Home > Economics > Richard Williamson smackdown watch: Richard Williamson edition

Richard Williamson smackdown watch: Richard Williamson edition

January 30, 2012 Leave a comment Go to comments

Yesterday, some guy obviously *pretending* to be me wrote some seriously crazy stuff on my blog. He thought that reserve ratios made no difference to the banking system, and basically bought the MMT line that the only thing that matters is bank capital. But here’s a pretty simple reductio: if reserve requirements are 100%, then deposits finance zero lending. Since banks make money by lending, no bank will (voluntarily) pay interest on deposits. 100% reserve requirements completely divorce lending and deposits. Duh.

How could that guy be so wrong? Well, maybe he thought about it this way. Suppose reserve requirements were increased in such a way that there were no longer enough reserves to sustain the current level of deposits in the economy. In order to prevent a likely deflationary contraction (decrease in V), the central bank creates more reserves (increase in M). As long as no one changes their intertemporal consumption preferences or the balance of their portfolios (a whopping great big howler of an assumption), this *appears* to have no effect at all on the economy or the banking system. The Fed can just create more reserves, whilst managing the marginal cost of loanable funds, and everything seems to go along as normal. But this cannot be right, because if reserve ratios increase then deposits ‘fund’ less lending and banks won’t pay as much to compete for them. The central bank makes up the difference. Interest on deposits fall, and ends up being paid to the central bank instead (as I’m assuming for the moment the Fed funds rate stays the same, and this is supported by repo transactions which earn the Fed interest). Of course, this isn’t even remotely close to an equilibrium, as a reduction in the interest rate on deposits will cause depositors to re-balance their portfolios, affecting both AD and the natural rate of interest (and hence the optimal Fed funds rate under the policy regime).

Basically, an increase in the reserve ratio (under a monetary policy regime like in the US) redistributes seigniorage away from depositors and towards the central bank*. Depositors then take some action to mitigate this by re-balancing their portfolios, with the central bank then counteracting any effects of said re-balancing on the policy target. If any of this re-balancing is towards higher consumption, the Fed funds rate will have to increase (reflecting the change in intertemporal consumption preferences, and hence the natural rate of interest). That being said, as the Fed remits any net income to the Treasury, it’s a little more complicated as less taxation/bonds would be required to finance any given level of government spending.

In conclusion, that guy who took over my blog really should have just spent Sunday morning watching the tennis instead. What an idiot**.

_______________________________________________________________________________________________________

*This, I think, is just another way of making Nick Rowe’s point in the comments on the previous post. I’m seriously considering just outsourcing all my beliefs to him, and being done with this whole ‘having opinions of my own’ thing

**In that guy’s defense, this stuff is (in my view) pretty damn hard. It’s unbelievably easy to make silly mistakes – even if you have a Nobel prize. So be nice… if you happen to see him around

Categories: Economics
  1. Max
    January 30, 2012 at 8:58 pm

    Maybe it’s easier to start by thinking of a system where deposits are required to be backed by t-bills (like a treasury money market fund). It’s clear that this doesn’t fundamentally change anything – it just removes risk from deposits. Now add a central bank which buys t-bills and provides reserves, which it pays interest on at the policy rate.

    Nick is assuming that reserves wouldn’t earn interest. That’s a strange assumption since reserves can, unlike currency.

    • January 30, 2012 at 9:16 pm

      Max,

      This would be like saying the central bank just remits the interest back to depositors (in the way I’ve framed it). You would (I think) achieve a very similar overall effect in the fractional reserve system by having a deposit insurance scheme backed by the printing press. This would *probably not* be a good idea, to put it mildly.

      The point as I originally made it was wrong, but I at least hope it was wrong in an interesting way.

      • Max
        January 30, 2012 at 10:15 pm

        “This would be like saying the central bank just remits the interest back to depositors (in the way I’ve framed it).”

        They get the Fed Funds rate (minus whatever service fee the bank charges), not the central bank profit.

        “You would (I think) achieve a very similar overall effect in the fractional reserve system by having a deposit insurance scheme backed by the printing press. This would *probably not* be a good idea, to put it mildly.”

        I’m confused…isn’t deposit insurance the current system?

      • January 30, 2012 at 10:36 pm

        Max,

        “They get the Fed Funds rate (minus whatever service fee the bank charges), not the central bank profit.”

        Ok, think I get your point.

        “I’m confused…isn’t deposit insurance the current system?”

        Deposit insurance doesn’t apply to all deposits and is currently backed up by premiums paid to the FDIC, not the printing press.

        Btw if that all doesn’t make any sense, it’s not you – it’s definitely me with a big ol’ mess in my head and not working through it logically.

    • January 31, 2012 at 2:15 pm

      Max is right about my implicit assumption. I should have made it explicit. And it is indeed very easy to make the opposite assumption, and assume that reserves pay interest.

      If we assume 100% reserves, and that reserves pay interest, then the tax/seigniorage issue I initially raised is off the table.

      The question now is; if currency in public hands is (say) 5% of GDP, and balances in chequing accounts is (say) 15% of GDP, do we really want the central bank’s balance sheet to expand form 5% to 15% of GDP? Should the central bank be holding the risky assets the banks used to hold? If not, who will hold them? What happens if the public debt is less than 15% of GDP?

    • January 30, 2012 at 9:43 pm

      Steve,

      My original point that it would make no difference was straightforwardly wrong, as I completely ignored the desire of banks to attract deposits. I think from your comments you have made no such mistake, and there’s a more basic question here about what the structure of the financial system should be which is also going on. But I did say in the original post, ‘this smacks of WAY-too-good-to-be-true’, and it was on the terms I laid out.

      Let’s put it this way: I’m pretty sure 100% reserves does not pareto-dominate. Which I thought, for less than 24 hours, it might be close to doing.

  2. January 30, 2012 at 9:54 pm

    Richard: “My original point that it would make no difference was straightforwardly wrong”

    Right. It would make $5 trillion in bank deposits un-lendable.

    “I’m pretty sure 100% reserves does not pareto-dominate.”

    I don’t have anything like that certainty, and I really don’t think anyone else does. As I said, 100% reserve could result in more bank capital so more lending. