuries.1 For analytical purposes, it is best to rearrange the balance sheet of the Fed according to Figure 2.1. Through this book, a lot will be done with L1, L2 and L3 as well as A1 and A2 because they are all central to the understanding of domestic monetary policy operations. In addition, L1 only contains the FRNs held by banks, the domestic public and foreigners. Indeed, for analytical purposes, economists like to measure the outstanding value of FRNs in circulation, that is, FRNs held outside the vaults of private banks (“vault cash”), of the Federal Reserve banks, and of the U.S. Treasury. FRNs held by the Treasury are included in L3, FRNs held by the Federal Reserve banks are included nowhere (they have not been issued so they are not a liability yet). Assets A1: Securities A2: Domestic private banks’ promissory notes A3: Foreign‐denominated assets A4: Coins and Treasury currency

Liabilities and Net Worth L1: Federal Reserve notes in circulation and vault cash L2: Reserve balances (Checking account due to banks) L3: Treasury’s account and Federal Reserve notes held by Treasury

A5: Other assets (buildings, furniture, L4: Accounts due to foreigners and etc.) others L5: Other liabilities (including equity capital)

Figure 2.1 A simplified balance sheet of the Federal Reserve System

FOUR IMPORTANT POINTS POINT 1: THE FEDERAL RESERVE NOTES ARE A LIABILITY OF THE FED. One immediately notes that the central bank does not own any cash or a bank account in US dollar, i.e. there are no domestic monetary instruments on its asset side besides a few Treasury currency items (United States notes, etc.) and some coins. The Fed does not use coins to spend, it acts as coin dealer on behalf of the Treasury,2 that is, Fed buys all new coins from the U.S. Mint at face value and sells them to banks at their request by debiting their reserve balances. The Fed also buys back coins that banks have in excess by crediting their reserve balances. Gold certificate account (first line under assets) are just electronic entries to record the safe keeping of some of the gold stock owned by the U.S. Treasury; The Fed does not own any gold.3 The Fed does own some foreign monetary instruments (SDR accounts, accounts at foreign central banks, foreign currency). 12

CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS What the U.S. population considers to be “money,” the Federal Reserve notes (FRNs), is recorded as a liability on the balance sheet of the Fed. FRNs are a specific security issued by the Fed and the Fed owes the holders of the FRNs. Chapter 15 studies what is owed. FRNs are secured by some of the assets of the Federal Reserve banks, most of them are Treasuries (Figure 2.2)

Figure 2.2. Level and composition of the assets pledged against the FRNs out of the Federal Reserve vaults, trillions of dollars Source: Board of Governors of the Federal Reserve System (Series H4.1) Note: USTS means U.S. Treasury security, MBS means mortgage‐backed security.

POINT 2: THE FED DOES NOT EARN ANY CASH FLOW IN USD When the Fed receives a net income in US dollars it does not receive any cash flow, i.e. no monetary asset goes up. What goes up is net worth. How does that occur? Suppose that banks request an advance of funds of $100 repayable the next day with a 10% interest. Today the following is recorded: Fed ΔAssets Promissory notes of banks: +$100

ΔLiabilities and Net Worth Reserve balances: +$100

The Fed just typed an entry on each side of its balance sheet, one to record the crediting of reserve balances and one to record the Fed is now a creditor of private banks by holding a claim on banks. The next day banks must pay back $100 and an additional $10. The full repayment of the principal leads to: Fed ΔAssets Promissory notes of banks: ‐$100 13

ΔLiabilities and Net Worth Reserve balances: ‐$100

CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS What about the $10 payment? It leads to an additional decrease in reserve balances and the offsetting operation is an increase in net worth at the Fed (and a decrease in net worth at private banks) Fed ΔAssets

ΔLiabilities and Net Worth Reserve balances: ‐$10 Net worth: +$10

These two T‐accounts are normally consolidated into one: Fed ΔAssets Promissory notes of banks: ‐$100

ΔLiabilities and Net Worth Reserve balances: ‐$110 Net worth: +$10

Here we go! The Fed records an income gain! How does it transfer that to the Treasury? Easy! A Fed employee types the following on a keyboard: Fed ΔAssets

ΔLiabilities and Net Worth Treasury’s account: +$10 Net worth: ‐$10

The transfer of funds between accounts is like keeping scores by changing amounts recorded on the liability side. Banks lost 10 points, Treasury gained 10 points.

POINT 3: THE FED DOES NOT LEND RESERVES AND DOES NOT RELY ON THE TAXPAYERS In Table 2.1, there is a line labeled “loan” on the asset side, and one will often hear and read—even in Fed documents—that the Fed lends reserves to banks. In the balance sheet of Figure2.1, there is no “loan” but instead there is “A2: Domestic private banks’ promissory notes.” This textbook will not the use the words “loan,” “lender,” “borrower,” “lending,” “borrowing,” when analyzing banks (private or Fed) and their credit operations. Banks do not lend money—they are not money lenders—and customers do not borrow money from banks. Words like “advance,” “creditor,” “debtor,” are more appropriate words to describe what goes on in banking operations. The word “lend” (and so “borrow”) is really a misnomer that has the potential of confusing—and actually does confuse—people about what banks do. “Lending” means giving up an asset temporarily: “I lend you my car for a few days” is represented as follows in terms of a balance sheet: Dr. T ΔAssets Car: ‐$100 Claim on borrower of car: +$100

ΔLiabilities and Net Worth

Alternatively, if someone goes to see a loan shark for his gambling habits and borrows $1000 cash, then the balance sheet of the loan shark changes as follows

14

CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS Loan shark ΔAssets Cash: ‐$1000 Claim on gambler: +$1000


The loan shark loses cash temporarily—he does lend cash—and if the gambler does not repay quickly with hefty interest, the loan shark comes with a baseball bat and breaks his legs (or worse!). “To lend” is really not a proper verb to explain what the Fed does because reserve balances and FRNs are not assets of the Fed, they are its liabilities. As shown in point 2, when the Fed provides reserve balances to banks, the Fed gives to banks its own promissory note (reserve balances) and banks give to the Fed their own promissory notes. What the Fed does is to swap/exchange promissory notes with banks. This is one way for banks to obtain reserves balances. Chapter 4 and Chapter 10 explain why banks are so interested in the Fed’s promissory note and how they obtain reserves. Figure 2.3 shows what the banks’ promissory note looks like.

Figure 2.3 Template of the promissory note issued by banks to the Discount Window Source: Federal Reserve Bank Services (Operating circular No. 10)

15

CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS In this legal document (and others attached to it), a bank recognizes that it is indebted to the Fed because the Fed provided an advance of funds, that is, credited the bank’s reserve balance. Now the bank promises to comply with the terms of the contract that details time table for repayment, interest, collateral requirements, covenants, what happens in case of default, etc. The Fed keeps a copy of this document in its vault; it is an asset for the Fed (A2 in Figure 2.1) because the bank made a legal promise to the Fed. The Fed can force the bank to comply with the demands of the promise. The main point is that, when the Fed provides funds to banks, the Fed does not give up something it first had to acquire. The Fed does not use “tax payers’ money” (or anybody else’s money) as we often heard during the 2008 financial crisis when large emergency advances had to be provided to many financial institutions. When the Fed provides/advances funds to banks, it just credits the accounts of banks by keystroking amounts. Chapter 10 shows that the same logic applies to private banks.

POINT 4: BANKS CANNOT DO ANYTHING WITH RESERVE BALANCES UNLESS THEY ARE DEALING WITH OTHER FED ACCOUNT HOLDERS One may also note that nobody in the U.S. population has a bank account at the Federal Reserve. Only domestic banks, foreign central banks, and other specific institutions (such as the International Monetary Fund and some government‐sponsored enterprises) have an account at the Fed.4 When banks use their accounts at the Fed to make or to receive a payment, the only other institutions that can receive the funds (or make a payment to banks) are those that also hold an account at the Fed. Banks cannot use their reserve balances to buy something from an economic unit that does not have an account at the Fed because funds cannot be transferred. Similarly, you and I cannot make electronic payments to a person who does not hold a bank account. This is what happens when banks spend $100 from their reserve balances: Fed ΔAssets


This T‐account is incomplete because it lacks the offsetting accounting entry. What are the possibilities? Below are three of them: 1‐ Banks ask for FRNs: Fed ΔAssets

ΔLiabilities and Net Worth FRNs: +$100 Reserve balances: ‐$100

2‐ Banks settle taxes (theirs or that of the US population): Fed ΔAssets

ΔLiabilities and Net Worth Reserve balances: ‐$100 Treasury’s account: +$100

3‐ Banks participate in an offering of securities by a government‐sponsored enterprise:

16

CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS Fed ΔAssets

ΔLiabilities and Net Worth Reserve balances: ‐$100 GSEs’ account: +$100

You may think of other ways to transfer $100 worth of funds on the liability side of the Fed. Once again, the Fed is basically keeping scores by transferring funds among account holders and keeping a tab. The main point is that banks cannot buy anything with reserve balances from anyone in the domestic economy except from each other and other Fed account holders. Banks as a whole cannot use reserve balances to acquire any security issued by the private sector or any goods and services (one bank could use its reserve balance to buy such things from another bank). More reserves do not provide banks more purchasing power in the domestic economy to buy existing bonds, stocks, houses, etc. If banks wanted buy something from someone in the domestic economy with Fed currency, they would have to get more vault cash first (case 1 above). Chapter 10 shows that banks do not operate that way to make payments. Nor do banks lend cash (they are not the loan shark of point 2).

CAN THE FED BE INSOLVENT OR ILLIQUID? No. The Fed cannot “run out of dollars” because it is the issuer of the dollar. The Fed could have a negative net worth and still be able to operate normally and meet all its creditors’ demands. The main role of net worth in a private balance sheet is to protect the creditors (the holders of the liabilities). Think of the house example in Chapter 1. The house was funded by $80k of funds obtained from a bank and $20k down. If the mortgagor defaults, the bank can foreclose and sell the house. With a net worth of 20k, the home price can fall by 20% before the bank is unable to recover the funds advanced to the mortgagor. If the down‐payment had been 0% (mortgage was $100k), when the bank forecloses it does not have any financial buffer against a fall in house price. For the Fed, this is financially irrelevant, although politically it may raise some eyebrows in Congress. It can meet all payments due denominated in USD at any time, no matter how big they are.

17

CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS

Summary of Major Points 1‐ The main liability of the Federal Reserve System is the cash we have in our wallet, Federal Reserve notes. 2‐ The main asset of the Federal Reserve System is Treasury securities. 3‐ Lending means temporarily giving up an asset; as such the Federal Reserve System does not lend reserves because reserves are its liability. 4‐ To credit the account of its account holders, the Federal Reserve System swaps promissory notes with them. 5‐ To obtain an advance from the Fed, private banks must provide collateral to back their promissory note. 6‐ Paying interest to the Fed increases its net worth and debits the Fed accounts of whomever is paying the interest. There is no cash flow gain, i.e. no increase in monetary balances on the asset side of the Fed’s balance sheet. 7‐ Banks can only transfer funds in/out of their Fed accounts from/to other Fed account holders, in the same way you and I can only transfer funds from our checking account to another checking account. As such private banks cannot buy anything with their reserve balances from the public. 8‐ The Federal Reserve System issues the U.S. currency so it cannot run out of U.S. currency and can pay any debt it owes denominated in the U.S. dollar. Keywords Currency in circulation, Federal Reserve note, reserve balance, loan, lending, advance, swapping. Review Questions Q1: Do the Federal Reserve banks own any domestic monetary instruments? Q2: Do the Federal Reserve banks use coins to buy assets? Q3: Why do the Federal Reserve banks not lend reserves? Q4: Why is it not possible for private banks to buy things from the public by using their reserve balances? Q5: What can private banks buy with their reserve balances? Q6: When private banks pay an interest to the Federal Reserve banks, how do Federal Reserve banks record this income gain? Is there any gain of cash flow? Q7: Why is it not possible for the Federal Reserve System to be insolvent? Suggested Readings Check the “General Information” https://www.frbdiscountwindow.org/

tag

of

the

Discount

Window

website:

Check “About the Fed” here: http://www.federalreserve.gov/aboutthefed/default.htm Check the website of the Board of Governors of the Federal Reserve System, especially the following: http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm. Table 5 contains an interactive section about the balance sheet of the Fed.

18

CHAPTER 2: CENTRAL‐BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS

Database Exploration How to retrieve time series data about the balance sheet of the Fed? Step 1: Go to Series H.4.1: http://www.federalreserve.gov/releases/h41/ Step 2: Click on “PDF” and look for Table 5. Use it as a reference point to select data. Step 3: Click on “Data download program.” Step 4: Select option A “Build your package.” Step 5: In “2. Category” select “Assets” and “Liabilities and Capital.”

Step 6: Continue with the subcategories and components. You can select more or less details relative to Table 5. Step 7: Continue with other miscellaneous selections (frequency, time frame, etc.) and download. Tip: Always download “total assets” and “total liabilities” so you can sum all the components of each category and make sure they equal the total. If not, you forgot a component. 1 For detail see Section 7 of Federal Reserve Act. 2

See Current FAQs: “What is the role of the Federal Reserve with respect to banknotes and coins?” at http://www.federalreserve.gov/faqs/currency_12626.htm 3 See Current FAQs: “Does the Federal Reserve own or hold gold?” at http://www.federalreserve.gov/faqs/does‐the‐ federal‐reserve‐own‐or‐hold‐gold.htm 4 A recent working paper released by the Bank of England proposes to expand the access to accounts at the Bank of England to the general population. Staff Working Paper No. 605, “The macroeconomics of central bank issued digital currencies” by John Barrdear and Michael Kumhof.

19

CHAPTER 3:

After reading this Chapter you should be able to understand: What reserves and monetary base are What the most common means to obtain reserves for banks are How the composition of reserves has changed over time How reserves and monetary base are injected into, and removed from, the economy

CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET The previous Chapter explained how the balance sheet of the Fed works. The current Chapter begins to study the details of how the Fed operates in the economy in terms of monetary policy. To understand what the Fed does, it is first necessary to define the monetary base and see how it relates to the Fed’s balance sheet. The Chapter quickly looks at the difference between monetary base and money supply, and also looks more carefully at what reserves are.

THE MONETARY BASE AND THE MONEY SUPPLY The monetary base (aka “high‐powered money”) is defined as: Monetary Base = Reserve balances + vault cash + currency in circulation In its widest meaning, “in circulation” refers to any monetary instrument not held by its issuer; Federal Reserve Notes (FRNs) outside the Federal Reserve banks and any Treasury‐issued cash outside the Treasury. Economists prefer to use a narrower definition. Currency in circulation is any currency outside vaults of private banks (“vault cash”), of the Treasury, and of the Fed—what is held by “the public.”

Figure 3.1 Monetary base, billions of dollars Sources: Board of Governors of the Federal Reserve System (H3 and H6 series) Technically, cash means currency and coins. The Fed and Treasury use the word “currency” to mean paper money only. Currency in circulation includes mostly FRNs, but also some Treasury currency (United States notes, silver certificates) and national bank notes (issued prior to the creation of the Fed in 1913) that the Treasury still agrees to take at face value at any time.1 The distinction between coins and currency is mostly statistical and does not have any analytical power. Chapter 15 shows that the material of which something is made is irrelevant to determine if it is a monetary instrument. This book uses the word cash and currency interchangeably. To simplify, the U.S. monetary base can be reduced to (see Figure 2.1 for meanings of L1 and L2): 21

CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET Monetary base = L1 + L2 That is, the monetary base is the sum of reserve balances and FRNs held by entities other than the Fed and the Treasury. Until recently, currency in circulation was the largest component of the monetary base and it grew steadily to almost $1.4 trillion today, most of which are FRNs,2 and between one‐half and two‐thirds of the value of currency in circulation is held abroad.3 The global financial crisis led a large increase in reserve balances from about $24 billion on average from January 1959 to August 2008 to about $2.5 trillion today (Figure 3.1).

Figure 3.2 Money supply (M1 aggregate), billions of dollars Source: Board of Governors of the Federal Reserve System (Series H.6)

The monetary base is not the same thing as the money supply. Money supply means monetary instruments held by non‐bank economic units and outside the Treasury and other official foreign institutions. There are several ways to measure that, and monetary aggregate M1 is the narrowest (Figure 3.2): M1 = Currency in circulation + Private‐bank checking accounts of non‐banks, non‐federal, non‐ official foreign economic units + others M1 relates to the Fed’s balance sheet only via part of L1. Since 1959, FRNs in circulation has represented a growing proportion of the monetary base (Figure 3.2). From 20% in the 1960s to 30% in the early 1990s. The 1990s recorded a rapid growth in the share of FRNs in circulation that peaked at 56% of the monetary base in 2007 and has been around 40% to 50% since the late 1990s. The proportion of demand accounts represented about 80% of the monetary base in the 1960s, but this share fell quickly and almost continuously following the emergence of alternatives to demand accounts. The share of demand accounts in the monetary base reached 20% of the monetary base right before the 2008 financial crisis. Since the crisis, the share of demand accounts has increased sharply to reach 40% of the monetary base. Traveler’s checks have always been an insignificant 22

CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET component of the money supply. For reasons related to monetary policy detailed in Chapter 5 (Question 1), the growth rate of M1 increased in 2009. It is important to make a distinction between the money supply and the monetary base because the central bank has no direct influence on the money supply. The Fed does not deal with the public directly, private banks do. Even for FRNs, private banks are in charge of injecting FRNs into the economy, and they do so only if customers want to withdraw cash. In a 2010 interview4 Chairman Bernanke noted regarding the announced purchase of $600 billion of Treasuries (aka “quantitative easing”): One myth that's out there is that what we're doing is printing money. We're not printing money. The amount of currency in circulation is not changing. The money supply is not changing in any significant way. Translated in the terms of what was presented above, Bernanke states that L2 has gone up dramatically but that M1 has not changed. The Fed did not issue FRNs to the public (L1 did not increase), it just credited the accounts of banks by buying Treasuries from them and, as Chapter 2 shows, banks cannot do much with reserve balances. One should note that the Treasury’s account at the Fed (L3) and its accounts at private banks (called Treasury Tax and Loans accounts (TT&Ls)) are not part of the monetary base or the money supply. They are “funds.” The outstanding value of the Treasury’s accounts is not counted in any definition of the monetary base or the money supply.

RESERVES: REQUIRED, EXCESS, FREE, BORROWED, NON‐ BORROWED Within the monetary base, reserves are central to monetary‐policy operations so this section studies a bit more carefully the reserve‐side of the monetary base. Total quantity of reserves is: Total reserves = Reserves balances + applied vault cash = L2 + part of L1 Applied vault cash are the FRNs that banks decide to use to calculate the quantity of reserves they report to the Fed (the rest of vault cash is called “surplus vault cash”). From the 1990s and until the Great Recession, applied vault cash had represented the majority of total reserves and peaked to about 80% of total reserves. Since August 2008, reserves balances have been, by far, the main component of total reserves (Figure 3.3). It is possible for reserve balances (L2) to be negative, that is, the Fed allows banks to have an overdraft; however, the Fed expects that banks close any overdraft at the end of each day. If a bank cannot do so, the Fed charges a very high interest rate because the overdraft is a form of uncollateralized advance, contrary to Discount Window advances. If the overdraft persists, the Fed may take a closer look at how the bank runs its business.

23

CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET

Figure 3.3 Decomposition of total reserves in terms of forms, billions of dollars Source: Board of Governors of the Federal Reserve System (Series H.3) Total reserves can be decomposed into other categories than those based on the form reserves take. One may also be interested in knowing how banks obtained their reserves. The Fed is the monopoly supplier of reserves and there are two ways for the Fed to provide reserves: -

Discount Window operations: advances funds by swapping promissory notes with banks (see Chapter 2): “borrowed reserves”

-

Open‐market operations: Fed buys some financial assets from banks either permanently (“outright purchases”) or temporarily (“repurchase agreements”): “non‐borrowed reserves” Total reserves = borrowed reserves + non‐borrowed reserves

Non‐borrowed reserves have been the main source of reserves for banks (Figure 3.4) because the Fed discourages the use of the Discount Window (interest rate is higher and Fed may increase supervision if a bank comes to the Window too often). The stigma of going to the Window is so strong that, during the 2008 crisis, the Fed had to change its Discount Window procedures to entice banks that desperately needed reserves to come. Non‐borrowed reserves was negative during most of 2008 and peaked at about ‐$330 billion in October 2008 just about at the same time as borrowed reserves reached their peak value (Figure 3.5). Non‐borrowed reserves is measured by total reserves minus borrowed reserves. Borrowed reserves is measured by A2 in Figure 2.1. For reasons related to monetary developments discussed in Chapter 4, total reserves became smaller than A2 during the 2008 financial crisis. The central bank provided a lot of advances but removes most of the reserve injection that resulted from the advance.

24


Figure 3.4 Decomposition of total reserves in terms of sources, billions of dollars Source: Board of Governors of the Federal Reserve System (Series H.3)

Figure 3.5. Borrowed and non‐borrowed reserves during the 2008 financial crisis Sources: Board of Governors of the Federal Reserve System (Series H.3) Finally, the total quantity of reserves can be decomposed in terms of the reasons why banks hold reserves. Banks in the United States must have a certain proportion of reserves relative to the outstanding value of the bank accounts they issued: 25

CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET -

Required reserves: The quantity of reserves banks must hold in proportion of the bank accounts they issued.

-

Excess reserves: whatever quantity of reserves that banks have in excess of required reserves. Total reserves = Required reserves + excess reserves

Up until the 2008 crisis, banks held reserves mostly because they had to do so (Figure 3.6). Excess reserves was virtually zero (Chapter 4 explains why). Up until the crisis, the quantity of reserves was also relatively stable over decades and averaged $40 billion (Figure 3.7). One may sometimes encounter the word “free reserves,” which just means the difference between excess reserves and borrowed reserves. Throughout this series, the most important categorization will be the last one: excess versus required reserves.

Figure 3.6 Decomposition of total reserves in terms of uses, billions of dollars Source: Board of Governors of the Federal Reserve System (Series H.3)

26


Figure 3.7 Decomposition of total reserves in terms of uses until august 2008, billions of dollars Source: Board of Governors of the Federal Reserve System (Series H.3)

HOW DOES THE MONETARY BASE CHANGE? The monetary base goes up or down depending on what happens to the other items in the balance sheet of the Fed. Following the point that balance sheets must balance we have (using Figure 2.1): L1 + L2 = A1 + A2 + A3 + A4 + A5 – L3 – L4 – L5 So monetary base will be injected when: ‐

-

27

The Fed buys something (i.e. acquires an asset) from banks or the public -

Higher A1: Buying securities (T‐bills, T‐bonds, etc.)

-

Higher A2: Advances of Federal Funds

-

Higher A3: Buying foreign currency from private banks

-

Higher A5: Buying a pizza, a building, or a service from someone

The other Fed account holders spend in the US economy and when the Fed pays dividends to banks -

Lower L3: Treasury spends

-

Lower L4: US exports, government‐sponsored enterprises buy mortgages from banks

-

Lower L5: Fed pays dividends to member banks

CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET Monetary base is reduced when the opposite transactions occur. Buying coins from the Treasury does not change the monetary base because L3 goes up by the same amount as A4; it is an intra‐ federal government transaction. Let us go through two examples: Case 1: The Federal Reserve buys T‐Bills worth $100 from banks Fed ΔAssets ΔA1: +$100

ΔLiabilities and Net Worth ΔL2: +$100

Banks ΔAssets T‐bills: ‐$100 Reserve balances: ‐$100


You have just witnessed the creation of monetary base: The central bank credits the account of banks by typing “100” on the keyboard of a computer. The Fed could also have printed bank notes (ΔL1 = +$100) but purchases from banks are done electronically because of convenience. Case 2: Dr. T pays his income taxes worth $1000. Assume that Dr. T still mails his income‐tax paperwork with a check payable to the United States Treasury. The Treasury receives the check and brings it to the Fed. To simplify, the following ignores Treasury’s tax and loan accounts (TT&Ls) because that just complicates the analysis without adding any insights at this point (see Chapter 6). The Fed sends the check to the bank of Dr. T. and so the bank debits the bank account of Dr. T by $1000. Bank of Dr. T. ΔAssets

ΔLiabilities and Net Worth Account of Dr. T.: ‐$1000

What is the offsetting operation on the bank’s balance sheet? The $1000 have to go to the Treasury. Given that we assumed that the Treasury only has an account at the Fed we know that the offsetting operation cannot be (it would be if TT&Ls had been included): Bank of Dr. T. ΔAssets

ΔLiabilities and Net Worth Account of Dr. T.: ‐$1000 TT&Ls: +$1000

The Treasury only has an account at the Fed so the following will occur when the $1000 are transferred (which would be the second step if TT&Ls were included in the analysis): Fed ΔAssets

ΔLiabilities and Net Worth Treasury’s account: +$1000

But that again begs the question: What is the offsetting accounting entry on the balance sheet of the Fed? It cannot be “Account of Dr. T: ‐$1000” because Dr. T does not have an account at the Fed. The answer is that when the Fed receives the check, it has a claim on Dr. T.’s bank. The bank settles that claim by giving up reserves and the funds are transferred into the account of the Treasury.

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CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET Interbank claims (claims among private banks, and between the Fed and private banks) are always settled with transfers of reserves. Bank of Dr. T. ΔAssets Reserve balances: ‐$1000

ΔLiabilities and Net Worth Account of Dr. T.: ‐$1000

Fed ΔAssets

ΔLiabilities and Net Worth Reserve balances: ‐$1000 Treasury’s account: +$1000

You have just witnessed the destruction of monetary‐base: taxes destroy monetary base. The central bank deleted $1000 in the reserve balance and keystroked $1000 in the account of the Treasury. Of course, if the Treasury spends then reserve balances are credited, and if Treasury spends more than its taxes then there is a net injection of reserves: fiscal deficits (government spending larger than taxes) lead to a net injection of reserves. Keep that in mind for Chapter 4. As a side note, one may note that Dr. T’s balance sheet changes as follows when taxes are paid: Dr. T. ΔAssets Account of Dr. T.: ‐$1000

ΔLiabilities and Net Worth Net worth: ‐$1000

An alternative accounting would be if Dr. T had owed a known dollar amount of taxes for a while, i.e. if the Treasury held some tax receivables against Dr. T. In that case, instead of net worth, it would be tax receivables that would go down by $1000.

CAN THE FED ISSUE AN INFINITE QUANTITY OF MONETARY BASE? Yes, it technically can because the monetary base is composed of liabilities of the Fed. In practice though, the Fed’s ability to inject reserves is constrained by the operational requirements of monetary policy. Chapter 4 shows that if the central bank issues reserves regardless of the needs of banks, it is not be able to achieve a specific policy interest rate it sets for itself unless it changes its operational procedures. At the origins of the Fed, some constraints were also put on the types of securities that the Fed could buy or that banks could pledge as collateral with their promissory notes to get an advance from the Discount Window. There was a fear that the Fed would over issue monetary base given its broad monetary power. Here is the language of the preamble of the 1913 Fed Act states: To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes. “Elastic currency” just means that the Fed is able to add and remove monetary base at the will of banks and the public, that is, in response to the needs of the economy. However, until 1932, the 29

CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET Fed operated under the Real Bills Doctrine (RBD). What that meant was that the Fed ought to only accept securities that “self liquidate” in A1 and as collateral for A2 (see Figure 2.1). Self‐liquidating securities are those that are issued and destroyed in relation to economic activity. Firms issue securities to produce goods and services (see Chapter 10) and repay them when firms sell their production. The idea was that by tying monetary‐base creation to the financing of economic activities, the Fed would avoid inflationary tendencies that could come from an elastic currency. Monetary base (and so money supply as the thought of the time—erroneously—went) would grow in‐sync with production. In practice, RBD never worked out well for both theoretical and practical reasons. WWI led to a large holdings of Treasuries by the Fed. The Great Depression led to the elimination of the doctrine, and the 1932 Banking Act widened dramatically the types of securities the Fed could accept if needed (Table 3.1).

Table 3.1 Holdings of securities by the Fed, 1915‐1950 Source: Marshall’s Origins of the Use of Treasury Debt in Open Market Operations: Lessons for the Present One of the problems of RBD is that it relied on private indebtedness (issuances of securities by companies to finance production, “real bills”) for monetary policy to work. During a recession, banks did not have enough real bills to sell or pledge to the Fed because economic activity is moribund so private issuance plunges. This is problematic because the scarcity of real bills limited the ability of banks to obtain reserves, just at the time when banks desperately needed additional reserves to counter bank runs (people running to banks to ask for cash) and make interbank payments. More recently, Dodd‐Frank Act of 2010 amended the Federal Reserve Act to constrain the capacity of the Fed to use “emergency powers,” that is, its ability to accept any type of securities from anybody. This was a reaction to the advances provided to AIG; AIG was not part of the Federal 30

CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET Reserve System. It was also a reaction to the opaqueness of the Discount Window operations during the crisis and how questionable some of the transactions were. The Fed needs to be able to fight panics and the ensuing liquidity crisis when everybody (including every banks) is trying to get their hands on the currency. This is, indeed, why the Fed was created. It can only do so by being able to buy, or accept as collateral, a wide verity of securities. This leads us to a final important point. Given that the Fed provides a safety valve in the financial system, this safety may lead to moral hazard. Financial‐market participants may take more risks knowing that, if things go south, the Fed will intervene to avoid a collapse of the financial system. As a consequence the Fed must do two things: -

The Fed should also have ample regulatory and supervisory powers, and it should use them. That is what the last bit of the preamble is all about.

-

The Fed should discourage moral hazard and promote safe banking practices by accepting only securities that are of quality (that is based on sound underwriting and not in default) and from solvent institutions: The Fed exists to squash banking liquidity crises (temporary inability to access funds), not to keep insolvent banks alive (permanent inability to pay creditors).

Unfortunately, these two conditions have not been met recently and moral hazard has increased dramatically. The alternative is Andrew Mellon’s advice to Hoover: “liquidate labor, liquidate stocks, liquidate farmers, and liquidate real estate…it will purge the rottenness out of the system.” However, the cleansing properties of market mechanisms do not work properly, especially so in times of financial crisis and panic (see Chapter 14). Summary of Major Points 1‐ Banks hold reserves mostly because they are required to do so. 2‐ The Fed provides reserves to banks mostly by buying short‐term Treasuries from them, either temporarily or permanently. 3‐ Currently, the Fed is able to provide as many reserves as needed by banks. 4‐ Until 1932, the Fed was limited in its ability to provide reserves to banks because of constraints on the type of assets it could buy or take as collateral from them. Keywords Total reserves, required reserves, excess reserves, free reserves, borrowed reserves, non‐borrowed reserves, reserve balances, vault cash, overdraft, applied vault cash, surplus vault cash, Real Bills Doctrine, elastic currency Review Questions Q1: When a bank borrows reserves from another bank is that classified as borrowed reserves? Q2: Is all vault cash part of total reserves? Q3: Are excess reserves those that are not wanted by banks? Q4: What is the impact of a fiscal deficit on the monetary base? Q5: When the Fed sells Treasuries to banks, what happens to the monetary base? Q6: What are the two types of operations that the Fed uses to provide reserves to banks? 31

CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL BANK BALANCE SHEET 1 See the following link for an explanation of the role of the Fed in terms of coins and notes: http://www.federalreserve.gov/paymentsystems/coin_about.htm 2 See http://www.federalreserve.gov/faqs/currency_12773.htm 3 Board of Governors of the Federal Reserve System, Currency and coins services: http://www.federalreserve.gov/paymentsystems/coin_about.htm 4 See the following 2010 interview with 60 minutes: https://www.youtube.com/watch?v=LxSv2rnBGA8

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CHAPTER 4: After reading this Chapter you should be able to understand: What monetary policy is all about Why monetary policy is done How the Federal Reserve implements monetary policy How monetary policy operations changed following the Great Recession How monetary policy can be conceptually analyzed

CHAPTER 4: MONETARY POLICY IMPLEMENTATION Chapter 2 examined the balance sheet of the Fed and Chapter 3 provided important information about the meaning of reserves and other basic concepts and their relation to the balance sheet of the Fed. This Chapter examines how a central bank implements monetary policy.

WHAT DOES THE FED DO IN TERMS OF MONETARY POLICY AND WHY? While the details of operating procedures have changed through time, the federal funds rate (FFR) has progressively gained in importance as a relevant operating tool (that is, as a means to implement monetary policy) since the 1920s. The FFR is the yearly rate of interest at which participants in the federal funds market lend and borrow federal funds (“fed funds” for short) to each other overnight. For example, if the FFR is at 3% it means that if a bank borrowed $100 continuously for a year at that rate it would have to pay a $3 of interest. The equivalent daily rate is 0.0081% so if a bank borrows $100 in the evening, it has to repay the $100 plus $0.0081 of interest payment the next morning. While that does not seem much, when tens of billions of dollars are involved daily even such small interest rate can bring substantial income to the lender of fed funds.1 Fed funds are the dollar value of the accounts at the Federal Reserve (L2, L3, and L4 in the balance sheet presented in Figure 2.1). Holders of these accounts include private banks, the U.S. Treasury, government‐sponsored enterprises, the International Monetary Fund, securities firms, among others. Some of these account holders need more funds (usually banks)2 while others usually have more than needed. The fed funds market3 allows these participants to meet and make deals.

Figure 4.1 Daily average of FFR (grey line) and FFR target (black line), percent Source: Federal Reserve Bank of New York. The Fed is highly interested in the FFR and aims at targeting that rate, that is, the Fed wants to make sure that the FFR prevailing in the market does not deviate too much from the FFR desired by the 34

CHAPTER 4: MONETARY POLICY IMPLEMENTATION Fed (the FFR target) (Figure 4.1). Most of the time the Fed targets a specific number but sometimes it targets a range. This is the case today with a range of 0.25‐0.5%. From the late 1970s until 1991, the Fed also had a range that was as high as 16%‐22% in mid‐1981 and as wide as 13%‐20% in early 1980 (Figure 4.2). Since 1994, the FFR target has been public information as the Fed has committed to be more transparent. The Fed is highly interested in this interest rate for two main reasons. First, the FFR is a cost for banks so if the cost changes, the interest rates they charge to customers change. Second, market participants make portfolio choices (that is, buy or sell assets) with the aim of maximizing the rate of return on assets. They compare portfolio strategies and choose those that provide the highest yield. While making these portfolio choices, financial‐market participants take into account future monetary policy (that is, future FFR targets), which ends up impacting the current interest rate of a wide range of securities. Regarding the cost side of FFR, banks need reserves for four purposes (see Chapter 10 for further explanation): ‐

Cash withdrawals by customers: people get cash from banks.

‐

Reserve requirements: banks must keep a certain quantity of reserves that is a proportion of the dollar amount in the bank accounts they issued.

‐

Interbank debt settlements: paying debts due to other banks.

‐

Payments to other Fed account holders: for example tax payments leads to a drainage of reserves.

Figure 4.2 Monthly FFR average and target FFR range, 1979‐1990, percent Source: Transcripts of the FOMC meetings Note: After 1990, the FOMC targeted a FFR digit 35

CHAPTER 4: MONETARY POLICY IMPLEMENTATION By far, the largest day‐to‐day need for reserves is interbank settlements because banks that do not have enough reserves to make the necessary payments must get reserves to avoid default. They may get them either from other banks or other fed funds holders, or may go to the Fed. In any case, banks have to pay interest and the FFR is what banks pay to get reserves through the fed funds market (“non‐borrowed reserves”). This cost is then routinely passed on to their customers so that when the FFR rises, rates on mortgages, advances to students, credit cards, etc. also go up (see prime bank rate in Figure 4.3). In terms of portfolio choices, say that in 2016 you have $1000 and you want to figure out a way to make the highest gains over the next two years. Say only two portfolio strategies are available. A “long‐term strategy” is to buy and hold for two years a 2‐year security that pays 5%. A “short‐term strategy” is to buy a 1‐year security that pays 3% and to reinvest the proceeds in 2017 into another 1‐year security. Your choice between the two strategies should depend on what you expect the 1‐ year rate to be in 2017. You are indifferent between the two strategies if they provide the same rate of return, which means that you expect a 1‐year yield of about 7% in 2017 (solve $1000*(1.05)2 = $1000*1.03*(1+x) where x is the expected one‐year rate in 2017). If you expect the 1‐year rate to be higher than 7%, the short‐term strategy is more profitable. In that case, financial‐market participants will sell outstanding 2‐year securities and buy 1‐year securities, which raises the 2‐year rate and lowers the 1‐year rate until the two strategies provide the same rate of return. For example, if the expected 1‐year rate is 8%, then if the 2‐year rate goes up to 5.2% the 1‐year rate is 2.5%. Generalizing the logic, a rising FFR (similar to 1‐year rate going up) raises the rates on longer‐term securities. Long‐term rates depend on expectations about future monetary policy and if FFR is expected to rise (fall), long‐term rates will rise (fall). There is a very high correlation between the FFR and all other interest rates. The correlation is about 0.99 for short‐term securities and about 0.8 for long‐term securities like T‐bonds (Figure 4.3). Beyond expectations about future FFR, the interest rate on securities, especially of longer terms to maturity, is also influenced by inflation risk, tax risk, credit risk, liquidity risk, among others, which makes the link between FFR and longer‐term securities less strong. By influencing all interest rates, the Fed hopes to influence the willingness of the private sector to spend on goods and services; the ultimate goal being to influence inflation and employment. For example, if the Fed thinks that inflationary pressures are building up, the reasoning goes at follows: Higher expected inflation by the Fed leads to a higher FFR target, which raises the FFR, which raises other rates, which discourages private economic units from seeking external funds and raises thriftiness, which slows down spending on goods and services, which lowers inflation (see Chapter 12). There are a lot of steps between FFR and inflation/employment, and one may doubt it works well, but that is the logic behind the intervention of the Fed in the fed funds market. The Fed has a dual mandate, that is, its goal is to achieve both price stability (currently defined unofficially as achieving a 2% inflation rate) and full employment (defined as being at an unemployment rate at which inflation is stable, the “NAIRU”). Other central banks, like the European Central Bank, only focus on price stability.

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CHAPTER 4: MONETARY POLICY IMPLEMENTATION

Figure 4.3 FFR and other rates Source: Board of Governors of the Federal Reserve System (series H.15)

TARGETING THE FFR PRIOR TO THE 2008 FINANCIAL CRISIS While banks do need reserves, they also do not like to hold more reserves than they need because reserves did not use to pay any interest. Chapter 3 shows that, prior to the crisis, banks held very few reserves, and most of them were held because the Fed required it. Banks like to keep a bit of

37

CHAPTER 4: MONETARY POLICY IMPLEMENTATION excess reserves to avoid the overnight‐overdraft penalty rate (Chapter 2 explains that reserve balances can be negative). What happens if banks cannot get enough fed funds for their needs? Banks cannot create more than what is available, only the Fed can. If the Fed does not add more fed funds then the FFR rises steeply and quickly given that bank must have the reserves they need. A higher FFR does not incentivize banks to demand less fed funds; their demand for reserves is inelastic and mostly non‐ discretionary. What happens if banks have too much fed funds? Banks cannot destroy/remove fed funds, only the Fed can. If the Fed does not remove enough fed funds, the FFR will fall very quickly to 0% given that banks do not have any other use for the excess reserve balances they have. A lower FFR does not give banks an incentive to supply less fed funds. To minimize fluctuations in the FFR and keep it around the target, the Fed intervenes daily to add or to remove fed funds by adding or removing reserve balances according to the needs of banks. If the FFR is above target then the Fed adds reserves, if the FFR is below target the Fed removes reserve balances. The way the Fed does this is via open‐market operations that usually involve exchanging reserves with T‐bills with banks (Figure 4.4): ‐

If FFR < FFRT, banks lend and borrow at an interest rate that is too low relative to what the Fed wants. To correct that the Fed sells T‐Bills to banks, which drains reserves. Fed ΔAssets ΔLiabilities and Net Worth T‐bills: ‐$100 Reserve balances: ‐$100

Banks ΔAssets T‐bills: +$100 Reserve balances: ‐$100 ‐


If FFR > FFRT, banks lend and borrow at too high an interest rate relative to what the Fed wants. Banks have too few reserves. To correct that the Fed buys T‐bills from banks by crediting their reserve balances. Fed ΔAssets T‐bills: +$100


Banks ΔAssets T‐bills: ‐$100 Reserve balances: +$100


The open‐market operations can be permanent (“outright purchase/sale” by the Fed) or temporary (“repurchase agreement” and “reverse repurchase agreement”: the Fed and banks agree to perform the opposite transaction the following morning). For banks to agree to trade with the Fed instead of putting reserves in the market—or for banks to get reserves from the Fed instead of

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CHAPTER 4: MONETARY POLICY IMPLEMENTATION borrowing from other banks—the Fed has to provide incentives. The Fed also has to make trades that ensure that the FFR stays around its target. Suppose that a bank has $1000 worth of reserves that it is ready to supply in the fed funds market. Suppose that the FFR is currently at 3% (so a daily rate of 0.0081%), where the Fed wants it to be, but if the bank supplied the funds the FFR would fall to 2%. How can the Fed entice the bank not to dump the funds in the market? One way is to do something similar to the following: the Fed sell to the bank one T‐bill for $999.92 and promises to buy it back the next day for $1000. This provides a daily rate of return of 0.0081% to the bank. The Fed does something similar when banks borrow fed funds at a rate higher than what the Fed wants (FFR > FFRT). It buys T‐bills at a price consistent with FFRT. That forces those willing to lend fed funds to comply with the FFRT; otherwise, no bank will borrow from them given that the Fed offers to provide reserves at a lower rate.

Figure 4.4 Targeting the FFR: Open‐market operations

The Fed could do this all day long and FFR would be on target all the time, but practically the Fed only intervenes once a day and accepts that the FFR fluctuates around the target. Each day, the Fed anticipates the approximate need for reserves by estimating how the items that change the monetary base will change during the day (A1 through A5, L3, L4, and L5 of Figure 2.1). The Fed is basically applying a sort of buffer‐stock policy on reserves in the same way diamond cartels limit the supply of diamond to control diamond price (I am sorry to tell you that diamonds are not rare). The main difference between the Fed and diamond cartels is that the Fed has complete pricing power because it is the monopoly supplier of reserves. Beyond day‐to‐day intervention in the fed funds market to maintain a FFRT, the Fed also sometimes changes its FFRT. Given that the demand for reserves is almost perfectly inelastic and given how small the increments and decrements in the FFRT are (usually 25 basis points at a time, that is, 0.25 percentage point), when the Fed changes its FFRT, it usually does not do anything for the target to be reached. If the Fed decides to lower the FFRT, it does not have to inject reserves first for the target to be reached. If the Fed decides to raise the FFRT, it does not have reduce the quantity of

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CHAPTER 4: MONETARY POLICY IMPLEMENTATION reserves to reach the target. The FFR will move quickly around the target following the announcement of a change.4 Another way to understand that point is to again go back to the point that banks cannot do much with reserve balances, so any reserves they have in excess they will supply in the fed funds market. If the Fed announces it will offer reserves at a lower FFRT, banks must comply with the new FFRT when they offer to lend reserves, otherwise nobody will borrow from them. If the Fed announces it offers reserves at a higher FFRT, banks with reserves to lend also raise at which they offer to lend reserves. Otherwise, they forego an income opportunity because banks that need reserves have nowhere else to go (only the Fed can create more reserves and it will do it only at a higher FFR). It is “the Fed’s way or the highway.”

A GRAPHICAL REPRESENTATION OF THE FEDERAL FUNDS MARKET The Fed supplies, at a cost equal to the FFR target, whatever quantity of reserves is needed (Figure 4.5). The demand for reserves is almost perfectly insensitive to changes in FFR.5 Banks must meet interbank payments, tax payments, reserve requirements and withdrawals regardless of what the FFR is, and banks have very little incentive to ask for more reserves when rates fall because, as explained in Chapter 3, banks cannot do much with them.

Figure 4.6 The federal funds market

The fact that the supply of reserves is horizontal seems to suggest that the Fed supplies an infinite quantity of reserves. That is not the case, all that is saying is that the Fed supplies whatever banks demand. If banks want more reserves (demand curve shifts to the right), the Fed supplies more. If banks want fewer reserves, the Fed removes reserves; the currency is “elastic.” The Fed does not proactively add or remove reserves: ‐

If the Fed adds reserves without consulting banks, the FFR falls to zero.

‐

If the Fed removes reserves without consulting banks, the FFR rises to infinity.

Thus, while the Fed does the injection and deletion of reserves, the Fed adds or removes only on a defensive basis to maintain the FFR on target.

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CHAPTER 4: MONETARY POLICY IMPLEMENTATION What monetary policy is all about is setting the price of reserves and letting the quantity of reserve adjust. The FFR is a policy variable that does not reflect any scarcity or abundance of reserves, or the preference of banks for reserves. A low FFR can prevail with very few reserves because if banks do not need many reserves, the Fed does not supply many at a given FFRT. A high FFR can prevail with a very large quantity of reserves because if banks need lots, the Fed supplies lots at a given FFRT.

TARGETING FFR AFTER THE GREAT RECESSION As the financial crisis grew from 2007 onward, the Fed began to lower its interest rate target from late 2007 (Figure 4.1) and, from early 2008, to provide significant quantities of emergency funds to the financial system (Figure 4.6). At first, the Fed neutralized the impact of all emergency advances by selling Treasuries so its supply of Treasuries fell by 40% in about six months (Figure 4.6). The Fed provided reserves to bank X that was in difficulty, bank X paid its creditor bank Y, bank Y had excess reserves available to lend in the fed funds market, Fed drained all excess reserves by selling Treasuries to bank Y. This allowed the Fed to maintain a positive FFR while also helping struggling financial institutions. In September 2008, the collapse of Lehman Brothers led to a panic and the Fed responded by providing large amounts of emergency advances (A2 of Figure 2.1 went up a lot). No fed funds market participant was willing to lend reserves to anybody; the fed funds market froze and the FFR became highly volatile (Figure 4.1). Emergency advances by the Discount Window led to a very large increase in reserve balances by almost $1 trillion by early 2009. From September 2008 until the end of the year, in order to keep FFR positive, the Fed did try to neutralize some of the impact of its massive emergency operations by working with the Treasury (Chapter 6 delves into the Treasury‐ central bank coordination). However, in order to fight the recession (and so potential deflation and unemployment), the Fed also rapidly lowered its FFR target, eventually to reach zero (0‐0.25% range to be precise) by December 2008 (Figure 4.1). The Fed then wondered what it could do next to help lower interest rates further given that the FFR target was at 0% and given that the Fed did not intend to have a negative FFR target. Two things were done: 1‐ Promise not to raise the FFR target for a long time (“forward guidance”): this pushed expectations of a rise in FFR further in the future and so lowered other interest rates. 2‐ Outright purchases of long‐term securities with the goal of lowering long‐term interest rates (“credit easing” followed by “quantitative easing”). By buying long‐term securities, the Fed raised the price of these securities which lowered their yield. The Fed bought outright long‐term Treasuries but also long‐term private securities (Mortgage‐ backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae)6 (Figure 4.6, Table 4.1). It did so without neutralizing the impact on reserves so reserves balances increased rapidly beyond the needs of banks (see Chapter 3). As a consequence, if the Fed had continued to operate as it did before the crisis, the FFR would have stayed stuck at 0% for as long as there would have been a large quantity of excess reserves.

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Figure 4.6 Assets of Fed and excess reserves (white line), trillions of dollars Source: Board of Governors of the Federal Reserve System (series H.4.1)

Table 4.1 Maturity distribution of securities, loans, and selected other assets and liabilities, January 20, 2016, millions of dollars Source: Board of Governors of the Federal Reserve System (series H.4.1)

Currently, the Fed wants to be able to raise the FFR even though banks have ample quantities of excess reserves. To do so, it has changed its operating procedures by paying interest on reserve balances (L2). This theoretically puts a floor on the FFR because if banks can earn interest on their Fed accounts, they do not have an incentive to lend these reserves in the fed funds market if the FFR goes below the interest rate on reserve balances (IOR). The Fed and other central banks now operate under a “corridor” framework (Figure 4.7). In theory, the FFR can only fluctuate between the IOR and the discount window rate (DWR). The FFR target is 42

CHAPTER 4: MONETARY POLICY IMPLEMENTATION set in the middle of the corridor and the three rates (IOR, FFRT and DWR) move together. There is a horizontal band instead of a horizontal line. Banks have no incentive to lend reserves if FFR is below IOR so FFR cannot fall below that. Banks have no incentive to borrow in the fed funds market if the DWR is lower than FFR so FFR will not rise above the DWR.

Figure 4.7 Interest‐rate corridor

In practice, the corridor in the United States is porous. In terms of the floor, other Fed accounts do not qualify to receive interest so their holders have an incentive to keep lending fed funds in the market even if FFR is below IOR. Government‐sponsored enterprises (in L4), especially the Federal Home Loan Banks,7 were a major source of excess supply of fed funds. Since the end of 2015, the Fed has solved this problem 8 by indirectly paying interest to other account holders through an auction mechanism. Now the IOR is a true floor. In terms of the ceiling, access to the Discount Window is highly stigmatized and contains some non‐monetary costs in terms of increased supervision and loss of reputation. As a consequence, banks refrain from going to the Window even if DWR is inferior to FFR. The true ceiling in that case is the overnight‐overdraft penalty rate. During the 2008 financial crisis, the Fed dealt with this problem by providing fed funds through the Window via occasional auctions in which participants could bid anonymously. A corridor policy does not have to be implemented only in period of excess reserves. If a central bank wants to intervene less frequently in the overnight market, a corridor policy can be useful to limit the volatility of the overnight interbank rate. For example, the ECB has been operating that way since the beginning (Figure 4.8). It intervenes in the market only once a week and lets the ceiling and floor do the job of containing the overnight rate around the target overnight rate during the rest of the week. Narrowing the gap between the floor and the ceiling would reduce the volatility of the overnight rate. The Fed had been on a semi‐corridor since 2003 when the Fed decided to raise DWR above the FFRT and to move both in sync while IOR stayed at zero all the time.

43


Figure 4.8 Corridor of ECB Source: Kahn’s Monetary Policy under a Corridor Operating Framework

Summary of Major Points 1‐ The Federal Reserve targets the cost of reserves not the quantity of reserves. It does so by setting the cost of providing advances (Discount Window operations) and by setting the cost at which banks lend to, and borrow from, each other (open‐market operations). 2‐ By setting directly the cost of reserves, the Federal Reserve can indirectly influence all other interest rates. The influence is the strongest on short‐term market rates and on interest rates that banks charge to their customers. 3‐ Through changes in interest rates, the Federal Reserve hopes to change spending habits and so to influence employment and inflation. 4‐ When the Fed changes its FFR target, it does not have to change the quantity of reserves to make the FFR move toward the target. In order to maintain the FFR around a given FFR target, the Fed intervenes daily to perform open‐market operations. 5‐ The Fed cannot supply fewer or more reserves than banks demand, otherwise it misses its FFR target. The Fed adds or removes reserves according to the demands of banks. 6‐ A high FFR can prevail with a large quantity of reserves and a low FFR can prevail with a small quantity of reserves. FFR is a policy variable not a market‐determined variable. 7‐ Quantitative easing led to a large increase in excess reserves. In order to be able to raise the FFR when it wants, the Fed changed its operating procedures by paying interest on reserves. Quite a few central banks now operate under a corridor framework. Keywords Federal funds rate, federal funds market, Discount Window rate, interest rate on reserves, corridor framework, quantitative easing, open‐market operation, outright purchase/sale, repurchase agreement, discount window operations, elastic currency. 44


Review Questions Q1: If the Fed supplies more reserves than banks want, what happens to the FFR? What if supplies less? What will the Fed do to maintain the FFR on target? Q2: What does a horizontal supply of reserves means in terms of the supply of reserves and the federal funds rate? Q3: How can a corridor framework help reduce the volatility of the FFR? What would happen to the FFR if the discount rate, interest rate on reserves and FFR target were all equal? Q4: Why are the interest rates set by banks highly correlated with the FFR? Q5: Why are market rates correlated with the FFR? What happens if it is expected that the FFR will fall? Q6: If the Fed had not adopted a corridor framework, what would have been the problem for future monetary policy? Q7: How could a corridor fail to contain the FFR? Q8: What does it mean for the Fed to provide an elastic currency? Suggested readings “Come with me to the FOMC” by Governor Duke briefly presents what goes on during a meeting: https://www.federalreserve.gov/newsevents/speech/duke20101019a.htm Chapter 7 of Meulendyke’s U.S. Monetary Policy and Financial Markets is a detailed version of Duke’s speech, albeit a bit dated: https://research.stlouisfed.org/aggreg/meulendyke.pdf Kahn’s Monetary Policy under a Corridor Operating Framework provides a readable presentation of the corridor framework. More advanced readings are: Dow, S.C. (2006) “Endogenous money: structuralist,” in P. Arestis and M.C. Sawyer (eds) A Handbook of Alternative Monetary Economics, 35‐51, Northampton: Edward Elgar. Fullwiler, S.T. (2008) “Modern central bank operations—General principles,” http://www.cfeps.org/ss2008/ss08r/fulwiller/fullwiler%20modern%20cb%20operations.pdf Fullwiler, S.T. (2013) “An endogenous money perspective on the post‐crisis monetary policy debate,” Review of Keynesian Economics, 1 (2): 171‐194. Lavoie, M. (2006) “Endogenous money: Accomodationist,” in P. Arestis and M.C. Sawyer (eds) A Handbook of Alternative Monetary Economics, 17‐34, Northampton: Edward Elgar. Lavoie, M. (2010) “Changes in central bank procedures during the subprime crisis and their repercussions for monetary theory,” International Journal of Political Economy 39 (3), 3‐23. Moore, B.J. (1988) Horizontalists and Verticalists: The Macroeconomics of Credit Money. Cambridge: Cambridge University Press. Moore, B.J. (1991) “Money supply endogeneity: ‘reserve price setting’ or ‘reserve quantity setting’,” Journal of Post Keynesian Economics, 13 (3): 404‐413.

