Category Archives: Banking

A Modest Response

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A Modest Proposal for Resolving the Eurozone Crisis

By Y. Varoufakis, S. Holland AND J.K. Galbraith

1. Prologue
Europe is fragmenting. While in the past year the European Central Bank has managed to stabilise the bond markets, the economies of the European core and its periphery are drifting apart. As this happens, human costs mount and disintegration becomes an increasing threat.

It is not just a matter for the Eurozone. The fallout from a Eurozone breakup would destroy the European Union, except perhaps in name. And Europe’s fragmentation poses a global danger.

Following a sequence of errors and avoidable delays Europe’s leadership remains in denial about the nature of the crisis, and continues to pose the false choice between draconian austerity and a federal Europe.

By contrast, we propose immediate solutions, feasible within current European law and treaties.

There are in this crisis four sub-crises: a banking crisis, a public debt crisis, a crisis of under-investment, and now a social crisis – the result of five years of policy failure. Our Modest Proposal therefore now has four elements. They deploy existing institutions and require none of the moves that many Europeans oppose, such as national guarantees or fiscal transfers. Nor do they require treaty changes, which many electorates anyway could reject. Thus we propose a European New Deal which, like its American forebear would lead to progress within months, yet through measures that fall entirely within the constitutional framework to which European governments have already agreed.

2. The nature of the Eurozone crisis
The Eurozone crisis is unfolding on four interrelated domains. Banking crisis: There is a common global banking crisis, which was sparked off mainly by the catastrophe in American finance. But the Eurozone has proved uniquely unable to cope with the disaster, and this is a problem of structure and governance. The Eurozone features a central bank with no government, and national governments with no supportive central bank, arrayed against a global network of mega-banks they cannot possibly supervise. Europe’s response has been to propose a full Banking Union – a bold measure in principle but one that threatens both delay and diversion from actions that are needed immediately.

Better understood as a lack of credible deposit insurance, which logically requires that the entity that provides the insurance- the ECB in this case- is responsible for the regulation and supervision of its banks.

Debt crisis: The credit crunch of 2008 revealed the Eurozone’s principle of perfectly separable public debts to be unworkable. Forced to create a bailout fund that did not violate the no-bailout clauses of the ECB charter and Lisbon Treaty, Europe created the temporary European Financial Stability Facility (EFSF) and then the permanent European Stability Mechanism (ESM). The creation of these new institutions met the immediate funding needs of several member-states, but retained the flawed principle of separable public debts and so could not contain the crisis. One sovereign state, Cyprus, has now de facto gone bankrupt, imposing capital controls even while remaining inside the euro.

During the summer of 2012, the ECB came up with another approach: the Outright Monetary Transactions’ Programme (OMT). OMT succeeded in calming the bond markets for a while. But it too fails as a solution to the crisis, because it is based on a threat against bond markets that cannot remain credible over time. And while it puts the public debt crisis on hold, it fails to reverse it; ECB bond purchases cannot restore the lending power of failed markets or the borrowing power of failing governments.

Better understood as failure of the ECB to explicitly guarantee national govt bonds against default. It was only when Mario Draghi said the ECB would ‘do what it takes to prevent default of national govt debt’ that spreads narrowed and the national funding crisis faded. And it is only the threat that Greece will be allowed to default that is causing the current Greek funding crisis.

Investment crisis: Lack of investment in Europe threatens its living standards and its international competitiveness.

He doesn’t differentiate between public investment in public infrastructure, vs private investment that responds to prospects for profits.

As Germany alone ran large surpluses after 2000, the resulting trade imbalances ensured that when crisis hit in 2008, the deficit zones would collapse.

How is ‘collapse’ defined here? The funding crisis was a function of ECB policy that presumably would allow member nations to default, as when Draghi said that would not happen that crisis ended.

And the burden of adjustment fell exactly on the deficit zones, which could not bear it.

However, there were and remain alternatives to said ‘adjustments’ including the permission to run larger budget deficits than the current, arbitrary, 3% limit. Note that this ‘remedy’ is never even suggested or seriously discussed.

Nor could it be offset by devaluation or new public spending, so the scene was set for disinvestment in the regions that needed investment the most. Thus, Europe ended up with both low total investment and an even more uneven distribution of that investment between its surplus and deficit regions.

True, however it is not recognized that the fundamental cause is that the 3% deficit limit is too low.

Social crisis: Three years of harsh austerity have taken their toll on Europe’s peoples.

From Athens to Dublin and from Lisbon to Eastern Germany, millions of Europeans have lost access to basic goods and dignity. Unemployment is rampant. Homelessness and hunger are rising. Pensions have been cut; taxes on necessities meanwhile continue to rise. For the first time in two generations, Europeans are questioning the European project, while nationalism, and even Nazi parties, are gaining strength.

True

3. Political constraints for any solution.
Any solution to the crisis must respect realistic constraints on political action. This is why grand schemes should be shunned. It is why we need a modest proposal.

But immodest enough to do more than rearrange the deck chairs on the titanic.

Four constraints facing Europe presently are: (a) The ECB will not be allowed to monetise sovereigns directly.

Not necessary

There will be no ECB guarantees of debt issues by member-states,

They already said they will do what it takes to prevent default, meaning at maturity and when interest payments are due the ECB will make sure the appropriate accounts are credited. However this policy is discretionary, with threats Greece would be allowed to default.

no ECB purchases of government bonds in the primary market,

Not necessary

no ECB leveraging of the EFSF-ESM to buy sovereign debt from either the primary or secondary markets.

Not necessary

(b) The ECB’s OMT programme has been tolerated insofar as no bonds are actually purchased. OMT is a policy that does not match stability with growth and, sooner or later, will be found wanting.

And accomplishes nothing of consequence for the real economy.

(c) Surplus countries will not consent to ‘jointly and severally’ guaranteed Eurobonds to mutualise debt and deficit countries will resist the loss of sovereignty that would be demanded of them without a properly functioning federal transfer union which Germany, understandably, rejects.

Said eurobonds not necessary for fiscal transfers.

(d) Europe cannot wait for federation. If crisis resolution is made to depend on federation, the Eurozone will fail first.

Probably true.

The treaty changes necessary to create a proper European Treasury, with the powers to tax, spend and borrow, cannot, and must not, be held to precede resolution of this crisis.

Nor are they necessary to sustain full employment.

The next section presents four policies that recognise these constraints.

4. THE MODEST PROPOSAL – Four crises, four policies The Modest Proposal introduces no new EU institutions and violates no existing treaty. Instead, we propose that existing institutions be used in ways that remain within the letter of European legislation but allow for new functions and policies.

