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Auerback Critiques Bernanke

Posted by Sada Mosler on December 21st, 2009


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Well stated!!

Bernanke doesn’t understand the basic economics of central banking

By Marshall Auerback

Dec 19 — I would like to incorporate a critique of quantitative easing based on Bernanke’s comments in Ed’s post “Quantitative easing and inflation expectations.”

You’ve got to focus on improving the conditions for potential borrowers, not on the banks’ balance sheets. Banks are never reserve constrained. Even the BIS, the central banks’ central bank, understands this. In a recent report, the BIS said the following:

In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly.

It is obvious why this is the case. Loans create deposits which can then be drawn upon by the borrower. No reserves are needed at that stage. Then, as the BIS paper says:

in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system.

The loan desk of commercial banks have no interaction with the reserve operations of the monetary system as part of their daily tasks. They just take applications from credit worthy customers who seek loans and assess them accordingly and then approve or reject the loans. In approving a loan they instantly create a deposit (a zero net financial asset transaction).

The only thing that constrains the bank loan desks from expanding credit is a lack of credit-worthy applicants, which can originate from the supply side if banks adopt pessimistic assessments or the demand side if credit-worthy customers are loathe to seek loans. Banks are never reserve constrained, so this comment below from Bernanke is either ignorant or deliberately misrepresents the actual operations of the banking system (as opposed to the nonsensical Economics 101 version).

Ultimately, if the economy normalized, and the Fed took no action, the banks would take those reserves, try to lend them out, and they would begin to circulate, and the money supply would start to grow. And then, ultimately, that would create an inflationary risk. So, therefore, as the economy begins to recover, and as we move away from this very weak economic environment, the Federal Reserve is going to have to pull those reserves out of the system.

The mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment. Quantitative easing merely involves the central bank buying bonds (or other bank assets) in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts. It is commonly claimed that it involves “printing money” to ease a “cash-starved” system, and based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates.

Bank lending is not “reserve constrained.” Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterward. Even the BIS recognizes this. In reality, if the banks are short of reserves then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost). But the reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep.

The current incoherence of our economic policy making could diminish if we had a Fed chairman who understood how the banking system genuinely operated, as well as one who would understanding the linkages between banking lending and fiscal policy, which he persistently downplays (or even worse when he starts calling for long term reforms to balance the Federal government’s budget). It is a national tragedy that this man is being given the chance at another term in office.


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21 Responses to “Auerback Critiques Bernanke”

  1. BFG Says:

    Warren:

    Quantitative easing merely involves the central bank buying bonds (or other bank assets) in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts.

    What would have happened if the central bank instead became banker for the public i.e. providing loans to the public. The public who had received the loans would deposit them in the commercial banks and their reserve accounts would still be credited.

    How do you know that the reserve build up is not new loan creation from the central bank? So the central bank would stop buying assets from the banks and instead provide loans to the public. You would still get an increase in reserves but they would come about through new loan creation from the central bank. Would it work or am I off track?

    BFG

    Reply

    Curious Reply:

    “What would have happened if the central bank instead became banker for the public i.e. providing loans to the public.”

    There would be no need for commercial banks (everybody could have an account at the Fed).

    “How do you know that the reserve build up is not new loan creation from the central bank?”

    http://federalreserve.gov/releases/h41/Current/

    Reply

    Richard Benson Reply:

    If everyone had an account at the fed, wouldn’t it be a logistical nightmare? Warren used to make loans to old ladies to buy lawnmowers (against his own best judgement), he knew the local situation and could make an informed decision if the loan was a good one or not. Today, in this global world, I fail to see how a loan officer in bute, montana who is only looking for an Xmas bonus before he moves to new york or london for his next job is really worried about making sure he makes good long term loans. A banking “system” of 8000 banks with local “ENTRENCHED” loan officers was a good system, but that system is not what we have today. My local bank of america has staff rotation probably every 6 months at this point, the employees never even get time to build up good long term relationships with the customers. Today all that local knowledge has been turned over to the FICO score, but it is a sad proxy for what we once had in local loan officers like Mosler used to do.

    Reply

    Jim Baird Reply:

    Yes, the sad thing is that we have a system aith all the problems of a publically-run centralized system (with loan decisions essentially determined by Washington-based bureaucracies like Fannie, Freddie, and the FHA), with all the corruption and unfairness of a fully private system. The worst of both worlds.