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CHAPTER 4: MONETARY POLICY IMPLEMENTATION 1

Historical data about the federal funds market can be found at the Federal Reserve Bank of New York: https://apps.newyorkfed.org/markets/autorates/fed‐funds‐search‐result‐page 2 See “Who’s Borrowing in the Fed Funds Market?” by Gara Afonso, Alex Entz, and Eric LeSueu at http://libertystreeteconomics.newyorkfed.org/2013/12/whos‐borrowing‐in‐the‐fed‐funds‐market.html 3 See The Federal Funds Market: A Study by a Federal Reserve System Committee by the Federal Reserve System at https://fraser.stlouisfed.org/docs/meltzer/bog1959.pdf 4 This absence of a liquidity effect has been well documented. See Fullwiler, S.T. (2003) “Timeliness and the Fed’s Daily Tactics.” Journal of Economic Issues 37 (4): 851‐880 5 This graph ignores complications that comes from reserves requirements, which would flatten the demand for reserves at the FFRT. See Fullwiler, S.T. (2013) “An endogenous money perspective on the post‐crisis monetary policy debate” Review of Keynesian Economics, 1 (2): 171‐194. 6The Federal National Mortgage Association (Fannie Mae) was a government agency created in 1938 to improve the liquidity of mortgages by acting as dealer of FHA/VA‐insured mortgages. Until the 1966 credit crunch, Fannie Mae remained a minor player in the secondary market for mortgages because it exclusively dealt in conforming mortgages. The crunch led Fannie Mae to enlarge its dealership to conventional mortgages and it became the largest player in the secondary mortgage market. In order to cope with this new state of affairs, Fannie Mae was split in 1968 into the Government National Mortgage Association (Ginnie Mae) and Fannnie Mae. Ginnie Mae took the previous role of Fannie Mae and is focused on maintaining a secondary market by providing guarantee on MBSs backed by FHA/VA‐insured mortgages. Fannie Mae was converted into a government‐sponsored enterprise by acting as a dealer of conventional mortgages. Federal Home Loan Mortgage Corporation (Freddie Mac) was created by an act of Congress in 1970 to compete with FNMA in the conventional mortgage market. 7 See “Who’s Lending in the Fed Funds Market?” by Gara Afonso, Alex Entz, and Eric LeSueur from the Federal Reserve Bank of New York at: http://libertystreeteconomics.newyorkfed.org/2013/12/whos‐lending‐in‐the‐fed‐funds‐ market.html 8 More details about the reverse repurchase agreement operations is available here: https://www.newyorkfed.org/markets/rrp_faq.html

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CHAPTER 5: After reading this Chapter you should be able to understand: Why targeting the quantity of reserves is not practically possible and goes against the purpose for which the Fed was created Why providing an elastic supply of currency is not by itself inflationary How quantitative easing impacts financial markets What a normalization policy is How central banks can set negative nominal interest rate Why central banks want interest rates to be negative What the impact of negative interest rates is on the profitability of banks What are some potential issues with fine tuning the economy with monetary policy

CHAPTER 5: FAQs ABOUT CENTRAL BANKING Previous Chapters studied the balance sheet of the Fed, definitions and their relation to the balance sheet of the Fed, and monetary‐policy implementation. This Chapter answers some FAQs about monetary policy and central banking. Each of them can be read independently.

Q1: DOES THE FED TARGET/CONTROL/SET THE QUANTITY OF RESERVES AND THE QUANTITY OF MONEY? The Fed does not set the quantity of reserves and does not control the money supply (M1). It sets the cost of reserves; that is it. In terms of reserves, the Fed was created to provide an “elastic currency,” i.e. to provide monetary base according to the needs of the economic system in normal and panic times. It would be against this purpose to implement monetary policy by unilaterally setting the monetary base without any regard for the daily needs of the economic system. In terms of the money supply, the Fed has no direct influence. Even Federal Reserve notes (FRNs) are supplied through private banks, and banks supply only if customers ask for cash. The Fed does not force feed FRNs to the public, i.e. FRNs cannot be “helicopter dropped” via monetary policy. If the Fed did this, not only would it operate against the Federal Reserve Act, but also it would lead people to take the FRNs, bring them to banks, banks would have more reserves, FFR would fall, Fed would remove excess reserves to bring FFR back up—back to square one. The Fed may have an indirect influence on the money supply through changes in its FFR target because changes in the cost of credit may change the willingness of economic units to go into debt, but the link is tenuous (see Q10). Through its policy of Quantitative Easing, the Fed may have an indirect influence in two other ways. First, if the Fed buys long‐term Treasuries from banks, banks usually have an incentive to replenish their holdings of Treasuries because they allow to meet capital requirements (see Chapter 9) without compromising too much profitability and liquidity. Treasuries have a low‐capital weight, have a liquid market, and pay interest income. Banks will buy securities from non‐bank economic units by crediting the bank accounts of the latter (see Chapter 10). Second, if the Fed wants to buy securities from non‐central‐bank account holders, the Fed works through banks and the following occurs: Fed ΔAssets Securities: +$100


Banks of sellers of securities ΔAssets ΔLiabilities and Net Worth Reserve balances: +$100 Account of sellers: +$100 Sellers of securities ΔAssets ΔLiabilities and Net Worth Account of sellers: +$100 Securities: ‐$100

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CHAPTER 5: FAQs ABOUT CENTRAL BANKING The money supply goes up by $100 when “account of sellers” increases by $100 (but it does not if only reserve balances go up by $100).

Q2: DID THE VOLCKER EXPERIMENT NOT SHOW THAT TARGETING RESERVES IS POSSIBLE? In the 1970s, the Monetarist school of thought gained some influence in policy circles. Monetarists argued that there is a close relation between the quantity of reserves and the money supply, and that the role of a central bank is to control the quantity of reserves in order to influence the money supply and ultimately inflation (see the quantity theory of money in Chapter 12). The Fed, under the leadership of Paul Volcker, tried to implement a monetary‐policy procedure that aimed at more closely targeting reserves and monetary aggregates, with the hope of taming a double‐digit inflation rate. Practically, the Fed changed interest‐rate targeting from a narrow range to a wide range (see Chapter 4), which increased the level and volatility of the FFR dramatically (Figure 5.1). The Fed did not allow the FFR to move freely as a targeting of total reserves implies. There is an academic debate about how truly “Monetarist” the Volcker experiment was, and this debate is reflected in the FOMC discussions of the time MR. ROOS. Well, if the level of borrowing comes in higher than we would anticipate, [can’t] you reduce the level of the nonborrowed reserves path accordingly? Can’t you adjust your open market operations for the unexpected bulge in borrowing or the unexpectedly low borrowing if you ignore the effect on the fed funds market? Can’t you just supply or withdraw reserves to compensate for what has happened? […] CHAIRMAN VOLCKER. The Desk can’t [adjust] in the short run. It’s fixed. In a sense they could do it over time if people are borrowing more, as they may be now. They seem to be borrowing more than we would expect, given the differential from the discount rate. But in any particular week it is fixed. MR. ROOS. Do we have to supply the reserves? CHAIRMAN VOLCKER. We have to supply the reserves. MR. ROOS. [Why] do we have to supply the reserves? If we did not supply those reserves, we’d force the commercial banks to borrow or to buy fed funds, which would move the fed funds rate up. (FOMC meeting, September 1980, page 6) Mr. Roos was deeply dissatisfied with the Fed still using a FFR target, albeit in the form of a wide range. While the Fed had a total‐reserve growth target related to the 3‐month growth rate of M1, if banks needed more than what was targeted, the Fed would supply extra reserves in order to relieve pressures on the FFR. Roos argued against this lenient reserve targeting and was for a total abandonment of any FFR targeting and a strict targeting of total reserves. Here he is in 1981: I think there’s a very basic contradiction in trying to control interest rates explicitly or implicitly and achieving our monetary target objectives. And I would express 49

CHAPTER 5: FAQs ABOUT CENTRAL BANKING myself as favoring the total elimination of any specification regarding interest rates. (Roos, FOMC meeting, February 1981, page 54) Most Federal Open Market Committee members were against that position on the ground that the role of the Fed is precisely to promote an elastic monetary base. The Fed was not created to dictate what the quantity of reserves ought to be but to eliminate liquidity problems through smooth interbank‐debt clearing and settlement at par, lender of last resort, and interest‐rate targeting. In addition, banks mostly hold reserves because they are required to, so if the Fed does not supply enough reserves to meet the requirements then banks will break the law. The experiment was a monetary‐policy failure. The Fed was never able to reach its reserve or money targets and the experiment contributed to massive financial instability and a double‐dip recession. One may even doubt that it contributed significantly to the fall in long‐term inflation, which had more to do with the downward trend in oil prices, oil‐saving policies and greater international labor competition: May I remind you that we shouldn’t take too much credit for the price easing? I never thought we were totally at fault for the price increases that we suffered from OPEC and food; and I don’t think the fact that OPEC and food have calmed down has a great deal to do with monetary policy per se, except in the very long run. (Teeters, FOMC meeting, July 1981, page 46) The Volcker experiment was, however, a public‐relation success. Most FOMC members knew that reserve targeting was not possible; still, it allowed them to claim that they were not responsible for the high interest rates of the period: I do think that the monetary aggregates provided a very good political shelter for us to do the things we probably couldn’t have done otherwise. (Teeters, FOMC meeting, February 1983, page 26) I think the important argument, and really the reason why we went to this procedure, was basically a political one. We were afraid that we could not move the federal funds rate as much as we really felt we ought to, unless we obfuscated in some way: We’re not really moving the federal funds rate, we’re targeting reserves and the markets have driven the funds rate up. That may have had some validity at the time, and I had some sympathy for it. But as time goes on, I’ve become more and more concerned about a procedure that really involves trying to fool the public and the Congress and the markets, and at times fooling ourselves in the process. (Black, FOMC meeting, March 1988, page 12) Of course the high and volatile FFR was precisely the result of the change in monetary‐policy procedures. If needed, some FOMC members were willing to do the same thing in the future: Well, I have only a little to add to all of this. I think Tom Melzer is probably right: We’re going to need to shift the focus to some measure or measures of the money supply as we proceed here if we can, both for substantive reasons and also because that has some political advantages as well, as we go forward. (Stern, FOMC meeting, December 1989, page 50)

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CHAPTER 5: FAQs ABOUT CENTRAL BANKING

Figure 5.1 Average and standard deviation of the FFR Source: Federal Reserve Board, NY Federal Reserve Bank

Q3: IS TARGETING THE FFR INFLATIONARY? With the failure of the Volcker experiment, the FOMC entered a period of operational uncertainty until the mid‐1990s. The Fed was back on a tight FFR target procedure (there was still a wide range until 1991 but the Fed mostly targeted the middle of the range) and this was deeply unsatisfactory to FOMC members. We’ve advanced from pragmatic monetarism to full‐blown eclecticism. (Corrigan, FOMC meeting, October 1985, page 33) No, I would say that we have a specific operational problem that we have to find a way of resolving. Just to be locked in on the federal funds rate is to me simplistic monetary policy: it doesn’t work. (Greenspan, FOMC meeting, October 1990, pages 55–56) In a world where we do not have monetary aggregates to guide us as to the thrust of monetary policy actions, we are kind of groping around just trying to characterize where the stance is. (Jordan, FOMC meeting, March 1994, page 49) The Fed was unwilling to disclose that it was targeting the FFR, and continued to announce targeted growth ranges for monetary aggregates even though it did not use them for policy purposes. [In response] to talk that says we can significantly influence this – or as the phraseology goes that if we lower rates, we will move M2 up into the range – I say “garbage.” Having said all of that, I then ask myself: ‘What should we be doing?’ Well, we have a statute out there. If we didn’t have the statute, I would argue that we ought to forget the whole thing. If it doesn’t have any policy purpose, why are 51

CHAPTER 5: FAQs ABOUT CENTRAL BANKING we doing it? By law [we have] to make such forecasts. And if we are to do so, I suggest that we do them in a context which does us the least harm, if I may put it that way. (Greenspan, FOMC meeting, February 1993, page 39) We do not, in fact, discuss monetary policy in terms of the Ms between Humphrey‐ Hawkins meetings. Don Kohn dutifully mentions them because he thinks he ought to, but that is not the way we think about monetary policy. (Rivlin, FOMC meeting, February 1998, page 91) To announce to the general public that the FOMC was targeting the FFR would be going against all the Monetarist principles (reserve targeting, money multiplier theory, quantity theory of money). Targeting an interest rate, and so having an elastic supply of reserves (horizontal supply at a given FFRT), seemed to indicate that the Fed was no longer willing to control inflation. FOMC members themselves believed that was the case: Many analysts, both inside and outside the Fed, argued that using the Federal funds rate as the operational target had encouraged repeated over‐shooting of the monetary objectives. (Meulendyke 1998 49) Talking about the FFR target became a taboo and “the Committee deliberately avoided explicit announced federal funds targets and explicit narrow ranges for movements in the funds rate” (Kohn, FOMC Transcripts, March 1991, page 1): I must say I’m still quite reluctant to cave in, if you will, on this question that we can do nothing but target the federal funds rate. (Greenspan, FOMC transcripts, March 1991, page 2) As a practical matter we are on a fed funds targeting regime now. We have chosen not to say that to the world. I think it’s bad public relations, basically, to say that that is what we are doing, and I think it’s right not to; but internally we all recognize that that’s what we are doing. (Melzer, FOMC transcripts, March 1991, page 4) We will see later why the entire Monetarist logic is flawed. Monetary policy is always about providing an elastic supply at a given interest rate. There is nothing intrinsically inflationary about this. Having an “elastic currency” usually just means supplying whatever quantity of reserves banks want, and usually banks do not want much. While all this was very well understood by many economists long before Volcker’s experiment (see for example Nicholas Kaldor),1 it took FOMC members until the mid‐1990s to get comfortable with FFR targeting.

Q4: WHAT ARE OTHER TOOLS AT THE DISPOSAL OF THE FED? Monetary policy is always about setting at least one interest rate. While today the Fed operates mostly through the fed funds market, it has other tools at its disposition to help influence interest rates. One is the (re)discount rate, the rate at which banks can obtain borrowed reserves (see Chapter 3). This interest rate is now higher than the FFR target but from the mid‐1960s until 2003 the discount rate was usually below the FFR target. The Fed decided to put the discount rate above the FFR target to put a ceiling on the FFR and so limit upward volatility in FFR (see Chapter 4). 52

CHAPTER 5: FAQs ABOUT CENTRAL BANKING Reserve requirement ratios can also help target the FFR. These ratios state how many total reserves banks must keep on their balance sheet as a proportion of the bank accounts they issued. While these ratios are often discussed in relation to the ability of banks to create checking accounts, their actual purpose is once again to help target the FFR. By raising reserve requirement ratios, the demand for reserves becomes more predictable given that a greater proportion of the reserves available must be held by banks. With a more stable demand for reserves comes less volatility in the FFR.

Q5: WHAT IS THE LINK BETWEEN QE AND ASSET PRICES? The link cannot be one where banks have excess reserves that they use to buy assets in the secondary market. Chapter 2 explains that banks cannot do this as a whole. They could buy from one another, but if they all have reserves they want to get rid of, this is not possible because no bank wants to sell assets for reserves. The link goes through the following channels: 1‐ The Fed buys large quantities of securities from banks which raises their prices and so lowers their yields. 2‐ As yields on these securities fall, economic units seek assets that provide higher yields. They will look for assets with large expected capital gains, especially so knowing that others are experiencing the same problems and are “searching for yield.” They will continue to buy these securities, which will raise their prices, until all rates of return are equalized once adjusted for risks. Financial companies have to do the second step because they try to reach the target rates of return that they promised to their stakeholders. Pensioners expect a substantial rate of return from their pension funds, wealthy individuals expect a substantial rate of return from hedge funds, mutual funds shareholders wants a substantial rate of return…and they all check every quarter if financial companies stay on course to meet the promised target. Long‐term Treasuries used to provide a safe and simple way to meet this promise; no longer so. Bill Gross (a well‐known portfolio manager who specializes in bond trading) brought the point forward very clearly. He hopes that the Fed will raise the FFR to make it easier to reach targeted rates of return. He notes2 that low FFR prevents savers from earning enough to pay for healthcare, retirement and other costs because yields on financial assets are so low compared to the expected 7% or 8%. If the Fed does not help by raising the FFR, financial‐market participants will take large risks on their asset side (speculative, high credit risk, and structured securities) and liability side (high leverage) to try to reach their targeted rate of return. There is a broad problem though. In an economy in which the growth of the standard of living is low, why should anyone expect that demanding 7‐8% be sustainable? Those can only be achieved through capital gains and leverage, and the combination of these two is highly toxic (see Chapter 9 and Chapter 14). Instead of the Fed raising its FFR, it should be the rentiers who should reduce their expectations of rates of return. An economy that grows at 2% per year cannot sustainably provide a real rate of return higher than 2%; even that is a stretch. Other means3 must be used to meet the challenge of an aging economy than increasing the financialization of the economy.

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Q6: HOW AND WHEN WILL THE LEVEL OF RESERVES GO BACK TO PRE‐CRISIS LEVEL? THE “NORMALIZATION” POLICY Normalization policy4 means the willingness of the Fed to do two things: 1‐to raise the FFR to a more normal level 2‐ to reduce the size of its balance sheet in order to return the proportion of excess reserves to pre‐crisis value. Chapter 4 shows how this would be done for the FFR. Regarding reserve balances, Chapter 3 shows that their dollar amount is determined as follows: L2 = Assets of the Fed – (L1 + L3 + L4 + L5) Most of L2 is now composed of excess reserves, which is unusual. A graphical representation of this balance‐sheet identity is Figure 5.2.

Figure 5.2 Balance sheet of the Fed and reserve balances Source: Board of Governors of the Federal Reserve System (Series H.4.1)

The implication of this balance‐sheet identity is that reserves balances will fall either when assets of the Fed decline given other liabilities, or when the other liabilities of the Fed rise given assets. Let us look at each case in turn. Given liabilities other than reserves balances, reserves will not go back down until the following happens to the securities held by the Fed: 1‐ Securities issued by non‐fed‐account holders mature (let us call them “private securities” to simplify) 2‐ The Fed decides to sell some securities to banks. If the Fed let Treasuries mature the account of the Treasury (L3), not reserve balances, is debited:

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CHAPTER 5: FAQs ABOUT CENTRAL BANKING Fed ΔAssets Treasuries: ‐$100

ΔLiabilities and Net Worth L3: ‐$100

Treasury ΔAssets L3: ‐$100

ΔLiabilities and Net Worth Treasuries: ‐$100

When private securities held by the Fed, currently agency‐guaranteed MBS,5 mature the following occurs: Fed ΔAssets Private securities: ‐$100


Banks of issuer ΔAssets Reserve balances: ‐$100

ΔLiabilities and Net Worth Account of issuer: ‐$100

Issuer of private securities ΔAssets ΔLiabilities and Net Worth Account of issuer: ‐$100 Private securities: ‐$100 If all MBS held by the Fed matured at once, that would reduce reserve balances by almost $2 trillion (the Fed does not plan to sell most of the MBS it holds).6 Given assets, reserve balances will go down if banks need to make payments to other Fed account holders or if banks convert reserve balances into cash. For example, if the Treasury ran fiscal surpluses, reserve balances would fall as funds would move from L2 to L3. While the Fed may ask, and has asked, for the Treasury’s help in managing monetary policy (see Chapter 6), the Fed has mostly no control over what happens to liabilities that impact reserve balances. One may note to conclude that, besides changes in assets and liabilities, another way to reduce excess reserves without reducing the quantity of reserves is to raise reserve requirement ratios. As to when the reserves will be back to their usual level, nobody knows. The pace of decline will change as the economic environment change, which brings us to a final point. There is no need for the Fed to be proactive about normalizing its balance sheet because, with the change in monetary policy procedures that occurred in 2008, the Fed can target the overnight interbank rate.

Q7: IS THERE A ZERO LOWER BOUND? This question is so 2013! There is no lower bound. The discount rate is the most straightforward to grasp because the Board of Governor has perfect control over the discount rate and can set it wherever it wants whenever it wants. There is no operational constraint that prevents the Board from setting a discount rate at ‐1%, ‐10% or even ‐100%, it just needs to announce tomorrow that this is what it is and that is it.

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CHAPTER 5: FAQs ABOUT CENTRAL BANKING The federal funds rate is slightly more complicated but not that much. To set a negative fed fund rate, the Fed just has to do overnight repos on securities at a premium. If one applies this to zero‐ coupon securities like T‐bills, the present value of a T‐bill is: P = FV/(1 + d)t P is the market price, FV is the face value, d is the discount factor, and t is time to maturity (let us set t = 1 to simplify). Usually, d is positive meaning that the Fed buys T‐bills at $90 and bankers agree to buy back the next day at $95 (d = 5%). After the 2008, one can assume that d = 0%, that is, if bankers want reserves from the Fed, they sell T‐bills at $90 and promise to buy them back at $90 the next day. To set d negative, the only thing the Fed has to do is to buy at $95 and resell at $90. In this case the federal funds rate target will be negative 5%: 90/95 – 1. If the Fed performs enough of these kinds of operations, the federal funds rate will reach the ‐5% target. Remember that the Fed sets the price of reserves. It can set it wherever it wants: “It is the Fed’s way or the highway.” Which interest rate can be below zero? Any of them as long as the Fed is committed to doing so by buying enough of securities at a price consistent with the interest rate it wants to target. The interest rates used in the corridor framework (see Chapter 4) are under the total control of the Fed so they are easy to make negative. The Swedish central bank shows us how this is done under a corridor framework (Figure 5.4). The Swiss central bank shows us how it is done with a negative overnight interbank rate range (Figure 5.3).

Figure 5.3 Target overnight rate range and daily overnight rate, Swiss National Bank, percent Source: Swiss National Bank

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Figure 5.4 Corridor of the Sveriges Riksbank, percent Note: The “deposit rate” is the interest rate on reserve balances, the “lending rate” is the rate charged by the central bank for advances (the discount rate of the Fed), the “repo rate” is the rate at which the central bank performs open‐market operations (the targeted overnight rate). Of course, if a central bank has negative policy rates and is expected to continue to have negative rates for a while, this enters into portfolio strategies and pushes longer‐term rates into/toward negative territories (Figures 5.5 and 5.6). But, the European Central Bank is going further and is buying large quantities of long‐term government bonds. And financial‐market participants took notice 7 and bought government bonds in anticipation of the intervention of the ECB. Financial‐ market participants are so sure the ECB will buy a lot of securities that they are willing to buy at a premium (so yields to maturity are negative) (Figure 5.4). They will sell to the ECB who will be the one taking the loss by holding to maturity. For example, take a 1‐year zero‐coupon government security with a face value of $1000. Normally, this security will trade at a discount, that is, economic units will only buy it for less than $1000 because it does not pay any coupon. They will earn an income by keeping the security until the Treasury repays the $1000 at maturity. If the security is bought at $800 then the rate of return is $200/$800 = 25% (rate of return is what the earning you get for what you paid for it). Rates of return on Eurozone government 1‐year securities are now negative because securities sell at a premium. For example, if one has to pay $1200 on a 1‐year zero‐coupon security and gets $1000 at maturity, the rate of return is ‐$200/$1200 = ‐17%. Nobody will want to buy that unless one expects someone else to buy at, say, $1300 in upcoming days or months. The ECB is willing to do so and will take a loss of $300 (‐23% rate of return) when the securities mature, while financial market participants make a return of $100/$1200 = 8%.

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Figure 5.5 Yields on government bonds Source: The Economist

Figure 5.6 Yields on Swedish government securities, percent Source: Swedish Central Bank

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Q8: WHAT ARE THE EFFECTS OF A NEGATIVE INTEREST‐RATE POLICY? It depends on which rate is concerned. A simplified bank profit is: Profit of banks = (ROA*other assets + IOR*R) – FFR*fed funds debt ROA is the return on assets held by banks (say you have a $1000 mortgage with an interest rate of 5%, this 5% is an income for the bank equal to ROA*mortgage = 5%*$1000 = $50). IOR is interest on reserve balances and R is reserve balances. There are no other debts than those incurred from getting reserves in the fed funds market either from Fed or from other market participants than banks. Interest payments on interbank loans cancel out in the aggregate profit of banks, it is an income for one bank and an expense for another). ‐

Given everything else, negative FFR raises the profitability of banks because banks are paid to get an advance of reserves.

‐

Given everything else, negative IOR lowers the profitability of banks. This is especially significant today given how large reserve balances are.

Banks will react to these effects in several ways in order to preserve their profitability. To counter a negative IOR, banks may do three things: ‐

Ask their customers to pay a fee on their checking accounts (either a larger one or raise the minimum quantity of funds in an account below which a fee is paid)

‐

Raise the bank prime rate (i.e. interest rate paid by the most creditworthy economic units) or acquire riskier assets so as to raise ROA.

‐

Raise leverage on the funding of assets with positive ROA.

If the fee on bank accounts is too large, customers may ask for cash and close their accounts, but that is not really a problem for banks given that: 1‐ If the FFR is negative, banks can borrow all the reserves they need and be rewarded for it. Today they have plenty of reserves so this effect is limited, but it also means that meeting cash withdrawals is easy. 2‐ Banks work by granting advances and making electronic payments so some individuals must have deposits. In addition, nobody can access cash (Federal Reserve notes) if one does not have an account in the first place, and banks create these accounts by providing advances. Advances pay interest. The real problem is a negative IOR in the context of a large quantity of excess reserves. It acts like a tax and may incentivize banks to take more risks. This effect is all the more strong given that banks do not need to borrow in the fed funds market so a negative FFR has a limited ability to offset the negative impact of a negative IOR. In terms of negative bond rates, the impact is that bondholders make capital gains by selling to the central bank (see Q7). The central bank hopes that bondholders will use some of their capital gains to consume and so stimulate the economy. Given how unequal wealth distribution is, the ability of this channel to work seems doubtful. It is a form of trickle‐down economics.

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Q9: HOW DID CENTRAL BANKERS JUSTIFY USING NEGATIVE INTEREST RATES AND QE? Here is the logic followed: 1‐ A negative policy rate in a time of deflation (or low/zero inflation) allows us to keep the real interest rate low (allows us to lower the real rate). Economic units pay attention to the real rate (interest rate less inflation) when they decide to go into debt. If policy rate goes negative that should incentivize economic units to go into debt. 2‐ By buying a lot of securities from banks, banks will have a lot of excess reserves and will be encouraged to provide credit. And there will be a demand for credit given step 1. 3‐ Now that QE provided banks with lots of excess reserves, banks are supposed “to lend” (see money multiplier theory in Chapter 10). By setting IOR negative, banks will have less incentive to cling on their reserves and instead will provide credit. Indeed, if they keep reserves a negative IOR would lead to losses (see Q8). 4‐ Beyond the positive impact of bank credit, negative policy rates and quantitative easing also help push down other rates, which promotes capital gains by securities holders and so consumption. There are several issues but the three main ones are: 1‐ The ability of banks to grant credit is unrelated to the quantity of excess reserves they have. Chapter 4 shows that banks cannot do much with reserve balances (see Chapter 10). Central banks can feed banks to tons of reserves and may even threaten banks’ profitability with negative IOR, but it is just like beating a dead horse; banks are stuck with reserves. 2‐ In a depressed and over‐indebted economy, incentivizing economic units to go into debt is the wrong way to proceed. 3‐ The form of trickle‐down economics that quantitative easing and negative yield rates represent has never worked. We need a bottom‐up approach8 that focuses on providing jobs, fighting poverty, and meeting the needs of the nation. Fiscal policy is the means to do so.

Q10: SHOULD THE FED FINE‐TUNE THE ECONOMY? While the Fed is heavily involved in “fine‐tuning” the economy—i.e. making sure the economy is not too hot (inflation) nor too cold (unemployment) by moving the FFR target up and down—one may note that the Fed (and other central banks) was not created for that purpose. Central banks were created either to finance the crown/state, or to promote financial stability (both goals are actually intertwined as shown in Chapter 6). Some economists, like Hyman Minsky, think that fine‐tuning and promoting financial stability are incompatible goals. A central bank should focus on promoting financial stability through low and stable nominal interest rates, as well as proper regulation, supervision and enforcement. The Fed could also influence financial innovations by refusing to accept as collateral any financial instrument 60

CHAPTER 5: FAQs ABOUT CENTRAL BANKING that promotes “Ponzi finance” (see Chapter 14). Fine‐tuning the economy with interest rates implies raising interest rate during an expansion, which ultimately contributes to problems with servicing debts. Given that decisions to go into debt are not interest‐rate sensitive, raising rates just pushes economic units to go more into debt to pay existing debts. The hope is that income and capital gains will ultimately enable the full repayment of debts. More broadly, the link between FFR and the end goals of employment growth and inflation control is tenuous and subject to perverse linkages. For example: ‐

The link between interest rates and business investment is very weak, with investment by companies overwhelmingly dependent on expected net cash flows.

‐

Higher interest rate raises the cost of doing business and firms may pass that cost to their clients, resulting in inflation.

‐

Higher interest rate also raises the income of rentiers and so their consumption. If the economy has a large proportion of rentiers (pensioners, wealthy individuals, etc.) then raising rates may be inflationary.

‐

Higher interest rate raises the private‐debt burden and promotes financial instability.

‐

Interest‐rate volatility promotes financial innovations to remove the sensitivity of profit to interest‐rate swings.

‐

Increments in FFR are small and announced well in advance, giving plenty of time to economic units to adapt in order not to let their decisions be influenced by the cost of credit.

Instead of nudging incentives so that, maybe, the private sector will spend, some economists promote a more direct approach. In times of crisis, implement large scale fiscal spending to meet the needs of the nations (in the US, one of these needs would be infrastructure that is in really bad shape).9 At any time, involve the government in direct job creation by employing people in similar way it was done in the New Deal; a Job Guarantee program. In times of expansion, constantly check financial innovations and forbid financial practices related to Ponzi finance or at least remove any safety net for them. Finally, there have been some debates 10 also about how to set the FFR target. In the more mainstream literature, this issue boils down to what to include in the Taylor rule (a rule that determines what the optimal FFR target should be given a state of the economy) and how much weight to put on each element that influences the rule. In the non‐mainstream approach, the discussion is broader and includes discussions about the distributive and destabilizing impacts of monetary policy. Some authors want the central bank to target a specific interest rate to make rentiers’ income stable and related to the productivity gains of the economy. Others want to leave FFR permanently around zero and let other rates do the job of sorting credit risk, inflation risk, etc. A positive FFR just adds extra income to rentiers and does not reward any risk (see Q5 with Bill Gross). For your reading pleasure below are three extracts from some Federal Open Market Committee meetings that illustrate some of the previous points. First on the lack of interest‐rate sensitivity: In addition to the input that we bring to these meetings and the usual sources of our own research staff and directors, last Friday when Vice Chairman Schultz visited us in San Francisco we called in a special small group of bankers, businessmen, and 61

CHAPTER 5: FAQs ABOUT CENTRAL BANKING academicians for a very frank exchange of views. We sounded them out about their feelings on the economy and on Fed policy, and I must say, Fred, that I thought the reactions were quite candid and somewhat humiliating in a way. The bankers generally expressed the view that as yet there’s very little evidence that the high level of interest rates is having any significant total effect on cutting off credit demand. Now, one has to add to that the expressions we got from them in our usual go‐around with bankers and bank directors that these high rates are having a cutting effect on the so‐called middle market for business borrowers – the smaller firms – and for mortgage loans and some small farmers. That’s where the incidence of the high interest rate effect has been felt thus far in our part of the country. But as a general matter, even if the businessmen present were mostly from big concerns, they simply indicated that the higher rates per se are not having any effect at all on their capital projects. If a project is worthwhile, it‘s not going to get cut off by a one or two percentage point increase in the cost of funds. A minority expressed the view that this is leading to some greater caution on inventory policy, which is already being viewed as quite cautious. One major real estate developer present indicated that the higher rates are just built into their projects and aren’t having any dampening effect at all. (Balles, FOMC meeting, September 1979, page 27) Second on the cost impact of raising interest rates: Interest rates may be [low] after tax, or in real terms, but they are still contributing to cost and are creating, I think, some of the upward pressure on prices. (Teeters, FOMC meeting, May 1981, page 10) There is deterioration in the inflation rate stemming from interest costs and energy costs, and those are not trivial sources of deterioration. At the end of the day it doesn’t have to be labor costs that are causing the overall inflation deterioration. (Greenspan, FOMC meeting, November 2000, page 85)

Q11: IS THE FED A PRIVATE OR A PUBLIC INSTITUTION? Partly due to the culture of the United States, and partly due to strong economic interests against centralized institutions, the Federal Reserve System is an oddly organized public‐private partnership. Member banks do hold stocks issued by the System that provide a dividend payment but this dividend payment is not guaranteed, the stocks do not provide any voting rights, and they cannot be traded. For example, recently 11 Congress decided to divert some of the dividend payments to fund highway expenses. In addition, all leftover income of the System must be transferred to the Treasury. Note that this makes for an odd situation. The Fed holds Treasuries that pay interest, part of this interest income ends up going back to the Treasury: the Treasury pays itself interest! In addition, the Treasury tries to maximize its earnings from the Fed through cash management.12 Instead of looking at stock holdings and income payment, a more relevant analysis of the political economy of the Fed looks at its structure and who can make decisions regarding monetary policy and emergency operations. In terms of monetary policy, the influence of Wall Street is large, with strong representation on the Federal Open Market Committee via members with former ties to 62

CHAPTER 5: FAQs ABOUT CENTRAL BANKING major banks (in 2016 half the Fed presidents have former ties to two major banks: Goldman Sachs and Citibank). Financial sector members tend to be more hawkish and more concerned, if not obsessed, with price stability. This leads them to want to raise the FFR target early, leading to a level of employment lower than it would otherwise have been. They are also friendlier to the financial industry and more lenient in terms of regulations and in terms of response to a financial crisis. Finally, there is a risk of regulatory capture. If one combines this with the fact that economists at the Board are mostly pro‐market supply‐sided economists (economic growth is ultimately a supply‐side thing), financial regulation and enforcement do not make much sense and raising rates very early in anticipation of inflation makes sense. Many economists, however, doubt that markets are efficient and that demand has no role to play in the long run.

Q12: WHAT ARE NO‐NO SENTENCES FOR WHAT THE FED DOES? (WILL GIVE YOU A ZERO ON MY ASSIGNMENTS) 1‐ “The Fed controls the money supply”: No, it does not, it sets an interest rate, what happens after that is up to firms and households and their desire for external funds (see Chapter 4). 2‐ “The Fed injects reserves which lowers the interest rate” or, worse offender, “The Fed injects money which lowers interest rate”. Under normal circumstances (that is, pre‐Great Recession, which is what most people have in mind when saying this), the Fed does not proactively inject reserves, it waits for banks to ask. And, the Fed’s monetary policy never injects money, i.e. never deals directly with the public (M1) (see Chapter 4). 3‐ “The Fed printed money during the financial crisis”: No, it just credited account by keystroking dollar amounts, no Federal Reserve notes were printed. More to the point, none of these funds entered the money supply, that is, funds held by the public. 4‐ “The Fed used taxpayers’ money during the financial crisis”: No, it just credited accounts of banks by keystroking dollar amounts (see Chapter 2). 5‐ “Banks use reserves to buy stocks and corporate bonds”: No banks cannot do that with reserves (see Chapter 2). 6‐ “The large inflow of reserves in banks did not lead to inflation because banks did not lend the reserves or based on reserves”: No, banks do not operate that way, bank credit and quantity of reserves are unrelated (see Chapter 10) 7‐ “Central banks lend reserves”: No, the Fed does not lend reserves because reserves are its liability (see Chapter 2). 8‐ “Fiscal deficits raise interest rates”: No, there was a hint about this in Chapter 3. More is coming in Chapter 6.

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Summary of Major Points 1‐ Setting an interest rate does not mean supplying an infinite quantity of reserves. It just means supplying what banks want. 2‐ The Volcker experiment aimed at following more closely the Monetarist principles of monetary‐ policy making. In practice, the Fed widened dramatically the target range for the FFR but it never completely let the FFR respond to market forces. 3‐ FOMC members did not understand that targeting the FFR was not inflationary until the middle of the 1990s. 4‐ Normalizing the balance sheets means returning the quantity of excess reserves back to its pre‐ Great Recession proportion in total reserves. This can be done by selling assets to banks or by letting some of the securities held by the Fed mature. 5‐ Normalizing the balance sheet of the Fed is not necessary given that the Fed has changed its procedures for setting the FFR. 6‐ The FFR and discount rate are policy variables completely under the control of the Fed. They can be set wherever the Fed wants, even in negative territory. 7‐ In order to set market rate into negative values, the Fed just has to complete enough purchases of securities at a premium. 8‐ By providing capital gains and by making it costly to hold reserves, a negative interest rate policy is supposed to promote economic activity. 9‐ Fine‐tuning the economy may be difficult and counterproductive because rising interest rates may promote financial fragility and may be inflationary. In addition, business investment is not very sensitive to changes in interest rates; the transparent and gradual monetary policy strategies used since the mid‐1990s have made spending decisions even less sensitive to interest‐rate hikes. Keywords Volcker experiment, premium, fine‐tuning, normalization, excess reserves, total reserves Review Questions Q1: How did the Volcker experiment lead to an increase in the volatility of the FFR? Did the Fed abandon completely interest‐rate targeting? Q2: FOMC members did not believe that setting an interest rate was a sustainable monetary policy practice; why not? Why were they wrong? Q3: How does QE impact the yields of securities? Why the link cannot be one in which banks buy securities with reserves? Q4: How can banks offset the adverse impact of negative interest rates on the profitability of banks? Q5: What are the two ways through which QE is supposed to boost economic activity? What are potential issues with this policy? Suggested readings For an analysis of FOMC meetings during the period 1979‐1999 see chapter 6 of Central Banking, Asset Prices, and Financial Fragility by Eric Tymoigne. Kaldor, N. (1982) The Scourge of Monetarism, Oxford: Oxford University Press.

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CHAPTER 5: FAQs ABOUT CENTRAL BANKING 1 A succinct profile of Nicholas Kaldor was written in the central bank of the Slovak Republic BIATEC, Volume XIV, 12/2006

http://www.nbs.sk/_img/Documents/BIATEC/BIA12_06/26_30.pdf See “Bill Gross: Americans are being "cooked alive" by the Fed's zero interest rates” by Chis Matthew at http://fortune.com/2015/09/23/bill‐gross‐federal‐reserve‐interest‐rates/ 3 See Wray, L.R. (2006) “Global Demographic Trends and Provisioning for the Future” Levy Economics Institute, Working Paper No. 468 at http://www.levyinstitute.org/pubs/wp_468.pdf 4 See “Policy Normalization Principles and Plans As adopted effective September 16, 2014” by the Federal Open Market Committee at http://www.federalreserve.gov/monetarypolicy/files/FOMC_PolicyNormalization.pdf 5 See “About MBS/ABS” by the Securities Industry and Financial Markets Association at http://www.investinginbonds.com/learnmore.asp?catid=11&subcatid=56&id=134 6 See “Policy Normalization Principles and Plans As adopted effective September 16, 2014” by the Federal Open Market Committee at http://www.federalreserve.gov/monetarypolicy/files/FOMC_PolicyNormalization.pdf 7 See “Euro Area's Negative‐Yielding Debt Tops $2 Trillion on Draghi” by Lucie Meakin at http://www.bloomberg.com/news/articles/2015‐11‐23/euro‐area‐s‐negative‐yielding‐debt‐tops‐2‐trillion‐on‐draghi 8 See Tcherneva, P.R. (2013) “Reorienting Fiscal Policy: A Critical Assessment of Fiscal Fine Tuning” Levy Economics Institute, Working Paper No. 772 at http://www.levyinstitute.org/pubs/wp_772.pdf 9 See the Infrastructure Report Card by the American Society of Civil Engineers at http://www.infrastructurereportcard.org/ 10 See Tymoigne, E. (2006) “Asset Prices, Financial Fragility, and Central Banking” Levy Economics Institute, Working Paper No. 468 http://www.levyinstitute.org/pubs/wp_456.pdf. See also 11 See “Fed Money Tapped in Highway Bill as Banks Get Dividend Break” by Cheyenne Hopkins at http://www.bloomberg.com/news/articles/2015‐12‐01/fed‐surplus‐tapped‐in‐highway‐bill‐as‐banks‐get‐dividend‐ break 12 Santoro, P.J. (2012) “The Evolution of Treasury Cash Management during the Financial Crisis,” Federal Reserve of New York Current Issues in Economics and Finance, 18 (3): 1‐8. 2

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CHAPTER 6:

After reading this Chapter you should be able to understand: How and why the central bank and Treasury must coordinate their fiscal and monetary operations How the Treasury helps the central bank implement monetary policy on a daily basis Why the Treasury is involved in the implementation of monetary policy Why the financing of the Treasury by the central bank is not optional and must always occur directly or indirectly How the central bank gets involved in financing the Treasury Why a monetarily sovereign government does not face any financial constraint What relevant questions a monetarily sovereign government must answer

CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS This Chapter concludes the study of central banking matters included in this draft. The Chapter studies how the Fed is involved in fiscal operations and how the U.S. Treasury is involved in monetary‐policy operations. The extensive interaction between these two branches of the U.S. government is necessary for fiscal and monetary policies to work properly. Once again, the balance sheet of the Federal Reserve provides a simple starting point. The Treasury holds an account (called Treasury’ General Account, TGA) at the Fed, which is part of L3. To simplify, this Chapter assumes that the Fed still follows the monetary‐policy procedures that it followed prior to the 2008 crisis.

MONETARY POLICY AND THE U.S. TREASURY When Treasury spends, the Fed debits the TGA and credits reserve balances. Simultaneously, private bank credits the account of private economic units. Say the Treasury buys $100 worth of paper from a paper company. Fed ΔAssets

ΔLiabilities and Net Worth Reserve balances: +$100 TGA: ‐$100

Bank ΔAssets Reserve balances: +$100

ΔLiabilities and Net Worth Account of paper company: +$100

Paper company ΔAssets ΔLiabilities and Net Worth Paper: ‐$100 Account of paper company: +$100 Treasury ΔAssets TGA: ‐$100 Paper: +$100


If Treasury receives $25 of income tax payments, the following happens: Fed ΔAssets

ΔLiabilities and Net Worth Reserve balances: ‐$25 TGA: +$25

Bank ΔAssets Reserve balances: ‐$25 67

ΔLiabilities and Net Worth Account of taxpayer: ‐$25

CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS Taxpayer ΔAssets Account of taxpayer: $25

ΔLiabilities and Net Worth Net worth: ‐$25

Treasury ΔAssets TGA: +$25

ΔLiabilities and Net Worth Net worth: +$25

Therefore, in case of a deficit (taxes less than expenses), there is a net injection of reserves. The consolidation of the two previous fiscal operations is: Fed ΔAssets


If the Fed does not neutralize the impact of the fiscal deficit by removing the extra reserves, banks will dump everything in the Fed Funds market and the FFR rapidly falls toward 0% (see Chapter 4). As long as the Fed targets a positive FFR, it has to neutralize the impact of daily fiscal deficits (L3 falls)—that lower the FFR—and the impact of daily fiscal surpluses (L3 rises)—that raise the FFR. The Treasury understood the impact of its fiscal operations on money markets long before the Fed was created. In the current set up, the Treasury has helped the Fed to achieve its FFR target through two means: 1‐ Cash management: The Treasury collects proceeds from taxes and bonds issuances in thousands of private bank accounts called the “Treasury’s Tax and Loan accounts” (TT&Ls). Treasury moves funds between its TT&Ls and TGA to help monetary policy. 2‐ Public‐debt management: The Treasury changes the level of its outstanding Treasuries, or changes the structure of its Treasuries (proportion of short‐term vs. long‐term securities). Given that fluctuations in the TGA (L3 in Figure 2.1) influence reserve balances (L2 in Figure 2.1), until the Great Recession the Treasury limited these fluctuations by keeping the TGA around $5 billion (Figure 6.1). Treasury employees met every morning with Fed employees to discuss the expected net cash flow on TGA for the day and to decide on the quantity of funds to move in or out of TT&Ls to meet the $5 billion target. For example, say the TGA is currently at $5 and that this is the target of the Treasury. If the Treasury expects to spend $2, it would call $2 from its TT&Ls during the day. Cash flows of the TGA are very erratic throughout the day so they cannot be offset perfectly. Assume that spending occurs first (payment to a paper company): Bank ΔAssets Reserve balances: +$2

ΔLiabilities and Net Worth Account of company: +$2

Fed ΔAssets

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CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS The injection of reserves is removed by calling funds from TT&Ls: Bank ΔAssets Reserve balances: ‐$2

ΔLiabilities and Net Worth TT&Ls: ‐$2

Fed ΔAssets

ΔLiabilities and Net Worth Reserve balances: ‐$2 TGA: +$2

So overall the net impact on reserve balances is zero and the balance sheet of the Fed is unchanged. The only change is on the liability side of private banks. Bank ΔAssets

ΔLiabilities and Net Worth Account of company: +$2 TT&Ls: ‐$2

Figure 6.1 TGA, weekly averages until 9/17/2008, billions of dollars Source: Board of Governors of the Federal Reserve System (H.4.1. series)

TREASURY’S INVOLVEMENT IN MONETARY POLICY DURING THE 2008 CRISIS Lehman’s collapse in September 2008 led to a large injection of reserves but this injection was partly contained by a rapid increase in other liabilities that peaked in value at $1.7 trillion on the week of November 5th 2008 (Figure 6.2). The cause of the increase is a massive cash and debt 69

CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS management operation by the Treasury that started late September 2008. First, Treasury transferred tens of billions of dollars from its TT&Ls into the TGA, thereby breaking with its attempt to maintain TGA at $5 billion. Second, Treasury issued “Supplementary Financing Program” T‐bills (SFP bills), and immediately put the proceeds into a new Treasury’ account at the Fed called “Treasury’s Supplementary Financing Account” (TSFA) (Figure 6.3).

Figure 6.2 Balance sheet of the Federal Reserve, trillions of dollars Source: Board of Governors of the Federal Reserve System (series H.4.1)

Why did the Treasury do this? To help drain reserves in order to maintain the FFR on target. The FFR target was positive until December 2008, so reserves had to be drained in order to maintain the FFR around the non‐zero target. Chapter 4 explains that the Fed had been neutralizing the impact of emergency programs on reserves since December 2007. It had been doing so by selling its holdings of Treasuries to banks and in six months the outstanding value of its holdings fell from $780 billion in January 2008 to $480 billion in June 2008. If the Fed had continued to neutralize emergency programs in that fashion, it would have run out of Treasuries very quickly with the panic of September 2008. It is all the more so that the Fed had started to lend some of its Treasuries, so the dollar amount of unencumbered Treasuries actually dropped to $250 billion. In order to avoid running out of Treasuries, the Fed asked the Treasury to help drain reserves via cash management (TT&Ls to TGA transfers) and debt management (issuance of SFP bills). The T‐ bills were issued at the request of the Fed for monetary‐policy purposes, that is, to help drain reserves. 1 The outstanding dollar amount of SFP bills peaked at almost $560 billion in late October/early November 2008. After that, the outstanding dollar amount went down quickly for reasons explained below. Combined with its cash management operations, Treasury removed up to slightly more than $600 billion worth of reserves. As the Discount Window was advancing reserves to banks in difficulty, the Treasury was simultaneously draining them (Figure 6.4).

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CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS

Figure 6.3 Treasury’s accounts at the Fed, billions of dollars Source: Board of Governors of the Federal Reserve System (series H.4.1)

Figure 6.4 Injection (+) and ejection (‐) of reserve balances, trillions of dollars Source: Federal Reserve (Series H.4.1) In its announcement of the Program, the Treasury misrepresented the purpose of SFP bills by stating that their purpose was to “provide cash for use in the Federal Reserve initiatives.”2 Of course this is incorrect because the Fed does not need cash from anybody, it creates cash. 71

CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS The Treasury rapidly reduced its help through the SFP program by agreeing to roll over only $200 billion of T‐bills. Treasury did so because its help was no longer as needed (FFR target was at zero), and because of the debt‐ceiling debate of the time that almost killed the program in early 2010.

OTHER EXAMPLES OF TREASURY’S INVOLVEMENT IN MONETARY POLICY The Treasury has used other debt and cash management techniques in the past in order to help monetary policy. For example, Treasury used to be able to have an intraday overdraft on its TGA; unlimited from 1914 to 1935 and up to $5 billion from 1942 until 1979 (Table 6.1).3 As such, at times, the TGA would carry a negative balance during the day and, by the end of the day, the TGA would be replenished by direct financing of the Fed. The Treasury issued “special certificate of indebtedness” to the Fed and in exchange the Fed credited the TGA. The Treasury used this overdraft authorization exclusively for monetary‐policy purposes. For example, before a major tax season: On occasion, the Treasury, in anticipation of heavy tax receipts during heavy tax months, will, under statutory authority, replenish balances at Federal Reserve Banks by borrowing directly from such banks through the issuance of special certificates of indebtedness, rather than withdrawing funds from Treasury tax and loan accounts. These funds are borrowed for only a few days and enable the Treasury temporarily to make disbursements in excess of its current receipts thus providing the banks with additional reserves in advance of a later unavoidable drain. (U.S. Treasury 1955, 282, italics added) This allowed the Treasury to replenish its TGA without having to drain its TT&Ls. The Treasury did this not because it was running out of money: At the time [Treasury’s administrators] have used the overdraft in the past, it has not been when they have had no balances with the banks. They have usually had very substantial balances with the banks. And they could have drawn on those balances to meet the overdraft. That, however, […] would be undesirable and unstabilizing to the money market to withdraw the [TT&Ls] for such a very short period of time. It would then build up unnecessary balances in the Reserve banks, and would create a deficiency of reserves in the banks throughout the country, and would compel them to sell securities or to borrow from the Federal Reserve banks (Eccles in U.S. House 1947, 7)) Throughout most of WWII, the Fed was targeting the entire yield curve (that is, all the interest rates on Treasuries) and Treasury helped through debt management (Figure 6.5). The strict targeting of T‐bond rate at 2.5% was relaxed a bit toward the end of the war, but Treasury and Fed still did not want the rate to deviate too much from 2.5%. After the war, fiscal surpluses removed T‐bonds from the market even though there was high demand for them. This situation raised their price and the yield on 10‐year T‐bonds declined steadily toward 2%. To bring back the T‐bond rate up toward 2.5%, more T‐bonds needed to be supplied. Unfortunately, the Fed did not hold enough T‐bonds so the Treasury supplied more:

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CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS At any rate, the effect of a budget surplus at that time was terribly important in all of the monetary and debt management operations that went on. […] At that time, the Federal Reserve System owned practically no long‐term Government bonds and, therefore, in its open‐market operations was unable to supply the market with that type of investment. The Treasury Department, however, held large amounts of long‐term bonds in various investment accounts. After consultations and discussions, both at a staff level and at a policy level, between the Treasury and the Federal Reserve and in full agreement, the Treasury Department, through the open‐market committee of the Federal Reserve, sold large amounts of long‐term Government bonds so as to fill the demand and to prevent a further decline in the long‐term interest rate. During this period, the Treasury sold $1.5 billion of long‐ term bonds. However, the amount was not adequate to satisfy the demand nor to increase the market yield on such securities. Thereupon, the Treasury Department, after consultation with the Federal Reserve and with full agreement on the part of both, sold a nonmarketable 18‐year issue in the amount of $1 billion. The purpose of this sale was to mop up any remaining investment funds that were exerting upward pressure on the market. (Wiggins in U.S. Senate, 1952, p. 227, p. 237)) From a fiscal perspective this seems strange—a Treasury trying to raise the cost of its indebtedness and a Treasury issuing securities when running a fiscal surplus—but again all this was done for monetary‐policy purposes, and more broadly for what was considered the social purpose. 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942

(1) 30 14 15 14 46 20 17 18 18 8 4 19

(2) 1 1 1 1 1 1 1 1 1 1 1 6

(3) 156.5 184 182 246 251.5 316 314 218 219.5 32 9 422

1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962

(1) 48 9 2 2 4 30 29 15 2 -

(2) 28 7 2 1 2 9 20 13 2 -

(3) 1,302 484 220 180 320 811 1,172 424 207 -

1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982

(1) 3 7 8 21 9 1 10 1 16 4 N/A -

(2) 3 3 6 12 7 1 6 1 7 4 N/A -

(3) 169 153 596 1,102 610 38 485 131 1,042 2,500 2,600 -

Table 6.1 Direct financing of the Treasury by the Fed to close the TGA overdraft: Number of Days Used (1), Maximum Number of Days Used at any One Time (2), and Maximum Outstanding at any Time (Millions of Dollars) (3) Sources: U.S. House (1962), U.S. Treasury (1978), Board of Governors of the Federal Reserve System (1979)

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Figure 6.5 U.S. Interest rates in the 1930s, 1940s and 1950s, percent. Sources: NBER, Board of Governors of the Federal Reserve System Note: Grey area is represents U.S. official involvement in World War Two.

There have been other cash and debt management techniques used by the Treasury but those above should give you a sense that the Fed cannot do it alone given the way it operates in terms of monetary policy (it uses Treasuries so Treasury must supply enough securities), and given that Treasury has an account at the Fed (a fiscal surplus/deficit drains/injects reserves). In other countries the institutional details change, but some coordination between Treasury and central bank is needed for monetary‐policy operations to work properly.