These institutions are:

· The European Central Bank – ECB

· The European Investment Bank – EIB

· The European Investment Fund – EIF

· The European Stability Mechanism – ESM

Policy 1 – Case-by-Case Bank Programme (CCBP)

For the time being, we propose that banks in need of recapitalisation from the ESM be turned over to the ESM directly – instead of having the national government borrow on the bank’s behalf.

‘In need of recapitalization’ is not defined. With credible deposit insurance banks can function in the normal course of business without capital, for example. That means ‘need of capital’ is a political and not an operational matter.

Banks from Cyprus, Greece and Spain would likely fall under this proposal. The ESM, and not the national government, would then restructure, recapitalize and resolve the failing banks dedicating the bulk of its funding capacity to this purpose.

Those banks are necessarily already ‘funded’ via either deposits or central bank credits, unless their equity capital is already negative and not simply below regulatory requirements, as for every asset there is necessarily a liability. And I have not been aware of the banks in question have negative capital accounts.

The Eurozone must eventually become a single banking area with a single banking authority.

Yes, with the provider of deposit insurance, the ECB, also doing the regulation and supervision.

But this final goal has become the enemy of good current policy. At the June 2012 European Summit direct bank recapitalisation was agreed upon in principle, but was made conditional on the formation of a Banking Union. Since then, the difficulties of legislating, designing and implementing a Banking Union have meant delay and dithering. A year after that sensible decision, the deadly embrace between insolvent national banking systems and insolvent member-states continues.

Today the dominant EU view remains that banking union must be completed before the ESM directly recapitalises banks.

Again, I don’t recall the problem being negative bank capital, but merely capital that may fall short of required minimums, in which case not only is no ‘public funding’ is required with regard to capital, but the concept itself is inapplicable as adding public capital doesn’t alter the risk to ‘public funds’

And that when it is complete, the ESM’s contribution will be partial and come only after a bail in of depositors in the fiscally stressed countries of the periphery. That way, the banking crisis will either never be resolved or its resolution be delayed for years, risking a new financial implosion.

Our proposal is that a national government should have the option of waiving its right to supervise and resolve a failing bank.

This carries extreme moral hazard, as it removes the risk of inadequate supervision from the national govt, and instead rewards lax supervision. Instead that right to supervise and regulate should immediately be transferred to the ECB for the entire national banking system in exchange for ECB deposit insurance.

Shares equivalent to the needed capital injection will then pass to the ESM, and the ECB and ESM will appoint a new Board of Directors. The new board will conduct a full review of the bank’s position and will recommend to the ECB-ESM a course for reform of the bank. Reform may entail a merger, downsizing, even a full resolution of the bank, with the understanding that steps will be taken to avoid, above all, a haircut of deposits.

That is functionally what I call sustaining credible deposit insurance which largely eliminates bank liquidity issues.

Once the bank has been restructured and recapitalised, the ESM will sell its shares and recoup its costs.

I agree with the resolution process.

The above proposal can be implemented today, without a Banking Union or any treaty changes.

The experience that the ECB and the ESM will acquire from this case-by-case process will help hone the formation of a proper banking union once the present crisis recedes.

POLICY 2 – Limited Debt Conversion Programme (LDCP)
The Maastricht Treaty permits each European member-state to issue sovereign debt up to 60% of GDP. Since the crisis of 2008, most Eurozone member-states have exceeded this limit. We propose that the ECB offer member-states the opportunity of a debt conversion for their Maastricht Compliant Debt (MCD), while the national shares of the converted debt would continue to be serviced separately by each member-state.

The ECB, faithful to the non-monetisation constraint (a) above, would not seek to buy or guarantee sovereign MCD debt directly or indirectly. Instead it would act as a go-between, mediating between investors and member-states. In effect, the ECB would orchestrate a conversion servicing loan for the MCD, for the purposes of redeeming those bonds upon maturity.

The conversion servicing loan works as follows. Refinancing of the Maastricht compliant share of the debt, now held in ECB-bonds, would be by member-states but at interest rates set by the ECB just above its bond yields. The shares of national debt converted to ECB-bonds are to be held by it in debit accounts. These cannot be used as collateral for credit or derivatives creation.6 Member states will undertake to redeem bonds in full on maturity, if the holders opt for this rather than to extend them at lower, more secure rates offered by the ECB.

Governments that wish to participate in the scheme can do so on the basis of Enhanced Cooperation, which needs at least nine member-states.7 Those not opting in can keep their own bonds even for their MCD. To safeguard the credibility of this conversion, and to provide a backstop for the ECB-bonds that requires no ECB monetisation, member-states agree to afford their ECB debit accounts super-seniority status, and the ECB’s conversion servicing loan mechanism may be insured by the ESM, utilising only a small portion of the latter’s borrowing capacity. If a member-state goes into a disorderly default before an ECB-bond issued on its behalf matures, then that ECB-bond payment will be covered by insurance purchased or provided by the ESM.

This can more readily be accomplished by formalizing and making permanent the ‘do what it takes to prevent default’ policy that’s already in place, and it will immediately lower the cost of new securities as well.

Why not continue with the ECB’s OMT? The ECB has succeeded in taming interest rate spreads within the Eurozone by means of announcing its Outright Monetary Transactions’ programme (OMT). OMT was conceived as unlimited support of stressed Euro-Area bonds – Italy’s and Spain’s in particular – so as to end the contagion and save the euro from collapse.

Instead I give credit for the low rates to the ‘do what it takes’ policy.

However, political and institutional pressures meant that the threat against bond dealers, which was implicit in the OMT announcement, had to be diluted to a conditional programme. The conditionality involves troika-supervision over the governments to be helped by the OMT, who are obliged to sign a draconian memorandum of understanding before OMT takes effect. The problem is not only that this of itself does nothing to address the need for both stability and growth, but that the governments of Spain and Italy would not survive signing such a memorandum of understanding, and therefore have not done so.

Thus OMT’s success in quelling the bond markets is based on a non-credible threat. So far, not one bond has been purchased. This constitutes an open invitation to bond dealers to test the ECB’s resolve at a time of their choosing. It is a temporary fix bound to stop working when circumstances embolden the bond dealers. That may happen when volatility returns to global bond markets once the Federal Reserve and the Bank of Japan begin to curtail their quantitative easing programmes.

There will be no funding issues while ‘do what it takes to prevent default’ policy is in force.

POLICY 3 – An Investment-led Recovery and Convergence Programme (IRCP)
In principle the EU already has a recovery and convergence strategy in the European Economic Recovery Programme 2020. In practice this has been shredded by austerity. We propose that the European Union launch a new investment programme to reverse the recession, strengthen European integration, restore private sector confidence and fulfill the commitment of the Rome Treaty to rising standards of living and that of the 1986 Single European Act to economic and social cohesion.

