Alt-M Ideas for an Alternative Monetary Future Tue, 09 Feb 2016 14:17:34 +0000 en-US hourly 1 No Exit Tue, 09 Feb 2016 14:17:34 +0000 Sartre famously wrote, "L'enfer, c'est les autres" (“Hell is other people").  In his recent speech, Fed Vice Chairman Stanley Fischer, assisted, as he says, by William English of the Board's staff, supplies an example of hell being the "other policy." The last substantive paragraph of Fischer’s speech includes the following...

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Fischer ThirdSartre famously wrote, "L'enfer, c'est les autres" (“Hell is other people").  In his recent speech, Fed Vice Chairman Stanley Fischer, assisted, as he says, by William English of the Board's staff, supplies an example of hell being the "other policy."

The last substantive paragraph of Fischer’s speech includes the following summary of current FOMC policy:

The Committee has indicated that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively.  But that statement leaves open the question of when we should begin to reduce the size of our balance sheet.  Because the tools I mentioned earlier — the payment of interest on reserve balances and the overnight reverse repurchase facility — can be used to raise the federal funds rate independent of the size of the balance sheet, we have the flexibility to adjust the size of our balance sheet at the appropriate time.  With the federal funds rate still quite low and expected to rise only gradually, I think there is some benefit to maintaining a larger balance sheet for a time.  Doing so should help support accommodative financial conditions and so reduce the downside risks to the economic outlook in the event of a future adverse shock to the economy.  Consistent with this view, the Committee has decided to continue to reinvest principal payments from its securities portfolio until normalization of the federal funds rate is well under way.  The decision about when to cease or begin phasing out reinvestment will depend on how economic and financial conditions and the economic outlook evolve.

From this statement one gathers a number of facts.  First, the Fed remains determined to stay on an interest rate-raising path, as circumstances allow.  The question here is, just what are the circumstances presently pointing to the desirability of further raising interest rates?

Second, the Fed plans to maintain its bloated Fed balance sheet, including reinvesting maturing asset balances, for the indefinite future, instead of looking hard for a chance to reduce it, as it has long promised to do.

Third, we're still going to pay increased interest rates on excess reserve balances (a subsidy) and maintain the raised rate on the already subsidized reverse repo transactions (principally for nonbanks).  One wonders what would happen in the market to those rates if the Fed allowed the balance sheet to shrink, even short of outright asset sales, by simply allowing maturing assets to roll off and stopping the implicit subsidy of reverse repos.  Has anyone on the Board's or FRBNY's staff done such a study?  If not, isn't the absence of such a study a hallmark of willful indifference to "data-driven policy"?  If such a study exists, shouldn't the transparent Fed release it so that we might see it?

Finally (a case of omission), Fischer’s speech says not a word, either in his summary or in the rest of his speech, about negative rates.  If the Fed (which created a generation's worth of new reserves in recent years) stopped intervening in the Federal funds market, one wonders where market rates would go.  I think they would go negative, at least briefly, before eventually recovering with normal economic activity.

A negative rates environment might be a powerful incentive to bankers, encouraged if need be by bank examiners and discount window officers, finally to restructure legacy (that is, pre-2009) debt at the household and firm level (the one very big thing that was done in the 1930s that was not done after 2008).  The payoffs for such restructuring would be resumption of natural economic growth as debt burdens are eased, with positive (but significantly lower than present) interest rates on the restructured debt.  In my tax practice, I still encounter too many households paying 8 or 9 percent interest on legacy mortgage, car loan, and student loan debt.  It won't do to say that credit scoring requires such outrageous spreads; credit scoring is rotten to the core, and bankers know it (or should know it).  The scores are low because the debt is not restructured.  Also, the insurance industry now sets rates using credit scoring; no one at the Fed appears to be concerned about this expansion of the use of credit scoring.  This bankers' and insurers' sword is not what was intended when credit scoring was invented as a shield for use in the banking industry in judging patterns of racial discrimination in mortgage lending in the 1980s and 1990s.  Congress and the Fed gave bankers a shield and they turned it into a sword.

In short, it looks as though the Fed is persuaded that economic growth will resume and increase once the prices of oil and other commodities stop falling.  If there is a historical or an econometric policy model supporting the Fed's current policy mix, I'd like to know what it is.  The data so far, and the Japanese experience since the 1990s, seem to suggest that maintenance of Fed-managed low interest rates to stimulate economic growth against a backdrop of elevated excess reserve levels tends, if anything, to depress economic activity.  (Japan finally took its official rates into negative territory last week, by the way.)  What Vice Chairman Fischer describes is but a procrustean attempt to make the Fed’s model fit the data.  One wonders what economy, shorn of its limbs, will emerge from the other side of the Fed’s latest, indefinite policy commitment.

I’m not suggesting that negative rates are a cure for all that ails us.  The Swiss experience indicates that negative rates merely stop the bleeding (in this case, adverse domestic economic effects of high foreign exchange value of the dollar), giving the patient a respite during which natural healing forces might take over.  In any case, Fed tolerance of temporarily negative rates cannot possibly have worse cumulative economic effects than the bloated balance sheet policy that actually has been followed, with no exit in sight.

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Can Money-Market Mutual Funds Reliably Avoid the Problem of Runs? Wed, 03 Feb 2016 14:07:45 +0000 The majority of federally insured savings and loans failed in the 1980s, wiping out the Federal Savings and Loan Insurance Corporation in 1989.  The fiasco ultimately cost taxpayers around $150 billion to make savings depositors whole.  Two years later, the failures of hundreds of commercial banks put the Federal Deposit...

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bank runs, FDIC, Lehman Brothers, money market mutual funds, moral hazardThe majority of federally insured savings and loans failed in the 1980s, wiping out the Federal Savings and Loan Insurance Corporation in 1989.  The fiasco ultimately cost taxpayers around $150 billion to make savings depositors whole.  Two years later, the failures of hundreds of commercial banks put the Federal Deposit Insurance Corporation in the red.  (The FDIC got a bridge loan from the US Treasury, which it eventually repaid.)  It became clear that deposit insurance had fostered immense moral hazard, enabling the growth of unsound S&Ls and commercial banks.

For many reformers these events raised the question of how the core services of banks (intermediation and payments) might be provided without the expense of tax-funded guarantees, and yet without the danger of runs that had prompted the creation of the FSLIC and FDIC.  A number of economists (myself included) pointed to checkable money-market mutual funds (MMMFs) as an alternative to bank deposits that are not run-prone and therefore have no need for taxpayer-funded guarantees.

MMMFs, like other mutual funds and unlike banks, offer savers not debt claims promising specified dollar payouts on specified dates but rather equity claims (shares) in the dollar value of a portfolio. Like other mutual funds, a MMMF buys back shares on demand at the current “net asset value” or NAV.  The modifier “money-market” means that a fund invests only in fixed-income securities with less than a year in remaining maturity, which means that present-value losses will be negligible from a rise in interest rates.  A fund can keep default and liquidity risks low by maintaining a diversified portfolio of highly rated securities with active secondary markets.

In 1976 Merrill Lynch introduced a MMMF that allowed customers to write checks against their account balances, an innovation which was quickly copied by other funds.  Money-market share accounts now combined the services of checking accounts with much higher returns, because they were not subject to the binding interest-rate ceiling (under the Fed’s Regulation Q) then constraining bank accounts.  To make them seem more like bank accounts, fund providers adopted the convention of pegging the share redemption value or NAV at $1, and varying the number of shares in an account, rather than varying the share price to reflect changes in the value of portfolio assets.  The popularity of MMMFs soared.  MMMFs that hold only Treasury obligations are called “government” funds. Those that hold mostly commercial paper and jumbo bank CDs are called “prime” funds.

J. Huston McCulloch put the case for MMMFs not needing government guarantees well in a 1993 article: “[E]ven though MMMFs invest in financial instruments that may not come due for many weeks or months, they are entirely run-proof.  Should the volume of withdrawals be high enough” to require net sales that shrink the asset portfolio, “the fund’s liability to its remaining depositors simply falls in the same proportion.”  That is, each MMMF share is a claim not for a fixed dollar sum, but only for a fixed percentage of the portfolio’s value.  A fall in the total value of the asset portfolio, whether from redemptions or from bad-news events that reduce assets’ market prices, immediately reduces the total value of shares so that they never over-claim the available assets.  Any bad-news net market value loss is immediately spread evenly over shareholders rather than being concentrated “on the last unlucky depositors in line, as occurs in a run on a traditional bank.”  With no greater losses falling on the person last in line to withdraw, there is no incentive to run to withdraw ahead of others.  Thus, “as long as MMMFs behave like true mutual funds,” continuously marking portfolio assets and shares to market value, the problem of the me-first incentive to run “cannot arise.”

I made essentially the same argument in chapter 6 of my text The Theory of Monetary Institutions. There I argued that a run arises from the combination of three conditions: (1) claims are redeemable in pre-specified dollar amounts (i.e. are debts), (2) redemption is unconditionally available on demand, with a first-come first-served rule for meeting redemption demands, and (3) the last claim in line has a lower expected value.  Mutual funds eliminate the first element (claims are equity rather than debt), which is sufficient to eliminate the run problem.  It’s no use rushing to redeem when bad news about the asset portfolio arrives, because your account balance has already been marked down.  They also eliminate the third element (because every share redemption receives the same percentage of the portfolio value) when assets are liquid enough or the fund is small enough to make “fire-sale” losses from asset sales negligible.

But wait — doesn’t this argument assume that MMMFs vary the price of their shares like ordinary mutual funds?  Doesn’t it matter that the share redemption value is pegged at $1?  McCulloch explained why it should not matter: “Some MMMFs offer investors a variable number of shares of fixed value instead of a fixed number of shares of variable value.  This is merely a cosmetic difference with no substance, however.”  The problem of claims exceeding portfolio value “arises [only] when funds try to offer investors a fixed number of shares of fixed value.”  In other words, so long as $1 shares are promptly subtracted from each account in proportion to any decline in total portfolio value, or alternatively promptly marked below $1 (an event called “breaking the buck”), there remains no incentive to run.