FISCAL POLICY AND THE FED For a government that has monetary sovereignty, one that issues its own currency and securities only denominated in its unit of account, the central bank always helps one way or another to finance the budget of the Treasury. After all, central banks were created in part to help finance the state, that is, to make sure that the state has the financial means to fulfill its goals expressed in the annual budget. Once again, the following focuses on the United States. The most straightforward involvement of the Fed into fiscal operations was the availability of an overdraft on TGA until the late 1970s. As stated in the previous section, in practice this overdraft facility had been strictly used for monetary‐policy operations, but it could be used for fiscal purposes in case of “national emergency.” The $5 billion limit was, however, very limiting for that purpose and there were Congressional hearings in the 1960s that looked into the possibility of expanding that limit and making the overdraft line permanent (authorization of the overdraft had to be renewed by Congress every two years). This went nowhere because the use of the overdraft for fiscal purposes was seen as inflationary and unsound. The Treasury always justified the use of

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CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS the overdraft as a brief and occasional means to finance its expenditures in order to avoid disruptions in the money market. Even though direct financing was discouraged and later forbidden, the Treasury uses Fed’s monetary instruments to spend. Thus, one way or another, the Treasury will get financed by the Fed because only the Fed supplies the funds that the Treasury uses. Indeed, while TT&Ls are used to receive bond and tax proceeds, they are just a tool that allows for smoothing out the impact of tax and bond proceeds on reserves. Ultimately, all the proceeds go to the TGA, which drains reserves. As a consequence the Fed has to ensure that banks have enough reserves to allow the Treasury to be able to make the transfer from TT&Ls to TGA. In addition, the Fed also has been heavily involved in treasury auctions4 to ensure that they go on smoothly. Chairman Eccles again provides an insightful insider’s view on the financing of the Treasury: [In past Congressional hearings] there was a feeling that […] Government [borrowing] directly from the Federal Reserve bank […] took off any restraint toward getting a balanced budget. Of course, in my opinion, that really had no relationship to budgetary deficits, for the reason that it is the Congress which decides on the deficits or the surpluses, and not the Treasury. If Congress appropriates more money than Congress levies taxes to pay, then, there is naturally a deficit, and the Treasury is obligated to borrow. The fact that they cannot go directly to the Federal Reserve bank to borrow does not mean that they cannot go indirectly to the Federal Reserve bank, for the very reason that there is no limit to the amount that the Federal Reserve System can buy in the market. […] Therefore, if the Treasury has to finance a heavy deficit, the Reserve System creates the condition in the money market to enable the borrowing to be done, so that, in effect, the Reserve System indirectly finances the Treasury through the money market, and that is how the interest rates were stabilized as they were during the war, and as they will have to continue to be in the future. So it is an illusion to think that to eliminate or to restrict the direct borrowing privilege reduces the amount of deficit financing. Or that the market controls the interest rate. Neither is true. (Eccles in U.S. House, 1947, 8) If the Treasury does not get the funds it needs to implement Congressional mandates, and if Congress passes a budget in deficit, then the democratic process will not be fulfilled (the budget cannot be implemented), and interest rates will rise. In terms of auctions of Treasuries, the Fed makes sure they are always successful; “bond vigilantes” have no influence. The Fed has done so in many different ways; one way was to buy whatever was leftover during an auction. The Fed had to do so, either because until the 1970s T‐bond auctions were not well established and so participation was not always as high as needed, or because the Fed was targeting the entire yield curve. Now today in pricing a new Treasury issue, the Federal [Reserve] is in the position of underwriter. During the period of the offering the Federal [Reserve] tries to see to it that the Treasury's issue is successful […] It stabilizes the market just the way any underwriter does. (Martin in U.S. Senate, 1952, p. 96) Another way has been to provide a dependable refinancing channel to the Treasury because the Fed is still allowed to participate in auctions to replace its maturing Treasuries. 75

CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS Finally, today the Fed participates indirectly in the financing of Treasury through the Primary Dealer System. During an auction, primary dealers must submit a reasonable bid and the Fed ensures that they have enough reserves at time of settlement by purchasing, or repoing, outstanding Treasuries. Prior to the Primary Dealer System, the Fed also ensured that banks had enough reserves to settle an auction. For example during World War Two (see Figure 6.6 for reserve data during that period): It was evident that all funds needed for financing the war which were not raised by taxation or by the sale of Government securities to nonbank investors would need to be raised by the sale of securities to the banking system. At first commercial banks were able to draw down excess reserves by several billion dollars, but later they had to be supplied with a considerable amount of additional reserve funds in order to purchase the necessary securities […] In general, further reserve funds were supplied by Federal Reserve purchases of short‐term Government securities. (Martin in U.S. Senate, 1952B, p. 288) Thus, one way or another the Fed will ensure that auctions never fail; and in the process it will be financing either directly or indirectly the Treasury.

Figure 6.6 Total reserves, Aug. 1917 to Dec. 1958, billions of dollars Sources: Banking and Monetary Statistics 1914‐1941, Banking and Monetary Statistics 1941‐ 1970.

A NECESSARY COORDINATION OF TREASURY AND CENTRAL BANK ACTIVITIES The Treasury and the central bank must work extensively together for fiscal and monetary policies to work properly. The central bank cannot be fully independent from the Treasury:

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CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS The history of central banking, as was brought out earlier by the chairman, is that central banking cannot get too far away from the policies of Government too long; and that while central banks historically have won battles against the Government, they have always lost the war. (Wiggins in U.S. Senate, 1952, p. 235) The central bank has independence of tools (interest‐rate setting) and goals (inflation, etc.) but must work Treasury operations into its daily activities. Similarly, the Treasury needs to work monetary‐policy considerations in its daily activities otherwise interest‐rate stability would not be maintained and inflationary pressures could more easily materialize.

TO GO FURTHER: CONSOLIDATION OR NO CONSOLIDATION? THAT IS THE QUESTION. It should be clear from the previous sections that ultimately all the funds that the Treasury uses come from the Fed. Indeed, while taxes and bond issuances debit the account of private economic units and credit TT&Ls, ultimately the Treasury needs funds in its account at the Fed (the TGA). And these funds cannot exist before reserves exist unless the Fed directly provides funds to the Treasury. Put in terms of T‐accounts, assumes that the TGA gets credited $100: Fed ΔAssets

ΔLiabilities and Net Worth TGA: +$100

There are only a few possible offsetting operation. One is that the Fed directly finances the Treasury: Fed ΔAssets Treasuries: +$100

ΔLiabilities and Net Worth TGA: +$100

Another is that other Fed accounts are drained as a results of tax settlement or the settlement of auctions of Treasuries: Fed ΔAssets

ΔLiabilities and Net Worth TGA: +$100 Other Fed accounts: ‐$100

In the latter case, the Fed previously had to provide those funds to the holders of these accounts, either by advancing funds to them or by buying something from them (see Chapter 4). The Fed is then indirectly financing the Treasury by working through intermediaries (primary dealers, banks, etc.). Pushing a bit further, it is quite clear that tax payments cannot be settled unless reserves are injected first in the banking system either by the Fed (through advances or purchases: assets go up, L2 goes up) or by the Treasury (via spending: L3 falls, L2 goes up). The same applies to proceeds from issuing Treasuries. Monetary financing of the Treasury is not optional, it occurs one way or another. Either the Fed buys Treasuries directly from the Treasury, or it buys them indirectly by first providing funds to primary dealers through some outright or temporary purchases of Treasuries.

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CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS Some economists following Modern Money Theory (MMT) have used these conclusions and noted that no analytical insight is gained from making a distinction between Treasury and central bank when dealing with a monetarily sovereign government. We might as well consolidate them into one economic unit, the government. Consolidation is actually not infrequent in economic analysis, but MMT pushes for consolidation based on a detailed analysis of the inner workings of Treasury and central bank relationships. It is a theoretical simplification that is grounded in a detailed institutional analysis. More importantly, MMT claims that consolidation has some implications for understanding the role of taxes and government‐bond issuances for a monetarily sovereign government. The balance sheets of Treasury and central bank look as follows (the word “currency” is used broadly to mean all forms of central bank monetary instruments: cash and reserve balances). Treasury Department Assets Liabilities and Net Worth A1T: Physical assets and financial claims on L1T: Treasuries held by central bank the non‐federal sectors L2T: Other liabilities plus net worth A2T: TGA+ FRNs held by Treasury Central bank Assets A1CB: Physical assets and financial claims on the non‐federal sectors A2CB: Treasuries

Liabilities and Net Worth L1CB: Monetary base L2CB: TGA + FRNs held by Treasury L3CB: Other liabilities and net worth

The government balance sheet is: Federal government Assets Liabilities and Net Worth A1: Physical assets and financial claims on L1: Monetary base the non‐federal sectors L3: Other liabilities held by the domestic non‐federal sectors and the rest of the world plus net worth Tax payments lead to: -

ΔL1 < 0: government currency is returned to the government

-

ΔL2 > 0: higher net worth of government (or ΔA1 < 0 if a tax liability is on the balance sheet, for example, tax receivables are part of A1)

Government spending (fiscal policy) and advances (monetary policy) inject government currency: ΔL1 > 0. Taxes do not fund the (consolidated) government, that is, there is no crediting of a government checking account, no accumulation of funds by government: taxes destroy government currency (ΔL1 < 0). In addition, injection of government currency (ΔL1 > 0) must occur before taxing because tax payment is done by handing over to the government its currency (ΔL1 < 0). This is exactly what was said in the previous sections.

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CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS Government‐bond issuance leads to -

ΔL1 < 0: government currency is returned to the government

-

ΔL2 > 0: interest‐earning securities are issued

Bond issuances are equivalent to a transfer of funds from a checking account to a savings account. They are part of monetary‐policy operations. The previous sections showed that this was illustrated in times of stress in the monetary system. MMT authors tend to like to work with a consolidated government because they see it as an effective strategy for policy purposes (see next section), but also because the unconsolidated case just hides under layers of institutional complexity the main point: one way or another the Fed finances the Treasury, always. This monetary financing is not optional and is not, by itself, inflationary.

TO GO EVEN FURTHER: WHAT ARE THE RELEVANT QUESTIONS TO ASK FOR A MONETARILY SOVEREIGN GOVERNMENT? An advantage of the “Taxes don’t pay for anything” position is that it allows one to frame existing debates differently. Instead of judging a program in terms of “how are we going to pay for it?”, one may now look at what the social needs are and figure out how to implement their production. That is the hard part. The financing of production is easy: it is always monetary financing, one way or another. Focusing the political discussion on taxes and how or who will pay, who gets the benefits, etc. moves away from the public purpose of government and into an individualized benefit/cost analysis: “I paid taxes, what do I get for it?” The simplest answer is maybe nothing because the purpose of government is not to benefit any specific individual but society as a whole. Or maybe an individual asking this question is too narrowly defining his/her benefits to their immediate, material and personal aspects. Some families may not have kids and so may not personally benefit from paying taxes for public schooling, but a better educated population has immense benefits now and for the future, which does impact the quality of life of all. In addition, moving away from the “taxes pay for” framework helps to better tackle some problems, simply because taxes for a monetarily sovereign government are not meant to pay financially for anything, but rather to free up some resources (goods, workers, services, raw materials, etc.) for the public purposes. For example, the Social Security problem is not a financial problem; Social Security cannot go bankrupt. There is no need for a Trust Fund, no need to put dollars in a locked box, no need for payroll taxes. Social Security benefits can be paid the day they are due just by typing a number on the computer. The funds will come from debiting the TGA. TGA will obtain funds directly or indirectly from the Fed. The hard part is figuring out how and what to produce to meet the needs of an aging society. We will need more infrastructure, workers, goods and services that cater to the needs of an older population; we will need to raise the productivity of available workers. That cannot be done by the Treasury saving dollars. Instead, the Treasury should probably spend more on making schooling and training easier to access, and should provide some financial help to individuals and businesses 79

CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS willing to be involved in solving the problems of the future. The government should also be involved directly through infrastructure spending and others. All this means more federal government spending today, not less. Taxes and tax structures are important but not for financing purpose but to promote price stability, to change behaviors and to correct arbitrary inequalities. Payroll tax does none of that. It raises the cost of labor, it discourages employment and it is regressive. In the end, the problem of paying for something is not a financial issue for a monetarily sovereign government, it is a political and productive one. If Congress is willing to do it, it will get funded; if it gets funded then comes the problem of finding the resources to implement the project. The really relevant questions are: “What do we want the government to do for us?”, “Do we want a government that represents 50% of GDP or 20% of GDP?”, “Do we want the burden of switching real resources to schooling, childcare, eldercare, etc. to be shared by society through higher taxes, or do we want to individualize that burden through higher personal expenses?”, “Do we prefer a society in which everybody fights for himself or do we prefer a cooperative society?” Once these questions are answered (hopefully through democratic process), the public purpose is clearly defined and the point becomes to implement it. Paying for its implementation in financial terms is easy; paying in real resources may be hard (especially at full employment). Keynes’s How to Pay for the War is a classic example of the correct way to frame the question. He notes that: “A government which has control over the banking and currency system can always find the cash to pay for its purchases of home‐produced goods.” The problem of how to pay is not a financial problem as long as goods and services are available for purchase in the denomination of the currency issued by the government. The problem is this at the time: “Every use of our resources is at the expense of an alternative use,” “the size of the cake is fixed.” There are opportunity costs and if nothing is done inflation will grow out of control as government competes with the private sector to access resources to fight the war. The problem is one of production and consumption. In peace‐time, the economy is usually below full employment so to produce more one just needs to employ more. But at full employment, some choices must be made that involve giving up some alternatives and making sacrifices; that is what “paying for” means. The private sector must sacrifice some consumption to free resources for government uses. The questions are: who should sacrifice the most? How much sacrifice should there be? How should the sacrifice be implemented? In the context of the war, priorities are easy to set given the broad political consensus about what the public purpose is (winning the war): when three quarters of the cake used to go for private consumption, now only one quarter can go for that purpose. People have to live at subsistence level to be able to win the war. Government could try to achieve this through voluntary saving (war bond issuances), or by rationing, but the most effective way to achieve that is to cut purchasing power at the source: if people do not have as big a monetary income they will not go shopping as much. This can be done through taxing (permanent sacrifice of private consumption) or deferred pay (temporary sacrifice of private consumption), with the aim of reducing private monetary income to what is needed to meet subsistence. While Keynes puts the choice in front of us in a blunt fashion given the dramatic situation of the time, the same applies in peace time. The two main differences are that, first, there is more flexibility in terms of resources given that usually the size of the cake can grow and, second, that a political consensus about the public purpose is less easily achieved. Of course, some countries that are monetarily sovereign may not have much resources and may not export enough to obtain the 80

CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS foreign goods and services needed to fulfill the public purpose. In that case it is difficult, but not impossible, to implement the social purpose. If, in addition, a country is not monetarily sovereign, then implementing the public purpose is even harder. Summary of Major Points 1‐ A fiscal deficit leads to an net injection of reserves and so pushes down FFR and other short‐term interest rates 2‐ To neutralize the impact of fiscal operations on the FFR, the Treasury uses cash and debt management techniques. These techniques have varied in amount and obviousness overtime depending on the circumstance and the political appetite for an overt interaction between central bank and Treasury. 3‐ The Treasury has helped to implement monetary policy by issuing Treasuries at the request of the Fed, by taking an overdraft at the Fed instead of using funds in its TT&Ls, by targeting a stable amount of funds in its TGA, among others. 4‐ The central bank has been involved in financing the Treasury, either directly or indirectly through the banking system. Monetary financing of the Treasury is not optional, it is required for monetary policy to work properly, for the settlement of taxes to be possible and for the settlement of auctions of Treasuries to be possible 5‐ The coordination between the Fed and the Treasury is always extensive and ensures that the Treasury always can finance its budget. Treasuries auctions cannot fail. 6‐ There is no financial constraint on the federal government, it cannot run out of dollars. There are, however, political constraints that define the public purposes, and productive constraints that define how much the government can spend without generating inflationary pressures. 7‐ During the Great Recession, the Treasury helped the Fed to drain some of the reserves injected via the Discount Window by issuing Treasuries at the request of the Fed and by moving all the funds in a special account at the Fed. 8‐ The Fed can target perfectly the entire Treasuries yield curve if it wishes to do so. It did so during World War Two. 9‐ Once one understands how deep the coordination between the Fed and the Treasury is, one may argue that taxes do not finance the government and neither do Treasuries. All financing is monetary because reserves must be injected first before taxes can be paid and Treasuries can be bought. Keywords TGA, TT&Ls, TSFA, excess reserves, FFR, cash management, debt management, tax receivable/payable

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Review Questions Q1: If the Fed or Treasury did not neutralize the impact of a fiscal deficit, what would happen to the FFR? What would happen to other rates? Q2: If the Fed did not ensure that banks have enough reserves, how would that create problems for tax settlements, Treasuries auction settlements, and targeting the FFR? Explain each case in detail. Q3: How did the Treasury help the Fed during the Great Recession? Why did the Fed request the help of the Treasury? Q4: Explain how the Fed was and is still involved in the direct financing of the Treasury Q5: Explain how the Fed has been involved in the indirect financing of the Treasury and why auctions of Treasuries cannot fail. Suggested readings For a more detailed analysis of the cash management technics used during the Great Recession by the Treasury read Santoro, P.J. (2012) “The Evolution of Treasury Cash Management during the Financial Crisis,” Federal Reserve of New York Current Issues in Economics and Finance, 18 (3): 1‐8. For a discussion of the historical role of the U.S. Treasury in monetary policy and the reasons for its involvement, see U.S. Treasury (1955) Annual Report of the Secretary of the Treasury on the State of the Finances for the Fiscal Year Ended June 30 1955. Washington, D.C.: Government Printing Office, pages 275‐290: http://fraser.stlouisfed.org/docs/publications/treasar/AR_TREASURY_1955.pdf Bruce K. Maclaury provides an interesting and accessible discussion of the independence of the central bank and its necessary coordination with the U.S. Treasury. https://www.minneapolisfed.org/publications/annual‐reports/perspectives‐on‐federal‐reserve‐ independence‐a‐changing‐structure‐for‐changing‐times. For an historical analysis of the auctions of long‐term Treasuries and the role the Federal Reserve has played, see Garbade, K.D. (2004) “The Institutionalization of Treasury Note and Bond Auctions, 1970‐75,” Federal Reserve Bank of New York Economic Policy Review, May: 29‐45. https://www.newyorkfed.org/medialibrary/media/research/epr/04v10n1/0405garbpdf.pdf More advanced readings are: Bell, S.A. (2000) “Do Taxes and Bonds Finance Government Spending?” Journal of Economic Issues 34 (3): 603‐620. Mitchell, W. F., and Muysken, J. (2008) Full employment abandoned: Shifting sands and policy failures. Cheltenham: Edward Elgar. (CHAPTER 8) Tymoigne, E. (2016) “Government monetary and fiscal operations: Generalising the endogenous money approach,” Cambridge Journal of Economics, forthcoming Wray, L.R (2007) “The employer of last resort programme: Could it work for developing countries?” International Labor Organization, Economic and Labour Market Papers 2007/5. http://natlex.ilo.ch/public/english/employment/download/elm/elm07‐5.pdf ______. (2015) Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems, Second Edition. New York: Palgrave. 82

CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS 1 See Federal Reserve Bank of New York, “Statement Regarding Supplementary Financing Program,” September 17, 2008 at https://www.newyorkfed.org/markets/statement_091708.html 2 See U.S. Treasury, “Treasury Announces Supplementary Financing Program,” September 17, 2008, HP‐1144 at https://www.treasury.gov/press‐center/press‐releases/Pages/hp1144.aspx 3 “Over the years, a variety of provisions had permitted the Treasury to borrow limited amounts directly from the Federal Reserve. Options for such loans existed until 1935. Temporary provisions for direct loans were reintroduced in 1942 and renewed with varying restrictions a number of times thereafter. Authority for any kind of direct loans to the Treasury lapsed in 1981 and has not been renewed.” (Meulendyke 1998, 238, n.3) 4 The following link brings you to a video made by two of my students that provides a visual explanation: https://www.youtube.com/watch?v=Wgcv_wJOLcA

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CHAPTER 7: After reading this Chapter you should be able to understand: What leverage is What the advantages and disadvantages of leverage are How beneficial leverage is for profitability Why leverage increases the sensitivity of an economic unit to developments in the financial sector

CHAPTER 7: LEVERAGE Given that the concept of leverage will be used often in the upcoming Chapters, this Chapter spends some time explaining what leverage is and some of its impacts on the balance sheet of economic units.

WHAT IS LEVERAGE? Leverage is the ability to acquire assets in an amount that is larger than what one’s own capital allows one to buy. Say that an economic unit has a net worth of $100, that it has no debt and that the counterpart is $100 in cash (Figure 7.1). The balance sheet looks like this:

Figure 7.1 A balance sheet without leverage What is the leverage? Leverage = asset/net worth = asset/equity = A/E = $100/$100 = 1. No debt used, all the cash the economic unit has was acquired without the help of any debt (e.g., grandpa gave you $100 for Christmas, or you worked to get $100). Now the economic unit decides to use its cash to buy a bond that pays 10% yearly (Figure 7.2).

Figure 7.2 Another balance sheet without leverage What is the leverage? Leverage = A/E = $100/$100 = 1. Still no leverage but asset portfolio allows the economic unit earns interest income: Cash inflow is $10 yearly as interest payment. Of course, buying a bond involves additional risks compared to cash: 

Default risk (the bond issuer does not pay the $10 interest and cannot repay part or all the principal due)



Market risk (the market value of the bond declines and one might have to sell it for less than what one paid for it)

Going back to case 1, now the economic unit decides to get a $900 advance from a bank at 1% and to buy 10 bonds that pay 10% (Figure 7.3). What is the leverage? Leverage = A/E = $1000/$100 = 10. The economic unit has acquired 10 times more assets than what its capital allows to buy. It did so by going into debt. This example is the simplest form of leverage. There are many ways to introduce leverage in a financial deal. Some of that leverage does not have to be reflected on the balance sheet in the form of a debt to someone. As long as one can acquire an asset by paying upfront only a fraction of the value of that asset, there is some leverage. 85

CHAPTER 7: LEVERAGE

Figure 7.3 A balance sheet with 10x leverage

WHAT ARE THE ADVANTAGES OF LEVERAGE? A key metric of profitability is the return on equity (ROE). This return is the ratio of profit over equity. The ROE can be decomposed as follows: Profit/Net worth = (Profit/Assets)*(Assets/Net worth) ROE = ROA * Leverage Return on Assets (ROA) measures the earning power of the assets on a balance sheet; ROE measures how successfully an economic unit used its own capital. Leverage multiplies the impact of ROA on ROE because it allows an economic unit to acquire more assets without having to pay the full amount due with one’s own funds. Thus leverage gives the following advantages: 1‐ Better nominal return: -

No leverage: income = net income = $10

-

10x leverage: income = 10 x $10 = $100, Net income = $100 ‐ $9 = $91 > $10

2‐ Better return •

•

Return on Asset (ROA) -

No leverage: interest/bond = $10/$100 = 10%

-

10x leverage: net interest/bond = ($100 ‐ $9)/$1000 = 9.1%

Return on equity (ROE) -

No leverage: interest/equity = $10/$100 = 10% = ROA

-

10x leverage: net interest/equity = ($100 ‐ $9)/$100 = $91/$100 = 91%

By leveraging 10x, ROE is 10 times higher than ROA (9.1% vs 91%) simply because one could acquire ten times more assets.

WHAT ARE THE DISADVANTAGES OF LEVERAGE? INTEREST‐RATE RISK

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CHAPTER 7: LEVERAGE What if the interest rate on bank debt goes up to 12% in the previous example? -

No leverage: cash outflow = $0 => net cash flow = $10

-

10x leverage: cash outflow = $900 x .12 = $108 => net cash flow = ‐$8.

This risk is especially high if an economic unit went into debt on a short‐term basis for a long‐term portfolio strategy. Assume one plans to hold 10 bonds for 2 years but issued debt with a 6‐month term to maturity; then one needs to refinance (i.e. repay the debt and ask for credit again) three times. But there are more worries because economic units care much more about percentage gains (ROE) than nominal gains. In this case, ROE losses are also multiplied by the size of the leverage. -

No leverage: ROA = ROE = 10%

-

10x leverage: ROA = ‐$8/$1000 = ‐0.8%

-

10x leverage: ROE = ‐$8/$100 = ‐8%

HIGHER SENSITIVITY OF CAPITAL TO CREDIT AND MARKET RISKS The same percentage decline in the value of bonds (due to default or loss of market value) leads to much bigger decline in equity (Figure 7.4). -

No leverage: A 10% decline in the value of the bond wipes out only 10% of net worth

-

10x leverage: A 10% decline in the value of bonds wipes 100% of net worth

Chapter 9 shows that banks can only tolerate a limited decline in the value of their assets. Indeed, not only are they highly leveraged, but there are regulations governing the amount of capital they are required to have, as well.

Figure 7.4 Impact on capital of a 10% decline in the value of bonds under no leverage and 10x leverage

REFINANCING RISK AND MARGIN CALLS IMPACT ON MORTGAGE DEBT

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CHAPTER 7: LEVERAGE Say that in 2006 a household wants to buy a house that costs $100k and that the bank states that one must provide a 20% down‐payment. How much of the cost of the house is the bank willing to fund at the maximum? 0.8*100000 = $80000 Now, say that the value of the home goes down to $50000. Assuming the bank is still willing to provide up to 80% of the house value, the maximum the bank will provide is: .8*50000 = $40000 For the same house, the bank is willing to provide less of an advance. Table 7.1 shows three different contract structures with actual numbers when a household agrees to issue an $80k mortgage note: Year Case Structure

Debt Service

2006 A A 30‐year fully amortized with a fixed rate of 10% $8,424.69 for 30 years

2006 2016 B C An 30‐year IO with a 30‐year 5% fixed‐rate 10% fixed rate, starts to fully amortized amortize after 10 years First 10 Years: $8000 $5153.49 for 30‐years Last 20 years: $9264.21

Table 7.1 Mortgage notes with different terms

In the U.S. the traditional mortgage is a fixed‐rate fully amortized (i.e. for which principal is repaid bit by bit every month) mortgage (case A). During the 2000s housing boom, a lot of prime and subprime households choose to issue interest‐only mortgages (IOs) (case B). With an IO, a mortgagor can choose to pay only the interest due for a certain time period (say 10 years), and after that the principal must be repaid bit by bit. This means that for a period of time, case B is cheaper than case A. The proportion of IO issued by non‐prime households in a given year went from virtually 0% to 30% of mortgages issued by non‐prime households. As the Fed started to raise interest rate in 2004, the proportion of pay‐option mortgages issued by non‐prime households grew (Figure 7.5). Pay‐option mortgages allow debtors to pay only part of the interest due. The selling point offered by mortgage brokers was that IO are cheaper to service for 10 years and that, while it is true that one might not be able to make that additional $1264 payment that will come in 10 years, there is no need to worry because refinancing at better terms is always possible given that home prices always go up. Come 2016 and the household can cannot make the additional $1264 payment. What can be done? Let us refinance by issuing an $80000 fixed‐rate mortgage with better terms (option C) and by using the funds to repay the $80000 due on the IO mortgage. So the household goes to a bank with the intention to get a credit of $80000. Unfortunately, the bank states it can only provide $40000, i.e. it refuses to refinance unless the household can come up with $40000. Why? Because the home value is now $50000. In times of crisis, the refinancing problem induced by the decline in the value of houses is actually reinforced by the fact that the loan‐to‐value ratio declines. So instead of granting an advance of up

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CHAPTER 7: LEVERAGE to 80% of the home value, now a bank will do only 60%, which means that the household can only get $30000 from the bank.

Figure 7.5 Share of exotic mortgages in non‐prime mortgage originations, percent. Source: Federal Deposit Insurance Corporation (FDIC Outlook, Summer 2006).

IMPACT ON SECURITY‐BASED DEBT: MARGIN CALL RISK A broker allows an economic unit to have outstanding bonds with a nominal value 10 times as large as the value of equity. What if suddenly: -

The value of bonds declines. Net worth declines so leverage is much higher than 10 and the broker demands additional collateral (and so net worth in the balance sheet) to restore a 10x leverage.

-

The broker increases the margin requirement (loan‐to‐value ratio declines), that is, decides to lower the allowed leverage from 10 to 5. This is equivalent to saying that now in order to be able to get external funds to buy $1000 worth of bonds one must put down $200 instead of $100.

EMBEDDED LEVERAGE Leverage comes in many forms and may not be directly observable in the balance sheet. In fact, financial institutions try to hide leverage as much as possible to circumvent regulation, and, in the worst cases, to confuse potential clients who are attracted by the high promised ROE. A form of leverage that gained attention during the recent crisis is embedded leverage—or leverage on leverage. Figure 7.6 presents a “simple” case of embedded leverage.

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CHAPTER 7: LEVERAGE

Households Houses

Subprime Mortgages

SPE1 Subprime Mortgages

High‐rate MBSs

SPE 2 Low‐rate MBS

High CDOs

rate

Mezzanine CDOs (14%) Equity (very thin or none)

Low‐rate MBSs (5%)

Low‐rate CDOs (10%)

SPE 3 Mezzanine CDOs

Senior‐AAA CDO2s (60 %)

Other CDO2 (40%)

Figure 7.6 Financial layering or embedded leverage. The following is going on in this picture: 1‐ A bunch of households with poor creditworthiness issued mortgages to a bank to finance 100% of their houses ($100k house is financed by $100k mortgage) (balance sheet A) 2‐ The bank did not want to keep the mortgages on its balance sheet so the bank created an SPE1 (special purpose entity 1) that purchased the mortgages. To finance the purchase, SPE1 issued bonds collateralized by the mortgages (mortgage‐backed securities, MBS) of two different ratings, low and high, with low representing 5% of the issuance. The debt service received from subprime mortgages is used to service the MBSs (balance sheet B) 3‐ Nobody wanted to buy the low‐rate MBS so the bank created SPE2 to purchase them. SPE2 issued bonds backed by MBSs (collateralized debt obligations, CDOs). The debt service from low‐rate MBSs is used to service CDOs (balance sheet C) 4‐ Nobody wanted to buy the mezzanine CDOs that represent 14% of all the CDOs issued by SPE2. The bank created yet another SPE that bought the mezzanine CDOs by issuing bonds backed by them (CDO squared). AAA CDO2s are bought by pension funds, others are bought by hedge funds and others. The debt service from the mezzanine CDOs provides the cash flow necessary to service the CDO2s (Balance sheet D) Taken in isolation, i.e. looking at SPE3 alone, AAA CDO2s seem very safe because the value of mezzanine CDOs must fall by 40% before the principal on the AAA CDO2s starts to be impacted (other CDO2s act as equity for AAA CDO2s). A pension fund that looks only at that deal does not even blink; AAA CDO2s provide higher yield than AAA corporate bonds: Buy! Buy! Buy! Of course, the higher yield was achieved by the embedded leverage. Say that households start to default, what is the default rate that makes AAA‐CDO2 worthless?

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A 5% loss on the mortgages makes low‐rate MBS worthless (they are the first to take the loss in this SPE structure), which makes SPE2 insolvent and so all CDOs worthless.

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CDO2 become worthless much faster. If the mezzanine CDOs are worthless then CDO2 are worthless. Mezzanine CDOs are worthless after a 1.2% decline in the value of subprime mortgages (5%*24%)! Suddenly those AAA CDO2 do not seem that safe anymore, especially so knowing that delinquency rates on subprime mortgages are way north of 1.2%. However, one needs to look at the entire chain of securitization to understand that. Most buyers of AAA CDO2 did not do that (they usually could not do that given the information available) and only looked at the high return of AAA CDO2 relative to AAA corporate bonds, together with the 40% buffer against loss provided by other CDO2.

CHAPTER 7: LEVERAGE There is a way to estimate what the leverage is in this type of transaction.1 Financial institutions created many SPEs that bought from each other.2

BALANCE‐SHEET LEVERAGE, SOME DATA The Financial Accounts of the United States provide simple measures of balance‐sheet leverage that are easy to get for the private non‐financial sector because actual balance sheets are provided. We are not so lucky for the financial sector for which data about total assets is not available. One can get an idea of the leverage used by financial institutions by using the ratio (liabilities + equity)/equity, knowing that in theory the sum of liabilities and equity ought to be equal to total assets. In practice the sum of liabilities and equity is not very reliable and gives leverage levels that sometimes are much too high. Figure 7.8 only presents preliminary data that seems to pass the smell test. Chapter 8 presents official leverage data in the banking sector. Figures 7.7 and 7.8 give a broad idea of the relative leverage across sectors and of the trend in leverage. Clearly, the non‐financial sector is less leveraged than the financial sector with households being the least leveraged of all sectors. Overall, leverage in the non‐financial sector grew relatively smoothly until the Great Recession, especially so for households. Leverage in the financial sector is much more volatile.

Figure 7.7 Balance‐sheet leverage in the nonfinancial private sectors, assets/net worth Source: Board of Governors of the Federal Reserve System (Series Z.1)

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Figure 7.8 Balance‐sheet leverage in the financial sector, (liabilities+equity)/equity Source: Board of Governors of the Federal Reserve System (Series Z.1)

THE FINANCIALIZATION OF THE ECONOMY The financial industry is in the business of dealing with leverage. Its business is about incentivizing other economic unit to go into debt (that is what most of its assets are: claims on others) and the financial sector itself uses a lot of leverage to boost the profitability of its business. Banks grant credit, pension funds rely on financial claims to pay pensions, etc. For every creditor there is a corresponding debtor and so for every financial asset there is a corresponding financial liability: “financialization” also means “debtization” of the economy. The financialization of the economy means that the financial sector has become much more important to the daily operations of the economic system than it used to be. The private nonfinancial sectors have become more dependent on the smooth functioning of the financial sector in order to maintain the liquidity and solvency of their balance sheets, and to improve or maintain their economic welfare. Households have become more reliant on financial assets to obtain an income (interest, dividends and capital gains) and have increased their use of debt to fund education, healthcare, housing, transportation, leisure, and, more broadly, to maintain and grow their standard of living. Nonfinancial businesses also have recorded a very rapid increase in financial assets in their portfolio and a growing use of leverage. Some of them, like Ford or GE (until recently), have a financial branch that provides more cash balances than their core nonfinancial activity (Figures 7.11) and about half of their cash flows. The counterpart of these trends has been a growing share of outstanding financial assets held by private finance (Figure 7.9). From the late 1960s, the share of financial assets held directly by households dropped significantly from about 55 percent to about 35 percent. Instead, a growing share of assets has been held by private financial institutions, which went from 92

CHAPTER 7: LEVERAGE 25 percent in the late 1940s to 40 percent right before the crisis. The rest of the world recorded most of the rest of the gains from 2 percent to 10 percent of U.S. financial assets. The share of national income going to the financial industry has also grown quite significantly after WWII (Figure 7.10). A first wave occurred in the 1950s and a second one in the 1980s and 1990s. Today, about 18% of national income goes to the financial sector, something not seen since the 1920s.

Figure 7.9 Distribution of U.S. financial assets among the different macroeconomic sectors. Source: Board of Governors of the Federal Reserve System (Series Z.1)

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Figure 7.10 Proportion of national income earned by the financial sector. Sources: BEA, Historical statistics of the United States

Figure 7.11 Percent of cash balance coming from financial activities Source: SEC (10K statements) 94

CHAPTER 7: LEVERAGE

Summary of Major Points 1‐ To leverage is the act of going into debt 2‐ This debt can be on the balance sheet or can be hidden off‐balance sheet 3‐ Leverage helps to boost the return on equity by multiplying gains but it can also multiply losses. 4‐ The use of leverage has increased throughout non‐financial economic sectors, while leverage is usually higher in the financial industry. The financial industry uses a lot of off‐balance‐sheet leverage. 5‐ The financial sector has played an ever increasing role in the economic life of the non‐financial sector by providing an increasing share of national income and by providing advances to maintain existing standards of living. Keywords Financialization, debtization, leverage, embedded leverage, return on asset, return on equity, interest‐rate risk, refinancing risk, margin call risk, interest‐only mortgage, pay‐option mortgage Review Questions Q1: Why may a decline in home prices create a problem for refinancing a mortgage? Q2: If the leverage is 3X, what does it mean? Q3: If the leverage is 3X, what would happen to net worth following a 5% decrease in the value of assets? What would happen to ROE given ROA? Q4: Why does the financialization of the economy implies the debtization of the economy? Suggested readings Chapter 1 of Guns, Traders and Money by Satyajit Das relates personal recollections surrounding leverage is a very clear and funny way and present how leverage can be built outside the balance sheet. For a more technical view of leverage and its relation to regulation, the Basel III leverage ratio framework provides an example of a regulatory framework for different forms of leverage: http://www.bis.org/publ/bcbs270.pdf 1 Check page 26 of Riddiough, T.J. (2010) “Can Securitization Work? Economic, Structural and Policy Considerations.” At https://www.fdic.gov/bank/analytical/cfr/mortgage_future_house_finance/papers/Riddiough.PDF 2 In 2010, Propublica made a nice visual made with actual data in “Interactive: CDOs’ Interlocking Ownership,” by Jeff Larson and Karen Weise at https://www.propublica.org/special/interactive‐cdos‐interlocking‐ownership#cdo/

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CHAPTER 8: After reading this Chapter you should be able to understand: What banks do How banks make a profit What the risks of the banking business are How the banking industry has changed over the past four decades

CHAPTER 8: THE PRIVATE BANKING BUSINESS The US financial system is extremely complicated and this preliminary text shades light only on some corners of that system by focusing on the banking sector. Since the beginning of this text, Chapters have emphasized the importance of balance sheets to get a solid understanding of the mechanics at play in the financial sector. This Chapter continues that trend.

THE BALANCE SHEET OF A BANK Figure 8.1 depicts the balance sheet of a commercial bank. Promissory notes issued by others include any kind of agreement between the bank and an entity that promised to pay some monetary amount(s). That entity can be a domestic or foreign, household (mortgage note or any other customer notes), company (business credit, corporate securities), and government (Treasuries, municipals). Promissory notes may or may not have a market in which they can be traded. If they have a market they are called “securities”, if they do not they are called “loans and leases” (Chapter 2 and Chapter 10 explain that the word “loan” is really inappropriate). Chapter 3 studied in details reserves, which are themselves a promissory note as explained in Chapter 15, but are singled out for analytical purposes. Non‐financial assets include real estate, computers, goodwill etc. Assets Reserve balances and vault cash Promissory notes issued by others (aka “loans and leases,” “securities”) Non‐financial assets

Liabilities and Net Worth Promissory notes issued by the bank (aka “accounts,” “CDs,” etc.) Net worth/Equity/Capital

Figure 8.1. Balance sheet of a typical commercial bank

Promissory notes issued by the bank include checking accounts, savings accounts and other transaction accounts. They also include other liabilities such as certificates of deposits (CDs), bonds and other securities issued by the bank. One may choose to include shares here or in net worth; for our purposes, it is not that important. As usual, net worth is the residual item and its main role, as explained in Chapter 2, is to protect the creditors of the bank, i.e. those who hold the promissory notes issued by the bank (you and I for the accounts, CD holders, etc.). Figures 8.2 and 8.3 show how the composition of financial assets and liabilities of US banks has changed since 1945 (quantity of non‐financial assets is not available). After WWII, banks were stuffed with Treasuries and reserves that represented about 75% of their assets. A switch occurred progressively toward privately‐issued notes and municipals as banks turned their business activity toward supporting the growth of the economy instead of the war effort. Today, percentage‐wise, Treasuries and reserves are marginal items in the assets of banks. Bank accounts (“deposits”) are still the main liability of commercial banks but the structure of accounts changed with checking accounts representing about 10% of liabilities in 2010 versus 75% after WWII. Time and savings accounts have grown in proportion, and they represented about 55% of the liabilities of banks in 2010. Figure 8.2 also clearly shows the rise of the federal funds market from the 1960s (see Chapter 4). Figure 8.2 does not show interbank lending debt given that it is the balance sheet of the banking sector. Indeed, if bank X owes to bank Y, when they are put together in one balance sheet the consolidation removes debt owed to each other. Federal funds and repurchase agreements (RPs) are liabilities with other participants of the federal funds market. 97

CHAPTER 8: THE PRIVATE BANKING BUSINESS Figure 8.3 shows how the predominance of “private depository institutions” (commercial banks and thrifts) in the financial sector has changed through time. From 1980 until 2000, the share of financial assets held by banks fell dramatically from 50% of all financial held by the financial industry to about 20%; this has been a stable proportion since 2000. Instead, money managers (mutual funds, pension funds, etc.) have gained in importance as did financial institutions related to securitization that together held about 55% of the financial assets held by the financial industry in 2015. Money lenders (pay‐day loans, etc.) have also recorded an increase in the proportion of financial assets they hold since the 1970s.

Figure 8.1 Financial assets of US‐chartered commercial banks Source: Board of Governors of the Federal Reserve System (series Z.1) Note: Other securities includes corporate and foreign bonds, mutual funds shares, corporate shares, and open‐market papers.

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Figure 8.2 Financial liabilities and corporate shares of US‐chartered commercial bank Source: Board of Governors of the Federal Reserve System (series Z.1) Note: Others include net taxes payables, corporate bonds, open‐market papers, net interbank transactions, and miscellaneous liabilities.

Figure 8.3 Allocation of financial assets within the financial sector Source: Board of Governors of the Federal Reserve System (series Z.1) 99


WHAT DO BANKS DO? The previous balance sheet hints that banks are involved in many crucial activities including: ‐

Credit services: Swapping promissory notes to allow liquidity, creditworthiness, and maturity transformation

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Payment services: Transferring funds between bank accounts

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Retail portfolio services: Providing income‐earning opportunities for small entities with excess monetary balances and providing cash at will.

A central aspect of the balance sheet of banks is that the promissory notes issued by banks have a shorter term to maturity than the promissory notes on their asset side. Banks are involved in maturity transformation. They accept promissory notes from their customers for which the principal will not be repaid for a long time. In exchange, they give their customers some promissory notes that are due relatively quickly. Checking accounts are due at the demand of their bearers and CDs come due at most in a few years, whereas the principal on mortgage notes will be fully repaid in decades. A central implication of maturity transformation is that banks have an inherent need for a stable refinancing source because they must fund long‐term positions in assets with short‐term liabilities. To limit the refinancing risk (that was exemplified with households in Chapter 7) that comes with this balance‐sheet structure, a central bank that provides stable low‐cost refinancing channels is crucial. Some of the promissory notes that banks issue have another other interesting property for potential clients. Chapter 15 explains that their financial characteristics are such that they ought to trade at par if they do not carry any credit risk and if the financial structure is properly set up. Today, transfers between bank accounts are done at par, conversions into Federal Reserve note are done at par, and in case of default FDIC guarantees the funds in bank accounts, and the interbank payment system works smoothly. The main takeaway is that banks provide to their customers a reliable means of payments that is widely accepted. By contrast, the promissory notes issued by clients are not widely accepted so making payments with them is difficult, if not impossible.

WHAT MAKES A BANK PROFITABLE? Like any other for‐profit business, a bank operates to meet its profitability target while being constantly on the look‐out to maintain its liquidity and solvency. At least, that is the hope. When banks are run by fraudsters or are focused on short‐term results, concerns about liquidity and solvency go out of the window.1 The profit of a bank depends on the following components: Profit of a bank = Net capital gains + Net interest income + Other income – Other expenses than interest payments Net capital gains is the difference between capital gains and capital losses. This net change can be positive (net capital gain) or negative (net capital loss). Net interest income (aka net interest margin) is the difference between interest earned on bank assets and interest paid on bank liabilities. Other income include fees and other charges imposed on customers. Net interest income 100

CHAPTER 8: THE PRIVATE BANKING BUSINESS is the biggest source of income for banks but its proportion in bank income has declined since the early 1980s for reasons explained in the last section. In 2014, net interest income represented about 60% of the income earned by banks compared to 80% from about the mid‐1940s to the early 1980s (Figure 8.4). Net interest income is the lowest proportion of profit for the largest banks.

Figure 8.4 Sources of income of FDIC‐insured banks. Source: FDIC Annual Financial Data

Banks, however, are not interested in monetary profit per se. Instead, a key measure of profitability is the return on equity (ROE), the ratio of monetary profit over net worth. Chapter 7 explains that this ratio can be decomposed into the return on assets (ROA) and leverage (Figure 8.5). ROE and ROA averaged 9.7% and 0.84% respectively from 1984 to 2014. The ROA of the largest banks is more volatile and has been relatively higher since the late 1990s (Figure 8.6). The larger the bank, the higher the leverage (Figure 8.7), but balance‐sheet leverage has mostly fallen over time and Tier‐1 leverage has converged to 9 for all banks, 11 for the biggest banks, 8 for the smallest. Banks have a ROE target (among other targets) in mind to which bonuses of employees are related (if a bank reaches or passes the target, employees can expect a good bonus). Bank employees have two means whereby to reach the target if ROE is falling away from it: raise ROA and/or increase leverage. Raising ROA means charging a higher interest rate on customers’ notes (higher mortgage rate, higher consumer credit rate, etc.), charging more fees, buying higher‐yield securities, trading securities more aggressively to make bigger capital gains, and/or reducing expenses. Given expenses, all this means taking more credit risk and market risk, because raising ROA implies catering to less creditworthy economic units or being involved in more volatile trading strategies. Raising leverage means increasing the size of liabilities relative to net worth. Chapter 7 explores the concept of leverage more carefully in terms of its advantages and risks. Chapter 9 explains that banks are limited at any point in time in their ability to leverage by regulation, but they always “innovate” over time to bypass regulations. 101


Figure 8.5 ROA, ROE, leverage of all FDIC‐insured institutions Source: FDIC Graph Book

Figure 8.6 Annual return on assets Source: FDIC Aggregate Time Series Data Note: Banks with over $10 billion in assets represent about 10% of the FDIC‐insured banks (595 institutions). Most FDIC‐insured banks (62% or 3800 institutions) are between $100 and $1 billion. 102


Figure 8.7 Tier‐1 leverage (inverse of tier‐1 leverage capital ratio) Source: FDIC Aggregate Time Series Data Note: Tier‐1 capital is a component of capital.

RISKS ON THE BANK BALANCE SHEET The profitability of a bank critically depends on the following:

•

•

The ROA which depends on:

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Creditworthiness of the issuers of promissory notes (credit risk): households, businesses, and government may not be able to service their promissory note, which means that a bank does not receive its expected income and instead records a loss.

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Actual and expected market value of securities (market risk): capital gain and losses are recorded on a daily basis for some assets.

The cost of funding the banking business (refinancing risks induced by interest‐rate risk, maturity mismatch risk): cost of acquiring reserves and cost of holding accounts (i.e. giving incentive to account holders not to withdraw their funds in order to avoid having to borrow reserves or to sell interest‐earning assets to get reserves). If the Fed raises FFR quickly, banks that have fixed‐rate long‐term assets see their net interest income dwindle quickly.

Creditworthiness, capital gains and losses, and bank‐funding costs are influenced by the state of the economy, expected interest rates, future monetary and fiscal policies and many other factors. For example, if it is expected that economic activity will slowdown, then one may expect that layoffs will rise and so that some debtors will have problems servicing their debts. Chapter 4 explains how expected monetary policy impacts current asset prices and refinancing cost.

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CHAPTER 8: THE PRIVATE BANKING BUSINESS This means that, to run a banking business properly, a banker must form expectations about a wide range of factors. Of course, these expectations usually turn out to be incorrect. When expectations are under‐optimistic, bankers are pleasantly surprised and may double‐down on the risks they take. When expectations are over‐optimistic, things can turn sour very quickly if credit analysis was not done properly, if capital, liquidity, and loss‐reserve buffers are inadequate, or if fraud has been prevalent. Figure 8.8 shows the impact of credit and market risks. The value of promissory notes falls as economic units default or the value of securities falls. This impacts net worth and so the ability to meet the capital requirements presented in Chapter 9 (in the example a 15% loss on promissory notes leads to a decline in the capital ratio from 20% to 5%). If a bank is unable to meet its capital requirements, regulators may demand that the bank be closed. Figure 8.9 shows the value of non‐tradable promissory notes that were past due by at least 30 days relative to the value of tier‐1 capital and loan‐loss reserves. Loan‐loss reserves are not the same thing as bank reserves, they are extra capital that banks keep to buffer against expected losses on the non‐tradable promissory notes of their clients. In general, the larger the banks the worst the performance, that is, the larger the bank, the higher the proportion of past due loans. This can be explained by looking at Figure 8.6. Major banks (those with assets worth at least $1 billion) have increased their ROA to maintain their ROE. Raising the ROA means acquiring more risky assets, that is, assets that have a higher likelihood of defaulting.

Figure 8.8 Impact of default and/or capital losses

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Figure 8.9 Noncurrent loans & leases as a percent of tier‐1 capital plus loan‐loss reserves Source: FDIC Aggregate Time Series Data

BANKING ON THE FUTURE A study of the profitability of banks clearly shows that this business is all about “banking on the future.” There is a myriad of future economic events that influences the assets and liabilities of banks and so how profitable, solvent and liquid banks are. In terms of assets, the role of banks is to judge and validate (or not) the expectations that are brought to the table by their clients. As the saying goes in the banking industry, “I’ve never seen a pro forma I didn’t like.” Economic units that want to go into debt with a bank always present a very favorable view of their project and future economic prospects. The role of bankers ought to be to tame that vision of the future into a more realistic view, in the sense that the view conforms more closely to past economic trends and past history of probable success. Bankers are supposed to do this by requesting documents that provide evidence that an economic unit will be able to fulfill the requirement of the promissory note (usually pay interest and principal due on time), and by requesting some guarantees in terms of covenants (e.g., ability to check how a business is run or ability to influence business management if needed) and collateral (ability to seize assets held by the economic unit in case of default). Bankers are then supposed to check this information against a given set of standards that defines what a creditworthy economic unit is. Such standards include among others: ‐

The debt‐service to income ratio: what is a sustainable amount of interest and principal payment relative to the income earned? 20%, 30%, 40%?

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The value of monetary balances relative to the value of debt: what is a sustainable amount of liquid savings that an economic unit should have relative to an amount of debt? 10%, 50%, 60%?

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The loan‐to‐value ratio: What is the maximum amount of credit a customer can ask relative to the value of a collateral? Is it ok to have a mortgage that represents 50% of the house value, 80%, 100%?

In practice, given that the future is uncertain and given the elastic nature of the standards used, assessing creditworthiness is not always easy. In addition, banking is a competitive sector so assessing creditworthiness is influenced, not only by the need to check carefully an economic unit’s ability to pay, but also by the need to maintain and grow market shares. If a TV maker has sold all the black‐and‐white TVs that could be sold, the next step is not to close shop or to rely only on repairs and replacements. The next step is to invent color‐TVs, flat‐screen TVs, 3D‐TVs, etc. so that consumers have an incentive to ditch their old TVs and buy new ones. The same dynamics are at play in banking. Maintaining market share may require banks to “innovate”: ‐

By pushing existing and new clients into new “low cost” products. A typical example of that was the mid‐2000s, when clients were incentivized to go into interest‐only mortgages, pay‐ option mortgages, cash‐out refinance mortgages, home‐equity advances.

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By incentivizing existing clients to go further into debt or to refinance. A typical example of that is the 2001 refinancing wave of prime mortgagors when they refinance into fixed‐rate mortgages with lower rates.

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By loosening credit standards when the pool of what is deemed a creditworthy client is shrinking and new business opportunities must be sought to maintain ROE. After the 2001 refinancing wave among prime households, banks turned toward non‐prime households for new business opportunities.

Thus, over time, credit standards may loosen. When previously one had to have a debt‐service to income ratio of at most 30% to be considered creditworthy, now banks are ok with 40%. The mortgage boom of the mid‐2000s broke all standards of creditworthiness, with bankers willing to provide high‐interest‐rate mortgages to customers with no proof of income, job or assets (the infamous “NINJA loans”) in an amount that represented over 100% of the value of a house. Even prisoners could get a mortgage.2 The only way to make that type of mortgage profitable was to resell the house at a price high enough to cover the repayment of all the principal and interest due. This implies finding another person willing to go into debt to buy the house at this higher price. A typical Ponzi game was at play. Some bank managers thought that “the whole system was based on raping the public” and refused to lower their credit standards; but, this came at the cost of accepting a massive loss of market share.3 Most bankers, especially on Wall Street, cannot accept such a decline; in fact they cannot even accept stable market shares, as Mr. Blankfein noted: It should be clear that self‐regulation has its limits. We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self‐interest in preserving and expending our market share, as competitors, sometimes blinds us—especially when exuberance is at its peak. (Blankfein 2009) Wall‐street financial institutions are growth‐oriented businesses and so must find ways to constantly expand their business. The loosening of credit standards will occur all the faster given that the banking structure is such that it rewards bankers based on the volume of promissory notes

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CHAPTER 8: THE PRIVATE BANKING BUSINESS accepted instead of the quality of promissory notes. As explained below, the banking industry has moved in that direction since the 1980s at least. This pressure to loosen credit standards has been illustrated neatly quite a few times. For example Wojnilower noted in 1977: In the 1960s, commercial bank clients frequently inquired how far they could prudently go in breaching traditional standards of liquidity and capitalization that were clearly obsolescent. My advice was always the same—to stick with the majority. Anyone out front risked drawing the lightning of the Federal Reserve or other regulatory retribution. Anyone who lagged behind would lose their market share. But those in the middle had safety in numbers; they could not all be punished, for fear of the repercussion of the economy as a whole. […] And if the problem grew too big for the Federal Reserve and the banking system were swamped, well then the world would be at an end anyhow and even the most cautious of banks would likely be dragged down with the rest. (Wojnilower 1977, 235‐236) John Maynard Keynes noted more than eighty years ago while talking about financial‐market participants: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”4

EVOLUTION OF BANKING SINCE THE 1980s The promotion of competition and short‐run rewards, together with the lack of regulatory enforcement (see Chapter 9) and a monetary policy focused on fine‐tuning the economy (see Chapter 4), have pushed banks to move away from a business model that promotes careful underwriting and toward market‐share growth. Figure 8.4 gives a hint of that trend. This banking system is more unstable because it promotes an increase in the size of leverage (indebtedness is bigger) and a decline in the quality of leverage (more dangerous financial products, fewer guarantees, less verification). Within banks, there are two important desks, the loan‐officer desk (whose task is to judge the quality of the projects proposed by potential clients and to tame optimism) and the position‐making desk (whose task is to finance and to refinance the asset positions taken by the bank). In the originate‐and‐hold banking model, the point of a bank is to establish long‐term relationships with clients based on trust and recurring credit agreements, and to make a profit based on the net interest margin. A bank carefully checks the 3Cs of credit analysis: cash flow, collateral, and character. Think of George Bailey in It’s a Wonderful Life as the stereotypical banker of this type of banking model: he knows his neighborhood well and does business there, he knows most of his clients personally, he keeps his clients’ promissory notes in the bank vault, he makes a profit by waiting patiently for debts to be serviced; if a client has a problem they sit down and try to work it out given that George’s success depends on his client’s success. This form of banking always exists at any point in time (that is what banking is after all), but it thrived after the Great Depression when competition in the financial industry was reduced and the central bank kept its refinancing cost stable and low. With increased competition from other financial institutions and changes in the monetary policy practices of the Fed, this banking model became less viable as the interest‐rate risk became too great. Chapter 5 shows that the Volcker 107

CHAPTER 8: THE PRIVATE BANKING BUSINESS experiment led to a very large increase in the level and volatility of the federal funds rate. This occurred at a time when banks had a lot of fixed‐rate long‐term assets on their balance sheet (think mortgages) so their net interest margin shrank. This is all the more so given that rising short‐term rate pushed banks to raise the rate on their savings accounts. Regulation Q (a Fed regulation regarding the maximum interest rate that savings account and certificates of deposit could carry) limited banks’ ability to do so, and so lots of economic units removed funds from their savings accounts and put them into more lucrative, but still liquid, financial instruments. Regulation Q was relaxed as FFR rose and was ultimately abandoned. Banks pushed for—and obtained—a deregulation of their business to allow them to diversify the assets they could buy and to allow them to provide more attractive rates on their liabilities. This ultimately led to the savings and loan (S&L) crisis when savings and loan institutions (banks that specialized in holding mortgage notes) were hit by massive credit risk. From the early 1980s, they had taken positions in more risky assets to offset the higher cost of their liabilities induced by the Volker experiment, and widespread fraud by top bank managers followed deregulation. 5 Other banks were not immune from the crisis and also recorded large defaults (Figure 8.9). The S&L crisis marks the end of the originate‐and‐hold banking model.