The Investment-led Recovery and Convergence Programme (IRCP) will be cofinanced by bonds issued jointly by the European Investment Bank (EIB) and the European Investment Fund (EIF). The EIB has a remit to invest in health, education, urban renewal, urban environment, green technology and green power generation, while the EIF both can co-finance EIB investment projects and should finance a European Venture Capital Fund, which was part of its original design.

A key principle of this proposal is that investment in these social and environmental domains should be europeanised. Borrowing for such investments should not count on national debt anymore than US Treasury borrowing counts on the debt of California or Delaware. The under-recognised precedents for this are (1) that no major European member state counts EIB borrowing against national debt, and (2) that the EIB has successfully issued bonds since 1958 without national guarantees.

EIB-EIF finance of an IRCP therefore does not need national guarantees or a common fiscal policy. Instead, the joint bonds can be serviced directly by the revenue streams of the EIB-EIF-funded investment projects. This can be carried out within member states and will not need fiscal transfers between them.

A European Venture Capital Fund financed by EIF bonds was backed unanimously by employers and trades unions on the Economic and Social Committee in their 2012 report Restarting Growth. Central European economies (Germany and Austria) already have excellent finance for small and medium firms through their Mittelstandpolitik. It is the peripheral economies that need this, to build new sectors, to foster convergence and cohesion and to address the growing imbalances of competitiveness within the Eurozone.

Rationale

The transmission mechanism of monetary policy to the periphery of Europe has broken down. Mr Mario Draghi admits this. He has gone on record to suggest that the EIB play a active role in restoring investment financing in the periphery. Mr Draghi is right on this point.

But, for the IRCP to reverse the Eurozone recession and stop the de-coupling of the core from the periphery, it must be large enough to have a significant effect on the GDP of the peripheral countries.

If EIB-EIF bonds are to be issued on this scale, some fear that their yields may rise. But this is far from clear. The world is awash in savings seeking sound investment outlets. Issues of EIF bonds that co-finance EIB investment projects should meet these demands, supporting stability and working to restore growth in the European periphery. We therefore submit that joint EIB-EIF bond issues can succeed without formal guarantees. Nonetheless, in fulfillment of its remit to support “the general economic policies in the Union”, the ECB can issue an advance or precautionary statement that it will partially support EIB-EIF bonds by means of standard central bank refinancing or secondary market operations. Such a statement should suffice to allow the EIB-EIF funded IRCP to be large enough for the purposes of bringing about Europe’s recovery.

Misleading arguments and unworkable alternatives:

There are calls for bonds to finance infrastructure, neglecting the fact that this has been happening through the European Investment Bank (EIB) for more than half a century. An example is a recent European Commission proposal for ‘Project Bonds’ to be guaranteed by member states. This assures opposition from many of them, not least Germany, while ignoring the fact that the EIB has issued project bonds successfully since 1958, without such guarantees.10

There is no high-profile awareness that EIB investment finance does not count on the national debt of any major member state of the EU nor need count on that of smaller states.11

There is a widespread presumption that public investment drains the private sector when in fact it sustains and supports it. There is similar presumption that one cannot solve the crisis by ‘piling debt on debt’. It depends on which debt for which purpose, and at what rates. Piling up national debt at interest rates of up to seven per cent or more without recovery is suicidal. Funding inflows from global surpluses to Europe to promote economic recovery through joint EIB-EIF bonds at interest rates which could be less than two per cent is entirely sustainable.

There is little awareness of the EIB’s sister organisation, the European Investment Fund (EIF), which has a large potential for investment funding of SMEs, high technology clusters and a variety of other projects, which it can cofinance with bonds, issued jointly with the EIB (see note 9). Why aren’t the EIB-EIF doing this now? Until the onset of the Eurozone crisis the EIB had succeeded in gaining national co-finance, or co-finance from national institutions, for its investments. But with the crisis and constraints on co-finance, total annual EIB financing fell from over €82bn in 2008 to only €45bn last year. The EIF can counterpart and thereby countervail this. It is a sister institution of the EIB within the EIB Group. Like EIB bonds, EIF bonds need not count on national debt nor need national guarantees. The EIB would retain control over project approval and monitoring. In sum, we recommend that:

The IRCP be funded by means of jointly issued EIB and EIF bonds without any formal guarantees or fiscal transfers by member states.

Both EIB and EIF bonds be redeemed by the revenue stream of the investment • projects they fund, as EIB bonds always have been.

If needed, the ECB should stand by to assist in keeping yields low, through direct purchases of EIB-EIF bonds in the secondary market.

I agree the role of the EIB could be expanded, however the political difficulties are substantial and the time to initial implementation will likely be a year or more- time the EU may not have.

POLICY 4 – An Emergency Social Solidarity Programme (ESSP)

We recommend that Europe embark immediately on an Emergency Social Solidarity Programme that will guarantee access to nutrition and to basic energy needs for all Europeans, by means of a European Food Stamp Programme modelled on its US equivalent and a European Minimum Energy Programme. These programmes would be funded by the European Commission using the interest accumulated within the European system of central banks, from TARGET2 imbalances, profits made from government bond transactions and, in the future, other financial transactions or balance sheet stamp duties that the EU is currently considering.

These revenues currently are returned to the member nations and without them compliance with the 3% deficit limit will reduce other spending and/or require additional taxes.

Rationale

Europe now faces the worst human and social crisis since the late 1940s. In member-states like Greece, Ireland, Portugal, but also elsewhere in the Eurozone, including core countries, basic needs are not being met. This is true especially for the elderly, the unemployed, for young children, for children in schools, for the disabled, and for the homeless. There is a plain moral imperative to act to satisfy these needs. In addition, Europe faces a clear and present danger from extremism, racism, xenophobia and even outright Nazism – notably in countries like Greece that have borne the brunt of the crisis. Never before have so many Europeans held the European Union and its institutions in such low esteem. The human and social crisis is turning quickly into a question of legitimacy for the European Union.

Reason for TARGET2 funding

TARGET2 is a technical name for the system of internal accounting of monetary flows between the central banks that make up the European System of Central Banks. In a well balanced Eurozone, where the trade deficit of a member state is financed by a net flow of capital to that same member-state, the liabilities of that state’s central bank to the central banks of other states would just equal its assets.

Not true. Target 2 is about clearing balances that can cause banks to gain or lose liquidity independent of national trade balances.

Such a balanced flow of trade and capital would yield a TARGET2 figure near zero for all member-states.

Again, it’s not trade per se that alters bank liquidity issues.