In practice, subtracting $1 shares is not done (for reasons not immediately obvious), and breaking the buck has become an occasion to liquidate the fund.  Accordingly parent companies, to keep a MMMF alive and preserve its brand-name capital, almost always choose to eat losses and maintain the $1 share value.  A 2010 report by Moody’s identified 147 occasions over the period 1980-2007 when a MMMF suffered a net decline in portfolio assets that, without a rescue, would require breaking the buck.  Only one fund actually broke the buck.  (It was then liquidated, with shareholders receiving 96.1 cents per share.)  In 146 cases the parent firm stepped in, absorbing losses to keep the share value at $1.  If a parent firm acts immediately, upon news of critical asset losses, either to break the buck or instead to pitch in to preserve the par value, then running to get a better payoff than other shareholders remains either impossible or pointless.

Fast-forward to September 2008.  At midday on Sunday the 15th, insolvent and without a rescuer, Lehman Brothers filed for bankruptcy.  A money-market fund called The Reserve Primary Fund was caught holding $785 million in Lehman paper, about 1.3% of its $62.5 billion in assets under management.  (This size put it in the top twenty, but outside the top ten.)  An immediate 20% write-down on Lehman paper meant that a $157 million gap needed to be filled immediately if the fund was to have the asset value necessary to maintain its $1 share price.  For the next 24 hours, shareholders ran on the fund.  They did not believe, for good reason as it turned out, reassurances from the fund’s sales reps, repeating what The Reserve’s ownership had said but not done, that the parent company would pitch in to support the price.  By 1pm Monday (the 16th) shareholders had redeemed a bit more than a quarter of their claims at $1 per share.  The ownership had dithered and did not fill the hole in the balance sheet.  The fund’s custodian State Street Bank finally refused to make further payouts, and the fund broke the buck.  The Reserve also imposed daily withdrawal limits on its other funds.

During that Monday, and again on Tuesday and Wednesday, other prime funds experienced heavier than normal redemption outflows.  Other MMMF parent firms, by contrast to The Reserve, immediately supported their prime funds that had Lehman-related losses, and continued to redeem at $1 per share.  No other funds broke the buck.  By the 19th the industry-wide dollar value of assets under management by MMMFs was down by $247 billion, a bit less than 7 percent of the value held ten days earlier.

After these three days of relatively heavy net redemptions following the Lehman bankruptcy and Reserve Primary buck-breaking, on Thursday the 19th, the US Treasury stepped in to stanch the redemptions, which it considered equivalent to runs, with something that it considered equivalent to federal deposit insurance.  It announced what Secretary Hank Paulson described as a “temporary guaranty program for the U.S. money market mutual fund industry,” assuring shareholders in participating funds that their shares would be redeemed at $1 even if their fund’s net asset value fell below par.  The Federal Reserve pitched in on September 22 by creating a special “Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility” to lend funds to banks for acquiring the commercial paper assets that MMMFs were shedding.

As later described by Philip Swagel, who was a Treasury official at the time, the MMMF guarantee program was initially funded, in an unprecedented and legally dubious move, from the Treasury’s Exchange Stabilization Fund:

The US Department of the Treasury (2008) used the $50 billion Exchange Stabilization Fund—originally established back in the 1930s to address issues affecting the exchange rate of the US dollar—to set up an insurance program to insure depositors in money market funds. … Use of the Exchange Stabilization Fund for this purpose was plausibly legal—after all, a panicked flight from US dollar-denominated securities could be seen as posing a threat to the exchange value of the dollar—but its use in this way was without precedent.

It should be noted that there was in fact no panicked flight from US dollar-denominated securities in general.  US Treasury securities rose in value during the crisis as investors worldwide considered them a safe haven.  The trade-weighted US dollar index actually rose sharply in the six months after Lehman fell and the Primary Reserve Fund broke the buck.  In its indifference to the rule of law, the US Treasury acted much like the Federal Reserve System did during the crisis.

After one year, the Treasury ended its MMMF guarantee program.  It has since imposed new pricing restrictions, liquidity requirements, and accounting rules on the funds in the name of reducing the problem of runs.  (I will discuss these regulatory changes in my next Alt-M post.)

So what happened in September 2008?  Is the run on Reserve Primary and heavy redemptions at other prime funds evidence that, contrary to McCulloch’s and my argument, prime MMMFs with a fixed $1 share price are in fact inherently fragile?

Stephen G. Cecchetti, former Director of Research at the Federal Reserve Bank of New York, and co-blogger Kermit L. Schoenholt have said so:

The fundamental problem facing U.S. regulators is that money market funds are banks in everything but their outward legal form.  They perform liquidity and credit functions that are identical to those of chartered banks; in particular, they offer the equivalent of bank checking deposits, making them vulnerable to a run.

This argument won’t do.  It completely fails to engage the basic counter-argument that checkable equity claims (MMMFs) are not run-prone because they distribute portfolio asset losses in an essentially different way from checkable debt claims (bank deposits).

Useful analysis of the run-proneness of MMMFs is provided by a 2013 comment on SEC rule proposals by the Squam Lake Group, a committee of 13 center-left to center-right financial economists.  They note that a MMMF (like a bank) will be run-prone whenever the aggregate redemption value of its shares or NAV exceeds the actual market value of the fund’s assets, so that early redeemers can expect to get more than late redeemers.  Under current accounting rules for money-market mutual funds (which they abbreviate MMFs), they point out, this can happen for two reasons:

First, mutual funds have the option to account for assets at amortized cost if they have a maturity of 60 days or less.  With that option, the [total redemption value of shares] is not a true reflection of the fair market value of fund assets.  Whenever investors can redeem at a NAV that is higher than the fair value of the assets, investors have incentives to run.

Second, and more fundamentally, prime MMFs invest substantially in assets without a liquid secondary market.  This creates an incentive for fund investors to run during a period of financial stress, because even “fair market value” may exceed by a significant amount the value at which the fund can quickly sell assets to meet investor redemptions.  Therefore, … the first MMF investors to redeem their shares during a crisis are likely to receive a higher price for their shares than those who follow once the fund is forced to meet redemption demands by selling assets that have not yet matured. … This first-to-redeem advantage, which is exacerbated by amortized cost accounting, creates an incentive for MMF shareholders to run.

In other words, MMMFs in August 2008 did not exhibit the immunity to runs that McCulloch and I expected in cases where the accounting rules did not, as we assumed they generally do, rule out an excess of aggregate share redemption value over actual asset portfolio value.  Some funds used accounting rules that allowed them not to mark 60-days-or-fewer assets to market at all, and not to mark other assets to a market price that corresponded to their actual immediate liquidation value.

In summary, we learned in August 2008 that MMMFs using certain accounting rules are not run-proof.  For 24 hours The Reserve Primary Fund carried a diminished asset portfolio without either topping it up or diminishing the claims against it, and consequently was rationally run upon. We did not learn that MMMFs are inherently fragile, but rather that run-proneness depends on the accounting practices that a fund uses.

From this diagnosis, no policy intervention is indicated.  What follows is rather that in a market where losses remain private, investors can be expected to consider the relative fragility under certain circumstance of funds that opt to use potentially run-incentivizing accounting practices. Such funds, if they do not offer some fully compensating advantage, should be expected to lose their market share.  Money-market mutual funds that instead credibly bind themselves to thoroughgoing mark-to-market accounting and other run-proofing practices (such as perhaps a pre-funded commitment by the parent company to shelter shareholders from losses), and advertise that fact, should be expected to flourish in the marketplace.  Such MMMFs remain an available payment mechanism that is not susceptible to runs and therefore has no need for guarantees at taxpayer expense.

To come in a later post: What to make of the US Treasury’s new restrictions on MMMFs?


*Acknowledgment: I thank Kyle Davidson for research assistance.

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Atta Boy! Sat, 30 Jan 2016 14:13:38 +0000 Although I was an academic economist for 30 years, almost all of them spent in departments with PhD programs, I was never much of a graduate student mentor.  As a matter of fact hardly any graduate students chose to work with me, and, unless I miss my guess, those that...

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David Beckworth, financial crisis, graduate students, New York Times, Ramesh PonnuruAlthough I was an academic economist for 30 years, almost all of them spent in departments with PhD programs, I was never much of a graduate student mentor.  As a matter of fact hardly any graduate students chose to work with me, and, unless I miss my guess, those that did do so ended up hating my guts, at least for a while.

At my first job, at George Mason, Steve Horwitz allowed himself to fall victim to my tender mercies; he had, after all, the excellent excuse that my reputation hadn't preceded me.  My own memory is about as porous as a yard of cheesecloth; but stories of how I liked to torture Steve still occasionally make their way back to me via the GMU grapevine.  The one I hear most concerns the time when, having told Steve that he and I were going to write a paper together, I assigned him the task of writing its opening.  I received the requested paragraph, read it, and stormed down the hall, into the office Steve shared with several other graduate students (most of whom now have their own grad students).  Steve didn't see me enter, as he was facing his carrel at the back of the office.  Instead he saw the paragraph he'd just written, savaged by my red pen, slapped-down before him, while hearing me say, "This is s**t: do it again."

Steve's second attempt was much better.

Whether more of that sort of thing would have hastened Steve's education, or led to his doing time at Mecklenburg after being found guilty of second-degree murder, is something we'll never know, since after only three years at GMU I transferred to Hong Kong, leaving him safely beyond my clutches.  What is certain is that he managed rather well without my help.

At Hong Kong I had no graduate students; nor can I even recall whether there were any.  In any case I taught there only for a year before being invited to join Larry White and Dick Timberlake at the University of Georgia, where I was to spend most of the remainder of my teaching career.

Hong Kong nevertheless provided me with an opportunity to contribute to a grad student's education in an important if unusual way.  The student was Kurt Schuler, who had been one of my NYU classmates, but who had left NYU for UGA, where he was studying with Dick and Larry.  The opportunity came the summer before I left GMU, which I also spent in Hong Kong, thanks to a grant administered by the Institute for Humane Studies.  The grant allowed me to work with John Greenwood, the architect (and continuing supporter) of Hong Kong's dollar peg.  As my time with John was wrapping up, he asked my opinion concerning an applicant for the same grant for the following summer.  I said, "Never mind him.  The fellow you want is Kurt Schuler!"  I think that was a pretty good call.

In all my years at UGA, though I sat on plenty of grad student committees, I only supervised three dissertations — a pretty dismal record.  Nor did my picking and choosing have much to do with it.  The sad truth is that those students were the only ones who chose me.  Being labelled a "kook" by some of my colleagues didn't help.  But the word also got out that I was no fan of "push-button" dissertations, meaning the sort where a student got together a "data set" (how I loathe the very phrase!), and then went about wringing asterisks from it.  Instead I had the ridiculous notion that my students should learn a fair bit about whatever topic they planned to write about before proceeding to write about it.  That amounted, so far as most were concerned, to yet another unpleasant hurdle, but one easily gotten around by taking their business elsewhere.