Figure 8.10 Trading revenues from cash and derivative positions Source: OCC Quarterly Report on Bank Derivatives Activities Note: Data discontinued for all banks as of Q2 2014 Note: The number and composition of “Top Banks” vary through time. Currently there are four top banks: JP Morgan Chase, Bank of America, Citibank, and Goldman Sachs. This model has now been replaced by an originate‐and‐distribute banking model. Profit‐making activities have been shifted toward the position‐making desk. While net interest margin is still a significant source of profit for banks, its importance has diminished substantially (Figure 8.4). Banks no longer look for a long‐term individualized relationship with recurring borrowers; the relation is impersonal and judged in minutes through a credit‐scoring method. Promissory notes of customers 108

CHAPTER 8: THE PRIVATE BANKING BUSINESS are packaged and sold to special purpose entities that fund the purchase by issuing bonds (mortgage‐backed securities, collateralized debt obligations, etc.). Banks make money from the fees that come from passing the debt service to the SPEs, and have been more involved in trading activities, especially top banks that currently get between 6% and 9% of their gross revenue from trading (Figure 8.10). Summary of Major Points 1‐ The main assets of commercial banks are mortgages, consumer credit and other promissory notes of economic units resulting in advances provided to the private sector. 2‐ The main liabilities of commercial banks are deposits of all sorts, with small time‐deposits (certificates of deposits) and savings accounts representing the majority of the liabilities. 3‐ Over the past 30 years, the importance of commercial banks and other depository institutions has declined, with a greater share of financial assets held within the financial industry going to money managers and issuers of securitized products. 4‐ The business of banking involves settling payments between private non‐bank economic units, providing opportunities for small savers to access higher earning financial assets, supplying the currency to the non‐bank sectors, and helping economic units to finance economic and speculative activities. 5‐ While the majority of the income of banks comes from interest receipts, the share of that income has declined by 20 percentage points since 1980. 6‐ The size of leverage in the banking industry has declined. Major banks (those with over $1 billion in assets) take more risks on their liability side (more leverage) and asset side (reliance on riskier financial assets that provide higher ROA). 7‐ The business of banking is influenced by all sorts of internal and external factors that influence the value of their assets, default risk, and the interest rate they pay on their liabilities. On one side, banks try to anticipate adverse changes in these factors to protect their balance sheet, but on the other side each bank also will tend to ignore those factors, or to discount them, if anticipating them decreases its current market share. 8‐ Banking is about anticipating the future while also keeping up with the competition to avoid losing market shares. As such, credit standards are elastic and tend to loosen over a period of economic prosperity and to sharply tighten during a recession. 9‐ Banks have moved away from a business structure that involves acquiring non‐tradable promissory notes and keeping them until they mature. Much more emphasis is put on trading securities. Keywords Bank profit, promissory note, loan and lease, security, certificate of deposit, mortgage, credit service, payment services, retail portfolio services, credit standards, maturity transformation, net interest income, net capital gain, return on equity, return on assets, leverage, loan‐to‐value ratio, debt service, originate and hold model, originate and distribute model

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Review Questions Q1: What is the impact of a decline in the value of bank assets on the net worth of banks? Why is that a problem for banks? Q2: Why do banks exist? Q3: If interest rates on the liabilities of banks go up, what happens to their profit? Q4: In order to provide an advance of funds, what does a bank do? Why does it need to do that? Q5: Why does the profitability of a bank depend on the ability of its customers to fulfill their promissory notes? Q6: Have banks become more or less dependent on the ability of their customer to service their debts? Q7: Do big banks take more or less risk than small banks? How so? Q8: Why is it important for a bank to loosen its credit standards at about the same pace as its competitors? What happens if it is more conservative than others? Less conservative then others? Suggested readings For a succinct view of the evolution of banking since the 1960s and a bullish view of its recent development, read “Banking” a 2004 speech by Chairman Greenspan: http://www.federalreserve.gov/BOARDDOCS/Speeches/2004/20041005/default.htm Hyman, H.P (1984) “Banking and industry between the two wars: The United States,” Journal of European Economic History, 13 (Special Issue): 235‐272. 1 See Black, W.K. (2005) The Best Way to Rob a Bank is to Own One. Austin: Texas University Press. 2 See Part 4 of Klein, A. and Goldfarb, Z.A. (2008) “The bubble,” The Washington Post, June 15, 16, 17 at http://www.washingtonpost.com/wp‐dyn/content/article/2008/06/14/AR2008061401479_4.html 3 See Schwartz, N.D. (2007) “Can the Mortgage Crisis Swallow a Town?” The New York Times, September 2 at http://www.nytimes.com/2007/09/02/business/yourmoney/02village.html 4 In Chapter 12 of the General Theory. Available at https://www.marxists.org/reference/subject/economics/keynes/general‐theory/ch12.htm 5 See Black, W.K. (2005) The Best Way to Rob a Bank is to Own One. Austin: Texas University Press.

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CHAPTER 9: After reading this Chapter you should be able to understand: Why banks need to be regulated and supervised How banks are regulated and supervised What has led to a decline in the ability and willingness to regulate banks and to enforce existing regulations Why economists may have different views about the more relevant way to perform bank regulation

CHAPTER 9: BANKING REGULATION It may surprise you to know that the banking sector is one of the most regulated industries in the United States, with each bank having to file regulatory documents with several agencies. These regulations determine how banks should and should not operate their business in terms of many aspects; from disclosure of information to potential customers, to means of determining creditworthiness of a potential client, to the quantity of reserves to hold, to management issues, among others. For example the National Association of Mortgage Brokers noted in 2006 Mortgage brokers are governed by a host of federal laws and regulations. For example, mortgage brokers must comply with: the Real Estate Settlement Procedures Act (RESPA), the Truth in Lending Act (TILA), the Home Ownership and Equity Protection Act (HOEPA), the Fair Credit Reporting Act (FCRA), the Equal Credit Opportunity Act (ECOA), the Gramm‐Leach‐Bliley Act (GLBA), and the Federal Trade Commission Act (FTC Act), as well as fair lending and fair housing laws. Many of these statutes, coupled with their implementing regulations, provide substantive protection to borrowers who seek mortgage financing. These laws impose disclosure requirements on brokers, define high‐cost loans, and contain anti‐discrimination provisions. Additionally, mortgage brokers are under the oversight of the Department of Housing and Urban Development (HUD) and the Federal Trade Commission (FTC); and to the extent their promulgated laws apply to mortgage brokers, the Federal Reserve Board, the Internal Revenue Service, and the Department of Labor. Let us focus on four examples of regulation.

EXAMPLES OF BANK REGULATIONS RESERVE REQUIREMENT RATIOS The reserve requirement ratio (RRR) dictates the quantity of total reserves banks must have in proportion to the accounts they issued (see Chapter 3). Table 9.1 shows what the ratios look like today in the US. If a bank issued less than $15.2 million of transaction accounts (checking accounts and others) it does not have to have any reserves, 3% between 15.2 to $110.2 million worth of outstanding transaction accounts, and 10% beyond that. Some countries do not have any reserve requirements.

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CHAPTER 9: BANKING REGULATION

Liability Type

Requirement % of liabilities

Effective date

$0 to $15.2 million2

0

1‐21‐16

More than $15.2 million to $110.2 million3

3

1‐21‐16

More than $110.2 million

10

1‐21‐16

Nonpersonal time deposits

0

12‐27‐90

Eurocurrency liabilities

0

12‐27‐90

Net transaction accounts 1

Table 9.1 Reserve requirement ratios for the United States. Source: Board of Governors of the Federal Reserve System

CAPITAL ADEQUACY RATIOS Say that a bank has the following balance sheet: the value of assets is $100, bank accounts are $90 and net worth is $10. The net worth acts has a buffer for account holders against losses on assets, i.e. as long as, the value of assets falls by 10% or less, the bank can fully repay all account holders by liquidating its assets (assuming, of course, that at time of liquidation markets are well behaved and allow quick liquidation at low cost). Regulators want to make sure that banks have enough capital to protect their creditors against a substantial decline in the value of bank assets. This is all the more so given that the government may guarantee that customers will get the funds in their bank accounts even if a bank goes bankrupt. Since 1988, with the Basel Accords, central banks have tried to make capital regulation more uniform across the world. Table 9.2 shows the current capital adequacy ratios (CAR) for FDIC‐ insured banks. We will focus on the total risk‐based CAR (Total RBC ratio column). In the US, a bank should have at least 8% of capital, preferably at least 10%, relative to its risk‐weighted assets. This means that the maximum weighted balance‐sheet leverage ought to be 12.5 (A/E = 1/0.08) and preferably 10.

Table 9.2 Capital adequacy ratios. Source: FDIC Capital Regulation Manual.

Assets are weighed according to the risk that their nominal value falls. Assume that a bank has the following balance sheet (Figure 9.1):

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Assets Mortgage notes = $40 (100%) Municipal bonds = $30 (80%) U.S. Treasuries = $30 (0%) Reserves = $10 (0%)

Liabilities and Net Worth Bank accounts = $104 Capital = $6

Figure 9.1 Bank balance sheet with weights

The ratio capital/assets is $6/$110 = 5.45%, which is below the 8% minimum CAR. However, assets weigh more heavily if they have a higher chance of generating losses. Mortgage notes are illiquid and contain credit risk so they are attached a 100% weight, municipals contain credit risk but are somewhat liquid so they have a weight of 80%, U.S. Treasuries contain no credit risk and trade in the most liquid financial market in the world so they are attached no weight. Same with reserves. So the actual capital ratio is $6/($40 + $24) = 9.38%, not ideal but adequate. Basel Accords have evolved over time as central banks have tried to account for changes in the financial industry and for drawbacks of the previous versions of the Accords (the Accords are in their third version). As one may expect, the way to set the weights and proper value of assets can get very complicated. The last section will explain why one may doubt that this type of regulation will be successful.

CAMELS RATING Beside the well‐known RRR and CAR, regulators such as the FDIC also calculate a CAMELS rating for each bank: –

C: Capital adequacy

–

A: Asset quality

–

M: Management quality

–

E: Earnings level and quality

–

L: Liquidity

–

S: Sensitivity to market risk (change in the nominal value of securities)

CAMELS rating goes from 1 (strong business) to 5 (highly troubled). A rating of 4 or higher leads regulators to check carefully a bank and if necessary to issue a cease and desist order In a cease and desist order, a bank must stop immediately its dangerous activities (risky credit, improper management, too low capital ratio, etc.) and must find means to restore its soundness permanently (as measured by the CAMELS rating). Restoring permanent soundness (i.e., desisting from dangerous activities) may imply significant changes in management and business strategies, and may involve finding reliable sources of funding, and other relevant restructuring operations. The board of a troubled bank is given a limited amount of time (e.g., 60 days) to comply with the demands of its regulator. If the board cannot comply, the bank is closed and the regulator uses the least costly procedure to take care of the problem bank: liquidation or facilitation of acquisition by another bank.

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UNDERWRITING REQUIREMENTS One would think that banks carefully check the creditworthiness of a customer before they accept her promissory note. They would ask for proof of income and verify with the Internal Revenue Services (nobody inflates his income on an income‐tax statement), carefully determine the value of available collateral, and judge ability to pay based on the overall debt service that would come due. After all, this is what banks are supposed to do; their job is precisely to judge ability to pay and to tame expectations. As noted in Chapter 8, during the housing boom all this went out of the window, banks manufactured creditworthiness by inflating it on credit application (sometimes raising the income stated on a mortgage application without the knowledge of the applicant), they did not bother to check with the IRS even though it can be done easily (they did not do so for the obvious reason that they lied on the application), they maintained a black list of house appraisers who were honest and would not provide an inflated valuation of a house, they qualified households on the basis of interest payments calculated from a very low interest rate (aka teaser rate) that would prevail only for a few months. It is as if your mechanic did everything to wreck the engine of your car. So it turned out regulations had to be put in place to tell bankers what they are supposed to do! This is included in Title 14 of the Dodd‐Frank act. It forces mortgagees to determine the capacity to pay of mortgagors on the basis of other means than the expected refinancing sources and expected equity in the house, as well as to verify income and to qualify individuals based on the full debt service: A determination under this subsection of a consumer’s ability to repay a residential mortgage loan shall include consideration of the consumer’s credit history, current income, expected income the consumer is reasonably assured of receiving, current obligations, debt‐to‐income ratio or the residual income the consumer will have after paying non‐mortgage debt and mortgage‐related obligations, employment status, and other financial resources other than the consumer’s equity in the dwelling or real property that secures repayment of the loan. A creditor shall determine the ability of the consumer to repay using a payment schedule that fully amortizes the loan over the term of the loan. (Dodd‐Frank Act, 768) While Title 14 is limited to residential mortgages (commercial mortgages were a big problem during the S&L crisis and other promissory notes should also follow the same underwriting methods), this Title is a great contribution to financial stability…if enforced. The need for such a regulation suggests how much the banking industry has changed for the worse.

WHY ARE THERE STILL FREQUENT AND SIGNIFICANT FINANCIAL CRISES IF REGULATION IS SO TIGHT? This is, at least, a three‐part answer: 1‐ there was some deregulation that has promoted competition and concentration, 2‐ the willingness and ability to enforce the law has diminished, 3‐ regulatory arbitrage and regulatory apathy.

DEREGULATION, COMPETITION AND CONCENTRATION 115

CHAPTER 9: BANKING REGULATION The Great Depression put in place financial regulations that compartmentalized the financial industry. Banks were forbidden to perform some activities related to financial markets, they were limited in the types of assets they could hold, and they had access to a low cost and stable refinancing source via the central bank. This led to a very stable banking system with very few and limited problems. Table 9.3 shows the gross saving of depository institutions grew at a slower but steadier pace compared to the post‐1970s period. The number of failures and assistances was also dramatically smaller—around 4 failures and assistances per year versus 113 from the 1980s—and represented only 2.8 percent of all failures and assistances that occurred between 1945 and 2010. Taking a broader historical perspective, Figure 9.2 shows that the stability of the banking from 1940 to 1980 also stands out. Gross Saving, Average Growth Rate 1945‐1971 1982‐2010 Gross Saving, Std. Deviation 1945‐1971 1982‐2010 Insured Bank Failures and Assistances 1945‐1971 1982‐2010

U.S. Depository Institutions 8.2% 24.0%

Credit Unions

Commercial Banks

15.1% 14.1%

9.1% 11.7%

15.1% 225.8%

20.1% 31.2%

16.4% 26.1%

Number (% of total)

Yearly Average

100 (2.8%) 3266 (93.5%)

3.7 112.6

Table 9.3 Gross saving and failures of FDIC‐insured depository institutions. Sources: Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation. Note: Gross saving is defined as undistributed profit plus consumption of fixed capital Chapter 8 notes that the enthusiasm of banks for the originate‐and‐hold model declined sharply in the 1980s. They pushed for a deregulation of their industry to be able to offer higher interest rate on their liabilities and to widen the type of assets they could hold (1980 Depository Institution Deregulation and Monetary Control Act, 1982 Garn St. Germain Act). Then, banks lobbied to deregulate branching restrictions (1994 Riegle‐Neal Interstate Banking and Branching Efficiency Act), to be able to participate in broader financial activities (1999 Financial Modernization Act), and to limit regulation in the derivative markets (2000 Commodity Futures Modernization Act). Today, the U.S. banking industry is highly concentrated (Figure 9.3) and a few large financial holding companies dominate the industry. 80% of the assets of the banking industry are concentrated in the 595 largest banks that account for about 10% of FDIC‐insured banks. Among these, the top 5/7 banks hold almost all the derivative contracts held by banks. Table 9.4 shows the recent data about derivative holding concentration among FDIC‐insured institutions; the seven biggest institutions hold 97% of derivate contracts held by FDIC‐insured institutions, worth almost $170 trillion notionally. The high concentration of the industry means that if one of the banks fails, it may have a major impact on the financial system. Banks may become “too big to fail,” and so must be saved even though they are not economically viable. This may promote moral hazard and increase financial instability over time.

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Figure 9.2 Annual number of bank suspensions (1892‐1941) and bank failures (1934‐2015) Sources: FDIC (Bank failures) and Monetary and Banking Statistics 1914‐1941 (Bank suspensions) Note: Bank suspensions include banks that closed temporarily or permanently on account of financial difficulty; excludes times of special bank holiday. Bank failures refer to banks that closed permanently.

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Figure 9.3 Concentration of the banking industry Source: FDIC Graph Book Note: Largest FDIC Insured Bank have over $10 Billion of Assets (595 institutions in 2016 or 10% of the industry)

Report Date

Derivative Contracts (Trillions)

Percent of Total Derivative Contracts

Number of Banks

Spot Foreign Exchange Contracts (Billions)

Size Grouping

December 31, 2015

$169.3

97%

7

$928.0

7 Largest Participants

December 31, 2015

$4.7

3%

1,400

$105.5

All Other Participants

Table 9.4. Concentration of derivatives notional amounts Source: FDIC Graph Book

DEENFORCEMENT AND DESUPERVISION Overall, there was a deregulatory trend but the fact remains that this industry is still heavily regulated. However, for a set of regulations to work properly it has to be enforced. With the return of free‐market thinking as a dominant framework of thought in the 1970s, enforcement took a toll. Free‐market thinkers who do not believe in government intervention were put in charge of major regulatory bodies; individuals such as Alan Greenspan at the Fed, Robert Rubin at the Treasury, and Christopher Cox at the SEC. These are individuals who believe in the self‐cleansing and self‐ stabilizing properties of market.1 As such, according to them, there is no need to do anything to prevent fraud and dangerous financial practices, or to make sure that banks do not get involved in 118

CHAPTER 9: BANKING REGULATION predatory business practices. Markets take care of it, after all, as the thought goes, a business is judged by its clients so if the clients do not like what a business does, the business will close. Thus, in recent years, regulators like the Federal Reserve deliberately loosely implemented existing regulations or chose “to not conduct consumer compliance examinations of, nor to investigate consumer complaints regarding, nonbank subsidiaries of bank holding companies”.2 In addition, the Federal Reserve and the Office of the Comptroller of the Currency (OCC) blocked efforts of federal regulators, and states like Georgia and North Carolina were prohibited by OCC and the OTS from investigating local subsidiaries of nationally chartered banks. Chairman Bair at the FDIC worked with Federal Reserve Governor Gramlich to raise concerns about predatory mortgage practices starting in 2001 but their effort did not lead anywhere. Chairman Born at the Commodity Futures and Trade Commission (CFTC) raised concerned about derivatives and wanted to make them more transparent but was shut down by Congress.3 In 1994, a Government Accountability Office (GAO) report strongly criticized the existing derivatives legislation. It noted that “no comprehensive industry or federal regulatory requirements existed to ensure that U.S. OTC derivatives dealers followed good risk‐management practices” and that “regulatory gaps and weaknesses that presently exist must be addressed, especially considering the rapid growth in derivatives activity”.4 None of the recommendations was implemented and instead large cuts were made by Congress to the budget of the GAO. These cuts were estimated to reduce the staff of the GAO by 850 persons (20 percent of its employees). Other regulators also suffered large cuts to their staff. The FDIC staff was cut drastically and constantly from 20,000 employees in the early 1990s to 5,000 employees right before the Great Recession (Figure 9.4). This occurred at the same time as the financial industry became more concentrated and more complex. In addition, the cut in staff was much more rapid than the decline in the number of FDIC insured institutions to be supervised, thereby increasing the burden of supervision on each employee. This double trend of increasing complexity and increasing burden on supervisors drastically decreased their capacity to perform effective supervision and regulations. The SEC, under Christopher Cox (who, like Alan Greenspan, is a follower of Ayn Rand’s economic thinking), also decreased its staff and, by 2009, the Securities and Exchange Commission had 400 people to examine 11000 investment advisers, which led it to contract with private auditors and other external reviewers. In addition, the SEC did not develop the necessary tools it needed to perform effective regulation.

REGULATORY ARBITRAGE Beyond deregulation, desupervision and deenforcement, banks themselves have always found means to bypass partly some of the regulations that they have found too constraining. An example of that are capital regulations that banks have bypassed partly through securitization. Securitization allows banks to remove highly‐weighted assets (that is carrying high risks) from their balance sheet without compromising their profitability. Regulatory arbitrage is a common response of banks to new regulations. To counter it, regulation needs to be flexible and broad enough, and regulators need to act quickly; both requirements are lacking with regulators today focused on limiting intervention to avoid hurting bank profits and competitiveness with foreign institutions. In addition, a bank can choose its main regulator, and a bank can change its regulator if it thinks another one will be more lenient. This “regulator shopping” is all the more prevalent given that regulators

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CHAPTER 9: BANKING REGULATION compete to get the most banks under their wings because regulators are funded partly through the fees they charge for supervision.

Figure 9.4 Number of employees at the Federal Deposit Insurance Corporation. Source: FDIC.

THEORIES OF BANK CRISES AND BANKING REGULATION: TWO VIEWS The way the banking system is regulated heavily depends on regulators’ understanding of what causes banking crises. There are two broad views regarding the origins of banking crises and financial crises more generally; one states that crises are random events in an otherwise self‐ stabilizing economic system based on market principles, another states that bank crises are the result of the inner working of markets.

LAISSEZ FAIRE, LAISSEZ PASSER: CRISES AS RANDOM EVENTS Greenspan summed up neatly the first view when he characterized the 2008 financial crisis as a “once‐in‐a‐century credit tsunami.” Crises are equivalent to weather calamities that affect the return on assets (see Chapter 7). These adverse random shocks are amplified by individual imperfections (think of any deviation from the cold rational homo economicus) and market imperfections (lack of information, etc.). Market imperfections can themselves contribute to the growing risk of financial crises if they contribute to the mispricing of securities, which leads rational agents to take too much risk on their assets and liabilities given the price signal. Thus, according to this view, the recent crisis is the product of mispriced assets (like CDOs) that led to the issuance of too many of them (see discussion about embedded leverage in Chapter 7), and of a “black‐swan”

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CHAPTER 9: BANKING REGULATION event, that is, an unusually large negative shock. One might call this view the “shit‐happens” view of financial crises. In this type of view, there is no point in trying to promote a regulatory framework that proactively helps prevent crises and limit their strength—in the same way no one can proactively prevent the occurrence and reduce the strength of tsunamis. Market mechanisms weed out problems by themselves because, with enough disclosure, financial‐market participants will not engage in fraudulent practices, and unsustainable business will be closed down. Anything that promotes market mechanisms is praised and that includes the recent innovations in derivatives and securitization. Policy makers such as Alan Greenspan and academics such as Philip Das made statements in the mid 2000 that illustrate well this position: Development of financial products, such as asset‐backed securities, collateral loan obligations, and credit default swaps, that facilitate the dispersion of risk… These increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter‐century ago. (Greenspan 2004, 2005) Financial risks, particularly credit risks, are no longer borne by banks. They are increasingly moved off balance sheets. Assets are converted into tradable securities, which in turn eliminates credit risks. (Das 2006) Given that markets usually get it right, instead of having regulations that constrain market mechanisms, regulation should focus on limiting the destructive impact of financial crises on economic activity and improving disclosure of information and market mechanisms. Following the tsunami analogy, the goal is to build high enough seawalls so that protection is available against most tsunamis. If there is a “once‐in‐a‐century” tsunami…well…too bad…at least we tried! In terms of banking regulation, the goal is to put in place large enough liquidity and capital buffers in the balance sheets of banks. The Basel accords are an example of such regulatory view: Given the scope and speed with which the recent and previous crises have been transmitted around the globe as well as the unpredictable nature of future crises, it is critical that all countries raise the resilience of their banking sectors to both internal and external shocks. (Basel 2010a: 2) With enough capital, banks will be able to protect their creditors against most declines in the value of their assets. With enough liquid assets, the value of assets will decline less than it would have otherwise. At the same time, having too much capital and liquidity puts downward pressures on the ROE that banks can earn because leverage declines and ROA is lowered (the more liquid an asset, the lower the ROA). The point, therefore, becomes to find the optimal level of capital and liquidity. The move toward risk management is the ultimate expression of this belief. It uses complex mathematical algorithms to determine what the appropriate level of buffers is given existing risks on‐ and off‐balance sheets. The goal has been to refine the measurement of different risks as well as the methods used to calculate the appropriate level of each buffer. The government has a limited role to play in determining appropriate buffers, especially for “sophisticated” financial institutions. The government also has not much to say about the way banks should be managed, the proper underwriting procedures, and the types of assets that banks should be allow to hold. Bankers know best.

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SAVE CAPITALISM CONTRADICTIONS

FROM

ITSELF:

CRISES

AS

INTERNAL

Another view of financial crises argues that they are the normal result of profit‐seeking operations of banks, and that the way the banking system is structured greatly dampens or amplifies the destabilizing effect of profit‐seeking operations. While an unstable banking system can be attributed in part to greed and irrational or “bad” people, the most important contributor is the way the banking system is set up. The more of a role is given to market mechanisms, the more unstable the financial system will be. The issue is not one of mispricing, lack of disclosure, black swan, massive tsunami, or imperfections. Tsunamis are created by the very practices of banks when trying to make a buck and, if banks are left alone, their practices will lead to a “once‐in‐a‐century tsunami.” Put differently, financial crises are not the results of “bad luck” because nature threw a tantrum; banks make their own luck. As such, one may also doubt that capital regulation and other buffer‐requirement approach will do much to prevent financial crises. 5 They are too passive regulations. As explained in Chapter 8, over a period of stability, banks are incentivized to change their underwriting practices by lowering credit standards and/or deemphasizing income as the main means of servicing debts. Some of this loosening is welcomed when banks have tightened credit standards so much that economic growth cannot proceed well. This tends to happen after financial crises, when bankers become too careful. 6 However, credit standards are elastic and, when profitability is threatened, loosening credit standards is the easy road, especially during a period of economic stability when economic news is good. Periods of economic stability feed the models used by bankers with information that suggests that leverage is safe and risk‐taking is warranted. Beyond banks, other financial institutions such as pension funds have an incentive to buy CDOs and other risky financial assets (even a non‐investment grade securities) in order to maintain the targeted ROE they promised their pensioners; this is so especially when interest rates are very low. More broadly, corporate businesses have some profitability target to meet that is largely invariant to the growth of their assets, thereby pushing them to innovate and to use leverage to reach that target. Again, a very rational response to profitability pressures defined by a target ROE. As such, risk‐management tools may provide information that suggests that it is safer not to engage in certain activities, but this information will be ignored if it threatens market shares and profitability: To some extent […] all risk management tools are unable to model/present the most severe forms of financial shocks in a fashion that is credible to senior management […].To the extent that users of stress tests consider these assumptions to be unrealistic, too onerous, […] incorporating unlikely correlations or having similar issues which detract from their credibility, the stress tests can be dismissed by the target audience and its informational content thereby lost. (Counterparty Risk Management Policy Group III 2008: 70, 84) This is so especially in an environment where it is difficult to reach the target ROE and the search for yield is intensive. Chapter 8 illustrates how the banking system (and financial system as a whole) is driven by competitive pressures and the need to stick with the majority to avoid losing market shares. As such, financial institutions will engage in unsustainable financial practices if that means keeping profitability up. Given that profit is the only relevant metric to judge a business, market 122

CHAPTER 9: BANKING REGULATION mechanisms will not weed out unsustainable practices if they sustain profit. As these accumulate, the economic system becomes more fragile and ultimately collapses under a debt‐deflation (see Chapter 14). The point is that the weeding out of bad apples that market proponents argue occurs to prevent crises does not happen. The problem comes from too much focus on profit as the key metrics of health for a business. From the bank managers’ standpoint, if the business is profitable, it means they do what customers want and so are fulfilling a need (never mind that this may involve “raping the public” as shown in Chapter 8). Regulators see profit as a key measure of health because profit grows capital (see Chapter 1) and so improves buffers against crises. However, from a financial stability perspective, a key issue is not merely if profit is generated but how that profit is generated. If this second question is ignored, the weeding out mechanism used by markets is the crisis itself, and that ends up destroying the entire economy and wiping out any buffer available. So much for a smooth self‐stabilizing mechanism. Given that credit standards are elastic concepts, one may wonder if there is a means to know what a sustainable credit practice is and how to use that for regulatory purpose. Fortunately yes. Hyman P. Minsky provides us with a useful categorization of underwriting practices in terms of Hedge, Speculative and Ponzi finance. Chapter 14 studies this categorization more carefully. The main point is that if debt is underwritten on the basis of income (income‐based credit), it is much less likely to lead to financial instability. If, instead, banks grant advances by qualifying clients on the basis of the expected rise in the value of a collateral or other assets (asset‐based credit), then the economic system is prone to financial instability. The recent housing boom with its dangerous mortgage practices, presented in Chapter 8, is an example of such unsustainable underwriting practices. The problem is not merely one of knowing if a customer will be able to service his debt (the main concern of banks), but also how a customer will service his debt: servicing debt with income is sustainable, debt servicing by liquidating assets is not. It is not sustainable because while an individual may be able to do it by relying on a bonanza (asset prices went up as expected and can be liquidated easily), for the system as a whole it is impossible to liquidate assets. Markets rely on a balance of buyers and sellers and if a significant proportion of debtors rely on a strategy that involves selling assets to service debts, asset prices will plunge when liquidation occurs. A Ponzi strategy is sustainable only for so long, given that the number of participants (and indebtedness) must exponentially grow to keep the strategy going. With the H/S/P categorization in mind, the point is to discourage, and if necessary, forbid any economic growth process that is not based on sound financial practices (income‐based credit), even if everybody is profiting from the continuation of this process in the short term, and even if the financial community ends up considering those practices acceptable and a normal way to do business. In order to do so, the financial practices of economic agents should be checked carefully and growing signs of asset‐based credit should be tackled immediately, even if there is no bubble, no rising default rate, rising wealth and profit. This policy agenda is, of course, much broader and more ambitious than the previous one, but its relevance has been demonstrated many times. For example, prior to the savings and loan crisis, several in‐field supervisors wanted to shut down some thrifts that were recording large profits, because they were suspected of being involved in Ponzi finance sustained by massive frauds. However, there were strong pressures from their bosses and politicians not to close these thrifts

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CHAPTER 9: BANKING REGULATION because their profitability made them models for the industry. 7 Those thrifts were allowed to continue to operate but ended up costing hundreds of billions of dollars when they failed. Similarly, during the housing boom of the mid‐2000s, households’ wealth grew very rapidly, financial companies registered record‐high profits, and homeownership also reached a record high, but all these gains were wiped out once the economy collapsed. Homeownership is back to its level prior to the housing boom, and is still falling (Figure 9.5).

Figure 9.5 Homeownership rate in the U.S. (Percent). Source: U.S. Census Bureau

Steps should have been taken since at least 2003 to prevent the unsustainable growth of homeownership and dangerous business practices. This should have been done by forbidding no‐ doc mortgages, by limiting access to pay‐option mortgages to households with enough cash buffer and income, by not allowing financial institutions to create Ponzi‐generating financial innovations, and by regulating closely all new financial activities. Instead, in 2004, Greenspan praised the dynamic mortgage market and argued that rising mortgage debt among U.S. households was not a problem because households’ wealth was rising thanks to rapidly rising home prices; precisely what asset‐based credit is all about.8 Finally, asset‐based credit is impossible to buffer properly in an economically profitable way and so should not be allowed at least by banks. An alternative is to remove any government backing from economic activities that rely on, or promote, asset‐based credit, which implies isolating the payment system from those activities. In the end, CDOs and other financial innovations were problematic not because they were mispriced (although they surely were), but because they were encouraging financial practices that are unsustainable even if priced correctly. Asset‐based credit always fails because there is ultimately no income to meet the debt service and assets must be liquidated in distress. Financial‐ market participants are always willing to pay for something if that means more profit (even more so when bonuses are based on short‐term profitability), and they will get a better idea of what to 124

CHAPTER 9: BANKING REGULATION pay with more information. But profit‐seeking activity is different from financial‐crisis avoidance activity. In fact, these two activities usually are complete opposite activities and the latter is never on the radar of any particular firm (“if we fail, we fail together, nobody gets blamed; let me focus on my profit” is the thought as Wojnilower illustrates in Chapter 8). Summary of Major Points 1‐ Banks are heavily regulated because they are at the core of the payment system. If they fail en masse, the economy freezes because other economic units cannot get paid, cannot make payments, and cannot obtain currency. 2‐ Banks must have a certain proportion of capital relative to the weighted value of their assets. This is supposed to allow banks to be able to sustain large unexpected adverse shocks on their assets, while still being able to pay their creditors 3‐ Banks must have a certain proportion of reserves relative to the outstanding value of the bank accounts that they have issued. This is supposed to allow them to meet unexpected large demand for cash by customers. 4‐ If banks do not comply with regulations, regulators may issue a cease and desist order and give a limited amount of time for a bank to comply. After that time, the bank is either sold to another bank or its assets are liquidated to pay the creditors. 5‐ The banking industry has become highly concentrated and highly dependent on derivatives and capital gains to maintain its profitability. This is the results of a period of deregulation, desupervision and deenforcemnt that have allowed major banks to broaden their activities. 6‐ Some economists believe that markets self‐regulate and that, at most, banks only need to be protected against the most probably shocks that may adversely impact their balance sheet. This can be done by passive regulation such as capital regulation. Other economists believe that banks make their own luck, that is, that financial crises are the product on the loosening of credit standards during period of economic prosperity. As such, regulation of the banking business must be more thorough, flexible and proactive, and must focus on the type of assets acquired by, and underwriting methods used by banks. Keywords Reserve requirement, capital requirement, CAMELS rating, efficient markets, financial instability hypothesis, risk management techniques, underwriting requirements Review Questions Q1: What is the role of capital regulation? Underwriting regulation? Q2: What does a CAMELS rating measure and how does it do it? Q3: What has happened to the banking industry over the past 30 to 40 years and why? Q4: What can be done in terms of regulation if one believes that financial crises are random events, aka black‐swan events? Q5: What type of regulation should be put in place if one believes that financial crises are the result of the way banks conduct their business? Q6: How can an increase in the concentration of the banking industry, together with deregulation and lack of enforcement, promote the occurrence of financial crises?

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Suggested readings For a relative easy read with a compelling narrative about saving & loan white collar crimes and the fight of some regulators to stop them read The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry by William K. Black. More advanced readings: Cargill, T.F. and Garcia, G.G. (1982) Financial Deregulation and Monetary Control: Historical Perspective and Impact of the 1980 Act. Stanford: Hoover Institution Press. Campbell, C. and Minsky, H.P. (1987) “How to Get Off the Back of a Tiger or, Do Initial Conditions Constrain Deposit Insurance Reform?” In Federal Reserve Bank of Chicago (ed.) Proceedings of a Conference on Bank Structure and Competition, 252‐266. Chicago: Federal Reserve Bank of Chicago. Minsky, H.P. (1975) “Suggestions for a cash flow‐oriented bank examination,” in Federal Reserve Bank of Chicago (ed.) Proceedings of a Conference on Bank Structure and Competition, 150‐184, Chicago: Federal Reserve Bank of Chicago. Knutsen, S. and Lie, E. (2002) “Financial fragility, growth strategies and banking failures: The major Norwegian banks and the banking crisis, 1987‐92.” Business History, 44 (2): 88‐111. 1 When the full blown crisis occurred in the September 2008, Greenspan and others conceded that they went too far in believing in the efficiency of markets—it was the time for a public mea culpa. Donald Kohn, former Vice Chairman of the Federal Reserve, stated: “I placed too much confidence in the ability of the private market participants to police themselves” (Kohn in House of Commons 2011: Ev3). A humble Greenspan was asked to testify to Congress and created some stir by stating: I made a mistake in presuming that the self‐interest of organizations, specifically banks and others, were such is [sic] that they were best capable of protecting their own shareholders and their equity in the firms. (Greenspan in U.S. House of Representatives 2008b: 34) Similar remarks were made in the United Kingdom by Adair Turner, chair of the U.K. Financial Services Authority (FSA): In the past, in the years running up to the crisis, it was the strong mindset of the FSA—shared with securities and prudential regulators and central banks across the world, it was almost part of our DNA—that we assumed that financial innovation was always beneficial, that more trading and more liquidity creation was always valuable, that ever more complex products were by definition beneficial because they completed more markets, allowing a more precise matching of instruments to investor demand for liquidity, risk and return combinations. And that mindset did affect our approach—and the approach of the whole world regulatory community—to the setting of capital requirements on trading activity; it affected our willingness to demand risk reduction in the CDS market; and it influenced the degree to which we could even consider short‐selling bans in conditions of exceptional market volatility.[…] [Stepping out of that mindset] poses for regulators the challenge of complexity, because it involves rejecting an intellectually elegant but also profoundly mistaken faith in ever perfect and self‐equilibrating markets, ever rational human behaviors. (Turner 2009) 2 Appelbaum, B. (2009) “Fed held back as evidence mounted on subprime loan abuses,” The Washington Post, September 27 at http://www.washingtonpost.com/wp‐dyn/content/article/2009/09/26/AR2009092602706.html 3 Watch “The Warning” by PBS Frontline at http://www.pbs.org/video/1302794657/ 4 Government Accountability Office (1994) Financial Derivatives: Actions Needed to Protect the Financial System, Report No. GAO/GGD‐94‐133, May, at http://www.gao.gov/assets/160/154342.pdf 5 http://www.levyinstitute.org/conferences/minsky2015/minsky2015_tymoigne.pdf 6 In 2014, Chairman Bernanke could not refinance his mortgage http://www.bloomberg.com/news/articles/2014‐10‐ 03/why‐even‐ben‐bernanke‐cant‐refinance‐his‐mortgage‐chart 7 See Black, W.K. (2005) The Best Way to Rob a Bank is to Own One. Austin: Texas University Press. 8 “The mortgage market and consumer debt,” remarks by at America’s Community Bankers Annual Convention, Washington, D.C., October 19, 2004. http://www.federalreserve.gov/boardDocs/speeches/2004/20041019/default.htm

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CHAPTER 10: After reading this Chapter you should be able to understand: What banks do before providing credit How banks create their monetary instruments How banks destroy their monetary instruments How banks make a profit What the limits to the monetary creation process by banks are

CHAPTER 10: MONETARY CREATION BY BANKS The last three Chapters have explained how the operations of banks are constrained by profitability and regulatory constraints, and how banks operate to try to bypass these constraints. It is now time to go into the details of how banks provide credit and payment services to the rest of the economy.

MONETARY CREATION BY BANKS: CREDIT AND PAYMENT SERVICES Bank A just opened for business and its balance sheet looks like this: Bank A Assets Building: $200

Liabilities and Net Worth Net worth: $200

Now comes household #1 who wants to buy a house worth $100 from household #2. #1 sits down with a banker (a.k.a. loan officer) who asks a few questions regarding annual income, available assets, monetary balances, the down‐payment #1 is willing to make, among others. The banker asks for documentation that corroborates the answers provided by #1. The banker also shows #1 what financing options are available; that is, the banker shows #1 what type of mortgage note household #1 has to issue to be accepted by bank A. Figure 10.1 is taken from an actual website. ‐

For 100% financing (no down‐payment by household), the bank is prepared to provide up to $330,000 and it will only accept a 30‐year 5.125% fixed‐rate mortgage note. The bank will not accept a 20‐year mortgage note, or a 3.875% note for 100% financing.

‐

For up to 97% financing (household provides at least a 3% down‐payment), the types of mortgage note that a household can issue to the bank widen. The bank is willing to accept a 30‐year 3.875% fixed‐rate note, or a 15‐year 3.125% fixed‐rate note, among others. The maximum face value of the note that the bank will accept is $417,000 unless the household is able to provide a 20% down‐payment.

#1 picks one of the options and fills up a credit application that is attached to all the documentation provided by #1. The credit application is then sent to the credit department for further analysis (check the 3Cs of Chapter 8) and either approved or not. All this is similar to bond issuances by corporations, except that mortgage notes do not have an active market in which they can be traded. In the case of a bond, a corporation may issue a bond with terms that are different than what market participants want. The bond will trade at a discount or a premium in that case. If Ford issues a 10‐year 5% corporate bond but the market yield is currently 6% (i.e. market participants want a 6% rate of return), market participants will only buy the bond from Ford at a discount. To simplify, assume a bond with a $1000 face value and a 5% coupon rate (every year the bond pays $50 of interest income), then to get a 6% yield someone should pay $833 (50/833=6%); a 17% discount. Unfortunately for #1, there is no active market for its promissory notes, so if #1 does not issue a mortgage note with the terms required by A, its note will trade at 100% discount; A will not buy it (#1 could always check what another bank would offer). That is the disadvantage of non‐tradable promissory notes over securities; the issuer is completely bound by what potential bearers require in terms of the characteristics of the promissory note (interest rate, term to maturity, etc.). 128

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Figure 10.1 Example of types of mortgage note a bank will accept

Figure 10.2 shows what a mortgage note looks like. It is a legal document that formalizes a promise made by a household to a bank. The household issued a 30‐year fully‐amortized fixed‐rate 7.5% note to a bank called “Shelter Mortgage Co.,” which means that, over 30 years, the household promises to pay an annual interest representing 7.5% of the outstanding note value and to repay some of the principal every month. That comes down to a monthly payment of $1896.27. The mortgage note is accompanied by a mortgage deed (and many other documents). The deed is a legal document that establishes the right of the bank to seize the house if the household does not fulfill the terms of the mortgage note.

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Figure 10.2 A mortgage note

Going back to our household #1 that wants to buy a $100 house, suppose that bank A agrees to acquire from #1 a 30‐year 5% mortgage note with a $100 face value. How does A pay for it? Bank A issues its own promissory note, called “bank account,” to #1. Bank A Assets 30‐year 5% mortgage note of #1: $100 Building: $200 Or, in terms of t‐account, we have the following first step: 130

Liabilities and Net Worth Bank account of #1: $100 Net Worth: $200

CHAPTER 10: MONETARY CREATION BY BANKS Bank A ΔAssets 30‐year 5% mortgage note of #1: +$100

ΔLiabilities and Net Worth Bank account of #1: +$100

#1 then pays #2 and, for the moment, let us assume #2 opens an account at A (we will see what happens below when #2 has an account at a different bank): Bank A Assets 30‐year 5% mortgage note of #1: $100 Building: $200

Liabilities and Net Worth Bank account of #1: $0 Bank account of #2: $100 Net Worth: $200

Or in terms of t‐accounts, we have the following when the payment occurs: Bank A ΔAssets

ΔLiabilities and Net Worth Bank account of #1: ‐$100 Bank account of #2: +$100

Household #1 ΔAssets House: +$100 Bank account at A: ‐$100


Household #2 ΔAssets House: ‐$100 Bank account at A: +$100


While the above shows the logic of what goes on when a bank provides credit services, the bank also provides payment services. This means that, in practice, the accounting is simpler because A makes the payment on behalf of #1, it does not let #1 touch any funds. Instead, A directly credits the account of #2 so the first step is actually: Bank A ΔAssets 30‐year 5% mortgage note of #1: +$100


And the final balance sheet is (#1 does not need to have a bank account for the payment to go through, A just credits the account of #2 by typing “100” on the computer) Bank A Assets 30‐year 5% mortgage note of #1: $100 Building: $200

Liabilities and Net Worth Bank account of #2: $100 Net worth: $200

The promissory note of the bank called “bank account” is one type of monetary instrument as explained in Chapter 15. 131


WHAT CAN WE LEARN FROM THE EXAMPLE ABOVE? POINT 1: THE BANK IS NOT LENDING ANYTHING IT HAS: WHEN PROVIDING CREDIT SERVICES, THE BANK SWAPS PROMISSORY NOTES WITH ITS CLIENTS The accounting of the previous section is commonly referred to as “bank lending,” i.e. the A is said to lend $100 to #1. As stated in Chapter 2, when studying central banking, “lending” means giving up temporarily an asset, “I lend you my pen for a minute.” This is clearly not what is going on. Banks are not in the business of allowing customers to temporarily use some of the banks’ assets: that is a loan shark business. The bank is not lending anything it owns. Lending would mean this: Bank A ΔAssets 30‐year 5% mortgage note of #1: +$100 Reserves: ‐$100


Household#1 is borrowing cash from the bank. But what happened is this: Bank A ΔAssets 30‐year 5% mortgage note of #1: +$100


One may ask: Is there not an indirect lending of reserves though? After #1 gets its account credited, it could withdraw reserves and make a cash payment to #2. #1 would then have to get reserves back to A. The answer is no for two reasons: ‐

We have just seen that in practice the bank makes the payment for #1. That payment does not need to result into any reserve drainage (it did not above).

‐

As shown below, #1 does not have to give back reserves to A to repay its debt, and #1 rarely, if ever, does so in practice.

So not only is #1 not borrowing reserves from A, but also #1 is not giving back reserves to A. There is no lending or borrowing of reserves going on between A and #1, either directly or indirectly. What a bank does do is to swap promissory notes with economic units and to make payments for them. Reserves may enter the picture at the time of the provision of payment services, never at the time of the provision of credit services.

POINT 2: THE BANK DOES NOT NEED ANY RESERVES TO PROVIDE CREDIT SERVICES While it may need reserves to provide payment services (that is to transfer funds to #2), A does not need any reserves to provide credit services to #1. All it does with household #1 is to exchange promissory notes:

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CHAPTER 10: MONETARY CREATION BY BANKS ‐

The household makes the following promise: pay 5% interest on the outstanding mortgage value for 30 years and repay some of the principal every month.

‐

The bank makes the following two promises: o

To convert bank accounts into Federal Reserve notes at the will of the account holders

o

To accept its own promissory note when #1 services the mortgage.

All these are promises and none of the issuers has to have what is needed to fulfill the promise right away when he issues his promissory notes. That is the point of finance; it is about banking on the future (see Chapter 8). Think of a pizza shop that issues coupons for a free pizza. The shop does not have to make pizzas first before it issues the coupons; it will make pizzas only if people show up with coupons. Converting the coupons into pizzas is costly for the shop and so affects its profitability, but the issuance of coupons is not constrained by the current availability to pizzas. The shop is just making a promise and anybody can make any kind of promise. The hard parts are, first, to convince someone of the genuineness of this promise and, second, to fulfill the promise once it has been accepted by someone. In the same way, a bank does not have to have any Federal Reserve notes now to be able to issue a bank account that promises Federal Reserve notes on demand. A bank will need reserves only if account holders request cash or make payments to someone who has an account at another bank. The Fed will provide reserves on demand, i.e. at the will of solvent banks, so banks never worry about being unable to get reserves (see Chapter 4). Reserves will never run out. What banks do need to worry about is the cost of acquiring reserves. In normal times, this cost is predictable and relatively stable but the Volcker experiment shows that a central bank may make reserves prohibitively expensive.

POINT 3: THE BANK IS NOT USING “OTHER PEOPLE’S MONEY”: IT IS NOT A FINANCIAL INTERMEDIARY BETWEEN SAVERS AND INVESTORS This is a development of the first and second point. A view of banking, from which the word “lending” probably comes from, is that banks are intermediaries between savers and investors. Some people come to deposit cash and then banks lend the cash. It is quite clear that a bank is not lending any funds that some deposited (nobody deposited anything in our example). And, worse offender, a bank is certainly not using others’ bank accounts to grant credit. Assume that household #3 comes to bank A to get a $100 credit, A never does this: Bank A ΔAssets

ΔLiabilities and Net Worth Bank account of #2: ‐$100 Bank account of #3: +$100

That is, it does not take the funds of #2 and give them to #3. This t‐account would be a payment from #2 to #3, not a credit by bank A. To provide a credit is exactly what credit means, it is about crediting accounts. The crediting is done by typing a number on the computer. Once this number is entered, the bank is liable to the account holder for the two reasons presented above. 133

CHAPTER 10: MONETARY CREATION BY BANKS Banks do not wait for depositors before they engage in the provision of credit services. Say household #3 comes to open an account by depositing $50 worth of Federal Reserve notes. The following occurs: Bank A ΔAssets Reserves: +$50


This deposit does not enhance the ability to provide credit services because A is not in the business of lending reserves to non‐bank economic units. The ability of the bank to acquire non‐bank private promissory notes is unrelated to the quantity of reserves on its balance sheet because a bank pays for them by issuing its own promissory notes. There is one case where a bank does need reserves to acquire a promissory note: if a bank buys the note from an institution with a Federal Reserve account. For example: ‐

If a bank participates in an auction of Treasuries, the Treasury only accepts federal funds in payment. In the past, the Treasury sometimes allowed banks to pay for the Treasuries by crediting the TT&Ls (another cash management method used for monetary‐policy purpose beyond the ones presented in Chapter 6), but it no longer does since 1989.

‐

if it buys promissory notes from another bank

In the first case, the balance sheet changes as follows (says the bank buys $10 worth of Treasuries from the Treasury) Bank A ΔAssets Reserves: ‐$10 Treasuries: +$10


And on the balance sheet of the Fed the following occurs Fed ΔAssets

ΔLiabilities and Net Worth Reserve: ‐$10 TGA: +$10

And the Treasury: Treasury ΔAssets TGA: +$10

ΔLiabilities and Net Worth Treasuries: +$10

Chapter 6 showed that the Fed always ensures that banks have enough reserves to make the auction successful. The supply of Federal Reserve notes by savers is irrelevant for the success of auctions of Treasuries.

POINT 4: THE BANK’S PROMISSORY NOTE IS IN HIGH DEMAND Why did #1 enter in an agreement with A? Because nobody else would accept #1’s promissory note and a large number of economic units accepts A’s promissory note (if someone does not, A offers

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CHAPTER 10: MONETARY CREATION BY BANKS conversion into cash that most accept in payments). Chapter 15 explains why bank monetary instruments are widely accepted. If #2 had been willing to accept #1’s promissory note then none of the previous agreement would have been needed. The problems with #1’s promissory note are two fold: ‐

There is a credit risk: #2 is not sure that it will get paid the interest due and that it will be able to make payments to #1 by giving back to #1 its promissory note. If #2 knew that it would become heavily indebted ($100 is a lot in our example) to #1 in the future, then assuming that #1 is creditworthy, #2 may be willing to accept #1’s promissory note for the payment of the house. Later #2 could use #1’s promissory note to pay debts owed to #1.

‐

There is a liquidity risk: the promissory note only comes due in 30 years so household #1 does not have to take it back before that time (though it could because mortgage notes usually allow accelerated repayment of principal). In the meantime, #2 is stuck with this promissory note that nobody else will accept.

Bank A’s promissory note is due at any time the bearer wants (it converts into cash on demand and it can be used to pay the bank at any time) and the creditworthiness of a bank is strong. This is all the more so given that the government guarantees that A’s promissory note can always be converted into Federal Reserve notes at par, and that the (nominal) value of A’s promissory note will not fall even if A goes bankrupt. All this makes the A’s promissory note free of credit risk and perfectly liquid.

HOW DOES A BANK MAKE A PROFIT? MONETARY DESTRUCTION Banks are dealers of promissory notes: banks take non‐bank non‐federal promissory notes and in exchange give their own promissory note. Banks make a profit by taking back their own promissory notes. At the beginning of the second month, #1 starts to honor its promise made to A by servicing the mortgage note. The monthly principal due is 27 cents ($100/(30*12), assuming linear repayment of principal) and the first interest payment is 41 cents (the annual interest rate is 5% so on a monthly basis the rate is 0.407% = (1.05)1/12 – 1) making the total debt service for the first month $0.68. How does #1 pay this? There are two ways this amount can be paid; one is by giving $0.68 in cash to the bank. Another more common solution is to follow up on the promise embedded in the bank’s promissory note: Bank A promised to take back its promissory note as means of payment of debts owed to Bank A. Thus, another means to pay the mortgage is to debit $0.68 from the account of #1. Let us assume that #1 has an account at A, that account first needs to be credited: Bank A Assets 30‐year 5% mortgage note of #1: $100 Building: $200 How can household #1 get funds credited to its account?

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Liabilities and Net Worth Bank account of #1: $0 Bank account of #2: $100 Net worth: $200


o

Case 1: #1 receives a $1 payment from the federal government either by selling something to the government or by receiving a transfer payment. The balance sheet of the bank would look like this (Chapter 6 shows that transactions with the federal government lead to reserve crediting and debiting)

Bank A Assets 30‐year 5% mortgage note of #1: $100 Reserves: $1 Building: $200 o


Case 2: #1 works for business α that produces widgets. Business α just started. It has not sold anything yet but must purchase raw materials and pay #1 (the only employee) to be able to produce widgets. In order to do that, α asked for a $10 operating line of credit from A (an operating line of credit is an off‐balance sheet item unless it is used). When α pays #1 the following happens:

Bank A Assets 30‐year 5% mortgage note of #1: $100 Credit line payable by α : $1 Building: $200


Business α has gone into debt by $1 to be able to pay the monthly wage of household #1. Note how similar case 2 is to the first section: business gets credit, banks makes payment, business does not touch any funds. o

Case 3: #1 receives a $1 from #2. Why? I will let you decide.

One may note that any payment made to #1 that does not come from the government (or an institution that has a federal reserve account) (case 1), or from funds that got created previously by #1 going into debt (case 3), requires that someone other than #1 goes into debt toward a bank (Case 2). Otherwise #1 cannot get access to the payment services offered by A. Let assume that case 2 prevailed so now #1 has enough funds to pay A the first monthly service of $0.68. How is that recorded? It is exactly the same procedure as debt‐service payments by banks to the central bank. Bank A Assets 30‐year 5% mortgage note of #1: $99.73 Credit line payable by α : $1 Building: $200

Liabilities and Net Worth Bank account of #1: $0.32 Bank account of #2: $100 Net worth: $200.41

Or in terms of t‐accounts: Bank A ΔAssets 30‐year 5% mortgage note of #1: ‐$0.27

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ΔLiabilities and Net Worth Bank account of #1: ‐$0.68 Net worth: +$0.41

CHAPTER 10: MONETARY CREATION BY BANKS Again, as in the case of a central bank presented in Chapter 2, the bank is not gaining any cash flow from the transaction. Its profit does not increase the quantity of reserves on the asset side. What profit does is to raise the net worth of the bank. As noted in the first Chapter, profit is just an addition to net worth, the monetary gain that profit represents may not translate into any cash flow gains. What the servicing of debts owed to banks does is to destroy bank monetary instruments, that is, bank liabilities. While there is no cash flow gain for A, profit is extremely important for the viability of its business. Indeed, the bank needs to meet its capital ratio and making a profit improves net worth. In addition, capital is extremely important to allow any bank to further develop its credit service because it can now create more promissory notes, given that it has more capital to protect its creditors. Let us look at how the capital position of A evolved through time (to simplify the unweighted capital ratio is calculated): 1‐ After it opened: Bank A Assets Building: $200


Capital ratio = net worth/assets = $200/$200 = 100% 2‐ After it granted credit to #1: Bank A Assets 30‐year 5% mortgage note of #1: $100 Building: $200

Liabilities and Net Worth Bank account of #2: $100 Net worth: $200

Capital ratio = $200/$300 = 66.7% 3‐ After it granted credit to α and made the payment to #1: Bank A Assets Liabilities and Net Worth Bank account of #1: $1 30‐year 5% mortgage note of #1: $100 Bank account of #2: $100 Credit line payable by α : $1 Net worth: $200 Building: $200 Capital ratio = $200/$301 = 66.4% 4‐ After it received the mortgage service payment from #1: Bank A Assets Liabilities and Net Worth Bank account of #1: $0.32 30‐year 5% mortgage note of #1: $99.73 Bank account of #2: $100 Credit line payable by α : $1 Net worth: $200.41 Building: $200 Capital ratio = $200.41/$300.73 = 66.64% Until A receives the mortgage service payment, its capital position worsens as A grants more credit. Profit allows a bank to restore its capital position and to further pursue the provision of credit services. It also allows a bank to pay its own employees without further lowering its capital position. 137

CHAPTER 10: MONETARY CREATION BY BANKS So if A has one employee (household #3) who receives a monthly salary of 20 cents, then the following is recorded: Bank A Assets 30‐year 5% mortgage note of #1: $99.73 Credit line payable by α : $1 Building: $200

Liabilities and Net Worth Bank account of #1: $0.32 Bank account of #2: $100 Bank account of #3: $.2 Net worth: $200.21

Bank A pays #3 by typing a number on the computer. The capital ratio is 66.57%, still better than the 66.4% that prevailed after A granted credit to α.

INTERBANK PAYMENTS, WITHDRAWALS, RESERVE REQUIREMENTS, AND FEDERAL GOVERNMENT OPERATIONS: THE ROLE OF RESERVES Reserves are conspicuously absent from the previous discussions but banks do need reserves as explained in Chapter 3. Reserves enter the picture with payment services (interbank payments), retail portfolio services (withdrawals and deposits), the law (reserve requirements) and federal government operations (taxes, government spending, and auctions of Treasuries), as well as transactions with other Fed account holders (we will leave that aside). Let us go back to the point where #1 pays #2 and now let us say that #2 has an account at bank B instead of bank A. In that case, A instructs B to credit the account of #2 on behalf of A and A acknowledges it is indebted to B: Bank A Assets 30‐year 5% mortgage note of #1: $100 Building: $200

Liabilities and Net Worth Debt to bank B: $100 Net worth: $200

Bank B Assets Promissory note: $170 Debt of bank A: $100 Building: $80

Liabilities and Net Worth Bank account of #2: $100 Other bank accounts: $50 Net worth: $200

Interbank debts are settled with reserves but there is a small problem: bank A does not have any reserves! How could A get them right now? There are several possibilities: 1‐ Selling non‐strategic tradable assets to another bank or the Fed, say Treasuries: bank A does not have any (the building is a strategic assets because A cannot operate without it, the mortgage note of #1 is not tradable). 2‐ Getting reserves in the interbank market: borrow from a fed funds market participant with excess funds (see Chapter 4). 3‐ Getting reserves from the Fed: swap promissory note with Fed via the Discount Window 138

CHAPTER 10: MONETARY CREATION BY BANKS 4‐ Recording an overnight overdraft on its reserve balance. Over time there will be other means for A to get reserves because: 5‐ Other banks will ask A to make payments on their behalf to economic units with accounts at A. 6‐ Some economic units will come to deposit Federal Reserve notes at A 7‐ The government will make payments to economic units with accounts at bank A (see case 1 above). But right now bank A does not have the reserves so it needs to use sources 1 through 4. Recording an overnight overdraft is the costliest solution because it requires the payment of very high penalties.1 Going at the window is possible but, in normal times, there is a large stigma in the US and it is costly. Borrowing reserves in the federal funds market is usually the preferred means to get reserves. Assume that, first, Bank A uses the overdraft facility to pay Bank B: Bank A Assets 30‐year 5% mortgage note of #1: $100 Reserves: ‐$100 Building: $200


As long as the balance is negative only during the day, bank A does not have to pay any interest on it. Before the end of the day, bank A borrows reserves in the interbank market from bank C: Bank A Assets 30‐year 5% mortgage note of #1: $100 Reserve: $0 Building: $200

Liabilities and Net Worth Debt to bank C: $100 Net worth: $200

This debt is due the next morning and, at the end of the next day, bank A will need to borrow again from bank C or another bank until it receives enough reserves from sources 5, 6, or 7. While it borrows from other banks, it must pay the interest rate that prevails on the interbank market, which, to simplify, is the Federal Funds rate target. Say bank A has to borrow every night for a month, then its profit for the first month, assuming a FFR of 2%, is: Profit = Interest received – interest paid = 0.41%*100 – 0.083%*100 = $0.327 As long as the FFR stays below the interest rate on the mortgage note, the bank is profitable. It is not as profitable as it would have been had it not borrowed reserves, but it is profitable. Beyond the need to make interbank payments, in some countries banks are also required to meet some reserve requirements. Bank A has the following balance sheet if we continue from the last balance sheet of the previous section: Bank A Assets 30‐year 5% mortgage note of #1: $99.73 Credit line payable by α : $1 Building: $200 139

Liabilities and Net Worth Bank account of #1: $0.32 Bank account of #2: $100 Bank account of #3: $.2 Net worth: $200.21

CHAPTER 10: MONETARY CREATION BY BANKS The outstanding value of bank accounts is $104.93 so A now needs to get $10.49 of reserves on its balance sheet if the reserve requirement ratio is 10%. Again the sources of reserves are 1 through 7 but if A needs them right away only sources 1‐3 are available for reserve requirement purpose (A cannot have an overdraft in that case). The accounting implications and profit implications are the same as just presented. For example if it borrows from bank B: Bank A Assets 30‐year 5% mortgage note of #1: $99.73 Credit line payable by α : $1 Reserve: $10.49 Building: $200

Liabilities and Net Worth Bank account of #1: $0.32 Bank account of #2: $100 Bank account of #3: $.2 Debt to bank B: $10.49 Net worth: $200.21

Beyond reserves needed for interbank debt settlements and reserve requirements, Chapter 6 also looks at the need to get reserves to settle auctions of Treasuries and to pay taxes. In all these cases (and the case of withdrawals of cash by account holders), the central bank always accommodates the needs of the banking system to ensure that the payment system works properly (economic units get paid and debts are settled), to ensure that banks follow the law (only the Fed can provide the reserves that banks need to meet reserve requirements), and to ensure that non‐ bank economic units can get the cash they need (see Chapter 4). Banks are never constrained by the quantity of reserves available, as long as a central bank merely targets an interest rate. While the quantity of reserves does not constrain bank A in any way, the Fed does set a price on the supply of reserves and this price impacts the profitability of bank A. As such, banks try to find the cheapest sources of reserves, which usually means attracting and keeping depositors. Banks also try to economize on reserve needs by net clearing interbank debts before settling them, among other means. Finally, banks do not try to hold more reserves than what they need. As shown in Chapter 3, in normal times, most reserves are held because banks are required to do so. Demand for excess reserves is very small and virtually zero. As shown in Chapter 4, banks have almost no incentive to keep excess reserves because they can get any quantity of reserves they want at any time, because they cannot do much with reserves, and because keeping excess reserves lowers ROA. Banks do not proactively try to get reserves ahead of credit activities and, if credit activity slows, they slow their demand for reserves and may want to avoid attracting new depositors to avoiding building excess reserves. They may keep a slight quantity of excess reserves to avoid having to record an overnight overdraft.

WHAT LIMITS THE ABILITY OF A BANK TO PROVIDE CREDIT SERVICES? Say that a bank really wants to increase aggressively its market share; this will tend to draw the attention of regulators for several reasons: 1‐ In order to grow fast, the best strategy is to provide credit to economic units that other banks do not want to qualify; for short non‐prime economic units. This can be done by loosening credit standards faster than other banks and/or, as shown in Chapter 8, by 140

CHAPTER 10: MONETARY CREATION BY BANKS offering to accept promissory notes with initial low monthly payments but upcoming large payment shocks (hopefully refinancing will be possible down the road). Both cases lead to a higher chance of default and so a higher probability of loss of net worth for a bank. The decline in the quality of assets may attract the attention of regulators. 2‐ The proportion of liquid assets relative to illiquid assets declines faster than its peers. 3‐ Its interbank debt will balloon rapidly as payments made on behalf of the bank grow quickly, which pushes down its profitability and so its ability to build its capital base. 4‐ The quality of its earnings declines. If a bank grants a lot of pay‐option mortgages to non‐ prime economic units, these units will usually only pay part of the interest due. However, accrual accounting allows a bank to record the whole debt service due as received and to record “phantom profits.” This may again attract the attention of regulators if accrual interest income grows out of proportion (accrual accounting is not a problem per se and is a convenient means to smooth business operations if used properly). Basically, if a bank grows faster than the rest of the industry, its CAMELS rating tends to increase relative to others and its interbank debt becomes unsustainable. Ultimately regulators will issue a cease and desist order. Note that if a bank grows fast by providing credit to non‐prime clients at a premium interest rate, then, given interbank debt, its short‐run profitability rises as leverage and ROA rise. However, such a bank will then experience massive losses in the near future that will lower rapidly profit and capital. As such, there are two limits to the monetary creation process induced by the swapping of promissory notes: ‐

The credit standards: if A considers that #1 does not meet the 3Cs of credit analysis, A will not accept #1 promissory note and so will not credit #1’s bank account (or #2’s).

‐

Regulation, but not through reserve requirements given that the Fed will provide all the reserves needed to fulfill the requirements, but, rather, through regulatory elements that impact CAMELS rating, that constrain the loosening of credit standards, and that limit the types of assets banks can hold (see Chapter 9).

MOVING IN STEP As noted in Chapter 8, there is safety in numbers. As long as banks grow in step, that is, as long as they create bank accounts at about the same speed (and so acquire assets at the about same speed), they may not attract the attention of regulators: 1‐ Interbank debt for a bank will not balloon out of control: requests to make payments on a bank’s behalf are offset by requests to make payments of behalf of others banks. 2‐ Leverage may rise, at least until debt servicing starts, and liquidity may fall but all this occurs at the industry level so no bank is singled out. As long as underwriting is done properly, ultimately, banks will make a profit and capital will be gained and so leverage will decline overtime. However, as explained in a Chapter 8, things may get out of hand if most banks aggressively pursue growth in market shares and search for yield.

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LIMITS TO MONETARY CREATION BY THE CENTRAL BANK AND PRIVATE BANKS Finance is not a scarce resource as long as the government is monetarily sovereign. Banks and the central bank can create an unlimited quantity of monetary instruments whenever they want. While they can create an unlimited quantity of monetary instruments, they will not do so for the following reasons:

-

For the central bank: under normal circumstances (see Chapter 4), the main limit to the reserve creation process is the need to maintain the overnight interbank rate positive, which basically implies that the central bank must supply whatever banks demand; no more, no less.

-

For banks: core limits to the monetary creation process are profitability and regulatory concerns.

I will finish this Chapter with Figure 10.4, which illustrates the points made above. The supply of credit is slightly upward sloping and then becomes vertical as banks ration credit given a set of credit standards. The supply slopes upward to reflect the fact that, at a point in time, as credit grows, the creditworthiness of the remaining pool of acceptable economic units falls. A given set of credit standards defines what a minimum level of creditworthiness is and anybody below that level will not be granted credit (hence the vertical supply of credit). The demand for credit is downward sloping but not very elastic. As explained in Chapter 5, demand for credit by businesses is very insensitive to interest‐rate conditions.

Figure 10.4 The market for bank credit

TO GO FURTHER: A SIDE NOTE ON ALTERNATIVE VIEWS OF BANKING: THE MONEY MULTIPLIER THEORY AND FINANCIAL INTERMEDIATION.

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CHAPTER 10: MONETARY CREATION BY BANKS A now discredited view of monetary creation by banks argues that banks actively seek excess reserves to be able to provide credit. The logic goes as follows with a 10% reserve requirement ratio: 1‐ The central bank injects excess reserves by buying $100 worth Treasuries from bank A 2‐ Reserves do not earn any interest, so Bank A provides a credit of $100 to household #1 who makes a $100 payment to households #2 at bank B. Bank B now has $100 of extra bank account on its liability side and $100 of extra reserves on its asset side. Bank B has $90 of excess reserves. It grants a credit of $90 to household #3 who pays $90 to household #4 at bank C. Bank C has now $90 of extra reserves and has issued $90 of extra bank account so excess reserves is $81, upon which Bank C provides $81 credit to household #5, etc. This continues until there are no excess reserves left in the banking system. 3‐ The sum of bank accounts created is $100 by bank A, $90 by bank B, $81 by bank C, $72.9 by bank D, etc., which amounts to $1000: With $100 of excess reserves banks could create $1000 of bank accounts. 4‐ Conclusion: bank credit is constrained by the quantity of excess reserves and the reserve requirement ratio. Both can be used by the central bank to target the money supply and ultimately inflation. There are several issues with this view of how banks provide credit and so create monetary instruments: -

Step 1 never happens under normal monetary policy set up (see Chapter 4): any unwanted excess reserves are drained out of the banking system to prevent a fall of FFR to zero. Chapter 3 notes that banks have very little need for reserves. The Volker experiment (see Chapter 5) tried to move toward reserve targeting with the goal of targeting money supply, but this was a failure.

-

It is just not how banks operate (step 2): Banks are profit‐seeking institutions; they do not wait for reserves to grant credit. They grant credit first and look for reserves afterwards, in the same way a pizza shop prints coupons first and then make the pizzas as needed. Flooding banks with reserves just reduces their ROA; it acts like a tax.

-

Banks cannot force economic units to go into debt. Bank credit is demand‐driven so even if banks have a lot of reserves that does not improve their ability to provide credit. Bank A had to wait for #1 to show up before anything could happen. And while bank A could have tried to entice #1 to come to the bank for financing, ultimately it is #1 who decides to take a credit.

-

Milton Friedman himself recognized the problem with this approach: “Given the monetary policy of supporting a nearly fixed pattern of rates on government securities [during WWII], the Federal Reserve System had no effective control over the quantity of high‐powered money. It had to create whatever quantity was necessary to keep rates at that level. Though it is convenient to describe the process as running from an increase in high‐powered money to an increase in the stock of money through deposit‐currency and deposit‐reserve ratio, the chain of influence in fact ran in the opposite direction—from the increase in the stock of money consistent with the specified pattern of rates and other economic conditions to the increment in high‐powered money required to produce that increase.” (Friedman and Schwartz 1963, 566). There are two main problems with his view:

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CHAPTER 10: MONETARY CREATION BY BANKS -

He seems to view the WWII experience as a special case instead of the general case: a central bank always targets interest rates, at least the overnight interbank rate and at least within a band (see Chapter 4).

-

His theoretical position is untenable: if causality is known with certainty to be reversed (money supply to reserves instead of reserves to money supply), then one cannot proceed as if the opposite were true because “it is convenient.”

Another view of banking is that banks lend “other people’s money.” People save and deposit cash in the bank, and the bank proceeds to lend the cash deposited. The Chapter touched on this above but here are the problems: •

Banks do not lend the savings of households: banks do not temporarily take Paul’s funds and given them to Pierre.

•

Banks do not lend reserves to non‐banks: they do not look if Paul deposited enough cash before granting credit to Pierre.

•

Banks are not in the business of lending anything they have: Pierre does not temporarily take cash from the bank, and, usually, does not give back cash to a bank when he services his debt.

•

Savers can deposit cash, but savers are not the source of cash, cash comes from the Fed. And the Fed creates cash at the demand of banks so saving does not constraint credit.

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Summary of Major Points 1‐ Banks are not money lenders because their monetary instruments are their liability not their assets. One cannot lend one’s own debt. 2‐ Banks are promissory note dealers. They take non‐bank promissory notes and in exchange give their own promissory notes. Contrary to most non‐bank promissory notes, bank promissory notes are widely accepted and perfectly liquid. 3‐ If customers’ default on their promissory notes, the value of the assets of banks falls and they do not earn a profit, so banks are very interested in making sure that customers are creditworthy. 4‐ Monetary creation by banks merely involves accounting entries. These accounting entries make banks liable because their promissory notes are convertible in cash and can be used to paid debts owed to banks. 5‐ The money supply does not fall from the sky; it involves a simultaneous debt creation. Banks promise to pay customers, customers promise to pay banks. Banks accept their customers’ promissory note because banks think that their customers are involved in activities that are profitable. As such, monetary creation moves in sync with the needs of the economic system; these needs may or may not be related to production and the purchase of goods and services. 6‐ Banks are not bound by the quantity of reserves when they create monetary instruments. Their monetary instruments are just promises to obtain reserves at the demand of the bearers. Banks do not have to what they promise to deliver when they create monetary instruments. In addition, the central bank provides reserves at the demand of solvent banks, so solvent banks never have to worry about not getting the reserves they need when needed (at a price). 7‐ Monetary creation by banks is limited by regulatory and profitability concerns. They have to comply with capital requirements and asset quality requirements, among others, and promissory notes that have a poor creditworthiness negatively impact their profitability. 8‐ The money multiplier theory and the financial intermediary theory of banks are no longer seen as valid by most of the academic community. Keywords Credit standards, promissory notes, overdraft, capital ratio, credit service, payment service, retail portfolio services, net worth, interbank debt, withdrawals, reserves, money multiplier, credit line, credit receivable/payable Review Questions Q1: When banks provide credit what is the accounting side of this operation? Q2: If a customer comes to ask for a bank credit what will the bank do? Why? Q3: When customers service their promissory notes what happens to the quantity of reserves held by banks? Q4: What do banks do with the cash that some customers deposit? Q5: Why is bank credit not limited by the quantity of reserves? Why are savers irrelevant for credit operations? Q6: How does profit help to meet capital requirement? And why is that allowing banks to continue to keep their business going? Q7: What are the problems with the money multiplier theory at each stage of the argument? What about the financial intermediation theory of banking? 145


Suggested readings For an oldie but goodie video that explains correctly how banks grant advances watch https://www.youtube.com/watch?v=OJMJ24U0Jp4#t=136 Following the failure of reserves injection to boost bank credit (or inflation), the Bank of England published a paper that explains correctly banking operations and rejects other theories: http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prerel easemoneycreation.pdf More advanced reading: Carpenter, S. and Demiralp S. (2012) “Money, reserves, and the transmission of monetary policy: Does the money multiplier exist?” Journal of Macroeconomics 34 (1): 59‐75. Dow, S.C. (2006) “Endogenous money: Structuralist,” in P. Arestis and M.C. Sawyer (eds) A Handbook of Alternative Monetary Economics, 35‐51, Northampton: Edward Elgar. Moore, B.J. (1988) Horizontalists and Verticalists: The Macroeconomics of Credit Money. Cambridge: Cambridge University Press. Keister, J. and McAndrews, J. (2009) “Why are banks holding so many excess reserves?” Federal Reserve Bank of New York Current Issues in Economics and Finance 15 (8): 1‐10: www.newyorkfed.org/research/current_issues/ci15‐8.pdf Lavoie, M. (2006) “Endogenous money: Accomodationist,” in P. Arestis and M.C. Sawyer (eds) A Handbook of Alternative Monetary Economics, 17‐34, Northampton: Edward Elgar. Wray, L. R. (1990) Money and Credit in Capitalist Economies: The Endogenous Money Approach, Aldershot: Edward Elgar. Wray, L. R. (2007) “Endogenous money: http://www.levyinstitute.org/pubs/wp_512.pdf

Structuralist

and

Horizontalist”

1 Federal Reserve’s policy on Overnight Overdrafts at http://www.federalreserve.gov/paymentsystems/oo_policy.htm

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CHAPTER 11:

After reading this Chapter you should be able to understand: Why economists disagree about how the financial system contributes to economic prosperity How the financial system can benefit, or be detrimental to, economic prosperity How different views about how money supply is created lead to different understandings of how money supply can contribute to economic prosperity What the role of monetary incentives is in influencing economic outcomes

CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM The previous Chapter concludes the study of banking operations. The next step is to incorporate them into the analysis of macroeconomic issues and this Chapter begins the discussion of such topics by focusing on economic growth. Money is the life‐blood of capitalist enterprise and finance is about money now for money later. As such, a well‐developed financial system is essential for economic activity in a capitalist economy. The broader the range of promissory notes that can be issued, the more accommodative the financial system is to the demands of the productive system. Households cannot fund the purchase of a house with a credit card and there is no point in buying groceries with a 30‐year mortgage. While all this may seem obvious, economists have been divided about the relevance of finance for economic activity. This divide ultimately rests on different premises on how to do economics, which John Maynard Keynes characterized as Real Exchange Economy versus Monetary Production Economy. Before I go further, a word of caution. Economists and national income accounts use the word “investment” in a specific way. Investment means adding to the quantity of real assets, i.e. growing productive capacities. One cannot invest in shares, bonds, and other financial assets but merely in machines and raw materials (knowledge is also an area emphasized by economists). Portfolio choice, which is usually what people have in mind when talking about (financial) investment, is not the same thing as (physical) investment.

THE REAL EXCHANGE ECONOMY MONEY SUPPLY IS A VEIL Until at least the 1980s, most economists believed that finance is neutral, 1 i.e. irrelevant for economic activity. The study of exchange within a barter economy with small independent producers—think of farmers with their own plot of land—is regarded as a satisfactory proxy to understand the basics of capitalism: Despite the important role of enterprises and of money in our actual economy, and despite the numerous and complex problems they raise, the central characteristic of the market technique of achieving co‐ordination is fully displayed in the simple exchange economy that contains neither enterprises nor money. (Friedman 1962, 13) The point is to understand how market exchange helps economic units to manage the prevailing natural scarcity of resources by allocating resources according to given sets of initial allocations, preferences and techniques of production. Once this is understood, money supply can be added to the analysis but it does not substantially change anything. It merely smooths exchange, is not sought after for itself, and so does not influence allocation, production, and distribution. Capitalism is equivalent to a barter economy with money. In addition, monetary instruments are conceptualized as commodities used as medium of exchange. As such, a willingness to hoard monetary instruments and to reduce spending on other things is merely changing the structure of demand for goods and services; it does not change its level. As a consequence, the level of economic activity is not impacted by monetary incentives and the willingness to hoard monetary instruments.

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CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM Put in terms of the financial industry, one may think of financial markets and banks as institutions used by economic units to borrow and lend current production; finance is a market for intertemporal output: It may be supposed in theory that the entrepreneur borrows these consumption goods from the capitalists in kind, and then pays them out in kind in the shape of wages and rents. At the end of the period of production he repays the loan out of his own product, either directly or after exchanging it for other commodities. […] If this procedure were adopted by all entrepreneurs who work with borrowed capital, competition would bring about a certain rate of interest that would have to be paid to the capitalists in the form of some commodity or other. […] Now if money is loaned at this same rate of interest, it serves as nothing more than a cloak to cover a procedure which, from the purely formal point of view, could have been carried on equally well without it. (Wicksell 1898, 103‐104) Assume a barter economy in which the only product is potatoes and in which workers and other income earners are paid in potatoes. Some economic units may have too many potatoes for current consumption, so they save potatoes. Potato savers can go into a market in which they lend their potatoes to economic units who plant potatoes—the potato investors. The following year, there will be more potatoes than what was planted, as each potato is a seed that can be used to produce more potatoes, the marginal product of potatoes. This marginal product is at the foundation of the interest rate earned by the potato savers; their reward is more potatoes in the future, which means that interest and principal servicing creates an automatic demand for output (as did payment of wages). Monetary considerations can be added to this story, but they do not add anything to the understanding of what goes on in the financial industry. Money supply and other financial claims are just claims on production, that is, the money supply is a mere medium of exchange. Monetary considerations are irrelevant and “the objectives of agents that determine their actions and plans do not depend on any nominal magnitudes. Agents care only about ‘real’ things, such as goods […] leisure and effort” (Hahn 1982, 34). As such, economic units strive to get involved in the most productive economic activities in order to produce as much as possible in relation to their preferences. Markets are there to help them discover the most productive economic activities in the most efficient way. This way of thinking goes back at least to 19th century Austrian economists such as von Böhm‐Bawerk and Menger. In many current macroeconomic models, this reasoning is simplified even further by getting rid of any market and assuming a farmer who is both a saver and an investor (as well as producer/consumer and employer/employee). He saves potatoes today to plant them. The amount he saves (and so invests) depends on the reward received to be next year. The reward is the marginal product of potatoes.

FINANCE AND THE ECONOMY This understanding of finance is grafted to a specific theory of economic growth. Economic growth is driven by “supply factors”, i.e. the growth rate of inputs: physical capital (“machines”) and labor. Finance helps economic growth because the ability to invest (that is, to grow physical capital: Kt = Kt‐1 + It‐1) depends on the ability to save and the point of finance is to allocate saving—saving drives investment. 149

CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM Going back to the potato economy, in order to have more potatoes next year, one needs to save more today. Say that if one plants a potato at year 0 one gets two potatoes at year 1. To get three potatoes at year 2, one must not consume one and half potatoes at year 1. Of course, saving is painful because one gets fewer potatoes to eat, so saving must be rewarded (one more potato next year). The question becomes: is the reward worth the pain? The graphical way to represent all this is the loanable funds market (Figure 11.1).

Figure 11.1 The loanable funds market

Economic units meet in a market to borrow and lend current output, “potatoes.” The higher the interest rate provided to reward saving, the more saving there is, i.e. the more economic units reduce their current consumption and supply potatoes to economic units who invest. The interest rate needs to rise because each additional unit of saving is increasingly painful. The interest rate is of course a physical reward, a real interest rate, more potatoes in the future. Savers/lenders are not interested in monetary earnings so their credit standards are set in real terms. The opposite goes on with the planters of potatoes/borrowers. The incentive to invest decreases as the reward to pay out increases. The reason for that is found in the production process. As more potatoes are planted, the nutritive quality of a given quantity of soil declines and so each additional potato seed will produce fewer potatoes. As such, investors can afford to pay a smaller reward for each additional potato that is invested. In technical terms, the marginal product of capital falls as more capital is used in the production process given other inputs. The government may come in the market to borrow real resources too: The government's fundamental objective is to borrow a given amount of real resources, not a given amount of money. (Friedman 1952, 690) This leads to the well‐known “crowding out” effect (Figure 11.2). As government enters the loanable funds market, the real interest rate rises and private investment declines. Assume a market without a government that is at equilibrium (Figure 11.1). As the government comes to borrow potatoes (Figure 11.2), it competes with the private sector for the current quantity of saved potatoes. As in any other “well‐behaved” market, a higher demand for something increases the

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CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM price of that thing. This is the market to borrow potatoes, so the real interest rate (i/P) will rise until the market finds a new equilibrium. A higher interest rate reduces the incentive to invest.

ΔI < 0 Figure 11.2 The crowding out effect

CONCLUSIONS In the end, finance is a mere intermediary between savers and investors and what finance does is to help barter intertemporal output. There are several conclusions one can draw from this view: 1‐ The amount of current investment is constrained by the amount of current output that has been saved. To encourage more investment today, one must discourage present consumption (that is, promote saving today), and saving allows the transfer of current output through time: saving is just delayed consumption. 2‐ The whole point of finance is to allocate saving to the most deserving investment projects, which are the ones who are involved in the most productive activities (the investment projects with the highest marginal product). 3‐ Banks are just intermediaries between savers and investors: banks lend unconsumed output on behalf of savers. 4‐ When government deficit spends, it discourages investment and so discourages the growth of the economy. Government should avoid deficit spending. 5‐ While the financial system works with money, money is just a veil, a mere medium of exchange to smooth market mechanisms. What is really going on is the borrowing and lending of current output. Monetary payments generated by financial contracts are irrelevant for the course of the economy because all contracts are real contracts, that is, account for inflation or deflation to maintain purchasing power constant; Valorism prevails (see Chapter 15) 6‐ The economy is always at full employment because saving is just delayed consumption, and firms know this given that there is a market for intertemporal output (financial markets) 151

CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM that signals future consumption. As such, a decline in current consumption does not lead firms to reduce their production. Instead, firms increase their productive capacities to respond to the higher future demand for goods and services induced by the payment of interest income. 7‐ Monetary results are driven by real results: nominal interest rates are driven by the marginal product of capital and expected inflation, economic growth is driven by the growth of inputs In the end, finance and its monetary dealings do not matter. The real exchange economy perspective has changed slightly since the early 1990s. What makes finance matter are market imperfections. Finance can specialize in circumventing imperfections such as asymmetries of information. In that case, finance can be rationed, which prevents the occurrence of the equilibrium that would prevail under a perfectly competitive set up (fewer potatoes are saved and so investment is lower than it would have been otherwise). Asymmetry of information can also reinforce negative shocks on the economy and create financial crises (see Chapter 14).

THE MONETARY PRODUCTION ECONOMY MONEY IS EVERYTHING Some economists argue that capitalism is not merely a barter economy with money. Capitalism is a monetary economy, that is, an economy in which allocation, production, and distribution are influenced by monetary/nominal incentives. While economic units may adjust nominal rewards to account for inflation and taxes, the nominal gains are not driven by underlying physical variables. Instead, it is the other way around, nominal outcomes drive real outcomes. As such, while the REE view sees limited or no role for the inclusion of monetary considerations in its core theoretical framework, Keynes noted that this is at odds with the way capitalism functions: The classical theory supposes that […] only an expectation of more product […] will induce [an entrepreneur] to offer more employment. But in an entrepreneur economy this is a wrong analysis of the nature of business calculation. An entrepreneur is interested, not in the amount of product, but in the amount of money which will fall to his share. He will increase his output if by so doing he expects to increase his money profit, even though this profit represents a smaller quantity of product than before. […] Thus the classical theory fails us at both ends, so to speak, if we try to apply it to an entrepreneur economy. For it is not true that the entrepreneur’s demand for labour depends on the share of the product which will fall to the entrepreneur; and it is not true that the supply of labor depends on the share of the product which will fall to labour. (Keynes 1933c (1979): 82–83) Monetary considerations are crucial at the beginning and at the end of the economic process. Businesses need monetary instruments to start the production process because employees and sellers of raw material demand monetary payments. Businesses judge the relevance of an economic activity—and so employ people in this activity—in relation to its ability to generate a large enough monetary profit. Firms and their employees are not interested in consuming what they produce; they are interested in selling their production for monetary gains. Going back to our potato farmer, 152

CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM his employees do not want to be paid in potatoes and the farmer is not merely interested in producing potatoes. As such, even if an individual is highly motivated and highly experienced in producing potatoes (his marginal product is very high), the individual will not be hired if it is expected that the output he will produce cannot be sold at a high enough price. Indeed, while lowering the price of potatoes may allow to sales more of them, deflation comes with its own problems given the existence of debts that require fixed monetary payments (see Chapter 14). Thus, monetary incentives have a strong influence on the level and organization of production. Veblen made this point that by focusing on the difference between the engineer’s perspective and the businessman’s perspective. From an engineer’s perspective, the goal is to produce as many potatoes as possible to solve a physiological problem (hunger). As such, the goal is to find the most efficient ways to produce an abundance of potatoes. From a businessman’s perspective, the only thing that matters is that a monetary profit be generated. This may entail a sabotage of production (leaving fields idle, letting potatoes rot) in order to maintain an artificial scarcity of potatoes. Indeed, capitalist techniques of production are so productive that letting them loose would drive the price of potatoes to zero. The supply of potatoes must be constrained. In addition, the demand side must constantly be aroused to create new needs and wants because people do not have naturally unlimited preferences. They get contented quickly unless invidious comparisons and consumption habits are constantly stimulated through advertisement and other means. As such scarcity is not a natural state; it is rather a requirement of an economy that is managed by capitalist businesses.2 While abundance is possible, it is not a viable economic state for capitalism.

WHY MONETARY INCENTIVES MATTER? AND WHAT ARE OTHER IMPLICATIONS? Part of the answer is that banks are in the business of dealing with promissory notes that involve monetary payments not in‐kind payments. Another has to do with state’s involvement in the monetization of economies via the imposition of monetary dues.3 If one focuses on the role of banks, the emphasis on monetary incentives is initiated at two stages of credit operations: 1‐ Banks judge ability to pay based on credit standards set in monetary terms (see Chapter 8): a “normal” nominal debt service to monetary income, or “normal” nominal value of collateral relative to bank advances, a “normal” nominal amount of liquid assets. 2‐ Debtors to a bank must make payments in monetary terms; they cannot pay banks with potatoes. Beyond the impact on incentives, bank operations have several important macroeconomic implications: 1‐ Banks are not constrained by the level of current saving to grant credit. As noted in Chapter 10, banks are not in the business of lending anything they own. They do not lend other people’s money, they do not lend reserves, and they do not lend potatoes on behalf of savers; not even “as if.” 2‐ Servicing the debts due to banks does not create an automatic demand for current output: payments to banks destroy monetary gains of non‐banks (see Chapter 10); that is it. Again there are no savers behind banks asking for their potatoes back with interest (in potatoes).

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CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM 3‐ The expected demand for goods and services becomes key to economic activity. Firms employ workers and use existing productive capacities only if they believe they will be able to sell their product to make a high enough monetary gains. 4‐ In this type of economy, purchasing power concerns, even though relevant, are usually outweighed by liquidity and solvency concerns. Economic agents are happier if their buying power increases but, usually, economic agents pay a lot more attention to balance sheet risks: “Liquidity is a fundamental recurring problem whenever people organize most of their income receipt and payment activities on a forward money contractual basis. For real world enterprises and households, the balancing of their checkbook inflows against outflows to maintain liquidity is the most serious economic problem they face everyday of their life.” (Davidson 2002: 78). Say that workers labor for one hour and earn a wage rate of w = $5, and that they have to pay a debt commitment of CC = $2 each month to service their debts, and assume that the general price level is P = $1. The real wage earned by workers is w/P = 5 and the net wage of workers is w – CC = $3. Assume that workers get a raise that doubles their wage so that w = $10, and that the general price level is also doubled P = $2. The real wage is unchanged but the capacity of workers to meet their debt commitments is much improved, w – CC = $8. 5‐ “Neutrality is […] restricted to the realm of ‘helicopter economics’” (Gale 1982: 15). In capitalism, banks do not suddenly allocated bags of money with which individuals do not know what to do; monetary creation by banks is endogenous to the economic process. In addition, bank monetary creation comes with a simultaneous creation of a debt that requires monetary payments (see Chapter 10). These monetary payments force economic units to focus their attention on monetary considerations in their decision‐making process. One can extend that point to monetary creation by the Treasury via fiscal policy. Automatic stabilizers generate an endogenous monetary creation by the state that comes with a simultaneous creation of net financial wealth (see Chapter 13). The state also imposes of tax liabilities that involves future monetary payments (see Chapter 15). 6‐ Eliminating a market surplus by lowering output prices may not be a viable solution. Firms must make sure that they can sell their output at a high enough price to generate a monetary gain that allow them to pay their creditors and to realize a monetary profit. If prices fall too much, a debt‐deflation occurs and market mechanisms promote financial instability (falling prices lead to higher surpluses of output) (see Chapter 14). 7‐ Current saving does not incentivize current investment; saving discourages investment: Firm will not invest if current spending (and so sales) is falling. Saving is not delayed consumption because savers are not paid in kind. This is all the more so given that a fall in sales leads to layoffs and so losses of income by employees. Thus, economic growth is driven by demand conditions because of monetary considerations. As such, expected sales are usually too low to justify employing everybody willing to work, so there is a chronic underemployment of resources. In addition, there is no given state of the economy out there (a “natural” growth rate) that is independent of current demand conditions. If productive capacities become too heavily used, firms invest.

FINANCE AND THE ECONOMY

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CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM The first phase of the economic process is to ask for credit at banks (the financing phase). The role of banks is to judge if the expectations of firms are reasonable (see Chapter 8). Banks provide credit to anybody who shows up and is deemed creditworthy. The standards of creditworthiness accommodate a range of economic units (think economic units with different credit scores). Banks charge more to less creditworthy economic units and ration credit (Figure 11.3).

Figure 11.3 The market for bank credit

Once they have been granted credit, businesses can buy the resources needed to start the production required to meet the expected demand. Will that raise inflation? Chapter 12 notes that if the growth of credit raises the output gap or pushes up the growth rate of unit cost of labor then yes; however, usually the economy operates below full employment and can adjust to an increase in the wage bill and spending. The next step (the funding phase) is to sell what was produced. If expectations are correct or are too pessimistic, then all output is sold; otherwise there are some inventories. Once they have sold their product, firms repay their debts to banks. Once debts and expenses have been paid, firms realize a profit, that is, their net worth rises. If monetary gains are not realized or are too small, a business may ultimately close. Households also save some of the incomes they received, which increases their net worth but reduces firms’ potential profits. Firms may try to capture some of the income saved by households by issuing securities to fund the acquisition of assets and/or to refinance their debts. Thus, saving is the end result of the economic process not the beginning. It matters during the funding phase but not the financing phase. At that time, like at any other time, interest rates are driven by monetary conditions. One of these monetary conditions is the policy rate of the Fed, which has a strong influence on all other nominal rates through cost and portfolio channels (and of course, economic units do care about nominal interest rates because of their impact on liquidity and solvency).4 As such, government deficit and investment may not have much of an impact on interest rates.

BEYOND INCENTIVES: THE ROLE OF MACROECONOMIC FORCES While monetary incentives are central to the dynamics at play in a capitalist economy, the MPE approach also argues that one cannot use microeconomic analysis to draw conclusions about the 155

CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM economy as a whole. By relying on conclusions drawn from studying how economic units make decisions in isolation (microeconomy), one misses the financial interdependences that exist among economic units. When these financial interdependences are taken into account, they lead to counterintuitive conclusions relative to personal experiences. For example, at the individual level, income is independent of spending (a household does not earn more if it shops more); however national income is not independent of spending. The more is spent, the more is earned: GDP = C + I + G + NX. To simplify, the more people shop, the more people are employed and so the greater the number of people who draw an income, and so the higher national income. When someone spends, that creates incomes for others. As such, saving cannot be the beginning of the economic process for an economy. Income allows saving, but, at the macroeconomic level, spending creates income and so spending creates saving. The Kalecki equation of profit more is a neat way to show that for business saving. National accounting identities tell us that gross domestic product can be determined in three ways, two of which are the income approach and the expenditure approach: W + Z + UnD + TU ≡ C + I + G + NX With U gross profit of firms, UnD the disposable net profit of firms (i.e. profit after accounting for business income tax, distribution, and subsidies), W employees’ compensations, Z the gross non‐ wage incomes paid by firms (dividends, interests, rental income), and TU business income tax (tax on profit), C the consumption level, I the level of investment, G the level of government spending, and NX net exports. Accounting for net tax payments induced by taxes and transfer payments in all sectors one gets: WD + ZD + UnD ≡ C + I + DEF + NX With the subscript D indicating disposable income (i.e. after tax and transfer payments), and DEF the government budget deficit (including transfer payments). Subtracting WD + ZD from each side and defining CU as the consumption out of disposable net profit one has: UnD ≡ CU – SH + I + DEF + NX With SH (= SW + SZ = (WD – CW) + (ZD – CZ)) the saving level of households (wage earners and rentiers). Kalecki argues UnD is not under the control of firms, whereas variables on the right side (expenditures) depend on discretionary choices, so the causality runs from spending to profit so: UnD = CU – SH + I + DEF + NX More spending leads to more business saving (profit). Saving is clearly differentiated from investment contrary to the REE approach. Saving is an increase in net worth; it is financial accumulation (see Chapter 1). It is different from physical accumulation, which is investment. In the REE approach saving and investment are the same thing—physical accumulation. For the MPE approach, this is not appropriate because capitalist economies are monetary economies so income is earned in monetary form and saving is done in monetary form. More importantly, at the macroeconomic level, it is not possible to transfer national income through time by saving it. Indeed, given that national income is driven by spending, as thriftiness goes up national income falls. The only way to transfer income through time is by investing it, i.e. by buying goods and services for the purpose of maintaining or increasing productive capacities;

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CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM however, not consuming (saving) depresses investment. If people consume fewer potatoes, there is no incentive to plant the resulting excess inventory of potatoes to produce more potatoes.

CONCLUSIONS Money supply is never neutral in a monetary production economy. The money supply is not only used as a medium of exchange but also as a means of payment, so it must be present at every step of the economic process for that process to work smoothly. Several conclusions can be drawn from this view: 1‐ There is no saving constraint on the economic system. At the macroeconomic level, saving is created by spending. 2‐ The financial system exists to provide financial resources to the most profitable economic activities. These activities may or may not be productive, may or may not be efficient, may or may not be useful; these criteria are not relevant to the decision to provide funds. The financialization of the economy has pushed businesses away from the production of goods and services (see Chapter 8). 3‐ Banks are not intermediaries: they do not lend on behalf of savers. A bank does not lend anything to non‐bank, it is not a potato lender nor a money lender; it is a dealer in promissory notes that require monetary payments (see Chapter 10). 4‐ When government increases deficit spending, it boosts sales and creates more monetary income, which promotes economic activity unless the economy is at full employment (in which case prices go up). There is no crowding out effect from government deficits because finance is not a limited resource (it is not based on saving) and production is demand driven (if government demands more output, more is produced). 5‐ Monetary incentives are crucial because debts owed to banks and government create a need to have reliable streams of future monetary incomes; Nominalism prevails (see Chapter 15). 6‐ The economy is usually below full employment because it usually goes against monetary incentives to be at full employment (it is not profitable, or as profitable, in money terms). Promoting thriftiness discourages economic activity because profit declines as sales decline. A market for intertemporal output does not exist. 7‐ Real results are driven by monetary results: Anything that is monetarily profitable and anyone who meets standards of creditworthiness will be financed. The financing stage allows the creation of output, and the output is used potentially to increase productive capacities during the funding stage. Beyond all these implications, Chapter 13 shows that economic activity requires that at least one economic sector goes into debt for economic activity to proceed.

CONCLUSION The way one should include finance into economic analysis is subject to sharp divisions among economists. These divisions ultimately rest of very different premises used to do economics. This 157

CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM division is old and can be found in debates between Malthus and Ricardo in the early part of the 19th century: “I cannot agree with Adam Smith, or with Mr. Malthus, that it is the nominal value of goods, or their prices only, which enter into the consideration of the merchant” (Ricardo 1820 (1951): 26). These different premises lead to very different policy prescriptions that rest on a very different understanding of how the financial system works with the rest of the economy. Chapters 15 and 16 shows that many of these differences can be boiled down to a different understanding of the nature of monetary instruments: For the REE, monetary instruments are a mere commodity and so demanding money is also demanding output; for MPE, monetary instruments are financial instruments. Summary of Major Points 1‐ The economic profession can be divided according to the premises it uses regarding the role of monetary incentives and monetary outcomes on the direction of economic activity. The real exchange economy view argues that monetary aspects are irrelevant, except for imperfections, and that capitalism can be understood without including monetary aspects. The monetary production economic view argues that monetary aspects are crucial and must be included at the beginning, the middle and the end of the analysis of capitalist economies. 2‐ In the real exchange economy, credit standards are set in real terms, finance is constrained by the amount of output saved, and finance is about moving output through time by incentivizing people not to consume. The economy is a giant market for current and future output and the role of finance is to allocate output between the present and the future. 3‐ In the intertemporal market, if government borrows real resources then it removes access to real resources by the private sector, which crowds out investment. There is a given size of output and any use by one economic unit is at the expense of others. 4‐ Monetary instruments are a mere medium of exchange; they help to make transactions more efficient but they do not alter the structure of transactions, which is determined by relative prices. 5‐ In the monetary production economy, credit standards are set in nominal terms, finance is not constrained by saving of output or by saving by depositors of cash. There is no way to transfer real output by saving it, i.e. by not consuming it. A decline in consumption depresses economic activity so reduces current output and future output. The only way to transfer output through time is by investing, but investment is not constrained by saving and is discouraged by thriftiness. Put differently, the size of the pie is not fixed so more demand leads to more output; and if individuals increase their thriftiness then sales fall and that discourages the expansion of productive capacities. 6‐ Given that monetary aspects are crucial in the monetary production view, the economy is demand‐led not supply‐led. Sales drive production not the other way around, so a decline in sales (higher saving) leads to a decline in production. 7‐ There are two phases of economic activity: the financing phase and the funding phase. The former involves the financial sector in the production of output; the latter involves the financial sector in the acquisition of output. Saving is created by income and income is financed by credit; therefore, saving cannot exist before credit. Saving may have a role to play in the second phase by reducing the demand for current output and by providing additional financial funds to acquire long‐ term assets. 7‐ This difference of opinion about how do to do economics is old and involves very different paradigms.

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Keywords Crowding out effect, intertemporal output, saving, investment, credit standards, demand‐led, supply‐led, financing phase, funding phase Review Questions Q1: What is the crowding out effect and how does it work? Q2: What are the arguments against the crowding out effect, both in terms of resources as well as finance? Q3: Why does saving not lead to a decline in economic activity in the real exchange economy? Why does it do so in the monetary production economy? Q4: What is the financing phase? How is finance involved in that phase? What about the funding phase? Q5: Does investment create saving or does saving create investment? Q6: Is saving needed for banking or is it not? Q7: Is economic activity demand driven or supply driven? How is that related to the views regarding the role of finance in the economy? Q8: According to John Maynard Keynes: “Dishoarding and credit expansion provides not an alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of increased saving.” Explain that sentence by using the monetary production economy view. Q9: In order to promote economic growth, should policymakers promote saving or should they promote spending? Q10: If economic units suddenly increase their willingness to hoard monetary instrument, will that lower economic activity? Why? Why not? Suggested readings Chapter 1 of Capitalism and Freedom by Milton Friedman is a very clear and concise presentation of the real exchange economy framework. Dudley, D. (1980) “A Monetary Theory of Production: Keynes and the Institutionalists,” Journal of Economic Issues 14 (2): 255‐273. Dugger, W.M. and Peach, J.T. (2008) Economic Abundance: An Introduction, Armonk: M.E. Sharpe. Keynes, J.M. (1933) “The characteristics of an entrepreneur economy,” reprinted in D.E. Moggridge (ed.) (1979) The Collected Writings of John Maynard Keynes, vol. 29, 87‐101, London: Macmillan. 1 See Gertler, M. (1988) “Financial structure and aggregate economic activity: An overview,” Journal of Money, Credit and

Banking, 20 (3), Part 2: 559‐588. 2 See Galbraith’s Affluent Society, especially Chapters 10, 11 and 13. 3 Forstater, M. (2005) “Taxation and Primitive Accumulation: The Case of Colonial Africa.” In The Capitalist State and Its

Economy: Democracy in Socialism, Research in Political Economy, Volume 22, 51‐65. 4 Tymoigne, E. (2006) “Fisher's Theory of Interest Rates and the Notion of 'Real': A Critique,” Levy Economics Institute, Working Paper No. 456 http://www.levyinstitute.org/publications/fisher‐theory‐of‐interest‐rates‐and‐the‐notion‐of‐real

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CHAPTER 12: After reading this Chapter you should be able to understand: How economists are divided about what causes inflation Why inflation occurs according to different approaches What the policy implications are of the different views of inflation

CHAPTER 12: INFLATION When inflation is mentioned, it is usually in relation to the cost of buying newly produced goods and services for consumption purposes. Another type of inflation concerns asset prices, i.e. the price of non‐producible commodities and old producible commodities. This Chapter does not study asset‐price inflation, which concerns theories of interest rate. There are two broad ways to categorize existing explanations of inflation (and deflation); monetary explanations and real explanations (“real” means related to production). Below are two popular theories based on such a categorization.

THE QUANTITY THEORY OF MONEY: MONETARY VIEW OF INFLATION The quantity theory of money (QTM) is a logical extension of the real exchange economy framework presented in chapter 12. It starts with the identity MV ≡ PQ with M the money supply, V the velocity of money (the speed at which the money supply circulates to complete all necessary transactions), P the price level, and Q the quantity of output. The identity is a tautology; it just says that the monetary value of transactions on goods and services (PQ) is equal the monetary value of financial transactions needed to complete the transactions on goods and services. To get a theory of output price (the QTM), one must make some assumptions about each variable and make a causal argument. The QTM assumes that: ‐

H1: M is constant (or grows at a constant rate) and is controlled by the central bank through a money multiplier (see Chapter 10).

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H2: V is constant (habits of payments are stable).

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H3: Q is constant at its full employment level (Qfe) or grows at its constant “natural” rate (gQfe). Supply conditions (productive capacities) are supposed to be independent of the demand conditions (spending on goods and services).

Given this set of hypotheses we have: P = MV/Qfe Or, in terms of growth rates (V is constant so its growth rate is zero): gP = gM – gQfe If the money supply grows faster than the natural rate of economic growth, there is some inflation (gP > 0). If gM = 2% and gQfe = 1% then gP = 1%. If the central bank increases the growth rate of the money supply, inflation rises by the same percentage points while the growth rate of production is unchanged. Inflation has monetary origins. The economic logic is the following in terms of price level. First, suppose some money falls into the hands of economic units. How? Milton Friedman is famous for arguing that economists do not need to care about how the money supply enters the economy; one can merely assume that it falls from a helicopter. Following H1, one may say that the central bank injects reserves, which leads to a large increase in the amount of bank credit. So now economic units have additional monetary instruments. They could save them but H2 implies that economic units have hoarded everything they wanted to hoard so economic units rush to stores to spend. Given that the economy is at full employment, the only way the economic system 161

CHAPTER 12: INFLATION can adjust to the large increase in the demand for goods and services is through an increase in prices. Money is “neutral,” it does not impact production. The main policy implication is that central banks are best suited to tackle inflationary problems, while productive issues are best left to relative price adjustments via market mechanisms. The central bank can manage output prices by targeting the quantity (growth rate) of reserves and by setting the reserve requirement ratio. This will constrain the quantity (growth rate) of the money supply and set a specific price level (inflation). Controlling inflation is an easy job; a central bank just needs to decide what its inflation target is (gPT) and to determine what the natural growth rate of the economy is (gQfe). If, for example, a central bank has an inflation target of gPT = 2% and the natural growth rate of the economy is gQfe = 3%, the growth rate of the money supply should be gM = 5%. Assuming a stable multiplier, this means that the growth rate of reserves should be 5%. This argument has been extended to a central bank that targets an interest rate. Most central bankers now recognize that monetary stimulus is not neutral in the short‐term, hence the ability to fine‐tune the economy—that is, to make sure the economy is neither too hot (rising inflation) nor too cold (rising unemployment)— through an interest‐rate policy. However, in the medium to long‐ run, the neutrality of money is argued to prevail, hence the importance of inflation targeting. Central bankers can use that to guide their short‐run policy. Central banks should determine a reference value for the growth of money supply (gM*). This value should be consistent with the inflation target (gPT), the prevailing natural growth rate, and the existing trend of velocity (gV): gM* = gPT + gQfe – gV If gM > gM*, a central bank is too lax (i.e., its interest rate target should be higher) and inflation will be above target in the medium term. There are several issues with that approach that relate to the hypotheses made to reach the conclusion, and to the causality at play: ‐

The money supply is not controlled in any way by the central bank. Not only does the money multiplier theory not apply, but also the growth of the money supply is driven primarily by the demand for bank credit by private economic units (banks cannot force feed credit to economic units) and by government spending and taxing (see Chapter 10 and Chapter 6).

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Interest‐rate targeting has only a remote and uncertain effect on the growth of the money supply, even more so on inflation (see Q.10 in Chapter 5).

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The economy is rarely at full employment so if the demand for goods and services increases the supply of goods and services increases.

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Measuring the natural growth rate of the economy is actually difficult. More importantly, the demand for goods and services and the supply of goods and services are not independent factors. Demand matters even in the “long run.” 1 Greenspan put it nicely during an FOMC meeting: Let me just say very simply – this is really a repetition of what I’ve been saying in the past – that we have all been brought up to a greater or lesser extent on the presumption that the supply side is a very stable force. […] In my judgment our models fail to account appropriately for the interaction between the supply side and the demand side largely because

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CHAPTER 12: INFLATION historically it has not been necessary for them to do so. (Greenspan, FOMC meeting, October 1999, pages 46–47) ‐

In terms of basic empirical evidence, the strong correlation between money supply and price that one should expect were this theory to be correct does not exist, even in the long‐ run (Figures 11.1 and 11.2). While correlation improves as the length of time increases (one‐year correlation is 0.55, five‐year correlation is 0.67, ten‐year correlation is 0.71), the correlation is weaker than what the theory suggests.

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The fact that inflation and money supply growth are positively correlated does not tell us the direction of causality. One may doubt that the causality goes from M to P given the strong assumptions required for that to be the case. The next section will develop this point.

Figure 12.1 Annual growth rate of CPI and of the money supply, percent Sources: Bureau of Labor Statistics, Board of Governors of the Federal Reserve System.

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Figure 12.2 Five‐year growth rate of CPI and of the money supply, percent Sources: Bureau of Labor Statistics, Board of Governors of the Federal Reserve System

INCOME DISTRIBUTION AND INFLATION: A NON‐MONETARY VIEW OF INFLATION Another theory of the price level starts with an identity grounded in macroeconomic accounting: PQ ≡ W + U This is the income approach to GDP. It says that nominal GDP (PQ) is the sum of all incomes. For simplicity, there are only two incomes: wage bill (W) and gross profit (U). All of them are measured before tax. Divide by Q on each side: P ≡ W/Q + U/Q W is equal to the product of the average nominal wage rate (w) and the number of hours of labor (L): W = wL (for example, if w is $5 per hour and L is equal to 10 hours, then W is equal to $50). Thus: P ≡ wL/Q + U/Q Q/L is the quantity of output per labor hour, the average productivity of labor (APL): P ≡ w/APL + U/Q w/APL is the unit cost of labor. U/Q is a macroeconomic mark‐up over the labor cost. To get to a theory, the following assumptions are made: ‐

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H1: the economy is usually not at full employment and Q (and economic growth) changes with expected aggregate demand (this is Keynes’s theory of effective demand).

CHAPTER 12: INFLATION ‐

H2: w is set in a bargaining process that depends on the relative power of wage‐earners (the conflict claim theory of distribution underlies this hypothesis)

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H3: U, the nominal level of aggregate profit, depends on aggregate demand (Kalecki’s theory of profit underlies this hypothesis, see below)

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H4: APL moves with the needs of the economy and the state of the economy; it is procyclical to the state of aggregate demand for goods and services.2 In general, in periods of labor‐ time scarcity gAPL goes up while, during an economic slowdown, gAPL goes down before employees are laid off.

Thus: P = w/APL + U/Q The price level changes with changes in the unit cost of labor and the size of the macroeconomic mark up. In terms of rates of growth: gp ≈ (gw – gAPL)sW + (gU – gQ)sU With sW and sU the shares of wages and profit in national income (sW + sU = 1). Thus, inflation has two sources: ‐

Cost‐push inflation: the growth rate of the unit labor cost of labor (gw – gAPL) depends on how fast nominal wage grows on average relative to the growth rate of the average productivity of labor. The correlation between the unit cost of labor and inflation is very strong both in the “short‐run” (0.82 for yearly growth rates) and “long‐run” (0.93 for five‐ year growth rates) (Figure 12.3).

‐

Demand‐pull inflation: U follows Kalecki’s equation of profit which states that the level of profit in the economy is a function of aggregate demand (see Chapter 11). Thus, the term, gU – gQ represents the pressures of aggregate demand on the economy; it is an output gap. If gU (the growth of aggregate demand) goes up and gQ (the growth of aggregate supply) is unchanged, then gP rises given everything else. However, to assume that gQ is constant is not acceptable unless the economy is at full employment. Usually, a positive shock on aggregate demand growth leads to a positive increase in aggregate supply growth because the rate of utilization of productive capacities is below one (that is, less than 100%) even in “the long run.”

Note that the money supply is absent from this equation. The money supply does not directly affect output prices. Spending may impact inflation but it depends on the state of the economy. One may note that the growth rate of wages is by itself not as relevant. It is its relation to the growth rate of the average productivity of labor that matters. Time‐series data provides another insight into the role of the unit cost of labor (Figure 12.4). From the mid‐1960s to the early 1980s, unit cost of labor was a main source of high inflation. Nominal wage growth outpaced productivity growth; both grew on average. The former was in the 5‐10% range whereas the latter was mostly in the 0‐ 5% range. In the late 1960s, wage growth outpaced productivity growth because of workers’ strength in wage bargaining due to low unemployment and strong unions. The 1970s oil shocks boosted inflation and workers tried to maintain their real wage (they failed) by demanding an increase in nominal wages. This further reinforced inflation because productivity could not keep up with wage demands. The internationalization of production processes and the decline in the power

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CHAPTER 12: INFLATION of unions have tamed the ability of wages to outpace productivity, even in periods of prolonged economic growth.

Figure 12.3 Annual growth rate of unit cost of labor and growth rate of PCE, percent Sources: Bureau of Economic Analysis, Board of Governors of the Federal Reserve System

Figure 12.4. Unit cost of labor growth rate and PCE inflation, percent Sources: Bureau of Economic Analysis, Bureau of Labor Statistics

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CHAPTER 12: INFLATION When combined with the explanation of monetary creation presented in Chapter 10, this theory of inflation provides an explanation of the correlation between price and money supply that involves a reversed causality compared to the QTM. Higher costs of production and higher demand pressures push up the price of goods and services, which increases the size of the bank advances that economic units request: higher P (gP) leads to higher M (gM). A broader point is that the growth of the money supply is not by itself inflationary because money supply grows with the needs of the economic system; economic units are not suddenly allocated bags of money supply with which they do not know what to do: ‐

Firms request bank credit to start production (pay workers, buy raw material) and repay their bank debts (which destroys money supply) once production is sold: money supply moves in part with the need of the productive system

‐

Federal government spending (that injects money supply) and taxing (that destroys money supply) move automatically in a countercyclical fashion to tame inflationary pressures (“automatic stabilizers”): during an expansion (a recession), the growth rate of government spending falls (rises) and the growth rate of taxes rise (falls). In the US, most of the automatic stabilizer effect comes from wild fluctuations in the growth rate of taxes (in a recession economic units have less income so they are taxed less) (Figure 12.5).

So the money supply is not something that falls from the sky, its injection and destruction in relation to the production process must be explained and the debts incurred by monetary creation must be included in the analysis (See Chapter 10). If the economy is growing, money supply grows, if economic units do not want to hold monetary instruments they may just use them to accelerate the repayment of their bank debts.

Figure 12.5 Automatic stabilizers. Source: Bureau of Economic Analysis.

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CHAPTER 12: INFLATION In terms of policy, the theory means that inflation is managed best by buffer‐stock policies and income policies, or a combination of both such as a job‐guarantee program.3 Monetary policy does not have much of a direct impact on inflation, and an increase in interest rates can contribute to inflation through the cost and demand impacts of higher interest rates (see below and Chapter 5). The role of a central bank is to preserve financial stability through the provision of a stable low cost refinancing source and through regulation.

TO GO FURTHER: KALECKI EQUATION OF PROFIT, INTEREST RATE AND INFLATION For readers who want to know more, this section develops a few points. The income‐approach to GDP can be developed further to account for rentiers’ income, which, to simplify, only comes from the distribution of profit. Gross profit is the sum of net profit, non‐wage income distribution, and taxes on profit: PQ ≡ W + U ≡ W + Z + UnD + TU  P ≡ w/APL + Z/Q + UnD/Q + TU/Q With U gross profit of firms, UnD the disposable net profit of firms (i.e. profit after accounting for business income tax, distribution, and subsidies), W employees’ compensations, Z the gross non‐ wage incomes paid by firms (dividends, interests, rental income), and TU business income tax (tax on profit). For small values of gQ and gAPL, we have: gP ≈ (gw – gAPL)sW + (gZ – gQ)sZ + (gUnD – gQ)sUnD + (gTu – gQ)sTu The assumptions are that gw results from a bargaining process between employees and firms. gZ depends on monetary policy and the state of liquidity preference (Z depends on the level and structure of interest rates). gAPL is procyclical to the state of the economy. gQ is determined by expectations of monetary profits (Keynes’s effective demand). As shown below, gUnD is determined by the Kalecki equation of monetary profit. Finally, the growth of profit taxes depends on the tax structure and economic activity. For the sake of the argument, one can assume that national income shares are constant and sum to one (sW + sZ + sUnD + sTu = 1). Inflation can go up and down as gUnD, gw, gZ and gTu go up and down, but their effects will be mitigated by changes in productivity growth and output growth. Only when the latter two are fixed or sluggish relative to the former four can inflation permanently take place; this is a state of “true inflation” to use Keynes’s terminology. One economic condition during which this can occur is full employment, but this is not the only one. Prices may go up quickly because of, for example, an uncontrolled wage‐price spiral induced by high expectation of inflation, competition between unions for relative wage improvements, or a rise in costs not controlled by residents (e.g., an oil shock for net oil‐importing countries). Rising interest rates also can promote inflation by raising costs of production (Chapter 5 noted that FOMC members are aware of this inflationary channel). This explanation of inflation does not discard the possibility of a monetary source of inflation, but it requires that several conditions be met because the relation between money supply and inflation is highly indirect. First, if funds are injected via portfolio transactions (swapping of non‐monetary assets for monetary assets), output‐price inflation may occur only if desired stocks of monetary assets are fulfilled, if receivers of monetary assets decide to spend their excess funds on existing goods and services, and if the economy is in a sluggish state. Economic units may want to hoard more, may use excess funds to buy financial assets (which would lower interest rates) and/or to 168

CHAPTER 12: INFLATION repay their bank debts (which would lower the money supply), and the economy usually is able to increase production when demand increases. Second, if funds are injected into the private domestic sector via income transactions (e.g., wage payments), inflation will occur only if the economy is slow to respond (so that UnD/Q increases). The Kalecki equation of profit expresses this more formally. Chapter 11 showed that UnD = CU – SH + I + DEF + NX Thus: gUnD = (gCusCu – gShsSh + gIsI + gGsG – gTsT + gXsX – gJsJ)/sTu Where si is the share of variable i in national income (or GDP) which is assumed to be constant. As the economy gets to full employment, any type of spending (public or private, consumption or investment) will tend to be inflationary. Higher interest rates can contribute to demand‐pull inflation if the growth of consumption by rentiers increases too fast as a result of higher interest income.4 The inflationary tendencies can be mitigated by the growth rate of tax, the growth rate of production, the growth rate of the average productivity of labor and the growth rate of saving. Summary of Major Points 1‐ The quantity theory of money asserts that inflation has monetary origins. The money supply grows too fast relative to the productive capacities of the economy. 2‐ According to the QTM, the main role of a central bank is to keep inflation under control either by targeting monetary aggregates through a money multiplier process (reserve targeting) or through variations in the cost of reserves (FFR targeting). Modern proponents of that view work the argument through a FFR‐targeting view. 3‐ According to some economists, the QTM makes some extreme hypotheses and has an inaccurate understanding of the monetary creation process. The economy is usually not at full employment and productive capacities are driven by demand conditions. The money supply is created and destroyed according to the needs of the economic system. It is not something that suddenly drops from the sky—and exogenously determined occurrence—that the system must find a way to assimilate. 4‐ Some economists view the root of inflation in the conflict over the distribution of income. This creates cost‐push and demand‐pull sources of inflation. As such, raising interest rates may be inflationary. 5‐ According to that approach, the job of a central bank is to promote financial stability. Other tools must be used to deal with inflation that have more fiscal aspects. Keywords Natural growth rate, velocity of money, unit labor cost, output gap, money multiplier, Kalecki equation of profit, inflation, income distribution

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Review Questions Q1: In the QTM, if the level of money supply suddenly rises what happens to the price level? What is the economic logic behind that result? What if it is the growth rate of the money supply that rise? Q2: If the central bank increases the growth rate of reserve what happens according to the quantity theory of money? Q3: What are the empirical and theoretical problems with the notion of natural growth rate? Q4: What is the view of monetary creation underlying the quantity theory of money and how is that at odd with the way money supply is actually injected in the economic system? Q5: If wage rate grows faster than the unit cost of labor, what happens to inflation? What is the economic logic behind that result? Q6: If aggregate demand growth faster than aggregate supply, what are the means for the economic system to adjust in the quantity theory and in the distribution theory? Q7: Rising interest rates can be inflationary according to the distribution theory; why? Suggested readings Friedman, M. (1987) “The quantity theory of money,” in Eatwell, J., Milgate, M. and Newman, P (eds) The New Palgrave: A Dictionary of Economics,. New York: Palgrave Macmillan. Kalecki, M. (1971) “The determinants of profits,” in M. Kalecki (ed.) Selected Essays on the Dynamics of the Capitalist Economy, 78–92, Cambridge: Cambridge University Press. Lavoie, M. (2014) “Inflation theory,” chapter 8 Post‐Keynesian Economics: New Foundations. Northampton: Edward Elgar Rowthorn, R. (1977) “Conflict, inflation and money” Cambridge Journal of Economics 1 (3): 215‐ 239. 1 See Chapter 6 of Marc Lavoie’s Post‐Keynesian Economics: New Foundations for a formal overview of the literature. 2

See Matias Vernango’s “Is labor productivity still pro‐cyclical? Okun's Law is still fine” at http://nakedkeynesianism.blogspot.com/2015/03/is‐labor‐productivity‐still‐pro.html 3 See Bill Mitchell’s “What is a Job Guarantee?” at http://bilbo.economicoutlook.net/blog/?p=23719 4 See Scott Fullwiler’s “Functional Finance and the Debt Ratio—Part IV” at http://neweconomicperspectives.org/2013/01/functional‐finance‐and‐the‐debt‐ratio‐part‐iv.html

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After reading this Chapter you should be able to understand: What balance sheet interrelations are What the basic principles of national accounting are Why not all sectors of the economy can be in surplus at the same time Why a government deficit is sustainable as long as monetary sovereignty prevails and other sectors want to net save Why taking proactive actions to reduce the public debt is unnecessary and counterproductive How business cycles can be explained partially by looking at balance‐sheet interrelations

CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY Earlier Chapters have focused on the mechanics of a specific balance sheet, specifically that of the central bank and of private banks. This Chapter looks at the balance‐sheet interrelations between the three main macroeconomic sectors of an economy: the domestic private sector, the government sector and the foreign sector. This macro view provides some important insights about issues such as the public debt and deficit, policy goals that are more likely than others to be achieved, the business cycle, among others.

A PRIMER ON CONSOLIDATION The balance sheet of the domestic private sector puts together the balance sheets of all domestic private economic units. This means that claims that these sectors have on each other are removed (that is, cancel each other out) from the balance sheet of the domestic private sector. For example, assume that the following two balance sheets exist Households Assets Bank accounts Foreign currency held by households Real assets of households

Liabilities and Capital Mortgages Net worth of households Banks

Assets Mortgages Treasuries held by banks Real assets of banks

Liabilities and Capital Bank accounts TT&Ls Net worth of banks

If they are consolidated we have as a first step: Households + Banks Assets Bank accounts Foreign currency held by households Real assets of households Mortgages Treasuries held by banks Real assets of banks

Liabilities and Capital Mortgages Net worth of households Bank accounts TT&Ls Net worth of banks

The terms in bold appear on both sides of the balance sheet and are eliminated in the consolidation process so the balance sheet of households and banks is: Households + Banks Assets Foreign currency held by households Treasuries held by banks Real assets of households and banks

Liabilities and Capital TT&Ls Net worth of households and banks

The only financial claims left are those issued to, and issued by, sectors of the economy other than households and banks. Thus, the consolidation process eliminates some important financial 172

CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY interlinkages. This is fine as long as one is merely interested in looking at relationship between sectors, but one should be mindful that this is a simplified picture that hides some important aspects of the economy.

THE THREE SECTORS OF THE ECONOMY The analysis of financial interlinkages among the three main sectors can be done by starting from the National Income and Product Accounts (NIPA), but the derivation from the Financial Accounts of the United States is more intuitive (the derivation from NIPA is done at the end of this Chapter). The following is a quick refresher from Chapter 1. A balance sheet is an accounting document that records what an economic unit owns (assets) and owes (liabilities) (Figure 13.1).

Assets Financial Assets (FA) Real Assets (RA)

Liabilities and Net Worth Financial Liabilities (FL) Net Worth (NW)

Figure 13.1 A basic balance sheet.

Financial assets are claims issued by other economic units and real assets are things that have been produced. Financial liabilities are claims issued to other economic units. A balance sheet must balance, that is, the following equality must hold all the time: FA + RA ≡ FL + NW. Or put diﬀerently: NW ≡ NFW + RA This means that the wealth of any economic sector comes from two sources, net financial wealth (NFW = FA – FL) and real wealth (RA). Each macroeconomic sector has a balance sheet (Figure 13.2). DP is the domestic private sector, G is the government sector, F is the foreign sector also called the “rest of the world.” The government sector includes all the levels of domestic government (local, state, federal) and the central bank. While the Financial Accounts of the United States include the balance sheet of the central bank in the domestic financial sector—the domestic financial sector includes domestic financial businesses and monetary authority—, it is more relevant to include the central bank in the government sector (see Chapter 6). The domestic private sector includes domestic households, domestic non‐profit organizations, domestic financial businesses, domestic non‐financial businesses, and domestic farms. The foreign sector includes anything else (foreign governments, foreign businesses, foreign households, etc.). Note that the adjective “domestic” is always used for the reference country that is studied. “Foreign” includes all other countries.

ADP

LDP

FADP

FLDP

RADP

NWDP

AG

LG

FAG

FLG

RAG

NWG

AF

LF

FAF

FLF

RAF

NWF

Figure 13.2 Balance sheets of macroeconomic sectors

For every creditor there is a debtor, so if one adds together the claims of the creditors and the debtors they must cancel out. For the world economy (all sectors consolidated together): (FADP – FLDP) + (FAG – FLG) + (FAF – FLF) ≡ 0 173

CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY This implies that the sum of all net worth equals the sum of all real assets, that is, only real assets are a source of wealth for the world economy (NW = RA): (NWDP – RADP) + (NWG – RAG) + (NWF – RAF) ≡ 0 For a domestic economy (government and domestic private sectors are consolidated), there are two sources of wealth: real wealth and net financial wealth obtained from the foreign sector. The public debt is not a source of financial wealth (or poverty) for the domestic economy because it is an asset for the domestic private sector but a debt of the domestic government. The domestic money supply is not a source of financial wealth for the domestic economy because it is an asset of a domestic holder and a liability of a domestic issuer. Given that the previous identities hold in terms of levels at any point in time (aka “stocks”), they also hold in terms of changes in levels over a period of time (aka “flows”): Δ(FADP – FLDP) + Δ(FAG – FLG) + Δ(FAF – FLF) ≡ 0 And, knowing that the Financial Accounts defines saving as a change in net worth (S = ΔNW) and investment as a change in real assets (I = ΔRA), it is also true that: (SDP – IDP) + (SG – IG) + (SF – IF) ≡ 0 This last identity is similar to the NIPA identity (S – I) + (T – G) + CABF ≡ 0 (see below for some differences). (S – I) and Δ(FA – FL) are both officially called “net lending”, one measured from the capital account, (S – I), and the other measured from the financial accounts, Δ(FA – FL). A few words on the way all this is sometimes presented by economists. Beware that economists may change the name of these two items. (S – I) may be called “net saving” (which is different from how the Financial Accounts define net saving) or “surplus” (if S > I) and “deficit” (if S < I), and Δ(FA – FL) may be called “net financial accumulation” (NFA). Thus, we have: NFADP + NFAG + NFAF ≡ 0 If an economic sector accumulates more claims on other sectors than the other sectors accumulate claims on the economic sector in question, the economic sector records a positive net financial accumulation, it is a net creditor (aka “net lender”) during the period—Δ(FA – FL) > 0. If the opposite is true, the sector is a net debtor (aka “net borrower”) during the period. Finally, this identity is sometimes rewritten as: DPB + GB + FB ≡ 0 With DPB the domestic private balance, FB the foreign balance (the opposite of the domestic current account balance), GB the government balance, and “balance” being measured either through the capital accounts (net saving) or through the financial accounts (net financial accumulation). Finally one may note that given that NW – RA ≡ FA – FL, then: (S – I) ≡ Δ(FA – FL) The operations on goods and services are mirrored by financial operations. Thus, a deficit, or net dissaving, is mirrored by a net financial disaccumulation; to spend more than what is earned one must sell assets or go into debt. Similarly, a surplus, or net saving, is mirrored by a net financial accumulation for the sector.

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CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY No theory, behavioral equations and statements of causal relations, was used above to explain the accounting identities (a bit of this is done below to examine the business cycle). The identities simply state that a net injection of funds by a sector must be accumulated in another sector. Every dollar must come from somewhere and must go somewhere.

SOME IMPORTANT IMPLICATIONS They are many implications but the main one is that one must not study a sector in isolation. Anything that a sector does has an impact on other sectors. When a forecast about the budgetary trend of the government is made, the forecaster must recognize the implications for other sectors to see if the forecast is realistic. This is usually not done. For example, the Congressional Budget Office in the early 2000s expected the federal government’s surplus to continue to grow but neglected to look at the implication in terms of the domestic private sector.1 A continuously rising government surplus implies continuously rising domestic private deficit given the foreign balance, which is not sustainable. Only the federal government of a monetarily sovereign government can sustain permanent deficits (see Chapter 6). There are many other implications and uses of this framework such as macroeconomic theory, the madness of fiscal austerity, among others. 2

POINT 1: THE BEGINNING OF THE ECONOMIC PROCESS REQUIRES THAT SOMEONE GOES INTO DEBT. Let us start with an economy in which nothing has been produced or acquired yet. ADP FADP = 0 RADP = 0

LDP AG LG FLDP = 0 FAG = 0 FLG = 0 NWDP = 0 RAG = 0 NWG = 0

AF LF FAF = 0 FLF = 0 RAF = 0 NWF = 0

Say that someone in the economy wants to build a house that costs $10 to build. In order for domestic production to start, workers must be paid, raw material must be purchased (those had to be produced first by the way). If a private business is in charge of doing all this, it must obtain funds and Chapter 10 explains how this is done. The balance sheet of the domestic private sector would look like this once the house is built: ADP RADP = 10

LDP NWDP = 10

Consolidation eliminates the debt owed by the homebuilder to a bank, as well as wages and raw material payments, because they are all internal to the sector. Once produced, if the house is acquired by a domestic household for $11, the following is recorded at the macro level: ADP RADP = 11

LDP NWDP = 11

Again all this hides quite a few underlying financial transactions: 1‐ Households got a mortgage and paid the homebuilder who made a $1 profit

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CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY 2‐ Firm repaid its $10 debt with interest 3‐ House was transferred from firms’ balance sheet to household’s balance sheet. The next period the process would start all over again. This time the firm may have some savings from the previous period to finance part of the production. If, instead, the government buys the house, it must first fund the purchase by using a promissory note (FLG): ADP FADP = 11

LDP NWDP = 11

AG RAG = 11

LG FLG = 11

Spending by the government has allowed the domestic private sector to acquire a financial claim. It is a claim on the government. If a foreign economic unit buys the house and the housebuilder requires payment in US dollars, there are several ways the payment can be done but all of them involve the foreign sector going into debt in dollars. For example: ‐

The foreigner may ask for a bank advance in US dollars at a domestic bank

‐

The foreigner may write a check in a foreign currency (say euros) but when the domestic bank of the housebuilder receives the check, it will send the check back to the foreign bank of the buyer to request a dollar payment. The foreign bank will need to borrow US dollars to settle its debt with the domestic bank.

Once the house is sold, the firm makes a $1 profit that it uses to pay interest, dividend and taxes. What is left over is retained earnings, the saving of the firm. Households will also save some funds. But none of that can occur unless someone goes into debt to start production. And for savings to be bigger, debt must increase.

POINT 2: NOT ALL SECTORS CAN RECORD A SURPLUS AT THE SAME TIME It is quite straightforward to notice that not all sectors can be net creditors at the same time. At least one sector must be a net debtor if another sector is a net creditor because for every creditor there must be a debtor. Most of the time, the domestic private sector is in surplus and the government sector is in deficit (Figure 13.3, Figures 13.4). From 2000 to 2010, New Zealand was a particularly odd case where the private sector was in deficit while government and foreign sectors were in surplus. To simplify, let us assume that NFAF = 0, therefore: NFADP ≡ ‐ NFAG That is, in a closed economy, for the private domestic sector (households and private companies) to be able to record a surplus (NFADP > 0), the government must run a fiscal deficit (NFAG < 0). Put differently, when the government spends, it injects funds into the economy, and when it taxes it withdraws funds from the economy (see Chapter 6). If the government spends more than what it taxes, there is a net injection of funds by the government in the economy and this net injection must be accumulated somewhere. In the simple case, it is the private domestic sector that must accumulate the funds injected. 176

CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY Of course, the reverse logic applies too. When the private sector deficit spends, it injects a net quantity of funds into the economy that can only go to the government. This allows the government to run a surplus. A powerful consequence of this simple accounting rule is that a policy that aims at achieving a government surplus implies, in a closed economy, that this policy aims at achieving a domestic private sector deficit. One way to avoid this is to try to achieve a domestic current account surplus, in which case, a country can achieve domestic surpluses across the board—let us call that the “golden state.” The green area on Figure 13.4b shows how small the golden state is relative to all other possibilities. Among OECD countries, it has been achieved mainly by northern European countries during the first decade of the new millennium (Figures 13.4b and Figure 13.4c). The Great Recession has led most government to deficit spend and only Norway has been able to maintain the golden state (Figure 13.4d). This state is difficult to achieve because a domestic current account surplus means that the foreign sector records a current account deficit (FB < 0). Again, not all sectors can be in surplus at the same time because for every net exporter (and/or net foreign income earner) there must be at least one net importer (and/or at least one net foreign income payer). Thus, for a domestic economy to achieve the golden state on a regular basis, there must be at least one foreign country that is willing to deficit spend vis‐à‐vis the domestic economy. This is hardly possible to sustain given that countries strive to reach current account surplus most of the time. More importantly, the golden state is not achievable at the world level. If all economies try to achieve a current account surplus, the best they can achieve is a balanced current account (FB = 0), which brings us back to the identity: NFADP ≡ ‐ NFAG Ultimately policy makers should confine themselves to trying to manage what goes on in their domestic economy. If a country is lucky, developments in the rest of the world may ultimately allow that country to reach the golden state; but basing policy choices on the goal of reaching the golden state is a very long shot. In addition, policies that aim at achieving the golden state limit the ability of domestic sectors to deficit spend, which constrains the ability of the domestic economy to grow. Indeed, the goal becomes to constraint domestic spending by curtailing wage growth, by curtailing government spending and by raising taxes. This keeps costs down (and so keeps the price of exports low to attract foreign buyers) and limits imports (a growing domestic spending usually requires more imports and so makes it difficult to reach a domestic current account surplus).

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Figure 13.3 Net financial accumulation in the United States, percent of GDP. Source: Board of Governors of the Federal Reserve System (Series Z.1)

Figure 13.4a Sectoral balances, an international perspective, 1995‐2000 average, Percent of GDP Source: OECD

178


Figure 13.4b 2000‐2005 average Source: OECD

Figure 13.4c 2005‐2010 averages.

179


Figures 13.4d 2010‐2014 averages Note: 2010‐1015 average for Italy, Norway, Sweden and the UK

POINT 3: PUBLIC DEBT AND DOMESTIC PRIVATE NET WEALTH The public debt of the United States is the face value of outstanding U.S. Treasury securities. It includes both marketable (T‐bills, T‐notes, T‐bonds, TIPSs, and a few others) and non‐marketable securities (United States notes, gold certificates, silver certificates, U.S. savings bonds, Treasury demand deposits issued to States and Local Gov., all sorts of government account series securities held by Deposit Funds). In the early 2000s, the expectation of the day was that fiscal surpluses would continue to go on and rise even more.3 Figure 13.5 shows the projected path of the public debt and the monetary base. What are the implications of such a trend of the public debt? To simplify the analysis, assume that: 1‐ the government sector only includes the federal Treasury and the central bank 2‐ at the moment the only liability of the government is Treasuries (no central bank liability is outstanding) 3‐ a closed economy (no foreign sector) 4‐ the following balance sheets prevail: ADP FADP (Treasuries): $100 RADP: $350

LDP FLDP (tax receivables): $50 NWDP: $400

AG FAG (tax receivables): $50 RAG: $1150

LG FLG (Treasuries): $100 NWG: 1100

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Figure 13.5 Public debt and monetary base. Source: Marshall’s Origins of the Use of Treasury Debt in Open Market Operations: Lessons for the Present Now the Treasury wants to eliminate all its financial liabilities: no more public debt! What are the means to do so? ‐

Case 1: Let Treasuries mature and do not repay holders of Treasuries: 100% tax on principal => FADP = 0, the domestic private sector losses all its financial assets. ADP FADP: $0 RADP: $350

‐


Case 2: Switch to a Treasury’s financial instrument not considered a liability (Coins are treated as equity by the Federal Accounting Standards Advisory Board): ADP FADP (Coins): $100 RADP: $350



LG FLG: $0 NWG: 1200

‐

Case 3: Switch to another liability of the government that is not included in the public debt: repay with Federal Reserve’s liabilities:

181


ADP FADP (Reserves): $100 RADP: $350



LG FLG (reserves): $100 NWG: 1100

All these cases are detrimental to the domestic private sector because they remove a default‐free, liquid, interest earning security from the balance sheet—Treasuries. Treasuries are essential to create wealth in the domestic private sector, to meet capital requirements, to earn interest income in a safe way, and to access the refinancing channels of the central bank. So be careful what you wish for when arguing for repaying the public debt.

POINT 4: BUSINESS CYCLE AND SECTORAL BALANCES One can get a partial understanding of the business cycle just by studying the interactions between the three balances. First, one may note that usually all three sectors wish to be in surplus: ‐

Domestic private sector needs to record a surplus to avoid bankruptcy.

‐

State and local governments need to record a surplus to avoid bankruptcy.

‐

Federal government

‐

o

strives to be in surplus to show that government is fiscally responsible like other domestic sectors.

o

tends toward a surplus during an expansion because of the automatic stabilizers.

Foreign sector: Political and financial stability reasons to reach a surplus.

Of course it is not actually possible for all of them to be in surplus at the same time, but all of them usually want to be in a surplus at the same time. Start with a situation where the non‐government sector (NG is the consolidation of DP and F) is at the surplus it desires (NGBd): ‐

Step 1: there is a growing economy with NGB = NGBd > 0: Non‐government sector net saves what it desires. In that case it must be true that GB < 0, the government is in deficit.

‐

Step 2: Government wants to be in surplus (GBd > 0). In a growing economy, automatic stabilizers lower the deficit of the government, which is what the government wants. But, if the government is dissatisfied with the pace of return toward a surplus, it may implement austerity policies that raise taxes (T) and/or lower spending (G) (“the country must live within its means”), which compounds the effect of automatic stabilizers. Thus ∆GB > 0 and so ∆NGB < 0.

‐

Step 3: NGB < NGBd so the non‐government sector tries to find ways to increase its net financial accumulation: o

182

If DPB < DPBd : consumption and investment decline

CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY o

If FB < FBd: Domestic exports decline (i.e. foreign imports decline)

‐

Step 4: Decline in non‐government spending (C, I, X), together with the decline in government spending (G), lead to a decline in aggregate income (GDP = C + I + G + NX). The decline in aggregate income leads to an automatic rise in G and an automatic decline in T, so the government balance falls (∆GB < 0). Income stabilizes.

‐

Step 5: the fall in the government balance leads to a rise of the non‐government balance (∆NGB > 0) until NGB = NGBd. Back to step 1.

The only two ways to get a short‐term stationary state (that is, a situation where the level of aggregate income does not change) are: ‐

Way 1: For GBd to be negative, i.e. the government is willing to be in deficit, and the deficit equals the equilibrium deficit level (GB*). The equilibrium deficit level is the one compatible with the desired net saving of the non‐government sector: GB* = NGBd. This is a viable solution for a monetarily sovereign government, but politicians are reluctant to argue for a permanent fiscal deficit given the lack of understanding of how a monetarily sovereign government operates by the general population, politicians and most economists. Bankruptcy, accelerating inflation, and bond vigilantes are usually invoked, although none of them are relevant (See Chapter 6).

‐

Way 2: For NGBd to be negative:

183

o

DPBd negative: this did happen in the late 1990s and early 2000s in the United States (Figure 13.3), which made GB > 0 possible. Australia, New Zealand and some European countries also have recorded a negative domestic private balance (Figures 13.4a, 13.4b, and 13.4c). However, domestic private sector in deficit is not sustainable because it implies, ultimately, Ponzi finance (see Chapter 14). The Great Recession led to massive government deficits that allowed the domestic private sector to reach a positive net saving in all OECD countries on record (Figure 13.4d).

o

FBd negative (desired negative current account balance by foreigners so domestic current account is positive and large enough to fulfill the desired net saving of the government and domestic private sector): A negative FB can be tolerated by a foreign sector if it is a developing country, or if the foreign country understands the need to provide the international reserve currency to satisfy the needs of the rest of the world. However: 

If a country needs to deficit spend vis‐a‐vis the rest of the world, it means that either the domestic private sector or the government do so, or both. If the domestic private sector does it, it is unstable, if the government does it, it depends on the denomination of the debt (if in domestic currency, no problem).



For the country supplying the international reserve currency, negative domestic CAB is sustainable only if the currency in unconvertible. If the currency is convertible, then the Triffin dilemma holds. The dilemma is that the country must have a deficit in its current account balance in order to supply the currency that the rest of the world needs, but the country faces threats of conversion demands as the supply of reserve currency grows among other countries.


CONCLUSION The macroeconomic sectoral balance identity shows that some desires are not compatible or extremely hard to achieve. As such, regardless of the number of economic adjustment— devaluation, change in interest rate, aggregate income fluctuation, etc.—some desires can never be achieved and it is highly destructive to continue policies that aim at achieving incompatible desires. It is best to set policy goals and desires that are compatible with accounting rules and to be aware that: -

One’s surplus is someone else’s deficit

-

One’s saving is someone else’s dissaving

-

One’s export is someone else’s import

-

One’s spending is someone else’s income

-

One’s financial asset is someone else’s debt

-

One’s credit is someone else’s debit

Accounting rules can be combined with insights from the way monetary systems work to draw some important conclusions: •

Private domestic sector should avoid being a net debtor because it tends to lead to financial instability (see Chapter 14)

•

A monetarily sovereign federal government usually needs to be in deficit, unless a domestic current account balance can be achieved, because such a government is always able to service debts denominated in its unit of account.

•

Some economies need to be net importers:

•

-

If they have limited economic development and resources. In that case, direct foreign aid instead of private lending is the way to go.

-

If they provide the international currency (United States today). In that case, the rest of the world wants to net save in that currency and so the currency‐issuing country must record a current account deficit.

Given that some countries need to be net importers, others need to be net exporters: there may be a need to clear debt overtime if it accumulates too fast, and to set the interest rate low relative to growth.

TO GO FURTHER: SECTOR BALANCES FROM THE PERSPECTIVE OF THE NATIONAL INCOME AND PRODUCT ACCOUNTS At the aggregate level, the National Income and Product Accounts (NIPA) managed by the Bureau of Economic Analysis records all economic operations on goods and services. NIPA shows us that the expenditure approach to gross domestic product (GDP) holds as a matter of accounting: GDP ≡ C + I + G + NX 184

CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY The gross domestic product is the sum of all final expenditures on goods and services, including domestic private final consumption (C), domestic private investment (I), government spending on goods and services (G), and net exports (NX). We also know that the income approach to GDP holds as a matter of accounting: GDP ≡ YD + T That is, with minor discrepancies, the gross domestic product is the sum of all gross incomes, or, stated alternatively, the sum of all domestic disposable incomes (YD)—wages, profits, interest and rent—and the amount of overall taxes (net of transfers) on income and production (T). This means that: YD + T ≡ C + I + G + NX We also know that, when accounting for international income sources, the U.S. International Transactions Accounts (USITA) (that accounts for the relation between the United States and the rest of the world) tells us that: CABUS ≡ NX + NRA The current account balance (CAB) is the sum of the trade balance (net exports) and net revenue from abroad (NRA) (net of unilateral current transfers). If one combines the NIPA and USITA and now includes in T the taxes earned on foreign income (NRAD is disposable net revenues from abroad) we get the following: YD + NRAD + T ≡ C + I + G + CABUS We also know that, in the NIPA, aggregate saving (S) is defined as the difference between disposable income and consumption, S ≡ YD + NRAD – C, therefore: (S – I) + (T – G) – CABUS ≡ 0 Or, given that for every net exporter there is a net importer (CABF = ‐CABUS): (S – I) + (T – G) + CABF ≡ 0 This last identity is similar to the one obtained from the Financial Accounts except that it is derived from GDP and so is merely concerned with current output (that is, newly produced goods and services).

TO GO EVEN FURTHER: NIPA AND FA DEFINITIONS OF SAVING The National Income and Product Accounts (NIPA) definition of saving is different from that of Financial Accounts (FA) and they are compatible only under specific conditions. 4 NIPA saving is defined as unconsumed income. For example, households saving is defined as disposable income minus spending on consumption goods: S = YD – C. FA saving is defined as the increase in net wealth: S = ΔNW. This difference reflects the different purpose of each account. NIPA is focused on measuring current economic activity with gross domestic product (GDP) at the core of the analysis. So, for example, say that an economy produces apples and some of the apples are used to make apple tarts. GDP is 185

CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY the dollar value of apples left for final consumption and the dollar value of apple tarts. This is the production for the year. NIPA saving is the value of whatever income was paid less purchases of apple tarts and apples for final consumption. FA is broader in its perspective, given that it aims at measuring what goes on in balance sheets. Balance sheets are impacted by many more things than just current production because, among others: 1‐ They contain real assets that were previously produced 2‐ They contain financial assets 3‐ The value of assets changes overtime because of changes in prices (capital gains/losses) instead of addition to the stock of assets via production or issuance of new securities. 4‐ Some consumption goods are durable. 5‐ Liabilities require principal repayment. For example, say that a household owns nothing and owes nothing. The household starts to work and gets paid $10 so its balance sheet is now: AH FAH (bank account): $10

LH NWH: $10

Saving is equal to $10 according to FA because net wealth increased by $10, and here NIPA would also agree given that nothing has been consumed. Now the household goes to the store and buys $2 worth of apples and that is the only spending for the month: AH FAH (bank account): $8 Apples: $2

LH NWDP: $10

According to NIPA, saving is $8 whereas it is still $10 for FA. Once the household eats the apples, the definitions give the same value again: AH FADP (bank account): $8

LH NWDP: $8

The source of difference in this case is that NIPA measures consumption by the amount of spending done for that purpose (buying the apple at the store). Consumption in a balance sheet means that the value of real asset falls (the apples have been eaten). Recently the Bureau of Economic Analysis created the Integrated Macroeconomic Accounts that aim at integrating the two approaches into one single accounting framework. Kenneth Boulding5 developed an entire framework based on definitions consistent with balance sheets. A clear difference is made between “spending” (using funds to buy the apples: real assets go up and financial assets fall) and “consuming” (eating the apples: real assets depreciate). Developments in economic theory have also aimed at making sure that the accounting of a model is tight. Stock‐flow consistent macroeconomic modeling ensures that a model accounts for all the interdependences between the sectors that the model contains.6

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Summary of Major Points 1‐ Balance sheets of different economic sectors are interrelated by a web of financial claims. Economic units owe and own claims on each other. 2‐ In order for an economic sector to accumulate financial instruments, i.e. to record a surplus, another sector must issue some financial instruments, i.e. record a deficit. There cannot be a creditor without a debtor. 3‐ If the government sector wants to reach a surplus, this necessarily means that it effectively desires that at least one sector be in deficit. Unless the foreign sector is willing to deficit spend, the previous statement means that the domestic private sector must deficit spend. 4‐ A fiscal surplus leads to a decline in the public debt, which means that other sectors lose Treasury securities. Treasury securities are central to maintaining the liquidity and profitability of other economic units. 4‐ Deficit spending by the private sector is not sustainable because it means that the sector is continuously dishoarding assets or going into debt. Both ultimately lead to insolvency. 5‐ A business cycle can be explained in part by the fact that all sectors try to reach a surplus at the same time. 6‐ In order to start the economic process, one sector must deficit spend. Keywords Public debt, surplus/deficit, net financial accumulation/disaccumulation, net saving/disaving, net lending/borrowing, golden state, Triffin dilemma Review Questions Q1: If the government runs a surplus, what does that usually mean for the domestic private sector? Q2: If the government runs a deficit, under what condition is it sustainable financially? Q3: What are the impacts of a government surplus on the cash flow and net saving of the domestic private sector? Q4: Why does a government surplus tend to create the condition for a recession? And why does a deficit tend to promote prosperity? Q5: What do national accounts tell us about the feasibility of a budgetary policy that aims at achieving a surplus? Q6: If a sector records a deficit what does it imply for its net financial accumulation? What happens to financial assets given liabilities? What happens to liabilities given financial assets? Find concrete example of what would happen if you recorded a deficit? Q7: Why is the golden state of a fiscal surplus, domestic private sector surplus, and domestic current account surplus hard to achieve?

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Suggested readings Papadimitriou D., Chilcote, E. and Zezza, G. (2006) “Are housing prices, household debt, and growth sustainable?,” Levy Economics Institute, Strategic Analysis, January. Papadimitriou, D., Shaik A., dos Santos, C. and Zezza, G. (2002) “Is personal income sustainable?,” Levy Economics Institute, Strategic Analysis, November. Godley, W. and Wray, L.R. (1999) “Can Goldilocks survive?,” Levy Economics Institute, Policy Note No. 1999/4. More advanced readings: Godley, W. and Lavoie, M. (2007) Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, New York: Palgrave Macmillan. Ritter, L.S. (1963) “An exposition of the structure of the flow‐of‐funds accounts,” Journal of Finance, 18 (2): 219‐230. Database Exploration How to retrieve time series data about the sectoral balance? There are three ways to do this; NIPA, IMA, and FA. All methods are presented (Tip: Summing across sector at a point in time must give you a value of zero, unless there is a statistical discrepancy, otherwise you did not select all the necessary sectors) With the Financial Accounts Step 1: Go to http://www.federalreserve.gov/releases/z1/ (Note: Series Z.1 is a complicated and constantly changing dataset) Step 2: Click on “Data download program.” Step 3: Select Category A. “Build your package.” Step 4: Select “FA Flow, SA” Step 5: Select “Rest of the world (S2)”, “General government (S13)” and “Private domestic sectors” Step 6: Select “Net lending (+) or borrowing (‐) (capital account)” (Note: net lending data from financial account contains a large statistical discrepancy) Step 7: Select frequency and others and then download With the National Income and Product Accounts Step 1: Go to http://www.bea.gov/iTable/index_nipa.cfm and click “Begin using the data…” Step 2: Click on “Section 5” and then “Table 5.1 Saving and Investment by Sector” Step 3: Select “Net lending or net borrowing” for the domestic private sector and for the government. The discrepancy will be the result of statistical discrepancies and the rest of the world. With the Integrated Macroeconomic Accounts Step 1: Go to http://www.bea.gov/national/nipaweb/Ni_FedBeaSna/Index.asp Step 2: Select “Table S.2.a Selected Aggregates for Total Economy and Sectors (A)” Step 3: Select “Net lending (+) or net borrowing (‐)” either from the capital account of the financial account. The capital account has less statistical discrepancy.

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CHAPTER 13: BALANCE‐SHEET INTERRELATIONS AND THE MACROECONOMY 1 Papadimitriou, D., Shaik A., dos Santos, C. and Zezza, G. (2002) “Is personal debt sustainable?,” Levy Economics Institute,

Strategic Analysis, November. http://www.levyinstitute.org/pubs/sa/perdebt.pdf See Scott Fullwiler’s “The Sector Financial Balances Model of Aggregate Demand and Austerity” http://neweconomicperspectives.org/2011/06/sector‐financial‐balances‐model‐of.html See Rob Parenteau’s “Leading PIIGS to Slaughter, Part 2” http://www.nakedcapitalism.com/2010/03/parenteau‐leading‐ piigs‐to‐slaughter‐part‐2.html 3 Papadimitriou, D., Shaik A., dos Santos, C. and Zezza, G. (2002) “Is personal debt sustainable?,” Levy Economics Institute, Strategic Analysis, November. http://www.levyinstitute.org/pubs/sa/perdebt.pdf 4 See “Alternative Measures of Personal Saving” by Maria G. Perozek and Marshall B. Reinsdorf at http://www.bea.gov/scb/pdf/2002/04April/0402PersonalSaving.pdf 5 See A Reconstruction of Economics by Kenneth Boulding 6 Watch two lectures by Marc Lavoie on stock‐flow modeling at http://neweconomicperspectives.org/tag/stock‐flow‐ consistent‐modeling 2

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CHAPTER 14: After reading this Chapter you should be able to understand: What happens during a major financial crisis Why financial crises exist What can be done to stop an on‐going financial crisis How financial crises can be prevented or tamed

CHAPTER 14: FINANCIAL CRISES While visiting the London School of Economics at the end of 2008, the Queen of England wondered "why did nobody notice it?" In doing so, she echoed a narrative that had been promoted among some prominent economists: the Great Recession (“it”) was an accident, a random extreme event that no‐one saw coming.1 This narrative is false. Quite a few economists saw it coming and it was not an accident.2 Chapter 9 shows how different theoretical frameworks about financial crises lead to different regulatory responses. This Chapter studies more carefully the mechanics of financial crises and how an economy gets there.

DEBT DEFLATION Definitions of financial crises can be more or less broad. Some economists restrict the definition to banking crises, others may use a statistical definition that takes a specific percentage fall in a financial index as an indication of a financial crisis. In any case, financial instability has increased since the 1980s.3 The most serious financial crises involve reinforcing feedbacks between asset prices and leverage, leading to a downward spiral of debt write offs and decreases in asset prices. These financial crises are called “debt deflations” after Irving Fisher’s analysis of the Great Depression. The main implication of a debt deflation is that market mechanisms break down under the combination of over‐indebtedness and deflation: lower prices do not clear markets but make matter worse.

Figure 14.1 An unstable equilibrium

One way to represent that graphically is with the supply and demand diagram of Figure 14.1. The demand curve is upward sloping because higher prices lead to higher wealth and so higher demand for goods and services. There is an equilibrium point but it is an unstable equilibrium, i.e. price mechanisms do not bring the market to equilibrium. For example, at P1 there is a surplus of goods and services, this leads to a fall in prices. Deflation decreases the quantity supplied and the quantity demanded in such a way that the surplus grows. A similar result can be found by postulating a downward sloping supply curve. As prices fall, more goods and services are supplied to try to service debts. There are many feedback loops involved in a debt deflation but the process starts with some

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CHAPTER 14: FINANCIAL CRISES economic units that become “overindebted.” The following presents Fisher’s argumentation in his 1932 Booms and Depressions.4

STEP 1: OVERINDEBTEDNESS AND DISTRESS SALES Some economic units, e.g. (non‐financial) businesses, are unable to pay their debts with their available monetary assets (cash and bank accounts). If refinancing options are not available—banks severely ration credit—businesses in difficulty must find ways to sell non‐monetary assets to recover enough funds to service their debts. They liquidate their inventories, sell other types of financial assets than monetary assets, and sell some superfluous real assets (Figure 14.2).

Figure 14.2 Distress sales Note: The “+” sign means that things move in the same direction: more overindebtedness leads to more distress sales (and less overindebtedness leads to less distress sales).

STEP 2: DISTRESS SALES AND DEFLATION, THE “DOLLAR DISEASE” The sudden massive sales of non‐monetary assets lead to a decline in their prices. The lower prices of assets lowers the ability of businesses to recover funds from the sales. Businesses are then forced to sell more at distress, which further pushes down prices. This is the first reinforcing feedback loop of a debt‐deflation.

Figure 14.3 Dollar disease Note: the sign “‐“ means that things move in the opposite direction: higher distress sales lowers prices, leading to higher distress sales.

STEP 3: DEFLATION AND DEBT LIQUIDATION; THE “DEBT DISEASE” Once they have recovered some funds, businesses service debts owed to banks and government— which reduces the money supply—and service debts owed to others (e.g., corporate bonds held by 192

CHAPTER 14: FINANCIAL CRISES households). Some businesses may have to default and ultimately their debts are written off by creditors, which negatively impacts the creditworthiness of businesses and the net worth of creditors (see Chapter 8). Following the quantity theory of money (which Fisher promoted), the decline in the money supply lowers prices even further, so there is a second reinforcing feedback loop: more distress sales lead to more debt liquidation, which leads to a lower quantity of money and so lower prices and then more distress sales.

Figure 14.4 Debt disease

STEP 4: PRICES AND PROFIT AND NET WORTH, THE “PROFIT DISEASE” The debt and dollar diseases create a deflationary spiral that is reinforced by additional feedback loops. First, as asset prices fall, the profit from sales and net worth of business fall given everything else, which further increases their overindebtedness and so feeds back into the dollar and debt diseases. Prices of assets fall even more.

Figure 14.5 Profit disease

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CHAPTER 14: FINANCIAL CRISES

STEP 5: THE “AMPLIFIER EFFECT” Declines in profit and net worth mean that non‐financial businesses have an incentive to lay off employees. Some banks may also have to close because losses from debtors are too high to be sustained by their balance sheet (see Chapter 8). Households, who record shrinkage of their income and prospects of unemployment, lower their consumption. Rising unemployment reduces aggregate spending, which further reduces profit and aggregate income. In addition, the decline in spending further pushes down the value of goods and services and other real assets. Now households, in addition to businesses, have problems in servicing their debts, which reinforces the debt write offs and decline in the net worth of banks.

Figure 14.6 Amplifier effect

STEP 6: PESSIMISM As the economy records falling prices, declining economic activity, rising unemployment, rising defaults, and shrinking balance sheets, confidence among economic units declines and hoarding rises. Higher hoarding lowers the velocity of money and so prices are pushed further down (again this presentation follows the quantity theory of money). Lower confidence also decreases the willingness of banks to grant credit, and increases their willingness to hang onto their reserves to meet withdrawals, interbank payments and other dues at the lowest cost possible; the overnight interbank market freezes (see Chapter 4).

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Figure 14.7 Confidence crisis

STEP 7: INTEREST‐RATE SPREAD With the crisis of confidence spreading and with raging deflationary pressures and economic crisis, interest rates shoot up. This quickly spreads through the outstanding debts if interest rates on financial contracts are floating rates, which squeezes net profit (profit – debt commitments) and so increases overindebtedness.

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Figure 14.8 Risk premium disease

CONCLUSION Overindebtedness and deflation feed on each other through several feedback loops. All these feedback loops make things worse and worse: difficulty to service debt leads to lower prices, which increases the difficulty to service debts. If left alone, a debt deflation stops only when the face value of outstanding debts has been lowered sufficiently through repayments and write offs to make the servicing of debts bearable. The decline in the debt burden loosens the need for distress sales (Figure 14.9). Of course, in the process banks close, households lose their savings and their economically active members become unemployed, businesses close, and resources are wasted (output is left to rot, labor power and knowledge are left unused and decay quickly, capital equipment depreciates, etc.). According to market proponents, this is fine because a debt deflation punishes all economic units that made “bad” decisions. Banks that overextended credit, businesses that did not satisfy their customers, households who are not flexible enough, etc. As Treasury Secretary Andrew Mellon stated during the Great Depression: “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate…it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.” There are two main problems with this view. First, Chapter 8 explains that what is considered in hindsight a “bad”/incompetent decision may have been necessary prior to the crisis in order to keep up with the competition and to avoid losing market share and income. Second, a debt deflation is not a selective process. It destroys economic status indiscriminately by spreading through declines in net wealth, job losses, losses of savings, declines in confidence, shutdowns of 196

CHAPTER 14: FINANCIAL CRISES financing opportunities, and an overall sharp decline in economic activity. Think of a fire that starts because someone smoked in bed. This person may “deserve” to have a destroyed home but, if nothing is done to stop the fire, the entire town may be destroyed.

Figure 14.9 A stabilizing loop

ORIGINS OF DEBT DEFLATION While the mechanics of a debt deflation are well known and widely accepted, what causes them is subject to debate: why do economic units become overindebted in the first place? Again, keeping with the distinction of previous Chapters on macroeconomic topics, this section makes a distinction between the real exchange view and the monetary production view.

REAL EXCHANGE IMPERFECTIONS

ECONOMY:

EFFICIENT

MARKETS

AND

In this view, money and finance are neutral and financial markets are efficient. The Efficient Market Hypothesis (EMH) states that markets allocate scarce resources toward the most productive economic activities, and allocate financial risks toward economic entities that are most able to bear them. The EMH also states that market mechanisms self‐correct and eliminate any disequilibrium such as bubbles or crashes. In order to introduce the possibility of financial crises, either markets have to be imperfect, or market participants have to behave imperfectly/irrationally. In terms of market imperfections, a lot of emphasis is put on the existence of asymmetries of information. Banks have much less information about the quality of a project than potential 197

CHAPTER 14: FINANCIAL CRISES customers. Bankers try to protect themselves by requiring collateral. This is supposed to give an incentive to economic units who request an advance of funds to do their best to make their project successful (otherwise economic units lose the collateral). Following a negative random shock, the value of collateral declines, which leads debtors to limit their entrepreneurial effort—because a decline in the value of the collateral means that they have less to lose by defaulting—, which increases the chances of financial difficulties. Banks take notice and start to ration credit. This generates a credit crunch, which leads to further declines in net worth and collateral and so less effort and a greater risk of default. Recent research efforts by scholars who follow the REE approach have focused on the reversion mechanisms (how a crisis occurs) instead of the propagation mechanisms (how a crisis spreads following a shock). Crises are rendered endogenous by linking effort to the business cycle. The more effort individuals put into their business, the more productive they are, which leads to a greater supply of commodities and so lower prices. Lower prices lead to lower net gains, which leads to lower effort and so to a greater risk of default. Given that the mathematical models developed to back this view are all set in real terms, and given that the random shock is applied to the productivity of an input (e.g., land), this type of analysis applies well to a pre‐capitalist agricultural economy (see Chapter 11). Nature decides which economic state occurs (good or bad weather). Financial crises are equivalent to weather calamities that decrease agricultural output. The imperfection view can be complemented by the Monetarist view of financial crises and by the irrational approach developed by behavioral economics. The former states that financial crises are due to the incompetence of policymakers, and the latter states that behavioral imperfections of individuals contribute to the emergence of crises. People have limited cognitive capacities that restrict their capacity to acquire and interpret information, and market participants care about things that a “rational economic man” should not care about. As a consequence, a market economy is prone to bubbles, herd behavior, cascade of information, and misallocation of resources, leading to overindebtedness and ultimately a debt deflation. One may try to correct for these behavioral problems by creating markets that provide signals that allow market participants to make the right decisions.

MONETARY PRODUCTION ECONOMY: THE FINANCIAL INSTABILITY HYPOTHESIS According to the MPE view, the previous type of analysis ignores important aspects of capitalist economies. For example, government deficits do promote financial stability, which is seen as an empirical puzzle in the REE view, given that deficits ought to crowd out investment and so make things worse. The REE view is also too micro‐oriented and lacks a system‐view of financial crises that recognizes major sources of instability outside the realm of individual behavior/effort. The Financial Instability Hypothesis (FIH) is an alternative to the EMH. The main claim of the FIH is that periods of economic stability are fertile grounds for the growth of financial fragility, i.e. the growth of the risk of debt deflation. Hyman P. Minsky, who relies on the work of Fisher, Keynes and Schumpeter, is the main developer of the FIH and provides a more detailed analysis of what “overindebtedness” means and its impacts. He concludes that stability is destabilizing.