And that was, more or less, the case throughout the Eurozone before the crisis.

However, the crisis caused major imbalances that were soon reflected in huge TARGET2 imbalances.

The clearing imbalances were caused by lack of credible deposit insurance exacerbated by potential bank failures, not trade per se.

As inflows of capital to the periphery dried up, and capital began to flow in the opposite direction, the central banks of the peripheral countries began to amass large net liabilities and the central banks of the surplus countries equally large net assets.

Yes, but not to confuse capital, which is bank equity/net worth, and liquidity which is the funding of assets and is sometimes casually called ‘capital’ the way ‘money’ is casually called capital.

The Eurozone’s designers had attempted to build a disincentive within the intraEurosystem real-time payments’ system, so as to prevent the build-up of huge liabilities on one side and corresponding assets on the other. This took the form of charging interest on the net liabilities of each national central bank, at an interest rate equal to the ECB’s main refinancing level.

The purpose of this policy rate is to make sure the ECB’s policy rate is the instrument of monetary policy, reflected as the banking system’s cost of funds.

These payments are distributed to the central banks of the surplus member-states, which then pass them on to their government treasury.

In practice, one bank necessarily has a credit balance at the ECB when another has a debit balance, and net debit balances exist to the extent there is actual cash in circulation that banks get in exchange for clearing balances. This keeps the banking system ‘net borrowed’ which provides the ECB with interest income. Additionally buying securities that yield more than deposit rates adds income to the ECB.

Thus the Eurozone was built on the assumption that TARGET2 imbalances would be isolated, idiosyncratic events, to be corrected by national policy action.

The system did not take account of the possibility that there could be fundamental structural asymmetries and a systemic crisis.

Today, the vast TARGET2 imbalances are the monetary tracks of the crisis. They trace the path of the consequent human and social disaster hitting mainly the deficit regions. The increased TARGET2 interest would never have accrued if the crises had not occurred. They accrue only because, for instance, risk averse Spanish and Greek depositors, reasonably enough, transfer their savings to a Frankfurt bank.

Yes, my point exactly, and somewhat counter to what was stated previously. Depositors can shift banks for a variety of reasons, with or without trade differentials.

As a result, under the rules of the TARGET2 system, the central bank of Spain and of Greece have to pay interest to the Bundesbank – to be passed along to the Federal Government in Berlin.

Which then pays interest to its depositors. The ECB profits to the extent it establishes a spread between the rate it lends at vs the rate paid to depositors. That spread is a political decision.

This indirect fiscal boost to the surplus country has no rational or moral basis. Yet the funds are there, and could be used to deflect the social and political danger facing Europe.

There is a strong case to be made that the interest collected from the deficit member-states’ central banks should be channelled to an account that would fund our proposed Emergency Social Solidarity Programme (ESSP). Additionally, if the EU introduces a financial transactions’ tax, or stamp duty proportional to the size of corporate balance sheets, a similar case can be made as to why these receipts should fund the ESSP. With this proposal, the ESSP is not funded by fiscal transfers nor national taxes.

The way I see it, functionally, it is a fiscal transfer, and not that I am against fiscal transfers!

My conclusion is that any improvement in the economy from these modest proposals, and as I’ve qualified above, will likewise be at least as modest. That is, the time and effort to attempt to implement these proposals, again, as qualified, will make little if any progress in fixing the economy as another generation is left to rot on the vine.

5. CONCLUSION: Four realistic policies to replace of five false choices Three years of crisis have culminated in a Europe that has lost legitimacy with its own citizens and credibility with the rest of the world. Europe is unnecessarily back in recession. While the bond markets were placated by the ECB’s actions in the summer of 2012, the Eurozone remains on the road toward disintegration.

While this process eats away at Europe’s potential for shared prosperity, European governments are imprisoned by false choices:

between stability and growth

between austerity and stimulus

between the deadly embrace of insolvent banks by insolvent governments, and an admirable but undefined and indefinitely delayed Banking Union

between the principle of perfectly separable country debts and the supposed need to persuade the surplus countries to bankroll the rest

between national sovereignty and federalism. These falsely dyadic choices imprison thinking and immobilise governments. They are responsible for a legitimation crisis for the European project. And they risk a catastrophic human, social and democratic crisis in Europe.

By contrast the Modest Proposal counters that:

The real choice is between beggar-my-neighbour deflation and an investmentled recovery combined with social stabilisation. The investment recovery will be funded by global capital, supplied principally by sovereign wealth funds and by pension funds which are seeking long-term investment outlets. Social stabilisation can be funded, initially, through the Target2 payments scheme.

Taxpayers in Germany and the other surplus nations do not need to bankroll the 2020 European Economic Recovery Programme, the restructuring of sovereign debt, resolution of the banking crisis, or the emergency humanitarian programme so urgently needed in the European periphery.

Neither an expansionary monetary policy nor a fiscal stimulus in Germany and other surplus countries, though welcome, would be sufficient to bring recovery to Europe.

Treaty changes for a federal union may be aspired by some, but will take too long , are opposed by many, and are not needed to resolve the crisis now. On this basis the Modest Proposal’s four policies are feasible steps by which to deal decisively with Europe’s banking crisis, the debt crisis, underinvestment, unemployment as well as the human, social and political emergency.

Version 4.0 of the Modest Proposal offers immediate answers to questions about the credibility of the ECB’s OMT policy, the impasse on a Banking Union, financing of SMEs through EIF bonds enabling a European Venture Capital Fund, green energy and high tech start-ups in Europe’s periphery, and basic human needs that the crisis has left untended.

It is not known how many strokes Alexander the Great needed to cut the Gordian knot. But in four strokes, Europe could cut through the knot of debt and deficits in which it has bound itself.

In one stroke, Policy 1, the Case-by-Case Bank Programme (CCBP), bypasses the impasse of Banking Union (BU), decoupling stressed sovereign debt and from banking recapitalisation, and allowing for a proper BU to be designed at leisure

By another stroke, Policy 2, the Limited Debt Conversion Programme (LDCP), the Eurozone’s mountain of debt shrinks, through an ECB-ESM conversion of Maastricht Compliant member-state Debt

By a third stroke, Policy 3, the Investment-led Recovery and Convergence Programme (IRCP) re-cycles global surpluses into European investments

By a fourth stroke, Policy 4, the Emergency Social Solidarity Programme (ESSP), deploys funds created from the asymmetries that helped cause the crisis to meet basic human needs caused by the crisis itself.

At the political level, the four policies of the Modest Proposal constitute a process of decentralised europeanisation, to be juxtaposed against an authoritarian federation that has not been put to European electorates, is unlikely to be endorsed by them, and, critically, offers them no assurance of higher levels of employment and welfare.