David Beckworth was, thank goodness, one of the brave (or unthinking) few who ended up with me.   I say "thank goodness" because, had it not been for him, I could not claim, after a long career of teaching, to have been the principal mentor of a single good economist.

And David has turned out to be a very good economist, if I may say so.  Besides being one of the Center for Monetary and Financial Alternatives' elite troupe of Adjunct Scholars, David is considered second only to Scott Sumner among leading Market Monetarists.  Like Scott he also has one of the more influential monetary- and macro-economics blogs.

David and National Review Senior Editor Ramesh Ponnuru scored a big hit just recently, with their excellent New York Times op-ed blaming misguided Fed actions for turning a severe housing bust into an all-out economic rout:

Through early 2008, even as investors kept pulling money out of the shadow banks, key economic indicators such as inflation and nominal spending — the total amount of dollars being spent throughout the economy — barely budged.  It looked as if the economy would be relatively unscathed, as many forecasters were saying at the time…

It took a bigger shock to the economy to bring the financial system down.  That shock was tighter money.  Through acts and omissions, the Fed kept interest rates and expected interest rates higher than appropriate, depressing the economy.  This point is easy to miss because the Fed lowered interest rates between September 2007 and April 2008.  But raising rates is not the only route to tighter money.

Between late April and early October, the Fed kept the interest rate over which it has most direct control, the federal funds rate, at 2 percent.  But when the economy weakens, the “natural” interest rate — the rate that keeps the economy on an even keel — falls.  By staying in place, the Fed’s target interest rate was rising relative to that natural rate.

Quite right.  Just how the Fed went about "staying in place" is something yours truly has dwelt on, in his post on sterilized lending, and in three later ones on interest on reserves.

Publishing an op-ed in The New York Times is always a coup; publishing one that criticizes the Fed. while delivering, en passant, a bouquet of orchids to Ted Cruz, qualifies as a minor miracle.  If you doubt it, have a look at the readers' comments.  If most of that paper's subscribers reacted to the op-ed the way those commentators did, one could confidently predict the imminent demise of America's second-largest-circulation print newspaper.

David and Ramesh end their essay by observing how "It took decades for the Fed’s responsibility for the Great Depression to be widely accepted," and that "it may take that long for most people to see its responsibility this time around."  But revising the record regarding the Fed's part in the Great Depression took as long as it did in part because Milton Friedman and Anna Schwartz didn't publish their groundbreaking Monetary History of the United States until 1963.  Thanks to the efforts of people like David and Ramesh (and Scott Sumner and Bob Hetzel, among others), there's good reason to hope that, this time around, the wait won't be nearly as long.

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The Fed’s Lack of Appreciation for the Healing Power of Markets Mon, 25 Jan 2016 16:14:38 +0000 In my recent Cato Institute policy analysis, “Requiem for QE,” I analyze the transcripts of the 2008 and 2009 Federal Open Market Committee (FOMC) meetings in some detail.  Among them, the March 2009 transcript stands out as particularly troubling, as it reveals the FOMC’s failure to appreciate an economy’s ability...

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Mr. Cellophane 2

In my recent Cato Institute policy analysis, “Requiem for QE,” I analyze the transcripts of the 2008 and 2009 Federal Open Market Committee (FOMC) meetings in some detail.  Among them, the March 2009 transcript stands out as particularly troubling, as it reveals the FOMC’s failure to appreciate an economy’s ability to heal itself through market mechanisms following an adverse macroeconomic shock.

Yet market economies do have self-correcting mechanisms: relative prices change, resources get reallocated, and consumer and business expectations adjust to new realities.  In the case of the financial crisis, expectations had to adjust to the fact that house prices were significantly out of line with economic fundamentals.  As they did,  perceptions of wealth declined in line with house prices.  Workers, particularly those in construction, began the process of acquiring new skills, finding alternative employment, starting new businesses, and so on.  That these self-correction processes were already at work prior to the March 2009 FOMC meeting is one reason why the recession ended just three months later, in June 2009.

The same self-correcting mechanisms can be seen in the very markets in which the financial crisis began.  Put simply, the financial crisis was precipitated by a decline in house prices which, in turn, sparked concerns about the default risk of banks and other financial institutions with large holdings of mortgage-backed securities (MBS).

The problem was that those holding the MBS had no knowledge of the specific real estate underlying the securities.  As a result, once house prices crashed, and mortgage default rates spiked, no one could work out how much a given security was actually worth.  MBS became “toxic assets” that couldn’t be sold on the secondary market.  In consequence, default risk spreads in interbank and other markets in which loans were made to institutions that held large quantities of MBS widened significantly in the early stages of the financial crisis, and subsequently exploded when Lehman made its bankruptcy announcement.

And yet even then, at the very height of the financial crisis, the market’s self-correcting mechanisms were at work.  Financial institutions had begun the process of discovering what specific real estate backed their MBS before Lehman’s announcement, and the process accelerated thereafter.  The success of these efforts is reflected in the fact that many default risk spreads had returned to their pre-Lehman levels (and in some cases to their pre-crisis levels) weeks before the March 2009 FOMC meeting.

Did the FOMC not see that financial markets and the economy had improved significantly by March 2009, or did it just have no confidence in the self-correcting nature of markets and market economies?  The transcripts of the March meeting suggest the second answer.

Early in the discussion, President Plosser noted that he and President Bullard had recommended a change in the proposed policy statement.  The proposed statement, which was distributed to participants prior to the meeting, read: “the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.”  Plosser and Bullard proposed that the statement be amended to read: “the Committee anticipates that market forces and policy actions will contribute to a gradual resumption of sustainable economic growth.”  Plosser noted that the proposed statement implied that

policy actions alone will stabilize the world.  And, frankly, I think creating an impression that the only game in town is policy actions and that market economies have no contribution to make in this stabilization is setting us up for failure and a credibility problem.  So we added the reference to market forces.

One might suppose that Plosser and Bullard’s recommendation generated considerable discussion and support, but one would be wrong.  Not a single person responded; not Bernanke, not anyone.  It was a Mr. Cellophane proposal — you’d never even know it was made.

Just before the policy vote was to be taken, Bernanke asked if there were any comments.  Despite being summarily ignored, Plosser responded, “I had suggested this notion of putting in market forces in terms of returning to stability.  I didn’t know whether you had forgotten that, but nobody ever commented on it.”  Bernanke asked if people were okay with substituting the sentence.  Governor Tarullo responded, “To what market forces are you referring?”  Governor Kohn then added, “I think what I heard around the table, Mr. Chairman, was not much confidence that market forces are moving in that direction and might even be moving in the other direction.”

“There’s not much confidence that government forces are going to fix it either," Plosser replied.  President Lacker interjected, “Surely, if the economy recovers, it’s going to be a combination of policy actions and market forces.  Surely that’s the case."  Bernanke responded, “Well, all we’re saying here is that these things [policy actions] will contribute.  We’re not saying that they’re the only reason.  Let me go on.”  But President Bullard interrupted,

I just want to press on that a bit.  It gives the impression that we’re hanging on a thread as to what the Congress does or what we do or something like that.  I don’t think you want to leave that impression.  Despite what the government does, you might recover faster or you might recover slower, and I think you should leave that thought in the minds of private citizens.

Bernanke replied, “Again, I think what we’re saying here is that we anticipate that these things [policy actions] will contribute to an overall dynamic.”  Bernanke went on with the vote.  The discussion was over.

The fact that only three of the 18 participants spoke out to suggest that the recovery would not be due solely to policy actions is disturbing.  Bernanke’s lack of support for the language is particularly worrisome because in his book, The Courage to Act, he notes that “as an economist, I instinctively trusted markets” (p. 99) and “I thought of myself as a Republican…with the standard economist’s preference for relying on market forces where possible” (p. 108).

Curiously, he did not take a strong stand for “market forces,” when he had the opportunity.  He could have said, “our actions and fiscal policy are only assisting the market.  We certainly don’t want to leave the impression that policy will do it all.”  He could have said this when Plosser first made the recommendation or at any time during the discussion toward the end of the meeting.  But he didn’t.  One is left to speculate why a person who instinctively trusts markets and market forces did not seize the opportunity to make a point about the role markets would play in mitigating the effects of the financial crisis and facilitating recovery.

The suggestion that market forces contribute to the improvement in the economy did not appear in the March 18, 2009, FOMC statement.  Interestingly, however, the phrase “market forces” did appear in the April policy statement.  But it received third billing: “the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability” (italics added).  The statement appeared in the draft language that was distributed to FOMC participants in advance of the meeting.  There was no discussion of the role of market forces at the April meeting or any meeting in 2009.  Was the statement included out of a deep-seated belief in the healing power of markets or merely to appease a small, but vocal, minority?

It is impossible to know for sure.  But there is little doubt that the Committee failed to recognize that healing takes time.  Monetary policy had already eased considerably by March 2009.  The Fed’s balance sheet more than doubled during the six months between September 18, 2008, and March 18, 2009 — increasing from $931.3 billion to $2 trillion.  Instead of waiting and giving these actions, and the market’s own healing power, time to work, the FOMC voted to expand the Fed’s balance sheet by an additional $1.15 trillion.

This action paved the way for the FOMC’s nearly 8-year zero interest rate policy, which has encouraged risk taking, redistributed income to the wealthy, contributed significantly to the rise in equity and house prices (which have surpassed their previous “bubble” levels), and created considerable uncertainty.  If the FOMC had maintained some confidence in markets’ ability to adapt, it would have waited a little longer to act and might have avoided an incredibly long-lived policy that will be extremely difficult to exit.

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One Sentence, or, Unpacking the Truth about the Founding of the Bank of France Thu, 21 Jan 2016 16:03:26 +0000 When, in my days as a professor, I occasionally assigned term papers, I used to smile when students wondered out loud how they could possibly come up with enough to say to fill a whole 20 (or 15, or 5, or whatever) pages.  After all, the problem, once you got...

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FirstConsulNapoleonWhen, in my days as a professor, I occasionally assigned term papers, I used to smile when students wondered out loud how they could possibly come up with enough to say to fill a whole 20 (or 15, or 5, or whatever) pages.  After all, the problem, once you got to be where I was, wasn't having too much space: it was not having space enough to say what needed saying.  It was all I could do sometimes to squeeze my ideas into the 25 double-spaced typescript page-limit that prevailed among scholarly economics journals.