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FINANCIAL FRAGILITY According to Minsky, the degree of financial fragility of economic units—how badly overindebted they are—can be classified as hedge finance, speculative finance or Ponzi finance. Hedge finance means that an economic unit is expected to be able to meet its liability commitments with the net cash flow it generates from its routine economic operations (work for most individuals, profit from going concerns for companies) and monetary balances. Even though indebtedness may be high (even relative to income), an economy in which most economic units rely on hedge finance is not prone to debt deflation, unless unusually large declines in routine cash inflows and/or unusually large increases in cash outflows occur. Even then, monetary savings are usually available in a large enough quantity to provide a buffer against unforeseen problems. As such, it is not expected that the servicing of debts will be problematic and so no refinancing (going into debt to service existing debts) and/or sales of non‐monetary assets is expected. Speculative finance means that routine net cash flow sources and monetary balances are expected to be sufficient to pay the income component (interest, dividend, among others), but too low to pay the capital component (debt principal, margin calls, cash withdrawals, among others) of liabilities. As a consequence, an economic unit needs either to go into debt or to sell some non‐ monetary assets in order to service the principal due. Economic units usually expect that rolling debts over (i.e. paying the principal on old debts by issuing new debts) will be possible instead of liquidating assets. The length of time during which routine cash flows are expected to fall short of capital repayment depends on the economic unit. Chapter 8 explains that the business model of banks is such that refinancing is usually needed to service the capital component of liabilities; as such banking requires a reliable and cheap refinancing source. Other businesses may only have a temporary need to roll over their debts. Ponzi finance, also called interest‐capitalization finance, means that an economic unit is not expected to generate enough net cash flow from its routine economic operations, nor to have enough monetary savings to pay the capital and income service due on outstanding financial contracts. As a consequence, in order to service a given level of outstanding debts, Ponzi finance relies on the growing availability of refinancing sources, and/or an expected liquidation of non‐ monetary assets at rising prices. At the microeconomic level, an economic unit that uses Ponzi finance to fund its assets is highly financially fragile. At the macroeconomic level, if key economic units behind the growth of the economy are involved in Ponzi finance, the economic system is highly prone to a debt deflation. Note that this categorization is not merely a measure of the use of external funding, i.e. of the size of leverage. It is also a measure of the quality of the leverage. At the core of this analytical categorization is an analysis of the means that are expected to be used to fulfill financial contracts. Hedge finance is not expected to require any refinancing operation or liquidation of non‐monetary assets to service debts; Ponzi finance requires a growing use of refinancing and liquidation to service debts. This has important regulatory implications as shown in Chapter 9, because knowing how one can service debt becomes as important, if not more important, than knowing if one can service debts: low default probability (if) does not mean low financial fragility (how). Ponzi finance should be differentiated from the existence or non‐existence of a “bubble.” The categorization does not aim at measuring the accuracy (however, defined) of the price of assets used to service debts. Ponzi finance means that leverage and asset prices end up going up together and feed on each other on the upside. Higher leverage requires higher collateral value and so higher 199

CHAPTER 14: FINANCIAL CRISES asset prices, and the funding of assets at a price that grows faster than income rises requires higher leverage. This is the crucial dynamic regardless of the correctness of the value of asset prices because, bubble or not, the size of a potential debt deflation grows with the duration of the use of Ponzi finance. Without Ponzi finance there cannot be a debt deflation because there is no leverage involved in the asset‐price appreciation. Without a debt inflation (that is a situation in which asset prices and debt become highly interdependent on the upside), there cannot be a debt deflation. Ponzi finance is also different from fraud (which can prevail at hedge, speculative or Ponzi stage). Ponzi finance is an unsustainable financial process regardless of the legality of a financial structure. Indeed, in order to persist, it requires an exponential growth of financial participation, which is not possible because, ultimately, there is a limited number of economic agents that can or will participate. The H/S/P categorization does not apply to monetarily sovereign governments, i.e. governments that issue their own nonconvertible currency and that issue public debt denominated in their currency. Examples of monetarily sovereign governments are the United States Federal Government, the Japanese national government, the United Kingdom national government, the Chinese and Mexican central governments. Examples of non‐monetarily sovereign governments are national governments of the Eurozone, the United States under the gold standard before 1933, state and local governments in the United States and, any country that issues securities denominated in a foreign currency. When a government is monetarily sovereign, it has a monopoly over the currency supply and so always can meet payments denominated in its currency as they come due. Hedge finance applies to any sovereign government that is monetarily sovereign because such a government cannot be forced to default; default is purely voluntary. In addition, the federal government may provide bonds and other default‐free liquid securities that boost the liquidity of the balance sheets of the private sector. The long period of financial stability in the United States after World War II was the result of highly liquid balance sheets in the private sector due to large government deficits during World War II that flooded the private sector with safe assets (see Chapter 8).

THE FINANCIAL INSTABILITY HYPOTHESIS According to the FIH, during a period of prolonged expansion, the proportion of economic units involved in speculative and Ponzi finance grows, and so the risk of a debt deflation increases. The period of expansion may record minor recessions—e.g., the 1991 and 2000 downturns in the United States—that do not significantly tame the state of expectations of private economic units and so do not significantly make underwriting practices more prudent. As such, the FIH is not a theory of the business cycle but rather focuses one what causes significant recessions. Contrary to the behavioral explanation, irrationality is not at the heart of instability. The boom, with its mania, just amplifies the dynamics that emerged previously during a period of prolonged expansion. Contrary to the market imperfection explanation, market mechanisms promote instability not stability. The heart of the problem is not found in individuals making dumb/irrational decisions but rather in the system in which they operate. Capitalism is a much more financially unstable economic system than those that previously existed. Capitalism’s incentives and mechanics push economic units into Ponzi finance. There are several channels through which financial fragility grows and they have to do with anything that changes the relation between income and debt service. Anything that pushes an economic unit 200

CHAPTER 14: FINANCIAL CRISES from a state in which income is greater than debt service to a state in which income is less than debt service represents such a channel. This can happen either because income level (or growth) falls and/or debt service level (or growth) rises. Factors that impact both are described briefly: •

•

•

•

Structural causes: -

Banks are speculative units: the maturity of banks’ liabilities is short relative to the maturity date of banks’ assets so they need to refinance all the time. Banks aim at lowering the maturity of their assets to limit the maturity mismatch, which promotes speculative finance in the non‐bank sectors. For example, in the US, the 30‐year mortgage is not a product of private banking but of government intervention and it must be subsidized to persist. Banks much prefer shorter‐term mortgages (say 10 years) that require households to refinance, which creates a dependence on the direction of home prices (Chapter 7 explains that if home prices fall refinancing may not happen).

-

Changes in banking business: move away from the originate‐and‐hold model to the originate‐and‐distribute model, which creates adverse incentives in terms of underwriting and debt reworking (see Chapter 8).

Economic causes -

Search for profit and market share, and market saturation: ROE = ROA x leverage (see Chapter 8).

-

Inequalities: the need to use debt to sustain a given standard of leaving has increased (student debt, healthcare debt, etc.)

-

Unexpected events: The FIH leaves some room for adverse random shocks (say a hurricane destroyed many houses and businesses, which triggers massive payments by insurance companies)

Policy reasons: -

Deregulation, desupervision and deenforcement (see Chapter 9): fraud grows and underwriting worsens.

-

Fiscal policy: A period of prolonged expansion that is led by a monetarily sovereign government will not lead to financial instability. Fiscal deficits boost macroeconomic profit (see Chapter 11) and personal savings and provides cash flows as well as safe financial assets to the private sector. However, as shown in Chapter 13, government’s desire to reach a surplus, combined with the automatic stabilizers, means that non‐ government sectors may be forced to deficit spend.

-

Monetary policy: During a period of expansion, the central bank raises interest rates and that increases the debt burden. Minsky is of the opinion that fine tuning and preserving financial stability are not compatible and argues for a central bank that focuses on financial stability.

Socio‐psychological reasons -

201

Long period of prosperity leads to a decline in risk perception because economic news is good and it is too costly to look too much backward (see Chapter 9).

CHAPTER 14: FINANCIAL CRISES -

Uncertainty means that economic units rely on norms to make decisions. These norms are rationalized through a convention, which is a mental construction about the current economic trends and about what to expect. There is a strong incentive to stick to the convention to avoid losing market share or drawing the attention of regulators (see Chapter 8). So if Ponzi finance is considered normal, a bank will do it and will find comfort in the fact that “everybody else is doing it so it is ok.”

HOW TO DEAL WITH FINANCIAL CRISES Financial crises that are severe create a lot of damages if they are not managed through government intervention. This government intervention involves both quick fixes to deal with the immediate problems and long‐term policies to prevent moral hazard and promote stability. The recent responses to the Great Recession provide examples of what not to do: •

Stop the liquidity crisis: central bank provides funds at penalty rate, against safe collateral, to solvent institutions. One may argue that, during a crisis, a lot of financial assets that previously looked safe may now be unsafe because of the lack of confidence and because of poor economic prospects. For example, prime mortgagees may default because they lost their job. There is a way around this issue. Central banks should accept only financial assets that were created by following strict underwriting, that is, those that involved hedge finance and speculative finance prior to the crisis. Central banks may record losses on them given that a debt deflation also impacts economic units with strong creditworthiness, but that should be minimal. Do not provide liquidity against Ponzi finance inducing financial instruments, even if they are not in default. –

•

Stop the solvency crisis: Bank holiday to examine the books of financial institutions in detail for a given period of time (say a week like during the Great Depression) and close insolvent banks. Act to sustain income and to lower the debt burden. Lower the debt burden by reworking debts of economic units who would be solvent with the reworking (during the great depression, government bought interest‐only mortgages from banks and replaced them with 30‐year fixed rate fully‐amortized mortgages). To sustain income, create large‐ scale long‐term fiscal policy such as a job guarantee program (Great Depression work programs were started in a matter of days). –

•

202

Recent crisis: Fed provided advances at near 0% rate, against poor to toxic collateral (accepted at par), to questionable institutions, to non‐bank entities

Recent crisis: no significant analysis of accounting books (only 2 Fed people sent at Lehman Brothers,5 superficial stress tests), insignificant and slow fiscal action to stabilize income (700 billion was not enough and was implemented over years), hide losses of financial institutions by widening level‐3 valuation, injection of capital in banks via Treasury without any real congressional oversight, no significant reworking of debts on non‐bank agents.

Change incentives and regulation, supervise and enforce: prosecute top managers for fraud, issue cease and desist orders, major reworking of regulation and supervision to deal with problems, promote hedge finance and if necessary forbid Ponzi finance.

CHAPTER 14: FINANCIAL CRISES –

Recent crisis: Not a single prosecution of top executives, even though fraud is obvious (ask the Federal Bureau of Investigation and rating agencies that finally had a look at mortgage contracts), civil instead of criminal cases (the financial institution pays fines and promises not do it again), no major reregulatory trends, no enforcement of existing laws prior and during crisis.

Even though a financial system may be on the brinks of collapse and panic is generalized, regulatory institutions or agencies must follow the law. If necessary, regulators may use emergency executive powers (bank holiday) to shut down the financial system temporarily and to get to the bottom of the problem. Lenience leads to long‐term instability because the existence of a government safety net promotes moral hazard. Without a safety net, such as a central bank acting as lender of last resort, economic crises would be very severe.

TO GO FURTHER: PONZI FINANCE AND THE BALANCE SHEET When an economic unit is involved in Ponzi finance, it has to go into debt to service principal and interest. Say that there is a balance of $100 on a credit card that represents expenses for the month and that there is also $10 of interest due. To service the credit card debt, one must open a new credit card to pay $110 due on credit card #1. The following month $110 + $11 of interest is due on the second credit card. The dollar amount of financial liabilities grows. Another way to service credit card #1 is to sell some assets worth $110. So Ponzi finance implies that the quantity of real assets (RA) falls and/or net financial accumulation (NFA) declines because either the quantity of financial assets falls or the quantity of financial liabilities rises. We know that RA and NFA are related to net wealth (see Chapter 13): ΔNW = ΔRA + NFA Given everything else, Ponzi finance leads to a fall in net worth. There are two ways to mitigate this decline: 1‐ Overtime the assets funded in a Ponzi way may start to generate enough cash flows to cover debt services. Say that a company was just created and needs some time to get its business to earn an income. In the meantime, it needs financing to pay employees, to get the business set up, etc. During that time, the net worth of the company will fall but it is expected that ultimately the business will be profitable and will generate enough cash flows to pay creditors. One may call this income‐based Ponzi finance; for a while income is insufficient but there is an expectation that this is only temporary. 2‐ The price of real assets and the price of financial assets that are still on the balance sheet go up fast enough to more than offset the rise in debt and the liquidation of assets. The recent housing boom that allowed households to record massive increase in net worth while they were going massively into debt is an example of such dynamics. The underwriting worsened so much (see Chapter 8) that the only way to make a mortgage profitable was to sell the house at a high enough price to cover interest and other payments due to creditors. One may call that asset‐based Ponzi finance, or a pyramid scheme; there is no expectation that income will ever be enough to service debts. The liquidation of the collateral and other assets at rising prices is the only expected means to make the Ponzi financing profitable and to keep net worth rising.

203


TO GO EVEN FURTHER: MINSKY AND INCOME VS. CASH INFLOW In most presentation of the FIH, income and cash inflow are not distinguished carefully. For example, the FIH is often presented from the point of view of the business sector with profit (U) reflecting the ability or inability to fulfill debt service (CC) so that U > CC is hedge finance. At the macroeconomic level, U is determined by the Kalecki equation of profit (see Chapter 11). At the theoretical level that might be good enough, but it is not so at the empirical level. Income and cash flows are two different things (see Chapter 1). Income is about measuring gains in net worth, cash flow is about measuring change in monetary assets. The Kalecki equation of profit does not say anything about gains of monetary balances. For example, an increase in unsold inventories raises profit because higher inventories increase real assets. Similarly for households, personal income includes quite a few items that are unrelated to monetary gains. Vegetables grown in the garden, service provided by owning a house, among other things, are counted as imputed income. Unfortunately, as explained in Chapter 12, creditors demand monetary payments so earning an income in real terms, as opposed to monetary terms, does not help an economic unit to service its debts. What is really important is what Minsky called the “cash box condition” and expectations based on it: how does the sum of cash inflows and monetary balances compare to cash outflows now and in the future? That may or may not be related to profit and personal income. The cash‐flow statement, rather than the income statement, together with the cash‐flow expectations embedded in financial contracts, give a better idea of the financial fragility of an economic unit. Summary of Major Points 1‐ During a major financial crisis, i.e. a debt deflation, there are several feedback loops that may develop, which reinforce the deflationary forces at play. A debt deflation is not self‐stabilizing; the longer it is allowed to proceed, the more destructive it gets. 2‐ A debt deflation is not self‐cleansing; it destroys economic value indiscriminately until enough debt has been liquidated to tame the deflationary forces. 3‐ How an economy is pushed to the brink of a debt deflation is subject to debate. Some economists believe that a debt deflation is the result of a very large adverse random shock that risk management models did not account for because it was too costly to do so. Other economists argue that the search for profit and the increased reliance of market mechanisms lead to an unstable economy. 4‐ In order to deal with a financial crisis, one must promote short‐term stability by stopping the liquidity crisis and must promote long‐term stability by dealing with the solvency crisis and the outdated regulatory framework. 5‐ According to the efficient market hypothesis, markets tend to allocate resources and risks properly and the only thing the government can do is to help protect against the most common adverse shocks that may impact markets. Profit is a good indicator of financial health. According to the financial instability hypothesis, markets tend to promote Ponzi finance and some regulations must be put in place about financial practices and financial innovations. Profit alone is not a good indicator of financial health because one must ask through what financial practices this profit was achieved. 204


Keywords Efficient market hypothesis, financial instability hypothesis, debt deflation, hedge finance, speculative finance, Ponzi finance, income‐based credit, asset‐based credit, debt liquidation, profit disease, debt disease, dollar disease, pessimism, irrational behavior Review Questions Q1: Why is the dollar disease a reinforcing feedback loop? What about the debt disease? What about the profit disease? Q2: When does a debt deflation stop if left to market mechanisms? Why is that not a smooth and effective way to cleanse the economy? Q3: What are the amplifier mechanism and reversion mechanism used in the real exchange economy view of financial crisis? Q4: What are the sources of financial crisis in the monetary production economy view? Is it mostly about irrational individual behaviors and improper incentives? Q5: What can be done to deal with a financial crisis? Did the recent response to the 2008 crisis follow the proper guidelines? Q6: Why Ponzi finance intrinsically unstable? What is the difference between income‐based Ponzi finance and asset‐based Ponzi finance? Does Ponzi finance necessarily, or even mostly, imply fraud or irrational behaviors? Suggested readings Fisher, I. (1932) Booms and Depressions: Some First Principles, New York: Adelphy. Minsky, H.P. (1982) “The financial‐instability hypothesis: Capitalist process and the behavior of the economy,” in C.P. Kindleberger and J.‐P. Lafargue (eds) Financial Crises: Theory, History, and Policy, 13‐39, New York: Cambridge University Press. Mishkin, F.S. (1991) “Asymmetric information and financial crises: A historical perspective,” in R.G. Hubbard (ed.) Financial Markets and Financial Crises, 69‐108, Chicago: University of Chicago Press. More advanced readings: Charles, S. (2016) “Is Minsky’s financial instability hypothesis valid?” Cambridge Journal of Economics 40 (2): 427‐436. Keen, S. (2013) “A monetary Minsky model of the Great Moderation and the Great Recession” Journal of Economic Behavior & Organization, 86 (1): 221–235. Schwartz, A.J. (1988) “Financial stability and the federal safety net,” in W.S. Haraf and R.M. Kushmeider (eds) Restructuring Banking and Financial Services in America, 34‐62, Washington, DC: American Enterprise Institute for Public Policy and Research. Shiller, R.J. (2000) Irrational Exuberance, Princeton: Princeton University Press. Suarez, J. and Sussman, O. (1997) “Endogenous cycles in a Stiglitz‐Weiss economy,” Journal of Economic Theory, 76 (1): 47‐71.

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CHAPTER 14: FINANCIAL CRISES 1 Bezemer,

D.J. (2010) “Understanding financial crisis through accounting models,” Accounting, Organizations and Society, 26 (7): 676‐688. 2 See “Got it Right Project” at http://afee.net/?page=heterodox_economics&side=got_it_right_project 3 Bordo, M., Eichengreen, B., Klingebiel, D. and Martinez‐Peria, M.S. (2001) “Is the crisis problem growing more severe?,” Economic Policy, 16 (32): 51‐82. 4 An electronic copy of Fisher’s book can be found at the St. Louis Federal Reserve: https://fraser.stlouisfed.org/docs/publications/books/booms_fisher.pdf 5 A blunt testimony by William K. Black at the hearings regarding the failure of Lehman Brothers can be found here: https://www.c‐span.org/video/?c2113/clip‐2008‐lehman‐brothers‐failure‐panel‐4

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CHAPTER 15: After reading this Chapter you should be able to understand: What a monetary system is How a monetary system works Why a monetary system may be dysfunctional Why monetary instruments are accepted What determines the nominal value at which a financial instrument circulates What promises are made by issuers of monetary instruments and how that determines their fair price

CHAPTER 15: MONETARY SYSTEMS Throughout this textbook, Chapters have used balance sheets extensively to get an understanding of the monetary operations of developed economies, but nothing has been said about what a monetary instrument is. It is time to spend some time on the nature of monetary instruments and the inner workings of monetary systems. A monetary system is composed of two core elements: 

A unit of account that provides a common method of measurement: the euro (€), the pound sterling (₤), the yen (¥), the dollar ($), etc.



Monetary instruments: specific financial instruments denominated in the unit of account and issued by the government and the private sector.

This Chapter first explains what financial instruments are and how monetary instruments fit within the existing range of financial instruments. It then delves into what determines the nominal and real value of monetary instruments, and into what makes them accepted.

FINANCIAL INSTRUMENTS Balance sheets contain many types of financial instruments. Some of them are issued by an economic unit (financial liabilities), others are held by that same economic unit (financial assets). Financial instruments are just formal promises to make monetary payments. The way a promise is structured varies widely depending on the needs of the issuer, but common questions that a promise must answer are: •

Who is the issuer? The mark of the issuer (name, head, etc.) is present so bearers know who is supposed to fulfill the promise embedded in the financial instrument.

•

What is the unit of account used? Financial instruments cannot exist before there is a unit of measurement for monetary transactions and outstanding balances.

•

At what price will the issuer take back its promissory note? There is a face/par value that specifies the number of units of account the financial instrument carries ($100, $10, $1, 25 cents, etc.).

•

When will the issuer take back its promissory note? There is a term to maturity: The length of time it will take to fulfill the promise, at which point the issuer must take back the financial instrument it issued (and then destroy it to make sure nobody can reacquire it to have a claim on the issuer). The term can go from zero (issuer takes it back whenever it is presented by bearers) to infinity (issuer takes back at its discretion, maybe never).

•

How will the issuer take back its promissory notes? The expected means that will be used by the issuer to fulfill his promises, called more technically the “reflux mechanisms/channels.” (Chapter 14 shows that the way this question is answered is crucial for financial stability)

•

What is (are) the reward(s)/benefit(s) for those willing to trust the issuer? Financial instruments may reward their bearers: income, voting rights, avoid prison, etc.

•

Are there any guarantees in case the issuer is unable or unwilling to fulfill the promise? Financial instruments may be secured/collateralized: if the issuer defaults on its promises, the bearers get paid by taking ownership of assets of the issuer (house for mortgages, etc.)

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CHAPTER 15: MONETARY SYSTEMS •

Is it possible to transfer the promissory note to another bearer? Financial instruments may be negotiable, i.e. the person to whom the promise has to be fulfilled can be changed by transferring ownership of the financial instrument. Some financial instruments are not transferable because they name the beneficiary (e.g. savings bonds issued by U.S. Treasury) and cannot be endorsed to someone else. Some, like checks, have limited transferability.1

Depending on how these questions are answered, the name of a financial instrument changes, in the same way dogs and cats have different names depending on their height, color of their fur, etc. For example, a Treasury bill does not provide any reward and is due within a year. A common share provides a reward depending on the profit of the issuing company, gives a voting right, and the company does not promise to take back its shares. As stated in Chapter 10, anybody can make any kinds of promise. The hard parts are, first, to convince others of the genuineness of the promise so they are willing to accept a financial instrument and, second, to fulfill the promise once it has been accepted. Finance establishes a legal framework to record the creation and fulfillment of promises, and it measures, more or less accurately, the credibility of these promises at any point in time. Finally, within a country, there is a hierarchy of financial instruments in the sense that some are more easily accepted. The most widely accepted financial instruments are those that are negotiable, of the highest creditworthiness, of the highest liquidity, and of the shortest term to maturity. In contemporary economies with a monetarily sovereign government, central‐bank monetary instruments are at the top of the hierarchy. They are followed by bank monetary instruments that were made perfectly liquid following the emergence of interbank par‐clearing and settlement and deposit guarantee. Below the previous monetary instruments are financial instruments traded on an organized exchange (issued mostly by governments and corporations: shares, bonds, notes, bills, etc.). At the bottom of the hierarchy, there are all sorts of promises such as local currencies and personal promissory notes. This hierarchy is not fixed and, throughout history, the top monetary instrument was not always a government monetary instrument.

A SPECIFIC FINANCIAL INSTRUMENTS

INSTRUMENT:

MONETARY

Some issuers make the following promise to bearers: •

I will take back my promissory note whenever you want me to do so: Term to maturity is instantaneous/zero.

•

I will take back my promissory note from anybody who presents it to me: Only the issuer’s mark is on the instrument and no beneficiary is named (either no name or “the bearer”).

•

I will take back my promissory note at par in payment of debts owed me: By handing to me my promissory notes, I will reduce any debt you owe me by the face value of the note. The government accepts reserves to settle taxes at face value (the government does not accept cash from the public in payment of taxes for security and tractability reasons, instead it works through banks), banks accept at face value the funds in bank accounts to settle what is owed to them (see Chapter 6 and Chapter 10).

The promise may contain two additional clauses: 209

CHAPTER 15: MONETARY SYSTEMS •

I will exchange my promissory note for something else whenever the bearer wants me to do so: there is a conversion clause. Banks promise to convert bank accounts (and banknotes when they used to issue them) into government monetary instruments on demand. Governments may promise conversion into gold or a foreign currency.

•

I will use gold or another precious metal to make the promissory note: the promissory note is secured. In the same way a house is collateral for a mortgage, gold may be collateral for a coin.

This type of financial instruments are monetary instruments. Similarly to any other financial instrument, the creation of monetary instruments involves someone becoming liable (the issuer of the monetary instrument) because monetary instruments embed a financial promise.

AT WHAT PRICE SHOULD A FINANCIAL INSTRUMENT CIRCULATE AMONG BEARERS? The nominal value, P, at which a financial instrument ought to circulate among bearers is called the fair price or fair value. The present value of expected financial rewards is a common way to judge the fair price of many financial instruments. It is the sum of all the discounted streams of payments that are expected by bearers until a financial instrument matures:

1

1

Where the subscript t indicates the present time, Pt is the current fair value, Yn is the nominal income promised at a future time n, FVN is the face value that will prevail at maturity, Et indicates current expectations about income and face value, dt is the current discount rate imposed by bearers, N is the time lapse until maturity (n = 0 is the issuance time) (The Σ character means “sum of”). There is a wide variety of financial instruments that use this formula. One can classify financial instruments according to the term to maturity (Figure 15.1).

Figure 15.1 Financial instruments and term to maturity Note: C is the coupon payment, a form of income At one extreme are modern government monetary instruments that provide no income (Y = 0), are redeemed at the discretion of bearers (N = 0), and are expected to be taken back by the government at their initial face value at any time, Pt = FV0. Government issued monetary instruments ought to circulate at par all the time because they are zero‐term zero‐coupon financial instruments. At the other extreme are consols that have a given expected income and are redeemed at the discretion of the issuer (N → ∞), Pt = Et(Y)/dt. They are infinite‐term positive‐coupon financial instruments. Shares have the same term to maturity as consols. If a collateral exists, in case of default, the fair value depends on the expected ability of creditors to recover some of the unpaid dues embedded 210

CHAPTER 15: MONETARY SYSTEMS in a promise. Thus, in case of default, the fair value is equal to the expected value of the collateral and available recourses discounted back to the present. For example, say that company X issues 3‐year bonds with a face value of $1000 and a coupon rate of 10%. This means that company X will buy back its bonds for $1000 in three years and will pay a $100 coupon during three years. In that case, what market participants are willing to pay for the bond today is (assuming an annual coupon payment to simplify): 100

100 1

1

100 2

1

3

1

1000 1

3

There is a missing element that prevents the determination of the fair price: what is the value of d today? d represents the interest rate that market participants want (the market rate). The market rate may be different from the interest rate offered by company X (the coupon rate): ‐

If d = 20% then P = $789.35. The bond trades at a discount (i.e. below face value). For the first $100 provided next year, market participants are willing to pay today $83.33 ($100/1.2) because $83 placed at 20% today provides $100 next year, etc.

‐

If d = 10% then P = $1000. Bond trades at par. Market participants agree that the interest rate proposed by company X is enough, so they pay full price for the bond.

‐

If d = 5% then P = $1136.16. Market participants are getting more reward from the coupon than what they wish, so they are willing to buy the bond at a premium (i.e. above face value). The value of the premium is just enough to make the rate of return on the bond equal to 5%.

As explained in Chapter 4, the value of d depends on a number of factors including the risk of default by the issuer. The higher the probability that coupons and/or principal cannot be honored, the steeper the discount rate, and so the further below par the 3‐year bond trades. For a $20 unconvertible Federal Reserve note, the government does not promise any coupon and promises to take back the FRNs at any time at $20, so: 20

20

0

1

The $20 FRN ought to trade at parity all the time. The discount factor does not matter because the term to maturity is instantaneous. These two examples assume that the issuer does not default. Say that right after the issuance of the 3‐year bonds, company X announces that it cannot make neither the $100 coupon payments nor the principal payment. Some negotiation with bondholders leads to an agreement that company X will pay $70 coupons and $500 of principal. Then the new fair value of the bond is:

70 1

70 1

1

70 2

1

500 3

1

3

Again, the fair value depends on d, and d must have increased tremendously following the announcement of default, which pushes down P even further. The same applies with Federal Reserve note and other monetary instruments. Say that the government announces it only accepts $20 FRNs for $10 at any time, i.e. a $20 FRN only redeems 211

CHAPTER 15: MONETARY SYSTEMS $10 of debts owed to the government. Then the new face value is actually $10 and so the fair price is $10. In the economy, the $20 circulates among bearers for $10. Shops take the $20 note only for $10 worth of items, banks that receive a $20 note only credit $10 to the bank accounts of the persons who hand the $20 FRNs, and repaying bank debts with a $20 FRNs only clears $10 of bank debts. Holders of FRNs take a 50% haircut. This may seem strange but only because we are not accustomed to that anymore. In the Middle Ages, kings used to change the face value of their coins all the time as explained in Chapter 17. Until the late 19th century, private bank notes were applied a discount that varied overtime.

FAIR VALUE AND PURCHASING POWER There are situations in which the value of all financial instruments changes at the same time relative to the value of goods and services (output‐price inflation or deflation) or relative to another unit of account (exchange‐rate depreciation or appreciation). These changes in purchasing power are due either to the decisions of a monetary authority (e.g., the government decides to devalue its currency) or to mechanisms at work in a monetary system. The changes in the value of the unit of account should be differentiated from the changes in the fair value of a monetary instrument. While both changes lead to the same result (changes in purchasing power), the mechanisms at play are different. Changes in the value of the unit of account relate to expected and actual changes in macroeconomic conditions (see Chapter 11). Changes in the fair value relate to expected and actual changes in the characteristics of a financial instrument (e.g., default) or in the financial infrastructure (e.g., disruption in the payment system). For bank and government monetary instruments, this second type of changes has not occurred since government guarantees have been put in place, interbank bank settlement at par has been done efficiently, and inconvertible currency has become common and its supply made elastic. One major debate of monetary history concerns the question of whether if the issuer of a monetary instrument, and more generally any other financial instrument, is liable for the decline in the purchasing power of what is owed to the bearers. Say that you owe $100 to someone; should you be liable if the purchasing power of that $100 declines? More broadly, should the principal amount you owe rise/fall to compensate for inflation/deflation? Legal scholars discuss this issue in terms of Nominalism (that answers no) versus Valorism (that answers yes). Recently, this question has been of greater concern for creditors, given that there has been an inflationary bias since the end of World War Two. Governments around the world have been unwilling to let deflationary forces develop following the horrible experience of the Great Depression (Figure 15.2). Nominalism has prevailed throughout history. As such, financial instruments cannot be considered to be claims on goods and services. Creditors bear the inflation risk, debtors bear the deflation risk. While debtors may choose to issue inflation‐protected financial instruments (e.g., Treasury inflation protected bonds), it is their discretion not their obligation. An implication of the prevalence of nominalism is that the creditworthiness of an issuer is only related to the ability to make the nominal payments promised (the Ys and FV in the fair price formula) and creditworthiness cannot be judged by looking at purchasing power. As such, inflation/deflation does not represent a decline/increase in the creditworthiness of a government, or banks, or any other issuer of monetary instruments.

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Figure 15.2 Consumer price index in the United States: 1774‐2015 (base: 1982‐84). Sources: Bureau of Labor Statistics and Historical Statistics of the United States. A simple way to understand why Nominalism has prevailed is that issuers of financial instruments have very little control over output‐price dynamics. Businesses can try to be more efficient to meet the demands of their creditors, and households have some influence over their income and expenditure sources. Governments have some part to play in the inflationary bias, and could do more to promote price stability by having structural policies that deal with employment and price stability, but even governments only have limited control over macro price dynamics. It would be unfair to ask the issuers of financial instruments to protect their creditors for something over which they have little control and which they have limited ability to influence. While cases of hyperinflation are often attributed to the government running the printing press, one needs to look at the underlying economic conditions to get to the bottom of the problem. Political, technological and natural causes are usually underpinning problems because inflation is usually not a monetary issue (see Chapter 11). The government printing monetary instruments en masse is just a last desperate response to a deeper underlying problem. For example, the German post‐World War One hyperinflation had its root in the costly Versailles agreements. The recent episode of hyperinflation in Zimbawe has its root in colonialism, land reform and decaying infrastructure.2 Table 11.1 shows inflation rates for several countries, all around the two world wars. Period Average monthly growth of prices

Austria 10/1921‐ 8/1922

Germany 8/1922‐ 11/1923

Greece 11/1943‐ 11/1944

Hungary 8/1945‐ 7/1946

Poland 1/1923‐ 1/1924

Russia 12/1921‐ 1/1924

47.1%

322%

365%

19800%

81.4%

57%

Table 11.1 Examples of hyperinflation. Source: Studies in the Quantity Theory of Money. 213

CHAPTER 15: MONETARY SYSTEMS To conclude, the financial characteristics of monetary instruments lead to a stable nominal value (parity) in the proper financial environment (see Chapter 16 for improper financial environments). This stable nominal value plays a crucial role in the stability of the financial system because it provides a reliable means of payment, which promotes liquidity and solvency. However, these characteristics do not guarantee a stable purchasing power and so a monetary instrument may not be a reliable medium of exchange. A good part of the story of monetary systems has been to try to establish a smoothly working monetary system based on a financial instrument that is both perfectly liquid and of stable purchasing power. This quest has been unsuccessful (only perfect liquidity has been achieved), but it has had a tremendous influence on the views of scholars, politicians and the general population about “money.”

ACCEPTANCE OF MONETARY INSTRUMENTS Anybody can create monetary instruments. There are many websites that allow one to do so, and Figure 15.3 shows a monetary instrument that I created. Let us call it the E.T. note. My name is present and the note is worth 5 cities. The “City” is the unit of account. I deliberately chose a weird name for the unit of account to make the point that the unit of account is an abstract and arbitrary unit of measurement that has no essential relation to anything. While some units of account find their origins in weight measures,3 they rapidly lost that connection (e.g., a pound sterling is not represented by a pound of fine silver, a pound sterling is just a pound sterling).4 Other names of units of account are just made up, sometimes to reflect political or cultural aspirations (the “Euro”), and have never had anything to objectify them. The E.T. note is a formal promise. By issuing it to bearers, I promise to take the note at par whenever it is presented to me. How can I get others to accept in payments that piece of paper? The answer depends on how credible my promise is to others: When will bearers have the opportunity to hand it back to me and what are the benefits for doing so? If potential bearers never see any opportunity to give the note back to me or if the reward for doing so is negligible, they will not accept the note in payment. As such, there are three ways to make bearers realize that my promise is credible: ‐

Forced acceptance: I kill you/cut your hands/put you in prison/(fill up the blank for any other miserable things I could to do to you) if you do not take it. The problem with force is that it is difficult and costly to enforce, and not a very effective way to promote confidence in the promise I made. Persuasion always works better than force so below are two ways to persuade.

‐

Convertibility into something valuable:

214

o

If you are one of my students: you automatically get an A in a course I teach if you hand me some E.T. notes (the higher the dollar amount in notes to provide the higher the demand for the notes). This is good as far as it goes, but very few people take my courses.

o

If you are not one of my students: When you give the note back to me, I will give you some gold worth 5 cities. That will help to widen acceptance provided that 5 cities worth of gold is significant, and provided that others believe that I have the means to get the gold I promised.

CHAPTER 15: MONETARY SYSTEMS ‐

Impose a debt on bearers that can be paid with E.T. notes together with penalties if payment is not performed: o

If you are one of my students: handing me some notes counts for a certain percentage of your grade. Acceptance will depend on how much doing so counts. For example, if handing back a certain number of notes counts for 100% of the grade, then demand for E.T. notes will be high, if 1% demand will be low. I imposed a tax on my students. Some economics departments have done such a thing with great success to promote community services performed by students (DVDs and Buckaroos).5

o

If you are not one of my students: Any debt you owe me can be paid by handing me some E.T. notes. Acceptance by potential bearers will depend on the extent to which others are indebted to me, as well as my ability to enforce the payments of dues owed to me (and to punish if payment is not made). Limited number of debtors, ability to evade dues, and lack of effective enforcement mechanisms will reduce the acceptance of my notes.

These means of creating an initial and basic demand for monetary instruments can be combined but today, the ability of an issuer to entice, or to force, other economic units to become indebted to the issuer is the main means used to create an acceptance for a monetary instrument. In my classroom, my ability to do so is very high and, as such, I can acquire many things from my students (including their labor power) by paying them with E.T. notes. I can then use that power for my own selfish interest (to buy stuff from my students for my own enjoyment) or for more social goals (community services to be performed by students). Beyond my classroom, I have no ability to make others indebted to me and my ability to impose force or to provide something valuable in exchange for my note is limited. As such the demand for E.T. notes is small outside the classroom. The same applies to a government within its borders, provided it is credible; as such the government can use that power to spend however it likes (hopefully for the benefits of its citizens) to fulfill the demand for its currency. Outside a country, leaving aside international arrangements that may promote a currency, the demand for a national currency will also be limited because the ability of a national government to impose debts on foreigners is limited. If the currency allows foreigners to obtain something valuable, either through conversion or because the economy produces things that foreigners want (see below for other sources of demand for a monetary instrument), foreigners will net save the currency. The broader your “captive” population, the greater your ability to impose debts on that population and to punish it if it does not comply, and the more widely your monetary instrument is accepted. Guaranteeing convertibility into something else valuable will help further.

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Figure 15.3 A E.T. note worth five cities.

The monetary instruments issued by the government and banks are in high demand because they have a large number of debtors. Government’s ability to impose tax liabilities and other dues (and to throw people in jail if the tax is not paid) has been the preferred method to create an initial willingness to hold government monetary instruments. The higher the ability to enforce the dues and the lower the ability to evade the dues, the higher the demand for the government monetary instruments. When the credibility of a state is low, the state may introduce a conversion clause that promises gold or foreign currency on demand. While this occurred quite frequently in the past, the financial basis for this conversion clause decreased dramatically with greater political stability, greater monetary stability, and better enforcement mechanisms. Chapter 17 shows why convertibility into gold used to be an important means to create a demand for government monetary instruments. Banks create monetary instruments by swapping promissory notes with their customers (see Chapter 10). As such, the issuance of bank monetary instruments simultaneously creates debtors of banks. These debtors have an automatic demand for bank monetary instruments as long as banks have the ability to enforce the claims they have on non‐bank agents (banks can seize assets or have other recourses if payment is not honored). For those who are not indebted to banks, the bank also promises conversion at par into government monetary instruments. Today, the credibility of the convertibility clause is strong, given that governments guarantee the bank’s ability to convert (FDIC deposit guarantee, lender of last resort, and maintenance of an efficient payment system). To conclude, in the broadest terms, the greater the credibility of the issuer, the greater its ability to find people willing to hold its promissory notes. The acceptance of a monetary instrument depends crucially on the credibility of the issuer in terms of fulfilling the promise it made. Indeed, more people will have to make payments to that issuer or can get something valuable from that issuer. This provides the core reason why a specific monetary instrument is accepted. Of course, the same applies to any other financial instruments. Bonds with a higher credit rating are more widely accepted, companies who are about to go bankrupt see their share price fall toward zero as demand for them plunges. Beyond this core reason, bearers may hold a monetary instrument to perform transactions now and in the future with other bearers (see last section). However, if the issuer decides to demonetize its promissory note, these other reasons to hold a monetary instrument do not maintain its fair value.

TRUST AND MONETARY SYSTEM: TRUST IN THE ISSUER VS. SOCIETAL TRUST

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CHAPTER 15: MONETARY SYSTEMS Acceptance introduces the central role of trust for a well‐functioning monetary system. Whenever there is promise, there is trust. But one needs to be careful to understand how trust matters. The answer to “why do you accept a $20 note?” is usually “because I trust others to do so.” To understand why this does not go far enough (beyond the fact that this answer is circular), let us start with another financial instrument. Going back to the fair value example presented above. We saw that the nominal value at which a bond trades is critically dependent on the ability of the issuer to fulfill the promises made. Say that company X now declares it cannot make any of the payments owed on the bond. In that case the fair value of the bond is $0—there is no demand for the bond—, unless bondholders have the ability to seize assets of company X. Similarly, if the government states that it will not accept its $20 FRN whenever presented by bearers, the fair price of the $20 FRN is now $0—the demand for it falls to nothing. There is actually a complication for FRNs because they are secured by the assets of the Fed, so, during the time of bankruptcy proceedings, FRNs will have a value equal to the expected value of the assets of the Fed that are used to back the FRNs. Regarding monetary instruments issued by banks, bearers must trust that: 1‐ banks will convert at par into government monetary instruments at any time, 2‐ that they can clear debts owed to banks with bank monetary instruments. This brings forward an important point. While societal trust (trust of bearers about other bearers’ willingness to hold a monetary instrument) may help financial instruments to circulate more broadly, the trust at the core of the circulation of a financial instrument is the financial credibility of the issuer (trust of bearers about the issuer’s willingness and ability to fulfill its promise). Without the latter, the fair value of an unsecured non‐recourse inconvertible financial instrument falls to zero. As one may expect, Chapter 17 shows that this trust is hard to earn. While all this necessarily follows from the logic of finance, it is not hard to find historical cases that illustrate it. The most recent one is the transition to the Eurozone. Figure 15.4 shows a 50 French franc note that the French government used to accept at face value in payments. From January 1 2002, the French economy moved to the Euro and its government refused French franc in payments. To make the transition smoother, for the next ten years, the Banque de France allowed conversion of its notes into euro‐denominated notes at the rate of 1 euro for 6.55957 French francs (people could go to any branch of the Banque de France to get their francs converted into euros). Since 2012, the French franc notes are no longer convertible into euro notes and their fair value is now zero units of account. French franc notes may still have a value as collectible objects but not as monetary instruments, they have become commodities.

Figure 15.4 A 50 French franc note. 217

CHAPTER 15: MONETARY SYSTEMS In the Middle Ages, coins did not have any face value marked on them. Bearers of the coins would have to periodically listen to royal proclamations in public spaces to know at what value the King would take his coins in payments, i.e. to know the face value. Chapter 17 shows that there were some drawbacks to that system. During the free banking era in the US in the mid‐1800s, Banks discouraged or refused conversion in species on demand: Banks sometimes used remote locations as their redemption points in order to avoid having to redeem their notes in specie. Another method used by the banks to discourage specie demands was to refuse to accept their own notes, except at a large discount. Customers were told that, if they waited, the notes would be later redeemed at par, but such promises were not always kept. The states attempted to require the banks to re‐ deem at par, but those efforts did not meet with success. (Markham 2002, 169) This problem was compounded by widespread forgery that reinforced the reluctance of banks to take their notes immediately at par, even in payments from debtors, because the truthfulness of the notes could not be established. As such, given that both the convertibility promise and the payment promise embedded in banknotes were violated, banknotes traded at a discount. This problem was compounded by the absence of an interbank par‐clearing and settlement mechanism, which prevented the holders of banknotes to exercise their right of immediate maturity. While none of us thinks about the ability to pay the issuer at face value with its monetary instrument when we accept them, without this ability there would not be a well‐functioning monetary system. The credibility of the issuer, if strong, creates an anchor toward which bearers’ expectations about Ys and FV converge and provides stable nominal value.

WHY ARE MONETARY INSTRUMENTS USED? THE MONETARY FUNCTIONS We now know why economic units accept a monetary instrument. While the necessity to pay the issuer and the availability of conversion create a demand for monetary instruments, economic units also want to use monetary instruments for other purposes, namely daily expenses, private debt settlements, portfolio choices, and precautionary savings. A monetary instrument can be used as: ‐

Means of payments: paying debts

‐

Medium of exchange: buying things

‐

Store of value: keeping some purchasing power for the future by saving monetary instruments

The ability to perform these functions is not limited to monetary instruments as defined above. Also, some authors, who define monetary instruments according to their functions (see Chapter 16), broaden the definition of monetary instruments to anything used as means of payment, and/or medium of exchange, and/or store of value. In any case, the ability of a monetary instrument to perform the previous functions is tied to the creditworthiness of the issuer of that monetary instrument; otherwise, monetary instruments would be a poor means of payment, a poor medium of exchange even the short run, and an even

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CHAPTER 15: MONETARY SYSTEMS more terrible long‐term store of value than they currently are. This would be the case not because of inflation (or depreciation), but because their fair value would not be constant. Note that a monetary instrument cannot perform the function of unit of account because there cannot be monetary instrument without a unit of account. As such, the unit of account cannot be a medium of exchange, a store of value, or a means of payment. Stated another way, a monetary system necessitates a unit of account and carriers of this unit of account, but they have separate roles—one measures, the other records the measurement. A unit of account can take the name of an object but it has an independent existence from the object. This manifests itself in two ways. First, the object may disappear but the unit of account persists; or, second, the relationship between the unit of account and the object can change. A cowry unit of account may exist without any cowry shell being used in transactions. If cowries are used, their value in terms of the cowry unit may change—one cowry shell may be worth one cowry at one time and three cowries at another time. Finally, going back to Chapter 13, if a monetary instrument is demanded for purposes and uses other than paying the issuer, then the issuer must issue more monetary instruments than what it gets back from its debtors. A net financial accumulation of monetary instruments by bearers means either that the issuer must be in deficit or that it provides more advances than what is repaid. Again, balance sheets are an easy way to explain this. To simplify, we may assume that there is only one monetary instrument in an economy that it is issued by the government, and that the government does not issue any other liabilities than its monetary instrument. We know that: ΔFLG ≡ (IG – SG) + ΔFAG (IG – SG) is the size of the fiscal deficit and ΔFAG is the net change (acquisition minus reduction) in the quantity of financial assets held by the government. In order for the net injection of monetary instrument to be positive (ΔFLG > 0) there are two possibilities: -

One, the government spends (I) more than it taxes (S) (taxes raise the net worth of the government as explained in Chapter 6).

-

Two, the government advances (ΔFLG > 0) more funds than what refluxes to the government (ΔFLG < 0). That is, the government must acquire more promissory notes from the non‐government sectors (ΔFAG > 0) than the quantity of principal repaid by the non‐ government sectors (ΔFAG < 0). This means that the non‐government sectors are increasingly indebted to the government sector.

Treasury issues government monetary instruments by spending and it destroys government monetary instruments by taxing. The fiscal deficit is a net injection of government monetary instruments in the non‐government sectors (financial asset go up) without a net increase in the financial liabilities of the non‐government sector (financial liabilities stay the same) (see Chapter 6 and Chapter13). This permanent net injection is possible because economic units want to net save the government monetary instruments for the purposes cited above. If economic units only want to hold government monetary instruments for tax purposes, the equilibrium fiscal position is zero; economic units have no desire to net save the government monetary instruments. This point is very well illustrated by the Massachusetts Bay colonies that issued inconvertible, unsecured bills that they promised to accept in payment of taxes. The provincial government noted the importance of a tax system for the stability of its monetary system (this allowed circulation at par of the bills); but the government also noted that taxes tended to drain too many bills out of the 219

CHAPTER 15: MONETARY SYSTEMS economy compared to what was desired by private economic units (which created deflationary forces). This created a dilemma: The retirement of a large proportion of the circulating medium through annual taxation, regularly produced a stringency from which the legislature sought relief through postponement of the retirements. If the bills were not called in according to the terms of the acts of issue, public faith in them would lessen, if called in there would be a disturbance of the currency. On these points there was a permanent disagreement between the governor and the representatives. (Davis 1900, 21) Private sector desired to hold bills for other purposes than the payment of tax liabilities, but, by draining most of the bills via taxes, the government prevented the domestic private sector from accumulating its desired dollar amount of bills. At the same time, taxes were at the foundation of that monetary system so they needed to be implemented as expected. Ultimately, the provincial government was unsure about how to proceed in terms of the dollar amount in bills to recall. Chapter 13 shows that some knowledge of national accounting helps to solve this dilemma: the size of the fiscal position (surplus, balanced, or deficit) should be left to be determined by what non‐ government sectors want to net save. Summary of Major Points 1‐ A monetary instrument is a financial instrument. All financial instruments follow the same basic rule of finance: the creditworthiness of the issuer is at the foundation of the nominal value of those instruments. This creditworthiness is about the expected ability of the issuer to fulfill the promises he made. 2‐ A government promises to take back its monetary instrument at any time at face value and does not promise to pay any income. This means that the fair price of a government monetary instrument is face value. A government may also a promise a conversion of its monetary instrument into something else. The same logic applies to any other issuer. 3‐ Anybody can issue monetary instruments, i.e. zero‐coupon zero‐term securities; the point is to get them accepted. This can be done by convincing others of the credibility of the promise embedded in a monetary instrument. 4‐ The acceptance of current monetary instruments at par is mostly based on the ability of the issuers to make others indebted to them and to enforce that debt. Banks make others indebted to them when they create monetary instruments because they acquire a promissory note at the time of the bank credit. Governments impose tax liabilities on most of their citizens. 5‐ Monetary instruments are used mostly in transactions with other economic units than the issuer. They can be used as a medium of exchange, store of value, and means of payment. In such cases, the issuer of monetary instruments must run a deficit or the non‐government sector must increase its indebtedness toward the government sector. 6‐ While creditworthiness enables the creation of perfectly liquid financial instruments, this does not guarantee a stable purchasing power. A stable purchasing power is not a promise made by issuers of monetary instruments, but at long as relative price stability prevails this is not a problem for monetary system. 7‐ There are two means for a monetary instrument worthless. One, it circulates at par but its purchasing power is poor (hyperinflation). Two, prices of goods and services do not change but it circulate at a very deep discount (default by the issuer or problem with the financial infrastructure). 8‐ A net injection of monetary instrument requires that the issuer deficit spends or that others have a growing amount of debt owed to the issuer. 220

CHAPTER 15: MONETARY SYSTEMS Keywords Unit of account, medium of exchange, store of value, means of payment, fair price, face value, redeemable, convertible, societal trust, reflux mechanisms, nominalism, valorism, secured, unsecured, recourse, term to maturity Review Questions Q1: What do you have to do if you want to issue a monetary instrument that functions properly? Q2: Why is societal trust not a satisfactory explanation of why monetary instruments are accepted? Q3: If the creditworthiness of the issuer of a financial instrument evaporates, what happens to the fair price of that financial instrument, if it collateralized? If there is no collateral but there are recourses? If it is an unsecured, non‐recourse financial instrument? Q4: If the purchasing power of face value falls, how does that impact the creditworthiness of the issuer of a monetary instrument? Q5: Can a unit of account be a medium of exchange? Q6: Can there be monetary instruments without a unit of account? Q7: What are the two means for the non‐government sector to obtain government monetary instruments? Suggested readings Bell, S.A. (2001) “The role of the state and the hierarchy of money,” Cambridge Journal of Economics, 25 (2): 149‐163 Innes, A.M. (1913) “What is money?” Banking Law Journal 30(5): 377‐408. ________. (1914) “The credit theory of money,” Banking Law Journal 31(2): 151–168. MacLeod, H.D. (1889) The Theory of Credit. London: Longmans and Green. Mann, F.A. (1992) The Legal Aspect of Money. Oxford: Oxford University Press. Olivecrona, K. (1957) The Problem of the Monetary Unit. New York: Macmillan. Smith, T. (1832) An Essay on Currency and Banking. Philadelphia: Jasper Hardin. Tymoigne, E. (2014) “A financial analysis of monetary systems.” In Papadimitriou, D.P (ed.) Contributions to Economic Theory, Policy, Development and Finance. New York: Palgrave Macmillan. Wray, L.R. (ed.) (2004) Credit and State Theories of Money, 223‐262, Northampton: Edward Elgar 1 A check drawn to pay Mr. X can be used by Mr. X to pay Mr. Y. See “How to endorse a check to someone else” at

https://www.youtube.com/watch?v=jSE6RwPOlNM 2 See Bill Mitchell’s “Zimbabwe for hyperventilators 101” http://bilbo.economicoutlook.net/blog/?p=3773 3 See “Origins of currencies: from jagged edges to flowers” http://blog.oxforddictionaries.com/2014/02/origins‐ currencies/ 4 Olivecrona, K. (1957) The Problem of the Monetary Unit. New York: Macmillan. 5 For the DVD program see http://depts.drew.edu/econ/DVD/. For the Buckaroo program see http://neweconomicperspectives.org/2009/07/berkshares‐buckaroos‐and‐bear‐dollars.html

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CHAPTER 16: After reading this Chapter you should be able to understand: Why a gold ingot is not and has never been a monetary instrument Why money is not what money does Why monetary logic is not circular Why monetary instruments circulate at face value even if they are unsecured and inconvertible. What errors have been made in the past when setting up monetary systems

CHAPTER 16: FAQs ABOUT MONETARY SYSTEMS The following answers a few question in order to illustrate Chapter 15 and to develop certain points.

Q1: CAN A COMMODITY BE A MONETARY INSTRUMENT? OR, DOES MONEY GROW ON TREES? Let us tackle the idea that “gold is money”. Clearly, a gold ingot is not a monetary instrument. There is no issuer, no denomination in a unit of account, no term to maturity or any other financial characteristic. A gold ingot is just a commodity, a real asset, not a financial asset. Gold coins have been monetary instruments and are still issued at times (Figure 16.1).

Gold ingots

2009 $50 American buffalo gold coin Figure 16.1 Gold vs. gold coin

Similarly, it is incorrect to state that “salt was money” because salt is a commodity that embeds no promise; however, Marco Polo noted that in the Chinese province of Kain‐du:1 There are salt springs, from which they manufacture salt by boiling it in small pans. When the water is boiled for an hour, it becomes a kind of paste, which is formed into cakes of the value of two pence each. […] On this latter species of money the stamp of the grand khan is impressed, and it cannot be prepared by any other than his own officers. Eighty of the cakes are made to pass for a saggio of gold. But when these cakes are carried by traders amongst the inhabitants of the mountains, and other parts little frequented, they obtain a saggio of gold for sixty, fifty, or even forty of the salt cakes, in proportion as they find the natives less civilized. It seems that salt cakes issued by an emperor (“grand khan”) might have circulated as monetary instruments. However, a lot of details are missing from this description: 1‐ What were the unit of account and face value? (definitely not the pound, it is China) 2‐ What was the term to maturity? Were the cakes accepted in payment of dues at any time by the emperor? 3‐ What were the means for the emperor to make the previous financial characteristics a reality? I.e., what were the reflux mechanics? Did the emperor levy dues that could be paid with salt cakes at par? Did the cakes provide conversion into something? Etc. Bearers need to be convinced, so trust about the issuer must be established. 223

CHAPTER 16: FAQs ABOUT MONETARY SYSTEMS 4‐ The bit about the amount of gold that salt cakes could buy is irrelevant. Polo is just telling us that a commodity (gold bullions) was cheaper in the mountains. He might as well have told us about how different the price of apples and potatoes are in different parts of the country. The broad point is that monetary instruments can be made of a commodity but that commodity itself is not a monetary instrument. We all know the expression “money does not grow on trees.” Monetary instruments are not a natural occurrence and for a commodity to become a monetary instrument some specific financial characteristics must be added: a unit of account, a face value, a term to maturity, among others. All this requires an issuer who promises to implement these financial characteristics. Say a gold miner wants his gold nuggets to be a monetary instrument, for that to be the case the goldminer must promise: 1‐ To distinguish his gold nuggets from other gold nuggets 2‐ To declare what their face value is in terms of a unit of account 3‐ To implement that face value by promising to take back at any time the gold nuggets in payments at the stated face value. Now the third condition introduces a problem because it means that the gold miner; must be willing to be paid in gold nuggets for his gold nuggets. A dubious business strategy, indeed! Most economists that work within the Real Exchange Economy framework, do consider monetary instruments to be commodities. Monetary instruments do grow on trees—there are fruits—and all debt payments are denominated in fruit.2 This creates difficulties to convincingly include “money” in models, and pushes to ignore the financial side of the economy (see Chapter 10 and 13) and the role of nominal aspects (see Chapter 11).

Q2: CAN A MONETARY INSTRUMENT BECOME A COMMODITY? Yes. Numismatists are specialists at treating current and former3 physical monetary instruments as commodities by determining the price of banknotes and coins as a function of their rarity, peculiarity, etc. For example the $1 FRN in Figure 16.2 is worth $1200 currently because of its peculiar serial number. But that is not its fair value as a monetary instrument. If one buys this note and goes to a store or to a government office, the person to whom one hands the note will only take it for $1. The same applies to the buffalo gold coin above. One can use it to pay debts owed to the government but only $50 worth, not more nor less, even though the coin is worth thousands of dollars as a collectible item.