    Curious Reply:

    “If everyone had an account at the fed, wouldn’t it be a logistical nightmare?”

    I think it would simplify things. If all banks were nationalized, there would be no need for reserve compliance, fed funds, etc.

    I’m not advocating it, I was just answering BFG’s question.

    Reply

    warren mosler Reply:

    These are all ‘public purpose’ discussions absent from an Administration, Congress, Fed, and Tsy who have lost sight of what banking and even government in general is all about.

    My proposals list on the left margin of this website is a start in that direction based on my vision of public purpose.

    Richard Benson Reply:

    http://www.interfluidity.com/v2/384.html

    This was an excellent post by JKH – comment #20 on the assymetry of the option of walking away from an underwater mortgage. The kleptocracy is winning.

  2. Floccina Says:

    The only thing that constrains the bank loan desks from expanding credit is a lack of credit-worthy applicants, which can originate from the supply side if banks adopt pessimistic assessments or the demand side if credit-worthy customers are loathe to seek loans. Banks are never reserve constrained, so this comment below from Bernanke is either ignorant or deliberately misrepresents the actual operations of the banking system (as opposed to the nonsensical Economics 101 version).

    This may be true for the most part but lower interest rates do make more people credit worth as they lower projected expenses.

    Reply

    zanon Reply:

    All else being equal, yes.

    Thing is, lots of factors go into creditworthiness, of which interest rates is just one. And maybe a very minor one.

    Monetarists believe that this is the only lever, and thus ignore everything else and wonder why their models don’t work.

    Reply

    warren mosler Reply:

    at the same time, at the macro level, low rates lower incomes as the non govt sector is a net saver.

    and, in this cycle, savings incomes are down more than borrowers savings, as net interest margins are larger for lender. so it’s been a large transfer of interest income from savers to banks.

    also, qe is causing the fed to transfer maybe 60 billion a year to the tsy due to interest income on its portfolio that the private sector used to earn.

    interest income is a factor in credit worthiness

    Reply

    RSJ Reply:

    “at the same time, at the macro level, low rates lower incomes as the non govt sector is a net saver.”

    Hmm — that’s a strange way of framing things. In the U.S., at least historically, return on capital has been 35% of GNI. With high rates, low rates, medium rates — 35% of national incomes is return on capital and 65% goes to labor. Of course that income is divided into dividend payments, rental income, private equity, bonds, etc.

    The question is — what is national income? If by “low rates”, you mean low levels of economic growth, then I agree, as returns are low. If by “low rates”, you mean high asset prices so that yields are low, I would say that those are bubbles that smooth out over time and are not relevant to the total capital income received.

    But if by “low rates”, you mean an environment of low bond yields combined with high nominal growth, then I would say that no, income from capital will not be lower at all. It is just that more of that money will be going to holders of equity as opposed to debt, so there will be some winners and losers, but the total income from financial claims will remain a fixed share of GNI as it has been since at least 1913.

    Reply

    warren mosler Reply:

    By ‘low rates’ I meant ‘low interest rates’

    I’m looking at nominal interest rates the non govt sector earns on bank deposits, tsy secs, etc. etc. which should also all be included in national income accounting under ‘personal income from interest earned’

    lower rates reduce govt interest payments on new tsy secs and as the old ones mature the govt’s interest bill has down even as total tsy secs outstanding has gone up.

    RSJ Reply:

    “I’m looking at nominal interest rates the non govt sector earns on bank deposits, tsy secs, etc. etc. which should also all be included in national income accounting under ‘personal income from interest earned’”

    Yes, net interest income (apart from income earned from the foreign sector) is pretty much set by government yields. In the NIPA accounting, this graph might be helpful to describe how a reduction in interest payments is offset by an increase in payments from corporate dividends or non-corporate returns on capital (e.g. proprietorships).

    http://4.bp.blogspot.com/_fevQMK7kLEI/Sqg-2CpxhdI/AAAAAAAAAEk/YWSM2Nd77x0/s1600-h/Proprietor_Asset_Income.png

    So total income will be unchanged, as a share of GNI.