These days I'm no longer compelled to wrestle with academic journal editors, thank goodness.  But I still face strict length limits now and then, like the one I'm confronting as I finally get around to writing my long-overdue review of Roger Lowenstein's America's Bank: The Epic Struggle to Create the Federal Reserve.   I'm supposed to limit the review to 1000 words.  Yet I could easily write 20,000 words about that book.  In fact I have written 20,000, and then some, in the shape of a Cato Policy Analysis called "New York's Bank: the National Monetary Commission and the Founding of the Fed."  Our respective titles give you some idea of where Lowenstein and I differ.  Anyway, the PA isn't ready yet.  When it is, probably about a month from now, I will let you know.

Despite that PAs length, it also leaves much unsaid.  It says nothing at all, for example, about the seemingly innocuous sentence in chapter five of America's Bank that reads: "The Bank of France was chartered in 1800 as an antidote to the financial turmoil of the French Revolution."

It is but a passing statement, in a work concerning the founding, not of the Bank of France, but of the Fed; and it is of no importance to that work's thesis.  And yet…and yet that sentence says plenty, for it represents as well as any sentence in Lowenstein's book its author's inclination — a very common one, to be sure — to view even the earliest central banks as sources of financial order and stability, despite the fact that doing so often means overlooking oodles of inconvenient facts.

In the case of the Bank of France, many of these inconvenient facts are, ironically enough, unabashedly set down in one of the volumes published by the National Monetary Commission — volumes that supposedly informed the Aldrich Plan and, indirectly, the Federal Reserve Act.  These volumes generally display a bias in favor of central banking, as their sponsors intended them to do. Were one looking for a rose-colored portrayal of the Bank of France's origins, one might expect to find it here.

Nevertheless, according to this particular volume's author,  André Liesse, the Bank of France was conceived, not as a remedy for France's post-revolutionary financial turmoil, but as one for Napoleon's fiscal difficulties.  What's more, far from having represented an improvement upon the status quo ante, its establishment marked the end of a remarkable though short-lived period of relative financial stability.

The disastrous failure, in 1721, of John  Law's Banque Royale, was, according to Liesse, entirely attributable to that bank's involvement with the financial operations of the French government, and to its having secured, in return for that involvement, an exclusive right to issue banknotes.  No wonder the bank's failure resulted in an edict establishing complete freedom of note issue.  Still, it was not until 1776 that the scars left by its collapse had healed sufficiently for another bank of issue to be established.

The new bank, the first Caisse d'Escompte, also ran into trouble as a result of "repeated state loans and government interference," eventually leading to its becoming "nothing more than a branch of the public administration of finance."  The episode led the great economist (and Inspector General to Louis XVI) Du Pont de Nemours, in Liesse's words,

to defend the true principles of banks of issue, asserting that  a bank without a privilege, not involved in business relations with a debt-ridden and needy State, without the prerogative of forced currency, can not do otherwise than pay in coin on demand the value of every note issued.

In 1793 what remained of the Caisse d'Escompte succumbed to the financial "paroxysms" of the Revolution.  Once again, according to Liesse, an institution that "would have been of real service to commerce if it had not allowed itself to become the State's banker" instead found itself "lending money to the State without sufficient security, and receiving nothing in return but privileges which could not fail to be disastrous to it."

But other banks of issue founded during the first Caisse d'Escompte's lifetime managed to keep going despite the Revolutionary turmoil, including the "dangerous and ruinous flood of assignats" that was eventually to result in hyperinflation.  Their owners and managers, mostly Protestants whose families had fled from France to Switzerland after the Edict of Nantes was revoked, had managed, "even in dealing with Napoleon," to avoid being "cajoled into granting the State favors of credit which would cost them dear."  Their banks would soon be joined by other private institutions, including the Caisse des Comptes Courants, a central clearinghouse and bankers' bank (it issued only very large denomination notes, meant for interbank settlements) established in Paris in 1796, and the Caisse d'Escompte du Commerce (or Caisse du Commerce, for short) — organized in 1797.

Thus began a brief but at least relatively glorious free banking interval.[1] "It can not be denied," Liesse observes,

that after the terrible years of the Revolution, in the midst of the confusion and anarchy of the Directory, these credit establishments, in spite of difficult conditions, survived, maintained their credit, and were of real services to the commerce and bankers of Paris.  They gave not the slightest occasion for complaint or interference on the part of the public authorities.  Without any sort of privilege, having no connection with the Government, they were able to meet their obligations even in the midst of serious panics.

In short, freedom in banking worked just as Du Pont DeNemours said it would.[2]

Yet this success was not allowed to last.  As Charles Conant puts it (History of Modern Banks of Issue, p. 44), the established banks

were doing an active and safe banking business when a new turn was given to the economic history of France by the coup d'état of the Eighteenth Brumaire (November 9, 1799), which made Napoleon Bonaparte First Consul and virtually supreme ruler of France.

Napoleon did not hesitate, despite the lessons of the past, to make plans for yet another government-controlled and privileged bank of issue, the Bank of France.   For Liesse this development, far from seeming perfectly sensible (as modern central bank enthusiasts would have it), was astonishing.  How could it happen, he wonders,

that this most satisfactory state of freedom came to an end and that in the course of a few years there was organized in Paris a bank with the exclusive privilege of issue?  Is it due to a series of natural causes?  No.  Not one of the Caisses just described had occasioned disaster or invited suppression.[3]  The new state of things came from the idea of credit which existed in the mind of General Bonaparte, as well as from his tendency to centralize everything, and because the government at the moment was in great need of money.

The "idea of credit which existed in the mind of General Bonaparte" boiled down to this: that he might have all the credit he wanted, if only he could establish a bank he could control, and award it a monopoly of currency extending throughout all of France.

At very least, Napoleon could have a lot more credit for a lot less than France's then-existing banks were either willing, or even able, to supply.  According to notes left by a member of Napoleon's Council of State, to which Professor Liesse refers, the First Consul had "determined to lower" the interest rate at which the government could borrow to something less than the rate of 3 percent permonth banks were then demanding, thanks to the government's poor credit.  Napoleon "could not get what he wanted from the free banks.  On the other hand, he felt that the Treasury needed money, and wanted to have under his hand an establishment which he could compel to meet his wishes. …It would certainly seem that here originated the idea of creating a new bank of issue."

Given the circumstances, raising capital for the new bank was no easy proposition.  To address that difficulty, the government first persuaded the  Caisse des Comptes Courants to merge with it.  To make further shares attractive, the new bank secured the privilege of holding various government deposits.  Still, less than 7500 of a requisite 15,000 shares (half of the Bank's stipulated capital stock) were taken, with Bonaparte's friends and relatives having pride of place among the subscribers.   (Napoleon himself was the Bank's first subscriber, with 30 shares.)  Further privileges were duly awarded it, until they sufficed to allow the remaining shares to be disposed of.

At first, the Bank of France had to compete with other banks of issue, including the Caisse du Commerce.  When attempts to persuade the older bank to merge with the Bank of France failed, and especially after the Caisse du Commerce refused the government a loan it sought, Napoleon resorted to coercion.  The details remain obscure.  According to one account (admittedly in an English newspaper) at first the Bank of France, with Napoleon's support, tried to bring its rival to submission by staging note-redemption raids.  When that strategy failed, Napoleon simply had some of his troops shut the bank down.  What's certain is that the law of 24 Germinal, An XI (April 14, 1803), against which the Caisse du Commerce protested vehemently, awarded the Bank of France the exclusive right to issue banknotes in Paris, compelling all other banks of issue to surrender their assets to it.

"The Bank of France was chartered in 1800 as an antidote to the financial turmoil of the French Revolution." It is one of those sentences that exposes a dominating — but distorted — worldview no less effectively than it obscures aspects of reality itself.


[1]This was, in fact, the second such interval in French banking history.  The first was still a still briefer episode, lasting only from 1790 to 1793, during which hundreds of "caisses patriotiques" flourished.  According to Eugene White, that episode also "provides evidence of the success of free banking."  It ended when the government closed down the caisses in November 1793.  See Eugene N. White, "Free Banking during the French Revolution," Explorations in Economic History 27 (1990): 251-276.

[2]For a more recent, but equally favorable, assessment of France's 1796-1803 free banking episode, see Philippe Nataf, "Free banking in France," in Kevin Dowd, ed., The Experience of Free Banking  (London: Routledge, 1992), pp. 123-36.

[3]Nor did suppressing inflation have anything to do with it.  The raging inflation brought about by the Revolutionary government's overissuance of assignats had come to a sudden end when, on July 16, 1796, the National Assembly decreed that people might conduct business using whatever money they chose, while allowing mandates, which had superseded assignats, to be accepted at their current value in specie.  From that moment on, France was effectively back on a metallic standard.

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Portugal-Style Bail-ins: The New Norm under Dodd-Frank? Wed, 20 Jan 2016 14:17:55 +0000 As 2015 came to an end, so perhaps did a central tenet of resolving failed companies, the notion that “similarly situated” creditors ought to be treated equally, or, as the lawyers like to say “pari passu” (Latin for “on the same footing”).*  The turning point was Portugal’s treatment of creditors...

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Banco de Portugal, Banco Espirito Santo SA, Chevron Deference, Dodd-Frank, pari passu, bankruptcyAs 2015 came to an end, so perhaps did a central tenet of resolving failed companies, the notion that “similarly situated” creditors ought to be treated equally, or, as the lawyers like to say “pari passu” (Latin for “on the same footing”).*  The turning point was Portugal’s treatment of creditors of Novo Banco SA.

Until its failure in August of 2014, Banco Espirito Santo SA had been Portugal’s second largest bank.  When it failed, the Banco de Portugal, acting as receiver, divided the failed bank into  “good” and “bad” components, as the FDIC commonly does in the event of a large U.S. bank failure.  Banco Espirito Santo SA continued as the “bad bank,” which was to be liquidated in an orderly process.  The “good bank” became Novo Banco SA, which would stay in business.

In such “good bank-bad bank” resolutions, all equity holders usually remain with the bad bank, while more senior creditors are transferred to the good bank.  In any event all creditors of the same class are treated alike.  Creditors assigned to the good bank are much more likely to recover some part of their investment.

In the case of Novo Banco, the usual practice was at first followed.  All creditors within certain classes were transferred to it in August 2014.  Those who weren’t transferred took losses instead of taxpayers, which was also the generally correct approach (would that it had been our approach during the financial crisis!).  But last month, something odd happened: a small number of bonds were re-assigned to Banco Espirito Santo SA.  The holders of those bonds were likely to recover less than if they had remained with the good bank.  This was done to reduce leverage at Novo Banco SA.  One can read the listing of bonds and the justification here.  The problem is that other bonds of similar seniority remained with Novo Banco.  That meant that the pari passu principle was violated.  Some bondholders would recover considerably more than others, despite holding bonds having the same priority.