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Figure 16.2 A $1 FRN worth $1200 as collectible items Source: www.collectorscorner.com

The same applies also to gold and silver certificates. Here is how the U.S. Treasury puts it: Although gold certificates are no longer produced and are not redeemable in gold, they still maintain their legal tender status. You may redeem the notes you have through the Treasury Department or any financial institution. The redemption, however, will be at the face value on the note. These notes may, however, have a "premium" value to coin and currency collectors or dealers. (U.S. Treasury) One can redeem them at the Treasury (to pay debts owed to the Treasury or to get Federal Reserve notes) or deposit them at banks, but only at face value. That is their value as monetary instrument. Their value as a collectible item is sometimes much higher. Finally, a fun example is the current case of the penny, which brings us back to darker times of monetary history (see Chapter 17). A while back, National Public Radio ran a segment on penny hoarders.4 These are people whose hobby is to hoard pre‐1982 pennies. Some even go to their local banks and spend their evenings triaging boxes of pennies. Why would they do that would you ask? Pre‐1982 pennies were made mostly of copper and, given that the price of a pound of copper tripled over the past ten years, the face value of a penny is half the intrinsic value (i.e. value of the content of copper): face value is 1 cent, intrinsic value is 2 cents, 100% profit from selling pennies for their copper content! Currently, there is one small problem with this portfolio strategy: It is illegal to destroy government currency. However, the government is considering the possibility of demonetizing the penny coin because it costs more to make than its face value, and because US residents mostly find it cumbersome to use. If the government ever demonetizes the penny coin, penny hoarders are ready to rush to their local scrap metal dealers.

Q3: IS MONEY WHAT MONEY DOES? Francis Amasa Walker concluded in the late 19th century that “money is what money does.” This has been an extremely influential way of analyzing monetary systems in many different disciplines: economics, anthropology, law, among others. It is used in a narrow way by economists who use the Real Exchange Economy framework (see Chapter 11) and who focus on the function of medium of exchange. In order to avoid the problem 225

CHAPTER 16: FAQs ABOUT MONETARY SYSTEMS of double coincidence of wants induced by barter (Joe has apples and wants pears, Jane has pears but wants peaches), a unique commodity was progressively sorted out as best for market exchanges, the story goes. Thus, a monetary system can be detected by checking for the presence of a medium of exchange. Anthropologists, among others, reject this narrow functional approach. In primitive societies, exchange was not done principally, or even at all, for economic reasons and so the nonexistence of a double coincidence of wants was not a problem.5 The broad functional approach classifies anything as a monetary instrument as long as it performs all or parts of the functions attributed to monetary instruments. The distinction between “all‐purpose money” and “special‐purpose money” follows. A main issue with the functional approach is that it does not explicitly define what “money” is, which creates several issues: ‐

Inquirer may pick and choose depending on the circumstances, which may lead the inquirer to impose inappropriately his own experience to explain the inner workings of completely different societies.

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Inquirer may tend to assume that monetary instruments must take a physical form when they may be immaterial.

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Inquirer may exclude things that are monetary instruments but are not used for any of the preferred functions. Collectible coins and notes are monetary instruments as long as the issuer does not demonetize them.

More broadly, too much emphasis is put on detecting things that fulfill the selected function and not enough effort will be devoted to a detailed account of the financial mechanics at play and their relation to the socio‐politico‐economic context: unit of account used, how the fair value was determined and if it fluctuated, how the reflux mechanisms were implemented, etc. The example of the salt cakes above is an illustration of that point. Just noting that something is used as medium of exchange or means of payment, and moving on to something else, is a poor way to perform monetary analysis. Finally, inquirers using this approach may confuse monetary payments and in‐kind payments, may assume that there is a monetary system where there is none, may make a truncated analysis of monetary systems consisting mostly in a mere recollection of objects, and may miss the presence of a monetary system. For examples, by relying on the words of an Arab merchant and an Arab historian of the 9th and 10th century, Quiggin reports that more than a thousand years ago cowry shells: formed the wealth of the royal treasury […] [and] when funds were getting low, the sovereign sent out servants to cut branches of coconut palm and throw them into the sea. The little mollusks climbed on to the branches and were collected and spread out on the sand to dry until only the empty shells were left. So the royal bank was filled again. Ships from India brought goods to the Maldives and took back millions of shells packed up in thousand in coconut palm leaves. It was a profitable trade, for even in the seventeenth century we hear of 9,000 or 10,000 cowries being bought for a rupee and sold again for three or four times as much on the mainland of India. (Quiggin, 1963, 25‐26) However, from this description, one cannot conclude that cowries were monetary instruments used by the king to finance the purchase of foreign goods and services. Indeed, it is not explained what 226

CHAPTER 16: FAQs ABOUT MONETARY SYSTEMS the unit of account of the Maldives was and how cowries were monetized, that is, who, if anybody, issued them as financial instruments (did the royal authority issue them and was the royal bank ready to accept cowries in payments?), and what their relation the unit of account was. In addition, the role of cowries as monetary instruments is doubtful for the Maldives because cowry shells were worth nothing against goods “except by shipload” (Polanyi 1966, 190)—an extremely inconvenient means of payment and medium of exchange. What one can conclude from the description is that the Maldives authorities were involved in the trade of cowries with Indian and Arab merchants. They were exporting cowries against imports of other goods—a situation of bilateral trade, not a situation of a cowry monetary system.

Q4: ARE CONTEMPORARY GOVERNMENT MONETARY INSTRUMENTS IRREDEEMABLE? OR, IS THE FAIR VALUE OF CONTEMPORARY GOVERNMENT MONETARY INSTRUMENTS ZERO? No. A well‐functioning monetary system requires that all monetary instruments be redeemable. Federal Reserve notes are redeemable, silver certificates are redeemable even though they are no longer convertible in silver (see the Treasury in Q2), and bank accounts are redeemable. They are redeemable as long as they can be returned to the issuer, hopefully at their initial face value (see Chapter 15). They can be returned to the issuer through two channels: ‐

Bearers demand conversion into something else at a given rate: government currency for bank accounts, foreign currency for government currency, etc.

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Bearers pay the issuer: governments take their currency in payments of dues owed to them, as do banks. The payment allows bearers to avoid jail time and other legal problems.

So to be redeemable a monetary instrument does not have to be convertible. As such, the fair value of a monetary instrument, its present value, is face value (see Chapter 15). In the past, some governments did forget to include, or removed, a redemption clause: Paper money has no intrinsic value; it is only an imputed one; and therefore, when issued, it is with a redeeming clause, that it shall be taken back, or otherwise withdrawn, at a future period. Unfortunately, most of the governments, that have issued paper money, have chosen to forget the redeeming clause, or else circumstances have intervened to prevent their putting it into execution; and the paper has been left in the hands of the public, without any possibility of its being withdrawn from circulation (Smith 1832, 49) Probably, no government paper money was ever sent forth which was not expected to be redeemed in full value, at some time, although that might be distant. […] Nevertheless, the issues of government money that have not been redeemed, or the payment of which has been either formally or tacitly renounced, have been very numerous. (Langworthy Taylor 1913, 309) In that case, the fair value of a monetary instrument is indeed zero because its term to maturity is infinity, which means that its fair value is (see Chapter 15): P = C/i 227

CHAPTER 16: FAQs ABOUT MONETARY SYSTEMS Given that no coupon was paid, P = 0. But this does not apply today because monetary instruments are redeemable on demand by bearers at a stable face value. All this does not seem to be well understood. For example, recently Adair Turner wrote (and he is far from the only one to have said so): Monetary base is an asset for the private sector, but for the government it is a purely notional liability (with NPV equal to Zero) since it is irredeemable and non‐ interest‐bearing. (Turner 2015) This confuses irredeemable and inconvertible. The monetary base is redeemable, that is, it can be returned to the issuer at face value at anytime. This point of view also raises other problems: ‐

Remember that balance sheets are interrelated (see Chapter 13) so if a financial liability is worth zero in one balance sheet, then a financial asset must be worth zero in another balance sheet. Turner makes an accounting error.

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Why would the private sector be willing to hold something that is worth zero? There is no benefit that comes from accepting such a monetary instrument, not even avoiding prison, because taxes cannot be paid with such government monetary instruments.

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If valued at zero then balance sheets should record a large loss of assets (and net worth) for banks, firms, and households: Your monetary balances would be worth nothing in nominal terms!

Q5: IS MONETARY LOGIC CIRCULAR? No. As with any other financial instrument, the acceptance of a monetary instrument by anybody ultimately rests on the confidence in the issuer, not on the confidence that other potential bearers will accept it. While bearers may never think about the creditworthiness of the issuer when accepting a monetary instrument from another bearer, one cannot infer from that that creditworthiness is not essential for acceptance. One merely has to study the stock market to see that this conclusion is incorrect. Most trading of stocks is done just for the sake of trading by humans or by computers focused on millisecond price movements. This does not neglect the central role of the creditworthiness of the firm that issued the stock in sustaining the fair price of the stock. Financial mechanics cannot be denied.

Q6: DO ISSUERS OF MONETARY INSTRUMENTS PROMISE A STABLE PURCHASING POWER? No. If that were the case, issuers of monetary instrument would have defaulted on their promise continuously since the beginning of financial times. They never were able to provide a stable purchasing power, even less so since the end of World War Two (see Chapter 15). As such, the demand for monetary instruments would be nil if a stable purchasing power was a promise embedded in monetary instrument because the creditworthiness of the issuer would be nil. A stable purchasing power is not a promise of any issuer of monetary instruments. This is fine for most bearers as long as the purchasing power of monetary instruments is relatively stable in the

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CHAPTER 16: FAQs ABOUT MONETARY SYSTEMS short‐term. If one wants something that holds purchasing power over the medium to long run, then one should switch to other assets.

Q7: ARE MONETARY INSTRUMENTS NECESSARILY FINANCIAL IN NATURE? Yes, remember: “money does not grow on trees.” While monetary instruments can be made of a commodity that commodity, does not tell us anything about the monetary nature of a thing. A gold coin is a monetary instrument not because it is made of gold but because of its financial characteristics. Gold is the collateral embedded in the coin. Similarly a house is not a mortgage, a house is the collateral for a mortgage and nothing can be learned about the inner workings of mortgages by studying how a house is made. The “primitive moneys” would need to be studied much more carefully to determine if some of them were monetary instruments. Just checking if they passed hands in exchange of goods and services, if they were used to pay for a bride, etc. is a poor means of determining the “moneyness” of something, given that one cannot differentiate between in‐kind payments and monetary payments. We saw above that cowry shells were not monetary instruments in the Maldives but they were in Africa and a detailed analysis was necessary and done to establish that fact.

Q8: ARE CREDIT CARDS MONETARY INSTRUMENTS? WHAT ABOUT PIZZA COUPONS? WHAT ABOUT PRETEND‐PLAY BANKNOTES AND COINS? WHAT ABOUT BITCOINS? No to all questions. A credit card is not a financial instrument—it does not have a maturity (issuers of credit cards do not accept credit cards in payment) and it is not related to a unit of account (it is not a carrier of the unit of account). The underlying credit line is not a financial instrument either. The line represents the maximum dollar value of a customer’s promissory note (called credit card receivables) that a credit company is willing to take on its balance sheet. Say that household #1 wants to get a credit card from Bank A. #1 fills up the required documentation so A can check #1’s creditworthiness. #1 is approved by A and gets a $1000 credit line. Where is that recorded on the balance sheet? Nowhere, it is an off‐balance sheet item. The line is just saying that A will take on its balance sheet up to $1000 of #1’s promissory notes without asking again to check #1’s creditworthiness. Chapter 10 shows what happens when a credit line is used: A’s assets rise by the amount of the credit line drawn by #1, #1’s liabilities rise by that same amount. What about a pizza coupon? It has an instantaneous maturity (one can go to the pizza shop at any time to claim a pizza), it is a convertible, but it is not a financial instrument because it does not involve monetary payments but merely in‐kind payments: it converts into a commodity. If the coupon could be used to pay debts owed to the pizza shop at any time and, if the pizza shop stated at what value it would take the coupon in payments, then it would be a monetary instrument.

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CHAPTER 16: FAQs ABOUT MONETARY SYSTEMS Figure 16.3 shows a set of play notes that my son got with his toy cash register. In order for the notes to become monetary instruments, the company that created them would need to do the following: 1‐ Change the design: too close to the design of Federal Reserve notes even though it is a crude imitation. “The United States of America” should be eliminated because they are not issued by the United States Government. 2‐ Promise to take the notes in payment: Bearers can pay the company with the notes to buy things from, and clear debts owed to, the company. Finally, bitcoins do not have any issuer and are irredeemable. The first problem prevents them from being a monetary instrument, the second problem makes them valueless as monetary instruments.6 Bitcoins are commodities/real assets, not financial assets.

Figure 16.3 Pretend‐play monetary instruments

Q9: WHAT WERE SOME ERRORS MADE IN PAST MONETARY SYSTEMS? Given the characteristics of monetary instruments, they should circulate at parity all the time; however, actual circulation at par does not define a monetary instrument. Par circulation is only the result of the inner characteristics of a financial instrument, the ability and willingness of the issuer to implement these characteristics, and the existence of a proper financial infrastructure that 230

CHAPTER 16: FAQs ABOUT MONETARY SYSTEMS allows these characteristics to be expressed in the fair value. Only recently have there been well‐ functioning monetary systems. They are not without problems, but, in general, they ensure a smooth processing of payments (see Chapter 14 when that is not the case) and can be used as a reliable medium of exchange (see Chapter 12 when that is not the case), both of which help to promote economic prosperity to some extent. For reasons related to poor techniques of production, inexperience, political instability, frauds, and poorly developed banking systems, it took quite a long time for the proper characteristics and infrastructure to be established. Below are some errors that were made along the way: •

No stamped face value: In the Middle Ages, kings cried up or down (i.e. changed by decree) the face value too many times. –

•

Free‐coinage: Anybody with gold can go to the mint and get coins stamped out of ingots (government keeps a portion of the ingots: seigniorage) –

•

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What is the problem? The term to maturity is no longer instantaneous as promised but depends on the expectations of bearers. As such the discount factor comes back into the valuation of the fair price and so the fair price is unstable and varies with the confidence of bearers about the issuer.

Full‐bodied coins: At issuance the face value (FV) is the same as the market value of the gold content (PgG with PG the price of gold per ounce and G the ounces of gold in the coin) –

•

What is the problem? Fair price is zero unless there is a collateral or a recourse.

There is a redeeming clause but no actual means to implement it because no payment is due to the issuer (Chapter 17 shows that taxes during the time of colonial bills were not always implemented when they were supposed to be), or conversion is very difficult (banks during the free‐banking era). –

•

What is the problem? Kings legalized counterfeiting. Anybody with gold could issue a debt of the king, i.e. make the king liable. Today, in the United States, an equivalent would be for the Bureau of Engraving and Printing to print Federal Reserve notes for anybody who came with paper that respected the Bureau’s specifications!

No redeeming clause: There is no way to return to the issuer its monetary instruments –

•

What is the problem? Nobody had any idea what face value was: “there were so many edicts in force referring to changes in the [face] value of the coins, that none but an expert could tell what the [face] value of various coins of different issues were, and they became highly speculative commodities” (Innes 1913, 386).

What is the problem? if ∆Pg > 0 => PgG > FV => coins disappear from circulation (melted into ingots or exported as commodities)

Lack of a proper interbank payment system: in that case interbank debts are difficult to clear and settle. This creates all sorts of problems going from delays in processing payments, to loss of purchasing power because some bank monetary instruments trade at a discount relative to other bank monetary instruments, to full blown financial crises because payments cannot be processed and so creditors do not receive what they are owed and in turn cannot pay their own creditors.


Q10: DO LEGAL TENDER LAWS DEFINE MONETARY INSTRUMENTS? WHAT ABOUT FIXED PRICE? Legal tender laws state that, in court settlements, creditors must accept whatever is defined as legal tender in payments of what is owed to them. If they do not accept it, they cannot sue their debtors for unpaid dues. This does not mean that a legal tender cannot be refused during petty transactions. The current legal tenders in the United States are Federal Reserve notes, but plenty of shops and government offices refuse cash payments. Something that is legal tender is not necessarily a monetary instrument. In the past, commodities have been included in the legal tender laws, thereby, compelling creditors to accept payments in kind. Chapter 17 develops the case of tobacco leafs in the United States, which came about because of a shortage of monetary instruments. Something that has a fixed price is also not necessarily a monetary instrument. It may just be a commodity managed by an economic unit via the use of a buffer stock; the economic units accumulates large inventories of the commodity to offset downward pressures of its price, and sells off its inventories to offset upward pressures of its price.

Q11: IS IT UP TO PEOPLE TO DECIDE WHAT A MONETARY INSTRUMENT IS? WHO DECIDES WHEN SOMETHING IS DEMONETIZED? Public opinion about what is or what is not a monetary instrument does not matter and popular belief by itself cannot turn something into a monetary instrument. To use an analogy, one can use a shoe to hammer nails but it does not make the shoe a hammer. The fact that everybody thinks that shoes are hammers does not turn shoes into hammers. If everybody is delusional enough to believe the contrary, there will be many more work‐related accidents and productivity will drop because shoes are not built properly to hammer nails. In a similar fashion, if everybody wants to believe that gold nuggets, tobacco leafs, or grains of salt are monetary instruments, the payment system will not work smoothly and economic activity will suffer. As explained in Q2, some monetary instruments are used merely as collectible items. Some persons may also use monetary instruments as ornaments and for other non‐economic uses. These other uses do not demonetize a monetary instrument. That can only happen if a monetary instrument seizes to be a promise and that is up to the issuer to decide.

Q12: CAN ANYBODY CREATE A MONETARY INSTRUMENT? Yes, as long as one does not counterfeit existing monetary instruments, one can do so.7 One should then have a monopoly over the issuance of such an instrument. Good luck getting it accepted!

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Summary of Major Points 1‐ A commodity cannot be a monetary instrument by itself, it needs additional financial characteristics fitted onto it. 2‐ In order to detect a monetary instrument one must study the financial characteristics of what is said to be a financial instrument. The fact that something is a legal tender, a medium of exchange, or circulates at a stable price does not tell us much about the monetary nature of that thing. 3‐ A proper monetary analysis involves dissecting the financial characteristics of a monetary instrument and determining if the means are available to make these financial characteristics a reality. In doing so, one must study the reflux mechanism and the issuer’s ability to fulfill the promises made in a financial instrument. 4‐ A monetary instrument is accepted by bearers for the same reasons that a stock or a bond is accepted by bearers: they trust the issuer’s ability to fulfill the promise embedded in the financial instruments. While on a daily basis bearers trade stock, bonds, cash and other monetary instruments without thinking about how creditworthy the issuer is, if the latter announces a default that has an immediate impact on the fair price. 5‐ Gold coins are not monetary instruments because they are made of gold. Gold is just a collateral embedded in the coin. 6‐ Inflation and deflation do not reflect a change in credit risk for the issuer of monetary instruments. Keywords fair price, face value, legal tender laws, debasement, crying down/up the coinage, term to maturity, collateral, free coinage, full‐bodied coin, redeeming clause, convertible, redeemable, Review Questions Q1: Explain why bitcoins and pretend‐play notes are not monetary instruments? Q2: Why may a legal tender not be a monetary instrument? Q3: If the issuer of a monetary instrument defaults, what happens to the fair price of that instrument? What does it mean for day to day transactions of that instrument? Q4: Who determines that something is a monetary instrument? Q5: Why is a gold nugget not a monetary instrument? Q6: What was the problem with free coinage? Full‐bodied coins? The absence of a redeeming clause? 1

See section on salt currency at the Encyclopedia of Money blog: http://encyclopedia‐of‐ money.blogspot.com/2011/10/salt‐currency.html 2 Kiyotaki, N. and Moore, J. (1997) “Credit Cycles,” Journal of Political Economy 105 (2): 211‐248. 3 See http://www.theguardian.com/money/2016/may/14/zimbabwe‐trillion‐dollar‐note‐hyerinflation‐investment 4 Listen to “Penny Hoarders Hope For The Day The Penny Dies” by Zoe Chase at http://www.npr.org/2014/05/21/314607045/penny‐hoarders‐hope‐for‐the‐day‐the‐penny‐dies 5 See Ilana E. Strauss’s “The Myth of the Barter Economy” http://www.theatlantic.com/business/archive/2016/02/barter‐ society‐myth/471051/ 6 See Eric Tymoigne’s “Fair price of bitzoing is zero” at http://neweconomicperspectives.org/2013/12/fair‐price‐bitcoin‐ zero.html

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CHAPTER 16: FAQs ABOUT MONETARY SYSTEMS 7 For example of pround counterfeiters who take their art very seriously, see “'Counterfeiting is an art': Peruvian gang of

master fabricators churns out $100 bills” at http://www.theguardian.com/world/2016/mar/31/counterfeiting‐peruvian‐ gang‐fabricating‐fake‐100‐bills

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CHAPTER 17: After reading this Chapter you should be able to understand: What some of the problems have been in setting up a monetary system How a functional approach to monetary systems can mislead an inquirer into the existence of a monetary instrument. Why medieval times were dark times for monetary systems

CHAPTER 17: HISTORY OF MONETARY SYSTEMS The goal of this chapter does not to present a complete history of monetary systems but rather to illustrate the points and framework presented in the two previous chapters. The goal of this chapter is to show how to study the history of monetary system by taking a few examples. The financial mechanics at play are emphasized and linked to the socio‐politico‐economic context.

MASSACHUSETTS BAY COLONIES: ANCHORING OF EXPECTATIONS AND INAPPROPRIATE REFLUX MECHANISM Massachusetts Bay colonies responded to the lack of currency by issuing bills of credit that “shall be accordingly accepted by the treasurer and receivers subordinate to him, in all publick payments, and for any stock at any time in the treasury” (Davis 1900, 10). The government spent by issuing the bills and levied a tax to allow bearers to redeem them. Initially, trust in the bill was low because of the political and financial risks: When the government first offered these bills to creditors in place of coin, they were received with distrust. […] their circulating value was at first impaired from twenty to thirty per cent. […] Many people being afraid that the government would in half a year be so overturned as to convert their bills of credit altogether into waste paper, […]. When, however, the complete recognition of the bills was effected by the new government and it was realized that no effort was being made to circulate more of them than was required to meet the immediate necessities of the situation, and further, that no attempt was made to postpone the period when they should be called in, they were accepted with confidence by the entire community […] [and] they continued to circulate at par. (Davis 1900, 10, 15, 18, 20) The population was unsure that the government would be willing or able to fulfill the promise to take back the bills at any times at par in tax payment. This lack of trust was compounded by the fact that, while the promise stipulated that bills could be returned at any time, in practice the tax levied to redeem the bills was initially implemented only once a year. Thus, when bills were issued initially, d was positive and bearers’ expectations about the term to maturity (E(N)) compounded the discount applied to the bills. 1

The government asked for the help of Boston merchants who agreed to take the bills at a small discount in payments from the government. Ultimately, the bills circulated at par as the government retired the bills as expected in a timely fashion. However, as explained in Chapter 15, tying the issuance of bills of credits to a specific tax created a dilemma. The private sector wanted to accumulate the bills but taxes prevent the accumulation of the desired dollar amount of bills. At the same time, taxes were at the foundation of the monetary system so they needed to be implemented as expected. Ultimately, the provincial government was unsure about how to proceed. One drastic method was to breach the promised term to maturity by postponing the implementation of the tax levy for several years. This was an effective default relative to the terms of the bills and a sure means to decrease the confidence in the bills and so their fair value (ibid., 108); “this fact alone would have caused them to depreciate, even if the amount then in circulation had been properly proportioned to the needs of the community” (Ibid., 236

CHAPTER 17: HISTORY OF MONETARY SYSTEMS 20). The discount rate became positive again which lowered the purchasing power of bills given output prices. Later on, the provincial government found a more appropriate solution to the dilemma by broadening the types of dues that could be paid with the bills. From this example, one can learn several useful lessons. First, trust in the issuer of a monetary instrument requires some work to be earned but is central for the ability of that instrument to circulate at par. Second, if the reflux mechanisms in place are inconsistent with the promise made, there will be problems to fulfill the promise made. Colonial governments promised redemption at the will of bearers but payments owed to the government were only implemented occasionally and narrowly. Third, once one has made a promise, one had better keep up with it; otherwise, bearers lose confidence quite quickly.

MEDIEVAL GOLD COINS: FRAUD, DEBASEMENT, CRYING OUT, AND MARKET VALUE OF PRECIOUS METAL The most complex historical case regarding the fair value of monetary instruments concerns the medieval coins made of precious metal. There are three broad problems in this case. One relates to the face value of the coins, another relates to the intrinsic/bullion value of the coins (i.e., the market value of the precious‐metal content), and a third one relates to the interaction between the first two problems. Up until recently, the face value was not stamped so it “was carried out by royal proclamation in all the public squares, fairs, and markets, at the instigation of the ordinary provincial judges: bailiffs, seneschals, and lieutenants” (Boyer‐Xambeu et al. 1994, 47). This announcement declared at what nominal value the King would take each of his specific coins in payments due to him, thereby establishing their face value. Frequent changes in face value led to confusion among bearers, especially so given that the spread of information was slow and inadequate. Coins made of precious metals were a way to partly deal with the uncertainty surrounding the face value of coins. Coins with high precious metal content would be demanded from sovereigns that could not be trusted, either because they cried down too much, or refused some of their coins in payments too often, or were weak politically. The higher the content of precious metal relative to the face value, the more limited the capacity of Kings to cry down the coinage because coins would disappear if the face value fell below the market value of the precious‐metal content. Coins would be melted (or exported as bullions) to extract the precious metal, because more units of a unit of account could be obtained per coin by selling the precious metal instead of handing over coins to the King. Finally, others (e.g., mercenaries) demanded payments in such a form because they did not expect to be debtors to the King or to meet someone in debt to the King, or to meet someone who would expect to make transactions with someone else indebted to the King. While the issuance of such coins was warranted given the poor political and financial stability of the time, they created several issues related to their intrinsic value and its impact on the fair value. If circumstances in the precious metal market pushed the value of the precious metal higher than the prevailing face value, mint masters and money changers would melt or illegally debase (e.g., clipping and sweating) the coinage even if the creditworthiness of a King was excellent. In theory, illegal debasements would occur until the intrinsic value was brought back to the face value but it became such a habit that it continued even when the value differential was nil. Expectations about future increases in the price of the precious metal (or future crying down) also encouraged illegal 237

CHAPTER 17: HISTORY OF MONETARY SYSTEMS debasements, even if no profit could be made right now. Fraud was further encouraged by the imperfect production methods. Coins with the same denomination and date of issuance had different weight and fineness even under the best circumstances. Coins also had uneven edges that made clipping difficult to notice, if done moderately. Fraud was problematic because it disturbed the uniformity and order that Kings wanted to establish to give confidence in their coinage; the stamp was a certificate of authenticity of the weight and fineness of the collateral embedded in coins. The King’s reputation was at stake. If allowed to go on, the country would be left with a coinage of an insufficient quantity and quality to promote smooth economic operations, and clumsy and deformed coinage encouraged forgery. In order to prevent this from happening, Kings actively fought any fraudulent alteration of the intrinsic value of coins. They did so through several means. One was to punish severely fraudsters: The coins were rude and clumsy and forgery was easy, and the laws show how common it was in spite of penalties of death, or the loss of the right hand. Every local borough could have its local mint and the moneyers were often guilty of issuing coins of debased metal or short weight to make an extra profit. […] [Henry I] decided that something must be done and he ordered a round‐up of all the moneyers in 1125. A chronicle records that almost all were found guilty of fraud and had their right hands struck off. (Quigguin 1965, 57‐58) Another means was to weigh the coins that were brought to pay dues, and to refuse in payments all coins that had a lower weight than at issuance. Finally, two other ways were either to debase (decrease the quantity of previous metal to decrease the intrinsic value) or to cry up the coinage (increase the face value): debasements were only necessary alterations in the quantity of silver in the coins, in order to keep pace with the rise in the price of silver bullion in the market; […] It has always been necessary to regulate the quantity of metal in the coins, because, if too much was put in, they would immediately be withdrawn from circulation and sold for bullion, […]; if too little was put, they might be imitated. (Smith 1832, 34) In this case, debasement was not a means to increase the financing capacity of the King. It was a legitimate means to preserve the stability of a monetary system in which the value of precious metal played a role as collateral. However, debasement was a limited solution to offset the rising price of precious metals because the risk of forgery grew with further debasement. Debasement also negatively impacted the King’s creditworthiness even though he may have had nothing to do with the problem and was trying to promote a stable monetary system. Crying up the coins was not constrained by the risk of forgery, but it created another problem, as potential inflationary pressures emerged when the money supply was raised unilaterally overnight in nominal terms. Price pressures in the precious metal markets could creep into the market for goods and services, and, once again, the King would be blamed. Finally, frequent crying up created further confusion among the public about the face value of coins; thereby, it reinforced distrust and demands for coins with a high content of precious metal. If one combines changes in face value, changes in intrinsic value, as well as their interactions, the determination of the fair value of medieval coins becomes complicated. On the one hand, abusing crying down led to two types of speculation; one regarding the occurrence of a future crying down; another concerning the face value of the coins relative to the intrinsic value. On the other hand,

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CHAPTER 17: HISTORY OF MONETARY SYSTEMS developments in the precious metal markets affected expectations about future debasements or crying up of coins. What can we learn from this part of monetary history? First, an issuer should have some control over when a collateral can be seized by bearers. If the collateral is embedded in the monetary instruments, a rise in the value of the collateral above face value may lead bearers to seize it even if the issuer has not defaulted. Second, if a monetary instrument is made from precious metal, the intrinsic value of the coins should be lower than the face value by a margin large enough to accommodate significant increases in the market value of the precious metal. Third, anchoring the expectations of bearers about the face value is important for a well‐functioning monetary system.

TOBACCO LEAFS IN THE AMERICAN COLONIES: LEGAL TENDER LAWS AND SCARCITY OF MONETARY INSTRUMENTS The case of Virginia and other U.S. colonies in the 17th and 18th centuries is usually put forward to make the case that tobacco leaf was a monetary instrument: Tobacco was an accepted medium of exchange in the southern colonies. Quit rents and fines were payable in tobacco. Individuals missing church were fined a pound of tobacco. In 1618, the governor of Virginia issued an order that directed that “all goods should be sold at an advance of twenty‐five percent, and tobacco taken in payment at three shillings per pound, and not more or less, on the penalty of three years of servitude to the Colony.” […] Virginia was using “tobacco notes” as a substitute for currency by 1713. These notes originated after tobacco farmers in Virginia began taking their tobacco crops to warehouses for weighing, testing, and storage […]. The inspectors at the rolling houses were allowed to issue notes or receipts that represented the amount of tobacco being held in storage for the planter. These notes were renewable and could be used in lieu of tobacco for payment of debts. […]Fines in Virginia were payable in tobacco. For example, a master caught harboring a slave that he did not own was subject to a fine of 150 pounds of tobacco. The Maryland Tobacco Inspection Act of 1747 was modeled after the Virginia statute. The Maryland statute required tobacco to be inspected and certified before export in order to stop trash from being put in the tobacco. […] Inspection notes were given for the tobacco that was inspected. Those notes were passed as money in Maryland. The use of warehouse receipts for tobacco and other commodities would spread to Kentucky as settlers began to cultivate that region. (Markham 2002, 44‐45) Hence, tobacco leafs served as media of exchange and so, following the narrow functional approach, were a monetary instrument. However, what the preceding description actually shows is that the colonies of Virginia and Maryland were at the center of a trading system of tobacco which was central to the economy of these states. By accepting tax payments, or any other dues, in tobacco at a relatively high fixed price, governments could influence tobacco output, could centralize output collection and redistribution, and make it easier for farmers—who usually did not have enough monetary instruments because of their scarcity—to pay their taxes. This, however, does not qualify payments in tobacco leafs as a monetary payment, but rather as a payment in kind at a price that was administered. Like in feudal times, taxes could be paid in kind. 239

CHAPTER 17: HISTORY OF MONETARY SYSTEMS However, the previous quote gives us some clues about the monetary system that existed. First, whereas tobacco was not a financial instrument, tobacco notes were a financial instrument of the government warehouses worth a certain number of pounds and collateralized by the value of the weight of tobacco that each note represented. Thus, tobacco notes may have become monetary instruments; nothing clear is said about that. Second, the provision of credit through bookkeeping was a common way to avoid the problems of barter: One method for financing private transactions in the colonies was through records of account kept by tradesmen and planters. Credits and debits were transferred among other merchants and traders. This was a form of “bookkeeping barter” in which goods were exchanged for other goods, and excess credits were carried on account. The barter economy that prevailed in the colonies required “voluminous record‐keeping … to carry over old accounts for many years.” This practice would continue through the eighteenth century […]. (Ibid., 46) The bookkeeping system was actually more complicated because credits on an account were sometimes transferable at par. Thus, a monetary system based initially on a unit of account named “pound” was present in the colonies, even though its functioning was not very smooth given the excessively high scarcity of top monetary instruments and the localized emergence of bookkeeping transfers. Tobacco leafs were not part of this monetary system.

SOMALIAN SHILLING: THE DOWNFALL OF THE ISSUER AND CONTINUED CIRCULATION OF ITS MONETARY INSTRUMENT In 1991, the Somalian government collapsed but its monetary instruments continued to circulate.1 One can explain why by noting that: 1. The state was central in establishing the trust about the currency prior to 1991. This is what anchored the expectations about the face value of the Somalian shilling. 2. Given the confusion at the time the state collapsed, citizens just relied on habits, anchoring induced by the inertia provided by historical acceptance created by the state. 3. If citizens believe that the collapse of the state is only temporary and the shilling will be reissued later then there is an incentive to continue using it. This is very different from the case of the transfer to the Eurozone when states spent years educating and informing their population about the demonetization of their currency, and gave a clear date about when demonetization would occur. In Somalia, everybody was left in the dark. 4. The belief that shilling would be again the national currency was reinforced by two aspects: a) local governments did accept them for tax payments at least temporarily b) armed militia, that substituted for government, started to forge some shilling notes to fill up the void left by the collapse of the official government, and, in addition, may have allowed dues to be paid in that currency. All this is similar to shares that continue to trade even as a company goes through liquidation and reorganization. Bearers are hopeful that the company will come back and be great again.

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Summary of Major Points 1‐ The use of tax liability and tax enforcement as means to create a demand for government monetary instruments has been a common practice of government for hundreds of years. 2‐ A monetary system based on gold or other precious metal is very inelastic and subject to monetary instability if gold is given too much importance. 3‐ While an issuer of a financial instrument may default, it does not mean that its financial instrument will disappear if there is an expectation that the issuer will be able to restore its creditworthiness in the future. 4‐ Tobacco leafs were not monetary instruments in the US because nobody issued them, i.e. nobody made promises embedded in the tobacco leafs; they had no issuer. Keywords Debasement, legal tender laws, fraud, reflux mechanism Review Questions Q1: How did the inclusion of tobacco leafs in legal tender laws help the payment system? Q2: Why is crying down the coinage problematic? How did the existence of coins made of precious metal limit the ability to cry down the currency? Q3: Was debasement mostly about improving the finances of the king by being able to issue more coins with the same amount of precious metal? Q4: How did the issuance of precious metal coins help to deal with the uncertainty of the time but also created some instability. Suggested readings Bell, S.A.(2001) “The role of the state and the hierarchy of money” Cambridge Journal of Economics 25 (2): 149‐163. Boyer‐Xambeu, M.T., Deleplace, G. and Gillard, L. (1994) Private Money and Public Currencies. New York: M.E. Sharpe. Forstater, M. (2005) “Taxation and primitive accumulation: The Case of Colonial Africa.” In The Capitalist State and Its Economy: Democracy in Socialism, Research in Political Economy, Volume 22, 51‐65. Henry, J. F. 2004. “The social origins of money: The case of egypt.” in Wray, L. R. (ed.) Credit and State Theories of Money. Northampton: Edward Elgar. Hudson, M. and Wunsch, C. (2004) Creating Economic Order. Bethesda: CDL Press. Ingham, G. (2000) “Babylonian madness: On the historical and sociological origins of money,” in Smithin, J. (ed.) What Is Money? New York: Routledge. Littleton, A.C. (1956) Studies in the History of Accounting. Homewood: Richard D. Irwin 1 For a summary of the topic see David Andolfatto’s “Fiat money in theory and in Somalia” at http://andolfatto.blogspot.ca/2011/08/fiat‐money‐in‐theory‐and‐in‐somalia.html

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GLOSSARY Bearer: A person who holds a financial claim on the issuer. In most cases, the bearer can sue the issuer if the promise embedded in the claim in not fulfilled.

Collateral: Assets held by debtors that can be taken by creditors in case of default. Assets are usually sold to try to recover some of the funds owed.

Board of Governors: The head institution of the Federal Reserve System. It is composed of at most seven governors.

Commercial paper (CP): A security issued by private companies with a short term to maturity (one year or less).

Asset: Anything that is owned by an economic unit.

Bond: A security with a relatively long term to maturity. It pays a coupon periodically.

Asset‐based credit (also collateral‐ based credit): A promissory note underwritten with the expectation that income of the issuer will never be enough to service the debt.

Borrowed reserves: Reserves obtained by going through the Discount Window (reserves “borrowed” from the Fed).

Conforming mortgage: A mortgage that has financial characteristics that conform to criteria set by Fannie Mae, Freddie Mac, and Ginnie Mae.

A Advance: Quantity of funds provided by a bank to a customer in exchange of the customer’s promissory note. Applied vault cash: The dollar amount of Federal Reserve notes that banks choose to use to comply with reserve requirements.

Asymmetry of information: A situation in which an economic unit knows less than another economic unit at the time of a contractual negotiation. Automatic stabilizers: Changes in the level and growth rate of government spending and of taxing that occur because of change in economic activity, and not because government decided to change its spending or taxing habits. For example, unemployment insurance goes up automatically in a recession and goes down automatically during an expansion. Similarly, tax revenues fall (rise) automatically during a recession (an expansion) because less (more) income is earned by the private sector.

Borrowing: Temporarily using the assets of someone else. C CAMELS rating: A rating that measures the soundness of a bank. Capital: See net worth. Capital requirement: Quantity of capital that a financial institution must keep relative to the size and quality of its assets in order to protect its balance sheet against unexpected losses. Cash flow: Inflow or outflow of monetary instruments. Cash management: A deliberate management of the level and structure of monetary balances to reach a specific goal.

Balance sheet: An accounting document that shows what is owned and owed by an economic unit.

Certificate of deposit (CD): A promissory note issued by banks with a term to maturity varying from short to medium term. It is similar to a savings account, except that it is illiquid until maturity.

Basis point: A one‐hundredth of a percentage point, 0.01%.

Clipping coins: The act of cutting bits out of coins.

B

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Consolidation: The act of merging two or more balance sheets into one. Consumption (also final consumption): The use of goods and service for personal enjoyment. Contingent liability: A claim that is due when a specific event occurs. Conventional mortgage: Any mortgage issued by non‐ government financial institutions. Unconventional mortgages are those insured by government agencies (such as the Federal Housing Administration) and that have unconventional characteristics that accommodate the needs of economic units with a higher chance of defaulting (e.g., low interest rate even though creditworthiness is not very good). Convertible: The ability to hand back to the issuer its promissory note and to get something else in exchange. Coupon: The income received from a bond and other similar securities. It is an interest income, that is, its payment is due periodically and represents a proportion of the face value of a bond. Bonds used to be in

GLOSSARY paper form with small coupons attached to them that needed to be detached and handed backed to the bond issuer to receive the interest payment due. Credit‐card receivable: Amount of debt outstanding on a credit card. Credit risk: The probability that an economic will default on its promise. Credit standards: Criteria used by bankers to determine how creditworthy an economic unit is. Creditworthiness: Expected ability of an economic unit to service its debts on time in full. Currency in circulation: Officially, it is mostly the value of Federal Reserve notes in the hands of economic units others that the Federal Reserve banks, the U.S. Treasury, and banks. Theoretically, coins held by others than the previously cited economic units are also included in the definition.

Debt management: The deliberate change in the level and structure of outstanding debt to reach a specific goal. Debtization: The growing use of debt in daily economic activities. It is the counterpart of the financialization of the economy. Default: The action of declaring the inability or unwillingness to service debts, either at all or according to the previously‐agreed time table. Deficit: A budgetary situation for which spending exceeds income. Demand liability: A claim that is due at the will of the bearer. Discount trading: The market price of a security is below fair price. Discount Window: A means for the Federal Reserve System to provide collateralized advances to banks.

D

Discount Window operation: An advance of reserves to bank. Banks sign a promissory note and in exchange get reserves. All promissory notes must be collateralized so if banks default, the Fed takes the assets banks put as collateral.

Dated liability: A claim that requires payments at specific periods of time.

Dividend: The income received from a stock. Its payment is a proportion of the profit of a company.

Debasement: A legal or illegal decrease in the quantity of precious metal included in a coin.

E

Crying up/down the coinage: The act of increasing/decreasing the face value of coins by decree.

Debt deflation: An economic situation in which overindebtedness and prices interact in such a way that it results in deflation, defaults, and a general decline in economic activity. Debt liquidation: The act of reducing the quantity of outstanding debts either by repaying them or by writing them off.

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Economic unit: An economic entity that, depending on the level of analysis, can be a household, a firm, a government, a country, or other entity that makes decisions. Elastic currency: A currency that can be injected and ejected from the economic system as needed. Excess reserves: Quantity of reserves that is kept by banks beyond what the Fed requires them to hold.

F Face value: The price at which the issuer promises to take back its financial instrument. The outstanding principal due by the issuer. Fair price (also fair value): The price at which a security ought to trade. It may or may not be the price at which a security actually trade (the market price). Fannie Mae: A government‐ sponsored enterprise that buys conventional and government‐ insured mortgages from banks as long as they conform to a set of standards it sets. It does so in order to encourage them to acquire more mortgages at more affordable rates. It buys mortgages by issuing mortgage‐backed securities. Federal funds: The dollar value of the accounts at the Federal Reserve banks. Federal funds market: A market in which participants borrow and lend federal funds. Federal funds rate: The interest rate that is paid (received) by an entity that borrows (lends) federal funds in the federal funds market. Federal funds rate target: The federal funds rate that the central bank wants to see in the market. Federal Open Market Committee (FOMC): A committee of the Federal Reserve System composed on the board of governors and the presidents of the Federal Reserve banks. It formulates monetary policy by meeting every six weeks or so and voting on the course of action in terms of the federal funds rate target. Presidents (except the president of the New York Federal Reserve bank) rotate their voting

GLOSSARY power and only five out of the 12 can vote at any time. Federal Reserve Bank: One of the twelve banks part of the Federal Reserve System. Federal Reserve System (Fed): A government agency created to provide the currency of the nation, to facilitate interbank payments, to regulate member banks, to promote an elastic currency, and to manage economic activity. While it is structured with some for‐profit features, its activities and goals are oriented toward fulfilling the public purpose expressed in its functions. Also the Fed can operate without making any profit. Financial asset: A claim held against someone that involves contractual monetary payments. Financialization: The growing importance that the financial sector plays in daily economic activity. Financing phase: A phase of economic activity in which bank credit is needed to start production Fine‐tuning the economy: Policy strategy used by the central bank and the U.S. Treasury to ensure that an economy stays close to full employment with stable prices. It involves nudging incentives in the private sector and the use of automatic stabilizers to move the economy in a specific direction and to ensure it is neither too hot (inflation pressures) nor too cold (high unemployment). Fiscal deficit: See deficit. It results in the issuance of new Treasuries. Fiscal surplus: See surplus. It results in the repayment of existing Treasuries. Forward guidance: A monetary policy that involves influencing expectations of the future path of

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federal funds rate target through a specific wording of current monetary‐policy decisions. Fraud: The act of gaining the trust of a person and then abusing that trust. It is the act of deceiving for personal benefit. Freddie Mac: A government‐ sponsored enterprise that competes with Fannie Mae. Free reserves: Non‐borrowed reserves held beyond what is required. Funding phase: A phase of the economic process in which finance plays a role for the acquisition of what has been produced. Funds: An outstanding quantity of monetary instruments. G Ginnie Mae: A government‐owned company that guarantees the timely payment of principal and interest on mortgage‐backed securities collateralized by federally insured or guaranteed mortgages. These mortgages are issued mostly by low‐ to‐moderate income households and by veterans. By doing this, Ginnie Mae encourages banks to fund homeownership for veterans and the poorer section of American households. Government‐sponsored enterprise (GSE): A for‐profit firm created by Congress to fulfill a public purpose. Such enterprises have been created to promote homeownership, education, the electrification of the country, among other goals that have been deemed relevant to fulfill the public purpose. They do so by encouraging banks to lower the interest rate and underwriting requirements on promissory notes issued to fulfill the activities that comply with the public purpose.

That is done by buying those promissory notes from banks or by insuring banks against defaults on the promissory notes. H Hedge finance: A financial situation in which an economic unit is able now and in the future to service its debts with its income. Household: A person of group of persons living in the same dwelling. I Illiquidity: Temporary inability to pay creditors. Income‐based credit: A promissory note underwritten with the expectation that the income of the issuer will be sufficient to service the debt, if not now at least sometime in the future. Income distribution: The distribution of national income among, wage earners and profit earners. Inconvertible: A promissory note that is not convertible. Inflation risk: The probability of a substantial fall in the purchasing power of future cash flows and outstanding financial assets Interest on reserves: Interest rate paid on reserve balances. Intrinsic value: The market value of material (paper for banknotes, gold for gold coins, etc.) used to make a monetary instrument. Insolvency: Permanent inability to pay creditors. Investment: The purchase of goods and services for the purpose of producing goods and services. Irrational behavior: Behavior that deviates from the standard neoclassical hypothesis about

GLOSSARY behaviors (maximization preference ranking).

and

Issuer: An economic unit that created a promissory note and gave it to others. That economic unit must now fulfill the promise embedded in the note. J Job guarantee program: An economic policy that provides the opportunities to work for all persons willing and able to do so. This helps make a person more employable, use her skills for more social purpose while unemployed, and provide some training experience. L Lease: The loan of an asset with the option to buy it after a period of time. Legal tender laws: Laws that dictate what is/are the ultimate means of payment. A creditor cannot pursue further legal actions against its debtors if it refuses payment in legal tender. Lending: Temporarily parting with an asset. Level‐1 valuation: Financial assets are valued based on their market price. Level‐2 valuation: Financial assets are valued based on a proxy market. Maybe because there is no readily available organized market for the assets held. Level‐3 valuation: Financial assets are valued according to a model created by the economic unit that holds them. Leverage: A measure of the indebtedness of an economic unit. Liability: Anything that is owed by an economic unit.

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Liquid asset: An asset that can be traded quickly without incurring large losses of capital. An asset with a relatively stable fair price. A perfectly liquid asset has a stable nominal value. Liquidity risk: The probability that the price of an asset will fall substantially when its owner tries to sell it quickly. M Monetary aggregates: Measures of the money supply. M1 is the narrowest indicator. Monetary base: The sum of reserves and cash in circulation. Monetary instrument: A security with specific financial characteristics such that its fair price is parity. Money supply: The sum of currency in circulation and other monetary instruments held by the public. Moral hazard: An increase in the risk taking of an economic unit once it knows it is protected against specific adverse events. The increase in risk taking increases the probability that such specific adverse events will occur. Mortgage: A promissory note backed by a residential or a commercial property. Mortgage‐backed security (MBS): A bond that is backed by mortgages. The cash flow for the interest and principal payments for the bond comes from the servicing of mortgages. N Natural growth rate: The growth rate of productive capacities induced by a given set of allocation, preference and technique of production.

Net acquisition: Acquisition minus reduction in the quantity of assets or liabilities. Net borrowing: The opposite of net lending. Net capital gain: Capital gains minus capital losses. Net cash flow: Cash inflow minus cash outflow. Net clearing of debt: The act of acknowledging what two (or more) economic units owe to each other and to calculate the net amount due by one of the economic unit. X owes $10 to Y, Y owes $3 to X, then X owes $7 to Y. Net clearing allows to simplify the settling of debts by reducing the number of transfers between debtors and creditors. Net financial accumulation: See net lending. Net lending: A positive difference between the change in the quantity financial assets and the change in the quantity of financial liabilities. Over a period of time, an economic unit acquires more claims on others than others acquire claims on that economic unit. Net income: expenses.

Income

minus

Net saving: See net lending. Net worth (also net wealth): The difference between the value of assets and the value of liabilities. Nominalism: A legal view that states that changes in the purchasing power ought not to impact the amount of principal owed. Non‐borrowed reserves: Reserves obtained through open‐market operations with the Fed or borrowed from other banks. Non‐financial asset: Something owned by an economic unit that does not involved contractual

GLOSSARY monetary payments to its owner. That includes machines, software, and goodwill, among others. Normalization: A monetary‐policy strategy that aims at bringing the FFR back to more normal levels in an environment of an abnormally large quantity of excess reserves. The strategy also aims at removing most of excess reserves in the long run. O Open‐market operations: The sale or purchases of securities by the central bank, on a permanent or temporary basis, respectively to remove or add reserves. The frequency of this market intervention varies depending on the central bank, with the Federal Reserve intervening daily while the European Central Bank intervening weekly. Originate and hold model: Banks acquire promissory notes and hold them to maturity. Originate and distribute model: Banks acquire promissory notes and sell them almost immediately. Output gap: The difference between the growth rate of aggregate demand and the growth rate of aggregate supply. Outright purchase: The action of permanently buying a financial asset, i.e. buying with the intention of holding it. This is done when the Fed expects that some of the reserves available will not be needed for an extended period of time. Overdraft: A negative balance in a bank account. Overnight interbank market: The market in which banks lend and borrow reserves to each other for the night.

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P Par value: See face value. Parity: See par value. Ponzi finance: A financial situation in which an economic unit is not able now and in the future to service its debts with its income. It must refinance or must sell assets to service the interest and principal due, at least for a period of time. Portfolio: The set of assets held on a balance sheet. Position: The dollar value of a specific asset held on the balance sheet. This position can be long (one owns the specific assets) or short (one borrowed the specific asset). Premium trading: The market price of a security is above its face value. Principal: Outstanding amount of debt left to be repaid. Promissory note: A contractual agreement to make one or several monetary payment(s) in the future. Public debt: The face value of outstanding Treasury securities. It goes up with a fiscal deficit and it goes down when Treasuries are repaid. R Rate of return: A measure of monetary gains in percentage rather than dollar amount. The amount earned relative to the cost of getting access to that earning. Real Bill Doctrine: A view according to which the financial assets of the Fed should only be composed of self‐liquidating assets, i.e. promissory notes that are issued and destroyed in relation to economic activity. Firms issue commercial papers to finance production and take back the papers when they make a profit.

Recourse: The ability of creditors to ask for more funds from debtors if the sale of collateral has not been sufficient to recover the funds expected. Redemption: When the issuer takes back its promissory note from the bearer(s). Redeemable: A security can be returned to its issuer at some point in time through some reflux mechanisms. Reflux mechanisms: The means available to the bearers to give back a financial instrument to its issuers. Refinance: The act of repaying an old debt by issuing a new debt. Repurchase agreement: When a party agrees to sell/to buy something today and to buy/to sell it back in the future. Required reserves: Quantity of reserves that a bank must have. Reserves: See total reserves. Reserve balances: Accounts of banks at the Federal Reserve. Reserve requirements ratio: Proportion of total reserves that a bank must have in relation to its transaction accounts. Return on asset: The value of monetary gains relative to the value of assets. Return on equity: The value of monetary gains relative to the value of net worth. Risk management: Means used to protect a balance sheet against expected and unexpected adverse shocks. S Saving: Depending on the context, it can be the unconsumed monetary income or the change in net worth.

GLOSSARY Scarcity: An economic situation in which there are limited resources to fulfill unlimited preferences. Secured: Backed by a piece of collateral. Security: A promissory note that is tradable. Depending on its financial characteristics, a security can take a different name such as stock, bond, or commercial paper. Settlement of debts: The act of paying debts. Speculative finance: A financial situation in which an economic unit is not able now and in the future to service its debts with its income. It must refinance the principal due at least for a period of time or must sell assets to do so. Speculation: The act of buying an asset with the view of reselling it to make a capital gain. Stock (also equity or share): Security that represents a share of the company. The bearer is the owner of the company. Common stocks allow the bearers to vote on the major strategic decisions of the company. Preferred stocks do not give a voting right but guarantee the payment of a dividend. Surplus: The opposite of deficit. Surplus vault cash: Federal Reserve notes that banks have in excess of what they use to meet reserve requirements. Sweating coins: The act of shaking coins in a bag to remove tiny bits of precious metal. A less easily detectable means of debasement than clipping. T Tax receivable (or payable): Taxes that recorded as due but not yet paid.

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T‐bill: A security issued by the U.S. Treasury with a term to maturity of at most one‐year and that does not provide a coupon payment. T‐bond: A security issued by the U.S. Treasury with a term to maturity of more than ten years. More loosely, the term is used to mean any treasuries with a term to maturity greater than one year. Term to maturity: Time left before the principal on a security is due. Total reserves: The sum of reserve balances and applied vault cash. Treasury’s general account (TGA): Account of the Treasury at the Federal Reserve that Treasury uses to spend. Treasury securities: See Treasuries. Treasury’s tax and loan account: Account of the Treasury at private banks that Treasury uses to collect funds received from taxes and the issuance of Treasuries. Treasuries: Securities issued by the U.S. Department of the Treasury. Triffin dilemma: If a currency is both convertible and in high demand by the rest of the world, the issuer of that currency must supply enough but as it supplies more the promise of convertibility becomes harder to fulfill. U Underwriting: The act of determining the creditworthiness of an economic unit. Unit labor cost: The ratio of wage over the productivity of labor. Unsecured: Financial claims that is not backed by any collateral (e.g., credit receivables). They may still be some recourses for bearers. V

Vault cash: The Federal Reserve notes in the vault of banks. Valorism: A legal view that argues that the principal owed should be adjusted to maintain its purchasing power constant. Volcker experiment: A change in monetary policy operations toward a looser targeting of the federal funds rate and a focus on targeting monetary aggregates. Y Yield: See rate of return. Yield to maturity: The yield obtained if a security is held until it matures. Z Zero‐coupon security: A security that does not pay any coupon.

ABOUT THE AUTHOR Eric Tymoigne is an Associate Professor of Economics at Lewis and Clark College, Portland, Oregon; and Research Associate at the Levy Economics Institute of Bard College. His areas of teaching and research include macroeconomics, money and banking, and monetary economics. His current research agenda includes the nature, history, and theory of money; the detection of aggregate financial fragility and its implications for central banking; the coordination of fiscal and monetary policies; and the theoretical analysis of monetary production economies. He has published in numerous academic journals and edited volumes. His most recent book, coauthored with L. Randall Wray, is The Rise and Fall of Money Manager Capitalism: Minsky’s Half Century from World War Two to the Great Recession. Tymoigne holds an MA in economic theory and policy from the Université Paris–Dauphine and a Ph.D. in economics from the University of Missouri–Kansas City.

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The Financial System and the Economy

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