We propose that four areas of economic activity be europeanised: banks in need of ESM capital injections, sovereign debt management, the recycling of European and global savings into socially productive investment and prompt financing of a basic social emergency programme.

Our proposed europeanisation of borrowing for investment retains a large degree of subsidiarity. It is consistent with greater sovereignty for member-states than that implied by a federal structure, and it is compatible with the principle of reducing excess national debt, once banks, debt and investment flows are europeanised without the need for national guarantees or fiscal transfers.

While broad in scope, the Modest Proposal suggests no new institutions and does not aim at redesigning the Eurozone. It needs no new rules, fiscal compacts, or troikas. It requires no prior agreement to move in a federal direction while allowing for consent through enhanced cooperation rather than imposition of austerity.

It is in this sense that this proposal is, indeed, modest.

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Kelton story in Forbes, attribution

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Confused, of course, but in the news!

Watch Out, MMT’s About, As Bernie Sanders Hires Stephanie Kelton

By Tom Worstall

Jan 12 (Forbes) — The idea that Modern Monetary Theory might actually become vaguely mainstream, even an influence on how the Republic is governed, entirely petrifies me. It’s not actually that I disagree very much with the economics that is being laid out in MMT: indeed, I’m terribly tempted to agree that they’re actually correct in much of what they say. Rather, it’s what it will do to the political process if they do gain real policy influence. For at present there does have to be some link, however vague or tenuous, between how much money the government takes in from all of us and how much money the government spends on giving prizes to all. The basic innovation of MMT is to point out that this no longer has to be so: and that’s simply not a tool that I want politicians of any stripe to have available to them.

Dylan Matthews has the story that has me hot and bothered:

President Obama’s biggest problem in the Senate is obviously its new Republican majority, but opposition from the left wing of the Democratic caucus appears to be growing too. Most prominently, Sen. Elizabeth Warren (D-MA) has clashed with the White House on a key Treasury Department position and the CRomnibus spending package. But new budget committee ranking member Sen. Bernie Sanders (I-VT) is poised to break dramatically from traditional Democratic views on budgeting, from Obama to Clinton to Walter Mondale and beyond.

His big move: naming University of Missouri – Kansas City professor Stephanie Kelton as his chief economist. Kelton is not exactly a household name, but to those who follow economic policy debates closely, tapping her is a dramatic sign.

If you want all of the grubby details of MMT then I recommend that piece and those it links to. I’ll just give a pencil sketch here.

It’s most certainly not obvious that MMT proponents are all barking mad or anything. Jamie Galbraith (who I’ve had one or two very limited interactions with) is certainly a reasonable guy. And his insistence that a budget surplus, despite the ribbing he gets about it, is in fact economically contractionary doesn’t seem to have anything wrong with it. Budget deficits are fiscally expansive, a surplus is fiscally contractionary, if there’s any one statement at the heart of Keynesianism that’s it. I might differ on the desirability of a surplus at times but not on that basic point about one being contractionary. My disagreement being that the old standard Keynesianism was based on the idea that at times we want the government to be contractionary. Not as a means of paying down the debt or anything but as just general good management of the economy. Sure, let’s add to aggregate demand in a slump but the flip side of that coin is that in the boom we want to temper things. Just as the old complaint about central banking goes (“the central banker’s job is to remove the punch bowl just as the party gets going” by raising interest rates) a budget surplus is the fiscal equivalent, just part of moderating both the booms and busts to which capitalism is prone.

So I’m certainly not thinking that the MMTers are over there with David Icke and whispering about the Grey Aliens or anything.

And their basic outline about money creation is true as far as I can see. If you’re a country with your own central bank you can print as much money as you like. And sure, you could indeed finance government just by printing more money. Print money, spend it, hey presto, you’ve financed government. Standard monetary theory also recognises this: we know that the Fed makes a pretty profit each year from printing Benjamins (20 cents of paper and 3 cents of ink really is worth $100 these days) and that’s worth perhaps $20 billion a year to the US government in seignorage. We really don’t complain about it either. That standard monetary theory then also says that doing too much of this (in more detail, printing or creating lots of base money, rather than the creation of credit in the manner that the banking system does) will be highly inflationary. Standard theory points to Wiemar Germany, post WWII Hungary and modern Zimbabwe as examples (that last so fun that the end series of banknotes were only printed on one side as they didn’t have enough “real money” left to buy ink).

At which point the MMT crowd say ah, but yes, that’s what taxes are for. Print the money, spend it, thereby injecting it into the economy, and if inflation rises then taxes are what sucks that money back out of the economy and thus kills off the inflation. And it’s that bit that absolutely terrifies me. The effect that idea has on the incentives for politicians.

Given that we are discussing monetary policy it seems appropriate to bring Milton Friedman in here. And he pointed out that if you ever have a chance to cut taxes just do so. On the basis that politicians, any group of politicians, will spend the bottom out of the Treasury and more however much there is. So, the only way to stop ever increasing amounts of the the entire economy flowing through government is simply to constrain the resources they can get their sticky little mits on. We could, for example, possibly imagine a Republican from the Neanderthal wing of the party arguing that what the US really needs is another 7 carrier battle groups. And one from the even more confused than usual Progressive end of the Democratic Party arguing that each college student needs her own personal carrier battle group to protect her from the microaggressions of being asked out for a coffee. You know. Sometime. Maybe. If you want to?

A Mea Culpa and Some Comments on MMT and Fiat Currency Economics

By Warwick Smith

Jan 12 — It has recently been pointed out to me that some of my writing on monetary economics has not given proper attribution to the intellectual tradition behind the ideas that I present and that this gives the impression that these are my ideas. I’m embarrassed to admit that the criticisms are spot on and I have made a major misjudgement in how I wrote these articles (one in The Conversation and one in The Guardian). I had no intention of stealing other peoples ideas but, nevertheless, this is in effect what I did. I apologise unreservedly to those who may have felt aggrieved by my actions.

I have a history in public policy activism and I have approached my recent popular political and economic writing somewhat from an activist standpoint where I viewed the main game as advocating and causing public policy change and increasing public awareness. The branch of monetary economics known as modern monetary theory (MMT) has something of an activist element to it where a minority who hold an accurate view of how things are and, perhaps to a lesser extent, how things should be, are vying for airtime against the overwhelming majority who hold (or at least communicate) a false perspective on monetary economics and public finance.

I thought that I could add a new voice and a new strategy to that struggle by simply writing about monetary economics from an MMT perspective but as if it’s just the uncontroversial (among economists) truth about monetary economics rather than a minority view among economists. I think the complexities of intra-discipline disagreement are impenetrable for newcomers and will put most people off investing the effort to understand the arguments.

Taking this line of thinking led me to make a serious misjudgement in what I wrote and how I wrote it because MMT is more an intellectual and academic discipline than it is an activist movement and, as such, people’s careers and their professional profiles are at stake. Again, I apologise to the people whose work has inspired some of my writing who have not been properly acknowledged including Warren Mosler, Perry Mehrling, Bill Mitchell and Steven Hail.

I wrote to the Guardian editors requesting a couple of additions. They agreed to add attribution to a line early in the article that credits Warren Mosler but not to make further edits post-publication. I’m a strong believer in owning up to mistakes and trying to remedy them when others are affected.

I believe MMT faces serious challenges in part because of its name and the way it is usually presented. A better name would be something like Fiat Currency Economics because MMT is not a theory but is primarily just a description of reality and the clear consequences that flow from that reality. No economist that I’ve found has any clear and well reasoned refutation of MMT to offer. All attempts at refutation appear to rely on misunderstandings or misrepresentations. This is why I took the approach of not referring to MMT at all in the pieces that I wrote. Nevertheless, I still should have referred to the people whose work contributed to or provided the ideas for the articles and I greatly regret that I did not. I promise I will not make this mistake again.

Below is a list in rough descending order of significance with respect to influencing my views on monetary economics.

Perry Mehrling’s Coursera course The Economics of Money and Banking
Warren Mosler’s book The Seven Deadly Frauds of Economic Policy
Various presentation given by Steven Hail
University of Newcastle’s CofFEE report on the Job Guarantee
Professor Bill Mitchell’s blog – this is the most comprehensive of the sources here but it’s low on my list because I came to it quite late in the formative period of my thinking on money and finance.

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Comments on crude pricing, the economy, and the banking system

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Crude pricing

The Saudis are the ‘supplier of last resort’/swing producer. Every day the world buys all the crude the other producers sell to the highest bidder and then go to the Saudis for the last 9-10 million barrels that are getting consumed. They either pay the Saudis price or shut the lights off, rendering the Saudis price setter/swing producer.

Specifically, the Saudis don’t sell at spot price in the market place, but instead simply post prices for their customers/refiners and let them buy all they want at those prices.

And most recently the prices they have posted have been fixed spreads from various benchmarks, like Brent.

Saudi spread pricing works like this:
Assume, for purposes of illustration, Saudi crude would sell at a discount of $1 vs Brent (due to higher refining costs etc.) if they let ‘the market’ decide the spread by selling a specific quantity at ‘market prices’/to the highest bidder. Instead, however, they announce they will sell at a $2 discount to Brent and let the refiners buy all they want.

So what happens?
The answer first- this sets a downward price spiral in motion. Refiners see the lower price available from the Saudis and lower the price they are willing to pay everyone else. And everyone else is a ‘price taker’ selling to the highest bidder, which is now $1 lower than ‘indifference levels’. When the other suppliers sell $1 lower than before the Saudi price cut/larger discount of $1, the Brent price drops by $1. Saudi crude is then available for $1 less than before, as the $2 discount remains in place. Etc. etc. with no end until either:
1) The Saudis change the discount/raise their price
2) Physical demand goes up beyond the Saudis capacity to increase production

And setting the spread north of ‘neutral’ causes prices to rise, etc.

Bottom line is the Saudis set price, and have engineered the latest decline. There was no shift in net global supply/demand as evidenced by Saudi output remaining relatively stable throughout.

The Global Economy

If all the crude had simply been sold to the highest bidder/market prices, in a non monetary relative value world the amount consumed would have been ‘supply limited’ based on the real marginal cost, etc. And if prices were falling do to an increased supply offered for sale, the relative price of crude would be falling as the supply purchased and consumed rose. This would represent an increase in real output and real consumption/real GDP(yes, real emissions, etc.)

However, that’s not the case with the Saudis as price setter. The world was not operating on a ‘quantity constrained’ basis as the Saudis were continuously willing to sell more than the world wanted to purchase from them at their price. If there was any increase in non Saudi supply, total crude sales/consumption remained as before, but with the Saudis selling that much less.

Therefore, with the drop in prices, at least in the near term, output/consumption/GDP doesn’t per se go up.

Nor, in theory, in a market economy/flexible prices, does the relative value of crude change. Instead, all other prices simply adjust downward in line with the drop in crude prices.

Let me elaborate.
In a market economy (not to say that we actually have one) only one price need be set and with all others gravitating towards ‘indifference levels’. In fact, one price must be set or it’s all a ‘non starter’. So which price is set today? Mainstream economists ponder over this, and, as they’ve overlooked the fact that the currency is a public monopoly, have concluded that the price level exists today for whatever ‘historic’ reasons, and the important question is not how it got here, but what might make it change from today’s level. That is, what might cause ‘inflation’. That’s where inflation expectations theory comes in. For lack of a better reason, the ‘residual’ is that it’s inflation expectations that cause changes in the price level. And not anything else, which are relative value stories. And they operate through two channels- workers demanding higher wages and people accelerating purchases. Hence the fixation on wages as the cause of inflation, and using ‘monetary policy’ to accelerate purchases, etc.

Regardless of the ‘internal merits’ of this conclusion, it’s all obviated by the fact that the currency itself is a simple public monopoly, rendering govt price setter. Note the introduction of monetary taxation, the basis of the currency, is coercive, and obviously not a ‘market expense’ for the taxpayer, and therefore the idea of ‘neutrality’ of the currency in entirely inapplicable. In fact, since the $ to pay taxes and buy govt secs, assuming no counterfeiting, ultimately come only from the govt of issue, (as they say in the Fed, you can’t have a reserve drain without a prior reserve add), the price level is entirely a function of prices paid by the govt when it spends and/or collateral demanded when it lends. Said another way, since we need the govt’s $ to pay taxes, the govt is, whether it knows it or not, setting ‘terms of exchange’ when it buys our goods and service.

Note too that monopolists set two prices, the value of their product/price level as just described above, and what’s called the ‘own rate’/how it exchanges for itself, which for the currency is the interest rate, which is set by a vote at the CB.

The govt/mainstream, of course, has no concept of all this, as inflation expectations theory remains ‘well anchored.’ ;)

In fact, when confronted, argues aggressively that I’m wrong (story of my life- remember, they laughed at the Yugo…)

What they have done is set up a reasonably deflationary purchasing program, of buying from the lowest bidder in competition, and managed to keep federal wages/compensation a bit ‘behind the curve’ as well, partially indexed to their consumer price index, etc.

And consequently, govt has defacto advocated pricing power to the active monopolist, the Saudis, which explains why changes in crude prices and ‘inflation’ track as closely as they do.