So far as I can tell, what Portugal did was perfectly legal (but I’m not a lawyer, keep that in mind).  And one could even justify it, if the alternative would have been to have the taxpayers take a hit.  Still there are good reasons for regretting Portugal’s action.  The whole point of bankruptcy law and its administrative cousin, receivership, is to establish a chain of priority in the event of insolvency.  Basically where you stand in line is predetermined.  You generally have the ability to contract as to where you stand in line, and generally your expected return reflects that risk (farther back in line you are, less likely are to get paid).  Pari passu dictates that everyone who contracted for a particularly spot in line is treated the same.  While pari passu seems to have arose originally as contractual boilerplate, it has somewhat taken the status of an implied contractual term.  If the recovery is insufficient, the proceeds are share pro rata.  If I hold bond A and you hold bond A, we both get the same pay-off.  If I get 50 cents on the dollar, you get 50 cents on the dollar.  A decent respect for equality under the law demands such, as well as the rule of law.

If pari passu no longer holds, the ability to estimate default recoveries is greatly  reduced, increasing uncertainty in the debt market.  Particular groups of creditors are also more likely to become playthings of politics.  Witness the treatment of certain pension funds in the auto bankruptcies, which were harmed in order to benefit the auto unions.  Deviations from pari passu risk turning the resolution process into a political game, rather than a legal proceeding.

Unless you’re investor in either Banco Espirito Santo SA or Novo Banco SA, why should you care about this?  You should care because thanks to Dodd-Frank’s Title II resolution process, the same thing is now a lot more likely to happen in the good-ol’ U. S. of A.  That’s because Dodd-Frank’s Title II resolution process explicitly allows for exceptions to pari passu.  Given how the recent financial crisis response played out, one could easily envision, under a Title II resolution, creditors in a Florida pension fund being treated differently than those in a California pension fund, especially in an election year.  One could also envision differing treatment depending upon whether the creditors were domestic or foreign, as was the case with Novo Banco SA.

Section 210 of Dodd-Frank is loosely modeled on Section 11 of the Federal Deposit Insurance Act (FDIA), which calls for strict adherence to the pari passu principle.  But while Dodd-Frank suggests that pari passu generally be followed, Section 210(b)(4) allows for various exceptions.  Pari passu may be set aside when the receiver determines that doing so serves, according to the language of the statute:

(i) to maximize the value of the assets of the covered financial company;

(ii) to initiate and continue operations essential to implementation of the receivership or any bridge financial company;

(iii) to maximize the present value return from the sale or other disposition of the assets of the covered financial company; or

(iv) to minimize the amount of any loss realized upon the sale or other disposition of the assets of the covered financial company.

Although a further clause states that these exceptions can be made only provided that “all claimants that are similarly situated under paragraph (1) receive not less than the amount provided in paragraphs (2) and (3) of subsection (d),” this clause merely requires that a creditor get at least what he would have gotten in a liquidation, allowing the receiver to disregard any going-concern value, including goodwill.  In practice, this is unlikely to be a constraint at all.

In short, I think it is fair to say that Dodd-Frank, far from enforcing pari passu, allows almost anything to happen, especially in a Chevron deference world.  In fact the protections for a receiver are tighter than in the Chevron case (see Section 210(e) of Dodd-Frank and its limit on judicial review).

As depositors have historically been the dominant, and sometimes the only creditors in bank resolutions, the discretion that Dodd-Frank allows may not matter much in such cases.  But Dodd-Frank’s application to non-banks raises a whole new set of disturbing possibilities for the extra-judicial treatment of creditors.

Congress, at the suggestion of the FDIC, included similar flexibility in the resolution procedures for Fannie Mae and Freddie Mac.  That whole process has, of course, gone swimmingly.


*Some additional legal background on pari passu, particularly in the case of sovereign defaults, is here. For a more skeptical legal read this.

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The Bank of England Fails Its Stress Test, Again Fri, 15 Jan 2016 14:23:36 +0000 On December 1, 2015, the Bank of England released the results of its second round of annual stress tests, which aim to measure the capital adequacy of the UK banking system.  This exercise is intended to function as a financial health check for the major UK banks, and purports to...

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Test Fixture for Three Point Flex TestOn December 1, 2015, the Bank of England released the results of its second round of annual stress tests, which aim to measure the capital adequacy of the UK banking system.  This exercise is intended to function as a financial health check for the major UK banks, and purports to test their ability to withstand a severe adverse shock and still come out in good financial shape.

The stress tests were billed as severe.  Here are some of the headlines:

“Bank of England stress tests to include feared global crash”
“Bank of England puts global recession at heart of doomsday scenario”
“Banks brace for new doomsday tests”

This all sounds pretty scary.  Yet the stress tests appeared to produce a comforting result: despite one or two small problems, the UK banking system as a whole came out of the process rather well.  As the next batch of headlines put it:

“UK banks pass stress tests as Britain's ‘post-crisis period’ ends”
“Bank shares rise after Bank of England stress tests”
“Bank of England’s Carney says UK banks’ job almost done on capital”

At the press conference announcing the stress test results, Bank of England Governor Mark Carney struck an even more reassuring note:

The key point to take is that this [UK banking] system has built capital steadily since the crisis.  It's within sight of [its] resting point, of what the judgement of the FPC is, how much capital the system needs.  And that resting point — we're on a transition path to 2019, and we would really like to underscore the point that a lot has been done, this is a resilient system, you see it through the stress tests.[1] [italics added]

But is this really the case?  Let’s consider the Bank’s headline stress test results for the seven financial institutions involved: Barclays, HSBC, Lloyds, the Nationwide Building Society, the Royal Bank of Scotland, Santander UK and Standard Chartered.

In this test, the Bank sets its minimum pass standard equal to 4.5%: a bank passes the test if its capital ratio as measured by the CET1 ratio — the ratio of Common Equity Tier 1 capital to Risk-Weighted Assets (RWAs) — is at least 4.5% after the stress scenario is accounted for; it fails the test otherwise.

The outcomes are shown in in Chart 1:

Chart 1: Stress Test Outcomes for the CET1 Ratio with a 4.5% Pass Standard

Dodd Graph 1

Note: The data are obtained from Annex 1 of the Bank's stress test report (Bank of England, December 2015).

Based solely on this test, the UK banking system might indeed look to be in reasonable shape.  Every bank passes the test, although one (Standard Chartered) does so by a slim margin of under 100 basis points and another (RBS) does not perform much better.  Nonetheless, according to this test, the UK banking system looks broadly healthy overall.

Unfortunately, that is not the whole story.

One concern is that the RWA measure used by the Bank is essentially nonsense — as its own (now) chief economist demonstrated a few years back.  So it is important to consider the second set of stress tests reported by the Bank, which are based on the leverage ratio.  This is defined by the Bank as the ratio of Tier 1 capital to leverage exposure, where the leverage exposure attempts to measure the total amount at risk.  We can think of this measure as similar to total assets.

In this test, the pass standard is set at 3% — the bare minimum leverage ratio under Basel III.

The outcomes for this stress test are given in the next chart:

Chart 2: Stress Test Outcomes Using the Tier 1 Leverage Ratio with a 3% Pass Standard

Dowd Graph 2

Based on this test, the UK banking system does not look so healthy after all.  The average post-stress leverage ratio across the banks is 3.5%, making for an average surplus of 0.5%.  The best performing institution (Nationwide) has a surplus (that is, the outcome minus the pass standard) of only 1.1%, while four banks (Barclays, HSBC, Lloyds and Santander) have surpluses of less than one hundred basis points, and the remaining two don’t have any surpluses at all — their post-stress leverage ratios are exactly 3%.

To make matters worse, this stress test also used a soft measure of core capital — Tier 1 capital — which includes various soft capital instruments (known as additional Tier 1 capital) that are of questionable usefulness to a bank in a crisis.

The stress test would have been more convincing had the Bank used a harder capital measure.  And, in fact, the ideal such measure would have been the CET1 capital measure it used in the first stress test.  So what happens if we repeat the Bank’s leverage stress test but with CET1 instead of Tier 1 in the numerator of the leverage ratio?

Chart 3: Stress Test Outcomes Using the CET1 Leverage Ratio with a 3% Pass Standard

Dowd Graph 3

In this test, one bank fails, four have wafer-thin surpluses and only two banks are more than insignificantly over the pass standard.

Moreover, this 3% pass standard is itself very low.  A bank with a 3% leverage ratio will still be rendered insolvent if it makes a loss of 3% of its assets.

The 3% minimum is also well below the potential minimum that will be applied in the UK when Basel III is fully implemented — about 4.2% by my calculations — let alone the 6% minimum leverage ratio that the Federal Reserve is due to impose in 2018 on the federally insured subsidiaries of the eight globally systemically important banks in the United States.

Here is what we would get if the Bank of England had carried out the leverage stress test using both the CET1 capital measure and the Fed’s forthcoming minimum standard of 6%:

Chart 4: Stress Test Outcomes for the CET1 Leverage Ratio with a 6% Pass Standard

Dowd Graph 4

Oh my!  Every bank now fails and the average deficit is nearly 3 percentage points.

Nevertheless, I leave the last word to Governor Carney: “a lot has been done, this is a resilient system, you see it through the stress tests.”


[1] Bank of England Financial Stability Report Q&A, 1st December 2015, p. 11.


Editors Note: For a helpful primer on the flawed assumptions and methodology of central bank stress tests, see Kevin Dowd’s article from the Fall 2015 issue of the Cato Journal.

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Interest On Reserves, Part III Tue, 12 Jan 2016 14:14:10 +0000 Why do I keep harping on interest on reserves?  Because, IMHO, the Fed's decision to start paying interest on reserves contributed at least as much as the failure of Lehman Brothers or any previous event did to the liquidity crunch of 2008:Q4, which led to a  deepening of the recession...

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HarpistWhy do I keep harping on interest on reserves?  Because, IMHO, the Fed's decision to start paying interest on reserves contributed at least as much as the failure of Lehman Brothers or any previous event did to the liquidity crunch of 2008:Q4, which led to a  deepening of the recession that had begun in December 2007.