  3. Floccina Says:

    But what if the central banks buys enough treasuries that people would have to put their money in treasuries cannot because none are available does this not force them to find other investments? Would you suggest that those people would hold in in cash or park it in banks at 0 interest. Would some people not benign to invest it in tangible assets (E.G. my favorite is home insulation which often has an impressive payback as do new air conditioners etc.).

    Reply

    Curious Reply:

    FDIC insured instruments (CD’s, savings and other interest bearing accounts) are identical to treasuries, no?

    Reply

    zanon Reply:

    Floccina: Treasuries are sold at auction, so all this means is that prices (%) will be so low that people will buy something else instead. This may be happening now. May create another credit bubble if people mindlessly start chasing yield — this may be the goal actually.

    It all depends on WHY people are wanting to save more. If it is because they already have too much debt, then buying ACs is not helping.

    FDIC insured instruments are similar to Treasuries in some ways (ie. Govt is behind them) but different in others (e.g. held in reserve account not Treasury account).

    Reply

    RSJ Reply:

    We know what would happen, as history is our guide. In the 50s-70s, the government regulated how much interest banks were allowed to pay, keeping this amount low, and what began to happen as inflation took off was the rise in money market funds. People pooled their resources to buy longer term assets, issuing shorter term liabilities.

    One way to look at this phenomenon was that banks enjoyed large spreads and so other players (money market funds) stepped in to take advantage of this spread. So no, people do not just accept low yields *if* there are better options out there. If there are no better options, then the economy as whole is stagnating, so the low yields are justified. People never accept negative (real) yields, unless the transactional benefit of the account is worth the value erosion.

    And we don’t need to look at our own history, we can look at what is happening in China today. Banks enjoy negative (real) cost of funds and pay almost no interest in an environment of high inflation; people are buying up real estate in enormous quantities, and not selling or renting it, but hoarding it as a tangible asset. Enormous equity bubbles. Many stories of pig farmers stockpiling copper and nickel with the assumption that these assets will at appreciate with the economy as a whole, whereas their bank accounts will not.

    Reply

  4. warren mosler Says:

    Marshall,

    Interestingly, we had translated an article that Warren had written on exactly that question in 1997 which was published in the Montréal-based newspaper Le Devoir. While they did publish it, it barely received a mention within sovereigntist circles. I know that people like Jacques Parizeau understand it, but it would seem that they would rather let sleeping dogs lie politically. As I had told you (if I remember correctly!) in an earlier message, at the Montréal conference on the dollar to which I had participated on December 1, all the Left nationalists, from within the Parti québécois and including the president of the Québec Federation of Labour, all subscribe to some form of monetary integration with the US. Officially, no one stands for an independent floating exchange rate. The fact that I raised problems with monetary integration did suscitate interest among some people there (and I did get some, especially trade unionists, asking for a copy of my presentation) but none high within the political hierarchy. As Parizeau understood it after the 1995 referendum, ordinary people are just too scared because of pensions, etc., to go it alone with a separate Québec currency and, therefore, politically it’s a dead issue. Hence, on matters of the macroeconomy, political independence would ultimately entail only minor tinkering with the status quo ante. The dictum “Plus ça change, plus c’est la même chose!” would seem quite à propos in this context!

    Cheers,

    Mario

    Reply

  5. Rodger Malcolm Mitchell Says:

    Low rates mean the federal government pays less interest (aka “stimulus”) into the private sector. Interest is the sole positive effect of T-securities. If the government eliminated T-securities and created money directly, thereby eliminating federal “debt,” we would eliminate debt hawks.

    It seems like a million years ago (actually, early 2008) that the government thought its $150 billion “stimulus package” would solve the problem. I wrote then that it was too little and too late. Amazing how one little word, “debt,” not only leads us into recessions, but slows our getting out, while also dooming us to inferior health care, inferior education, aging infrastructure and many of the biggest problems afflicting America.

    If we merely called it “total federal money created,” rather than “federal debt” what a lovely world this would become.

    Reply

  6. JKH Says:

    Cleveland Fed article on policy at the zero bound, where any potential legitimacy is butchered by a clear failure to understand the reserve system:

    http://www.clevelandfed.org/research/commentary/2009/1009.cfm

    Reply

  7. warren mosler Says:

    Another disgrace

    Reply

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