Therefore, the way I see it is the latest Saudi price cuts are revaluing the dollar (along with other currencies with similar policies, which is most all of them) higher. A dollar now buys more oil and, to the extend we have a market economy that reflects relative value, more of most everything else. That is, it’s a powerful ‘deflationary bias’ (consequently rewarding ‘savers’ at the expense of ‘borrowers’) without necessarily increasing real output.

In fact, real output could go lower due to an induced credit contraction, next up.

Banking

Deflation is highly problematic for banks. Here’s what happened at my bank to illustrate the principle:

We had a $6.5 million loan on the books with $11 million of collateral backing it. Then, in 2009 the properties were appraised at only $8 million. This caused the regulators to ‘classify’ the loan and give it only $4 million in value for purposes of calculating our assets and capital. So our stated capital was reduced by $2.5 million, even though the borrower was still paying and there was more than enough market value left to cover us.

So the point is, even with conservative loan to value ratios of the collateral, a drop in collateral values nonetheless reduces a banks reported capital. In theory, that means if the banking system needs an 8% capital ratio, and is comfortably ahead at 10%, with conservative loan to value ratios, a 10% across the board drop in assets prices introduces the next ‘financial crisis’. It’s only a crisis because the regulators make it one, of course, but that’s today’s reality.

Additionally, making new loans in a deflationary environment is highly problematic in general for similar reasons. And the reduction in ‘borrowing to spend’ on energy and related capital goods and services is also a strong contractionary bias.

UPDATE: Saudi Arabia cuts all oil prices to U.S., Asia – Bloomberg (OIL)

Dec 4 — Saudi Arabia cuts all oil prices to U.S. and Asia, according to Bloomberg headlines.

UPDATE: Reports have the message issued by Saudi Aramco — the state-owned oil and gas giant — now recalled.

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Weekly credit update comments

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I got this email supporting the idea that bank credit expansion has been at the expense of non bank lenders, with low total credit growth.

As previously discussed, I don’t see the credit growth necessary to sustain the 3%+ GDP growth being forecast. Instead, I see the q1 negative growth and H1 total growth of only 1.2% as indicative of the underlying trend.

Warren: With respect to the recent “surge” in bank credit, please see below info that I prepared from Z.1. I recall you once suggesting that the expansion in bank credit may be attributed to banks taking share from non-bank lenders. Based on below table and graphs, that appears to be the case. When you combine bank and non-bank lenders (what I refer to as “Bank & Non-Bank Finance”), growth in credit market assets is essentially zero/nominal over recent periods, and you can see the recent increase in bank credit appears to be largely offset by a decrease in non-bank credit. Most non-banks are essentially “agents” of banks in my opinion so should view together for macro perspective. Note below that my definition of “Adjusted Credit Market Assets” is the FRB’s definition plus money market, rev repo and security credit. Not sure if this is the “correct” way to view things and I could be way off base but figured may be worth passing along. Also, for the “Insurance & Inv Mgmt” Sectors, I think the growth there may support your demand leakage narrative (but excludes equities). Thx


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The first L shaped US ‘recovery’

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Some 5 years ago when the talk was about whether the US recovery was going to be V shaped or U shaped, I suggested that it would be more L shaped, as a 0 rate policy requires a larger deficit, etc. That is, after a sharp fall it would go sideways.

Here are a few illustrative charts:

Adjusting this next one for population growth makes the point even more:

The growth rate of personal consumption has leveled off at over half of prior cycles:

And looks like deep down ‘those demon banks’ haven’t fared all that well either:

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today’s observations

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Not much sign of any move towards higher deficits today. Just talk of more bank liquidity, which doesn’t matter, and more to weaken the euro, which doesn’t work either.

Hard to say why the euro has been going down, but it’s not ECB policy per se which, while meant to weaken the euro, instead continues to be ‘strong euro’ biased. So must be portfolios selling euro, maybe in response to Russia’s actions.

“French Prime Minister Manuel Valls called for more action from the ECB to lower the value of the euro.Mr Valls said: “the monetary policy has started to change”. While he called the ECB’s package of measures taken in June a “strong signal,” he also said that “one will have to go even further.”

German Finance Minister Mr Schaeuble said deficit-fueled growth leads to economic decline, signalling discord with Italy and France as euro-area policy makers seek ways to avoid deflation and spur growth. Euro-area countries that pursued austerity policies in return for sovereign bailouts are “doing much better than all the others in Europe,” Schaeuble.

ECB’s Coeure says ready to adjust monetary policy if needed: In an article published in Greek daily Ta Nea, ECB’s Coeure said that ECB’s measures so far, have contributed to stability in the euro zone while its recent decisions have ensured a particularly accommodative direction in monetary policy in the single-currency bloc. “The ECB will provide additional liquidity to banks on the condition that they increase credit directed to the real economy, and it is ready to further adjust the direction of its monetary policy, if needed,” Coeure said (Ta Nea, Reuters) ”

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Comments on Professor John Cochrane’s – A Few Things the Fed Has Done Right

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A Few Things the Fed Has Done Right

The Fed’s plan to maintain a large balance sheet and pay interest on bank reserves is good for financial stability.

By John H. Cochrane

Aug 21 (WSJ) — As Federal Reserve officials lay the groundwork for raising interest rates, they are doing a few things right. They need a little cheering, and a bit more courage of their convictions.

The Fed now has a huge balance sheet. It owns about $4 trillion of Treasury bonds and mortgage-backed securities. It owes about $2.7 trillion of reserves (accounts banks have at the Fed), and $1.3 trillion of currency. When it is time to raise interest rates, the Fed will simply raise the interest it pays on reserves. It does not need to soak up those trillions of dollars of reserves by selling trillions of dollars of assets.

Correct!

The Fed’s plan to maintain a large balance sheet and pay interest on bank reserves, begun under former Chairman Ben Bernanke and continued under current Chair Janet Yellen, is highly desirable for a number of reasons—the most important of which is financial stability. Short version: Banks holding lots of reserves don’t go under.

Not true.
Confusing reserves with capital to some extent.
Banks can fail via losses that wipe out capital even with plenty of liquidity.

This policy is new and controversial. However, many arguments against it are based on fallacies. People forget that when the Fed creates a dollar of reserves, it buys a dollar of Treasurys or government-guaranteed mortgage-backed securities. A bank gives the Fed a $1 Treasury, the Fed flips a switch and increases the bank’s reserve account by $1. From this simple fact, it follows that:

• Reserves that pay market interest are not inflationary. Period. Now that banks have trillions more reserves than they need to satisfy regulations or service their deposits, banks don’t care if they hold another dollar of interest-paying reserves or another dollar of Treasurys. They are perfect substitutes at the margin. Exchanging red M&Ms for green M&Ms does not help your diet. Commenters have seen the astonishing rise in reserves—from $50 billion in 2007 to $2.7 trillion today—and warned of hyperinflation to come. This is simply wrong as long as reserves pay market interest.