That the liquidity crunch marked a turning point in the crisis is itself generally accepted.  Bernanke himself (The Courage to Act, pp. 399ff.) thinks so,  comparing the crunch to the monetary collapse of the early 1930s, while stating that the chief difference between them is that the more recent one involved, not a withdrawal of retail funding by panicking depositors, but the "freezing up" of short-term, wholesale bank funding.  Between late 2006 and late 2008, Bernanke observes, such funding fell from $5.6 trillion to $4.5 trillion (p. 403).  That banks altogether ceased lending to one another was, he notes, especially significant (p. 405).  The decline in lending on the federal funds market alone accounted for about one-eighth of the overall decline in wholesale funding.

For Bernanke, the collapse of interbank lending was proof of a general loss of confidence in the banking system following Lehman Bothers' failure.  That same loss of confidence was still more apparent in the pronounced post-Lehman increase in the TED spread:

The skyrocketing cost of unsecured bank-to-bank loans mirrored the course of the crisis. Usually, a bank borrowing from another bank will pay only a little more (between a fifth and a half of a percentage point) than the U.S. government, the safest of all borrowers, has to pay on short-term Treasury securities. The spread between the interest rate on short-term bank-to-bank lending and the interest rate on comparable Treasury securities (known as the TED spread) remained in the normal range until the summer of 2007, showing that general confidence in banks remained strong despite the bad news about subprime mortgages. However, the spread jumped to nearly 2-1/2 percentage points in mid-August 2007 as the first signs of panic roiled financial markets. It soared again in March (corresponding to the Bear Stearns rescue), declined modestly over the summer, then showed up when Lehman failed, topping out at more than 4-1/2 percentage points in mid-October 2008 (pp. 404-5).

These developments, Bernanke continues, "had direct consequences for Main Street America. … During the last four months of 2008, 2.4 million jobs disappeared, and, during the first half of 2009, an additional 3.8 million were lost.” (406-7)

There you have it, straight from the horse's mouth: the fourth-quarter, 2008 contraction in wholesale funding, as reflected in the collapse of interbank lending, led to the loss of at least 6.2 million jobs.

But was the collapse of interbank lending really evidence of a panic, brought on by Lehman's bankruptcy?  The timing of that collapse, as indicated in the following graph, tells a much different story.

Interbank Loans All Commercial Banks

The first of the three vertical lines is for September 15, 2008, when Lehman went belly-up.  Interbank lending on the next reporting date — September 17th —  was actually up from the previous week.  Thereafter it declined a bit, and then rose some.  But these variations weren't all that unusual.  As for the TED spread, although it rose sharply after Lehman's failure, the rise reflected, not an actual increase in the effective federal funds rate (as the "panic" scenario would suggest), but the fact that that rate, though it actually declined rapidly, did not do so quite as rapidly as the Treasury Bill rate did:

TED Spread

OK, now on to those other vertical lines.  They show the dates on which banks first began receiving interest payments on their excess reserves.  There are two lines because back then two different sets of banks had different "reserve maintenance periods," and therefore started getting paid at different dates.  (The maintenance periods have since been made uniform.) Those (mostly smaller) banks with one-week reserve maintenance periods began earning interest on October 15th; the rest, with two-week maintenance periods, started getting paid on October 22nd.  The collapse in interbank payments volume coincides with the latter date.  Notice also that the collapse continues after the TED spread has returned to a level not so different from its levels before Lehman failed.

If you still aren't convinced that IOR was the main factor behind the collapse in interbank lending, perhaps some more graphs will help.  The first shows the progress of interbank lending over a somewhat longer period, along with the 3-month Treasury Bill rate and (starting in October 2008) the interest rate on excess reserves:

IOR and Interbank Lending

To understand this graph, think of the banks' opportunity cost of holding excess reserves as being equal to the difference between the Treasury Bill rate and the rate of interest on excess reserves.   Prior to October 15th, 2008, the opportunity cost, being simply equal to the Treasury Bill rate itself, is necessarily positive.  But when IOR is first introduced, it becomes practically zero; and shortly thereafter it becomes, and remains, negative.  Mere inspection of the chart should suffice to show that the volume of interbank lending tends to vary directly with this opportunity cost.

Once the interest rate on excess reserves is fixed at 25 basis points after mid-December 2008, things get simpler, as the volume of interbank lending varies directly with the Treasury Bill rate.  Here is a chart showing that period, with the opportunity cost itself (that is, the Treasury Bill rate minus 25 basis points) plotted along with the volume of interbank lending:

Opportunity Cost

Now, it would be one thing if Bernanke were merely guilty of misunderstanding the cause of the decline in interbank lending, without having actually been responsible for that decline.  But Bernanke was responsible, as was the rest of the Fed gang that took part in the misguided decision to start rewarding banks for holding excess reserves in the middle of a financial crisis.

What's more, it is hard to see how Bernanke can insist that the Fed's decision to pay IOR had nothing to do with the drying-up of the federal funds market given the justification he himself offers for that decision earlier in his memoir, which bears quoting once again, this time with emphasis added:

 [W]e had been selling Treasury securities we owned to offset the effect of our lending on reserves… . But as our lending increased, that stopgap measure would at some point no longer be possible because we would run out of Treasuries to sell….The ability to pay interest on reserves…would help solve this problem. Banks would have no incentive to lend to each other at an interest rate much below the rate they could earn, risk-free, on their reserves at the Fed (p. 325).

Yet when he turns to explain the causes of the collapse in interbank lending, just eighty pages after this passage, Bernanke never mentions interest on reserves.  Instead, he blames the collapse on panicking private-market lenders, while treating the Fed — and, by implication, himself — as a White Knight, galloping to the rescue.  "As the government’s policy response took effect," he writes, "the TED spread declined toward normal levels by mid-2009" (p. 405).  What rubbish.  We've already seen why the TED spread went up and then declined again.  And although interbank lending itself revived somewhat during the first half of 2009, it declined steadily thereafter, ultimately falling to lower levels than ever.

And the Fed's "policy response"?  According to Bernanke, it had "four main elements: lower interest rates to support the economy, emergency liquidity lending…and the stress-test disclosures of banks’ conditions” (409).  Let Kevin Dowd tell you about those idiotic stress tests.  As for "lower interest rates," they were proof, not that the Fed was taking desirable steps, but that it was failing to do so, for although the Fed did get around to reducing its federal funds rate target, its doing so was a mere charade: the equilibrium federal funds rate had long since fallen well below the Fed's target, and the subsequent moves merely amounted to a belated recognition of that fact, without making any other difference.  Finally, although the Fed's emergency lending aided the loans' immediate recipients, as well as their creditors, it contributed not a jot to overall liquidity, the very point of IOR having been — as Bernanke himself admits, and as I explained in my first post on this topic — to prevent it from doing so!

As the next chart shows, IOR, besides contributing to the collapse of interbank lending, also played an important part in the dramatic increase in the banking system reserve ratio.  The vertical lines represent the same three dates as those referred to in the very first chart.  Although the ratio did  rise considerably following Lehmans' failure, it rose even more dramatically — and, quite unlike the TED spread, never recovered again — after the Fed started paying interest on excess reserves:


To better understand what went on, here is another diagram, this one showing banks' choice of optimal reserve and liquid asset ratios as a function of the interest paid on bank reserves:


In the diagram, the vertical axis represents the interest rate on reserve balances, in basis points, while the horizontal axis represents the reserve-deposit ratio.  The picture shows two upward-sloping schedules.  The first is for reserve balances at the Fed, while the second is for liquid assets more generally, here meaning (for simplicity's sake) reserves plus T-bills.  The horizontal line shows the yield on T-bills at the time of implementation of IOR, here assumed to be a constant 20 basis points.  The two dots, finally, represent equilibrium ratios, the first (at the lower left) for before the crisis and IOR, the other for afterwards.  Note that, the high post-IOR ratio reflects, not just the interest-sensitivity of reserve demand, but that, with IOR set at 25 basis points, reserves dominate T-bills.  Thus, although the demand for excess reserves may not be all that interest sensitive so long as the administered interest rate on reserves is less than the rate earned by other liquid assets, that demand can jump considerably if that rate is set above rates on liquid and safe securities.

The last chart I'll trouble you with today tracks changes in total commercial bank reserves, interbank loans, Treasury and agency securities, and commercial and industrial loans, from mid-2006 through mid-2009, this time with a single vertical line only, for October 22, 2008, when IOR was in full effect:

Composition of Bank Assets

The chart shows clearly how the beginning of IOR coincided, not only with a substantial decline in interbank lending (green line), but in a leveling-off of other sorts of bank lending, which later becomes a pronounced decline.  For illustration's sake, the chart shows the course of C & I lending only; other sorts of bank lending fell off even more.

Don't get the wrong idea: I don't wish to suggest that IOR was responsible for the post-2008 decline in bank lending, apart from overnight lending to other banks.  There's little doubt that that decline mainly reflects the effects of both a declining demand for credit and much stricter regulation of bank lending, especially as Dodd-Frank and Basel III came into play, Nor do I believe that merely eliminating IOR, as opposed to either reducing the regulatory burdens on bank lending, or resorting to negative IOR (as some European central banks have done), or both, would have sufficed to encourage any substantial increase in bank balance sheets, and especially in bank lending, after 2009, when most estimates (including the Fed's own) have "natural" interest rates sliding into negative territory.  But as I noted in my first post in this series, when IOR was first introduced, natural rates were, according to these same estimates, still positive.  And one thing IOR certainly did do, both before 2009 and afterwards, was to allow banks, and some banks more than others, to treat trillions in new reserves created by the Fed starting in October 2008, not as an inducement to expand their balance sheets, but as a direct source of risk- and effort-free income. (Note, by the way, how, just before IOR was introduced, but after the Fed stopped sterilizing its  emergency loans, bank loans and security holdings did in fact increase along with reserves.)

Moreover, it's evident that the FOMC itself, rightly or wrongly, sees IOR as continuing to play a crucial part in limiting banks' willingness to expand credit.  Otherwise, how can one possibly understand that bodies' decision last month to raise the rate of IOR (and, with it, the upper bound of its federal funds rate target range) from 25 to 50 basis points?  That decision, recall, was aimed at making sure that bank credit expansion would not progress to the point of causing inflation to exceed the Fed's 2 percent target:

The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective. Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent. The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

Bernanke's implementation and defense of IOR would be more than bad enough, were it not also for his particular determination to avoid repeating the mistakes the Fed made during the Great Depression.  "[M]ost of my colleagues and I were determined," he says, "not to repeat the blunder the Federal Reserve had committed in the 1930s when it refused to deploy its monetary tools to avoid a sharp deflation that substantially worsened the Great Depression” (p. 409).  Among the Fed's more notorious errors during that calamity were its failure to expand its balance sheet sufficiently, through open-market purchases or otherwise, to offset the dramatic, panic-driven collapse in the money multiplier during the early 1930s, and its recovery-scuttling decision to double reserve requirements in 1936-7.