Yes and no.

Yes, the mix of Fed liabilities per se isn’t inflationary.

No, even if they didn’t pay interest it wouldn’t be inflationary. In fact, it would mean a reduction in govt interest payments which is a contractionary bias.

And his point is best stated by stating that both reserves and tsy secs are simply dollar denominated ‘bank accounts’ at the Fed, the difference being the duration and rates, directly or indirectly selected by ‘govt’.

• Large reserves also aren’t deflationary. Reserves are not “soaking up money that could be lent.” The Fed is not “paying banks not to lend out the money” and therefore “starving the economy of investment.”

True.

Every dollar invested in reserves is a dollar that used to be invested in a Treasury bill.

Wrong statement of support. He should state that the causation goes from loans to deposits. ‘Loanable funds’ applies to fixed fx, not floating fx.

A large Fed balance sheet has no effect on funds available for investment.

True, they are infinite in any case. Bank lending is constrained only in the short term by capital, as there is always infinite capital available with time at a price that gets reflected in lending charges.

• The Fed is not “subsidizing banks” by paying interest on reserves.

It is to the extent that paying interest is subsidizing the economy in general, as govt is a net payer of interest.

The interest that the Fed will pay on reserves will come from the interest it receives on its Treasury securities.

Sort of. Better said that the interest received on the tsy’s will equal/exceed/etc. the interest paid on reserves. ‘Come from’ is a poor choice of words.

If the Fed sold its government securities to banks, those banks would be getting the same interest directly from the Treasury.

True.

The Fed has started a “reverse repurchase” program that will allow nonbank financial institutions effectively to have interest-paying reserves. This program was instituted to allow higher interest rates to spread more quickly through the economy.

True.

Again, I see a larger benefit in financial stability. The demand for safe, interest-paying money expressed so far in overnight repurchase agreements, short-term commercial paper, auction-rate securities and other vehicles that exploded in the financial crisis can all be met by interest-paying reserves.

Sort of. The term structure of rates constantly adjusts to indifference levels is how I’d say it.

Encouraging this switch is the keystone to avoiding another crisis. The Treasury should also offer fixed-value floating-rate electronically transferable debt.

Why??? Indexed to what? The one’s they are doing indexed to T bills make no logical sense at all.

This Fed reverse-repo program spawns many unfounded fears, even at the Fed. The July minutes of the Federal Open Market Committee revealed participants worried that “in times of financial stress, the facility’s counterparties could shift investments toward the facility and away from financial and nonfinancial corporations.”

This fear forgets basic accounting.

True.

The Fed controls the quantity of reserves. Reserves can only expand if the Fed chooses to buy assets—which is exactly what the Fed does in financial crises.

Furthermore, this fear forgets that investors who want the safety of Treasurys can buy them directly. Or they can put money in banks that in turn can hold reserves. The existence of the Fed’s program has minuscule effects on investors’ options in a crisis. Interest-paying reserves are just a money-market fund 100% invested in Treasurys with a great electronic payment mechanism.

Available to banks.

That’s exactly what we should encourage for financial stability.

The Open Market Committee minutes also said that, “Participants noted that a relatively large [repurchase] facility had the potential to expand the Federal Reserve’s role in financial intermediation and reshape the financial industry.”

Not really.

It always has been about offsetting operating factors one functionally identical way or another.

Yes, and that’s a feature not a bug. The financial industry failed and the Fed is reshaping it under the 2010 Dodd-Frank financial-reform law. Allowing money previously invested in run-prone shadow banking to be invested in 100%-safe reserves is the best thing the Fed could do to reshape the industry.

They can only do that if they reduce the institutional additions to the bank’s cost of funds/lower risk restrictions to make the banks more competitive with non bank lenders.

Temptations remain. For example, with trillions of reserves in excess of regulatory reserve requirements, the Fed loses what was left of its control over bank lending and deposit creation. The Fed will be tempted to use direct regulation and capital ratios to try to micromanage lending.

That’s all it ever had. Lending was never reserve constrained.

It should not. The big balance sheet is a temptation for the Fed to buy all sorts of assets other than short-term Treasurys, and to meddle in many markets, as it is already supporting the mortgage market. It should not.

I see precious little difference apart from option vol considerations.

The Fed is making no promises about the stability of these arrangements—a large balance sheet and market interest on reserves available to non-banks. It should. In particular, it should clarify whether it will allow its balance sheet to shrink as long-term assets run off, or reinvest the proceeds as I would prefer.

It doesn’t matter for what he’s talking about.

Most of the financial stability benefits only occur if these arrangements are permanent and market participants know it. We can debate whether interest rate policy should follow rules or discretion, be predictable or adapt to each day’s Fed desire. But the basic structures and institutions of monetary policy should be firm rules.

The remaining short-term question is when to raise rates. Ms. Yellen has already made an important decision: The Fed will not, for now, use interest-rate policy for “macroprudential” tinkering. This too is wise. We learned in the last crisis that the Fed is only composed of smart human beings. They are not clairvoyant and cannot tell a “bubble” from a boom in real time any better than the banks and hedge funds betting their own money on the difference. Manipulating interest rates to stabilize inflation is hard enough. Stabilizing inflation and unemployment is harder still.

Especially when they have it backwards.

Additionally chasing will-o-wisp “bubbles,” “imbalances” and “crowded trades” will only lead to greater macroeconomic and financial instability.

Here too a firm commitment would help. Otherwise market participants will be constantly looking over their shoulders for the Fed to start meddling in home and asset prices.

Plenty of uncertainties, challenges and temptations remain. Tomorrow, we can go back to investigating, arguing and complaining. Today let’s cheer a few big things done right.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at the Hoover Institution, and an adjunct scholar at the Cato Institute.

Doesn’t mention/forgets that the Fed buying secs is functionally identical to the tsy not selling them in the first place, etc.

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Bank lending weekly update

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What was touted as an acceleration of growth seems to have leveled off over the last few weeks, and is looking more like a dip in growth (cold winter?) followed by a recovery that’s leveled off.

More troubling, however, is the late cycle pattern of a slowdown in the growth of lending followed by borrowing to fund cash shortfalls that turns into negative growth, but in this case seems the recent growth is coming from the smaller banks:

At the same time, net interest margins for banks continues to fall:

(August 7 release)

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