Of course, Bernanke's Fed didn't commit the very same mistakes committed by the Fed of the 1930s.  But, as David Beckworth had already recognized by late October 29, 2008, it made remarkably similar ones that also resulted in a collapse of credit.  "History," Bernanke  credits Mark Twain with saying, "does not repeat itself, but it rhymes” (p. 400).  If you ask me, Bernanke himself was a far better versifier — and a far worse central banker — than he and his many champions realize.


Addendum (1-12-2016, 6PM): As Forbes' Frances Coppola, in replying to my criticism of her in an earlier post in this series, claims that I am inconsistent in my various posts regarding to bearing of IOR on bank lending, allow me to clarify my position by means of the following précis:

1. IOR was implemented in October 2008 for the avowed purpose of checking bank credit expansion in response to the Fed's creation of fresh bank reserves.

2. In fact, IOR contributed to the fall 2008 wholesale credit crunch, most obviously by causing a dramatic decline in interbank lending.   Again, this contribution was anticipated by Bernanke and others responsible for the policy.

3. Once the rate of IOR exceeded the yield on Treasuries and other low-risk assets, as it did shortly after the program began, banks had an incentive to accumulate excess reserves instead of attempting to acquire such securities.  Thus the normal process of bank balance-sheet expansion and deposit creation in response to reserve injections was short-circuited.

4. IOR also contributed to the relative decline in risky bank lending by increasing the marginal opportunity cost of such lending.  This portfolio effect of IOR on risky lending was very small relative to that of increasing regulatory burdens, including capital requirements, especially after 2008.  But as at least some banks had both surplus capital and surplus reserves, capital constraints alone did not prevent IOR from also having some influence.

5.  Fed officials, including Bernanke, who would deny that IOR had the consequences I have just outlined, are at least obliged to reconcile their denials with the justifications offered for implementing the program in the first place.

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The Importance of Sound Money and Banking: Lessons from China, 1905–1950 Fri, 08 Jan 2016 14:13:01 +0000 The history of China’s banking system in the first half of the 20th century offers powerful insights into the conduct of monetary policy and the consequences of government intrusion into banking and monetary institutions that are well worth considering today.  Monetary economists and monetary historians would do well to study China’s...

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Yuan note 1906The history of China’s banking system in the first half of the 20th century offers powerful insights into the conduct of monetary policy and the consequences of government intrusion into banking and monetary institutions that are well worth considering today.  Monetary economists and monetary historians would do well to study China’s example, and, in particular, Chang Kia Ngau’s 1958 book, The Inflationary Spiral: The Experience in China, 1939-1950.  As you’ll see, sound money and sound banking matter a great deal in creating a harmonious and prosperous society.

In 1905, during the final years of the Qing Dynasty, the first government bank, the Hupu Bank, opened in Peking.  It was established by the Imperial Ministry of Revenues when China was still on the silver standard to help finance government deficits by issuing paper currency (see specimen above).  In 1908, the bank was renamed the Ta Ching Government Bank (Great Qing Bank), and in 1912, under a new charter, the bank became known as the Bank of China.  Another government bank of issue, the Bank of Communications, was established in 1908.

The constant pressure for central and provincial governments to increase spending beyond revenues led to attempts to suspend convertibility.  For example, in 1916, President Yuan Shih-kai of the Republic of China ordered the Bank of China and the Bank of Communications to halt convertibility of their bank notes, and the public was instructed to accept those irredeemable notes at par.  The largest note-issuing bank, the Shanghai Branch of the Bank of China, refused to comply with the president’s order and was able to defend its notes against a bank run.  The Peking Branch of the Bank of China, however, complied with the order, as did the Bank of Communications (Chang: p. 5).

In Manchuria, officials imposed the death sentence on individuals who exchanged irredeemable bank notes at less than par.  Despite this severity, there were heavy discounts on provincial government bank notes “which placed a very real limit on the extent to which these issues could be increased.”  By 1922 all irredeemable notes from the Bank of China and the Bank of Communications were withdrawn (Chang: p. 5).  The public then slowly regained confidence in paper currency as banks recommitted to redeem their notes in silver.

Institutional Limits on the Quantity of Money

In March 1928, the Bank of China sought to enhance the credibility of its currency by embarking on institutional reform to limit note issue.  The bank established a “Supervisory Committee” in Shanghai, comprised of members from the Chamber of Commerce, the Bankers’ Association and the Native Bankers’ Association, designed to ensure that the bank had sufficient silver backing for its notes.  The Committee published quarterly reports on the bank’s reserve position that were certified by a public accountant (Chang: p. 6).

This institutional check on the credibility of the bank’s promise to honor its commitment to maintain a convertible currency was also adopted by the newly created Central Bank of China, as well as by the Bank of Communications and private banks.  To quote Chang (p. 6), “The public became less wary of holding bank notes, and note circulation increased rapidly in the years after 1928.  Sound currency gradually drove the unsound notes of the provincial banks out of circulation except in Manchuria and Canton” (emphasis added).

Currency Reform

The silver backing of bank notes was relaxed by the rule change that allowed banks to back up to 40 percent of their note issues with government bonds, and, in November 1935, the central government replaced the silver standard with a foreign exchange standard.  The currency reform provided that only notes issued by the Central Bank of China, the Bank of China, and the Bank of Communications would be acceptable as legal tender, and would henceforth be called “the Chinese National Currency” (CNC).  Silver could no longer be used to back bank notes, and the public would have to return all monetary silver to a government appointed Currency Reserve Board or to its agents in exchange for CNC (Chang: p. 7).

Those who drafted the new currency plan had recommended additional measures to safeguard the value of money: (1) make the Central Bank of China independent of the Ministry of Finance; (2) establish a Supervisory Committee to limit note issue and avoid inflation; and (3) rationalize government financing to minimize deficit spending and debt monetization.  However, those sensible measures were never instituted and instead bank notes in circulation were increased from CNC $453 million in 1935 to nearly CNC $1.5 billion by mid-1937 (Chang: p. 8).

Fiscal Dominance, Inflation, and Repression

Demands on the fisc increased during the Second Sino-Japanese War (1937–1945).  The lack of central bank independence and the lack of any hard anchor for the price level under a pure government fiat money system led to an inflationary spiral.  During the early war years, from 1937–39, inflation in “Free China” (areas not held by the Japanese) averaged 40–50 percent per year; inflation then accelerated to 160 percent per year until the end of 1941, and during the last four years of the war averaged more than 300 percent per year (Chang: p. 12).

Following the war, the Nationalist government continued to rely on the printing press to finance deficits, inflation spiraled upward, and the government imposed wage and price controls to suppress inflation.[1]  Direct measures were also used and “economic instability finally led to a general loss of confidence in the Nationalist government, and total collapse of political and social morals followed” (Chang: p. 367).


Several lessons emerge from China’s experiences prior to the Communist Party takeover in 1949.  The first lesson is that long-run economic growth and prosperity depend on “respect for the soundness of private enterprise and banking.”  When the government engages in massive debt monetization, the resulting inflation destroys “popular confidence in banking institutions” (Chang: p. 368).

Second, allocating capital to state-owned enterprises crowds out private investment.  “Overzealousness in forcing the pace of economic development [by supporting state-owned enterprises] often results in little more than the destruction of private capital formation, thus defeating the very purpose of development” (Chang: p. 368).

Third, the inclination of underdeveloped countries to inflate means that “the establishment of an institutional framework for budget control and the independence of the central bank are of paramount importance for the long-term welfare of the population” (Chang: p. 368).

Fourth, “once inflation is under way, the government is perforce led to the path of increasing intervention and direct control.”  Thus, inflation inevitably leads to the loss of economic and personal freedom as the government imposes wage and price controls and allocates resources.  Corruption becomes endemic (Chang: pp. 368–69).

Fifth, the experience of Nationalist China shows “without equivocation that the complexity of modern economic life defies the grasp of any single individual” (Chang: p. 369).  This point may seem trivial but is one that Nobel laureate economist F. A. Hayek often emphasized in such works as “The Use of Knowledge in Society” and The Fatal Conceit.  Central bankers who favor pure discretion in the conduct of monetary policy — as opposed to rules — are prone to think that their intricate macroeconomic models capture the complexity of the real economy and that they can accurately forecast the path of the economy.  In contrast a rules-based regime recognizes the difficulty of monetary planning and the benefits of what legal scholar Richard Epstein calls “simple rules for a complex world.”

The most important lesson, perhaps, is that “inflation is no less an enemy of the free society than Communism and, as we have seen in China, may be a harbinger of a Communist triumph” (Chang: 369).


China’s economic experiences during the first half of the 20th century reinforce fundamental principles about the importance of sound money and banking, fiscal rectitude and economic freedom for creating a harmonious society.  It also suggests that the adoption of a rules-based monetary regime, which limits money creation and allows competing currencies, also deserves further attention.


[1] This was the second time the Nationalist government resorted to wage and price controls; the first use was in December 1938.  However, enforcement was difficult because as Chang (p. 343) notes, “The public . . . was antagonistic to all forms of government controls on the economy; still prevalent was the laissez faire view that market problems would best solve themselves if only the government would not interfere.”

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Interest On Reserves, Part II Tue, 05 Jan 2016 14:03:18 +0000 Of the many bemusing chapters of the whole interest-on-reserves tragicomedy, none is more jaw-droppingly so than that in which the strategies' apologists endeavored to show that paying interest on reserves did not, after all, discourage banks from lending, or contribute to the vast accumulation of excess reserves. Apart from resting...

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banking theory, excess reserves, financial crisis, interest on reservesOf the many bemusing chapters of the whole interest-on-reserves tragicomedy, none is more jaw-droppingly so than that in which the strategies' apologists endeavored to show that paying interest on reserves did not, after all, discourage banks from lending, or contribute to the vast accumulation of excess reserves.

Apart from resting on logic that's bound to bring a smile to the face of anyone reasonably conversant with the rudiments of Money and Banking 101, these demonstrations fly in the face, both of the original justification for IOR, as offered by Federal Reserve officials themselves, and of the Fed's recent decision to double IOR (and, with it, the upper-bound of the Fed's federal funds rate target range) so as to prevent inflation from rising above the Fed's 2 percent target.

Now, unless general understanding of basic monetary economics has deteriorated even more than I suspect it has over the course of the crisis and recovery, that understanding still sees inflation as a consequence of "too much money chasing too few goods."  But money can either chase after goods, or rest in bank vaults (or in the virtual vaults consisting of deposits at the Fed).  It can't do both.  Thus the logic (and for once it is logical logic) behind the Fed's decision, both in October 2008 and last month, to check inflation by raising the interest return on bank reserves.

Now on to the exhibits.  I start with another passage from the Richmond Fed article by Walter and Courtois referred to in my earlier post.  There I noted how these authors shared Bernanke's own understanding of the Fed's decision to introduce IOR in October 2008.  "Once banks began earning interest on the excess reserves they held," Walter and Courtois write, "they would be more willing to hold on to excess reserves instead of attempting to purge them from their balance sheets via loans made in the fed funds market."

Perfectly correct.  Nor do Walter and Courtois suggest that there was anything wrong with the Fed's understanding of what it was up to.  Yet, some paragraphs later, the same authors declare that banks' subsequent accumulation of excess reserves

has mistakenly been viewed by some as a sign that the Fed’s lending facilities — the goal of which has been to maintain the flow of credit between banks, and therefore from the banking sector to firms and households — have not worked.

Now, this is already rather confusing, for as we've seen, according to these authors themselves, the whole point of IOR was, not to "maintain the flow of credit" in the sense of keeping it from shrinking — for shrink it most certainly did — but to make sure that the Fed's additions to the total stock of reserves did not increase that flow, which is to say, did not serve to arrest the flow's decline.

But let us set our befuddlement aside, in order to allow our authors to dispute the view that the vast post-IOR accumulation of excess reserves was evidence that the Fed's emergency loans and asset purchases weren't serving to "maintain" an adequate flow of credit:

To the contrary, the level of reserves in the banking system is almost entirely unaffected by bank lending.  By virtue of simple accounting, transactions by one bank that reduce the amount of reserves it holds will necessarily be met with an equal increase in reserves held at other banks, and vice versa.  As described in detail in a 2009 paper by New York Fed economists Todd Keister and James McAndrews, nearly all of the total quantity of reserves in the banking system is determined solely by the amount provided by Federal Reserve.  Thus, the level of total reserves in the banking system is not an appropriate metric for the success of the Fed’s lending programs.

A gold star to all who spot the fallacy here.  For those who can't, it's simple:  "reserves" and "excess reserves" aren't the same thing.  Banks can't collectively get rid of "reserves" by lending them — the reserves just get shifted around, exactly as Walter and Courtois suggest.  But banks most certainly can get rid of excess reserves by lending them, because as banks acquire new assets, they also create new liabilities, including deposits.  As the nominal quantity of deposits increases, so do banks' required reserves.  As required reserves increase, excess reserves decline correspondingly. It follows that an extraordinarily large quantity of excess reserves is proof, not only of a large supply of reserves, but of a heightened real demand for such, and of an equivalently reduced flow of credit.

And what about Keister and McAndrew's 2009 paper, which Walter and Courtois refer to as the locus classicus of their argument?  As Jamie McAndrews has generously contributed, in the course of several recent email exchanges and also in his published works, to my own understanding of the whole IOR business, I'm pleased to report that a careful reading of that paper does not support the conclusion that  Walter and Courtois draw from it. On the contrary: Keister and McAndrews understand that, unlike the total quantity of reserves, the quantity of excess reserves is a function of banks' willingness to lend.  Moreover, they remind their readers that the Fed began paying interest on reserves "to prevent the increase in reserves from driving market interest rates below the level it deemed appropriate given macroeconomic conditions," and that it was only owing to IOR that banks willingly held on to so many excess reserves instead of lending them away.

But while the 2009 paper by Keister and McAndrews cannot be said to confuse the determinants of banks' excess reserve holdings with those of banks' total reserve holdings, the same cannot be said of an August 27, 2012 Liberty Street Economics post by Keister and Gaetano Antinolfi.  Antinolfi and Keister explicitly deny that the Fed, by lowering the interest return on excess reserves, might encourage banks to "lend out some of these 'idle' balances."  Why not?  Because, according to their reasoning, "lowering the interest rate paid on reserves wouldn't change the quantity of assets held by the Fed."  Since lowering the rate of IOR is also unlikely to increase the share of the monetary base consisting of currency rather than bank reserves, it follows that it "will not have any meaningful effect on the quantity of balances banks hold on deposit at the Fed."

Here is that silly fallacy again: for the question isn't whether a lower rate of IOR can reduce banks' total reserve balances.  It is whether it can reduce their excess ("idle") balances by inducing them to lend more.  For while such lending wouldn't serve to reduce the aggregate stock of reserves, it would lead to an increase in the nominal quantity of bank deposits, and a proportional increase in banks' required reserves.  So, even as they caution their readers that "Language Matters," Antinolfi and Keister blunder badly by neglecting to heed the crucial distinction between the total quantity of bank reserves, which no amount of bank lending can alter, and the quantity of excess reserves, which, by means of sufficient bank lending, might always be reduced to zero.

Speaking of language, one of the peculiarities of how it evolves, according to my own (admittedly inexpert) observations, is the particular tendency of bad language memes to go viral.  Once upon a time, some moron imagined that "incentivise" was a word, and the next thing you knew every other moron couldn't wait to slip it into a sentence. Before long, Webster's scouts cottoned-on to the new coinage, and, voila!: English done got itself a brand-new — and perfectly superfluous — verb.

In the same way, bad monetary analysis has a way of spreading like a wildfire.  So I suppose it was only to be expected that Antinolfi and Keister's "proof" that lowering IOR wouldn't promote bank lending would be cited approvingly (or at least not disapprovingly) by numerous other commentators.  Jon Hilsenrath reported favorably on Antinolfi and Keister's argument for the Wall Street Journal's Real Time Economics blog, as did Jonathan Spicer for Reuters, while  Mark Thoma included a large chunk of their post in a post of his own, without expressly endorsing it, but also without suggesting that there was anything wrong with it.

The mistaken understanding of Keister and  McAndrews (or, as now seems more likely, the correct understanding of Keister's own contribution to that work) likewise became, in some quarters at least, the popular understanding.  Thus, according to Frances Coppola, writing for Forbes,

The volume of excess reserves in the system is what it is, and banks cannot reduce it by lending.  They could reduce excess reserves by converting them to physical cash, but that would simply exchange one safe asset (reserves) for another (cash).  It would make no difference whatsoever to their ability to lend.  Only the Fed can reduce the amount of base money (cash + reserves) in circulation.  While it continues to buy assets from private sector investors, excess reserves will continue to increase and the gap between loans and deposits will continue to widen.

Nor, according to Ms. Coppola (writing in another Forbes column), has IOR anything to do with it:

Banks are not being paid not to make loans.  They don’t lend out reserves to customers. They only lend reserves to each other.  By competing with banks in the market for reserves, the Fed controls the price at which they lend reserves to each other. It has nothing whatsoever to do with customer lending.

There you have it: banks can hold on to reserves, and yet lend all they wish to (though not, for some reason, overnight).  Such a marvelous business!  Whoever said that one can't have one's cake and eat it, too?

Well, banking would indeed be a marvelous business if it worked as our expert at Forbes assumes.  Alas, it is not so marvelous as that.  For despite what Ms. Coppola claims, banks do, in effect, lend "reserves" to customers no less than to other banks.  The lending of "reserves" is more apparent in the overnight market simply because it is reserves per se that borrowers in the market are after, for they need extra reserves to avoid shortfalls that would otherwise subject them to penalties, or to what amounts to the same thing: a visit to the Fed's discount window.

If, on the other hand, a businessman borrows $500,000 from a bank, it isn't cash itself that the businessman wants, but other things that can be got for the cash.  But as soon as the proceeds of the loan, originally received as a deposit balance, are drawn upon for the sake of acquiring these other things, the withdrawals, whether by check or draft, lead quickly to redeposits in other banks, and thence to  a $500,000 adjustment to the pattern of interbank clearings and settlements at the expense of the lending bank and in favor of rival institutions compared to what would have been the case had the loan not been made.

All this is entirely elementary.  Yet it is not just the folks at Forbes that don't get it.  Here is what The Economist had to say back in December 2009 about the piling-up of excess reserves:

The point is that the Fed is not trying to increase lending by increasing reserves; it is trying to increase lending by lowering long-term rates and directly supplying credit to borrowers who can't get it elsewhere.  Higher reserves are the unintended byproduct.  Well, unintended or not, couldn't all those excess reserves spur credit growth and inflation?  No.  Reserves have not been a relevant constraint on bank lending for decades, if ever.  Bank lending is constrained by customer demand and by capital.  Right now, loan demand is moribund (in spite of  a zero federal funds rate) and capital is in short supply.

Although it is certainly true that the Fed wasn't trying to get banks to lend more, it did not itself believe that reserves were not a "relevant constraint on bank lending."  If it had thought so, it would not have bothered sterilizing its pre-Lehman lending, and it would not have resorted post-Lehman to paying interest on excess reserves.  Jose Berrospide has it right when he says that, once that policy was in place,

banks sold assets worth selling, such as treasuries and [other] government securities, because the return on those assets was almost zero.  Banks accumulated cash and excess reserves at the central bank because of the interest earned on reserves balances.

The Fed's creation of vast quantities of fresh reserves did not result in a like increase in bank lending, not because reserves had ceased to be a relevant constraint on lending "decades before," but because, thanks to IOR, "the marginal return on loans [was] smaller than the opportunity cost of making a loan" (ibid.).

Nor, as I pointed out in my previous post, was bank lending capital constrained except for a brief time during 2009.  After that, many banks held both excess reserves and excess capital.  As for lending being "constrained by customer demand," oh puh-lease!  The quantity of loans demanded, which is what the writer ought to be talking about, depends on the rate charged.  The problem is that no bank was willing to lend for, or to buy assets yielding, less than the rate paid on reserves themselves.

Economists seem lately to have built a little cottage industry around the notion that those old-fashioned accounts of bank lending, what with their reserve multipliers and clearing losses and all that, are passé.  To subscribe to them is to be hopelessly out of fashion.  Well, call me an old fogey if you must, but I say, show me some au courant writings on the matter, and I will show you some fashionable nonsense.

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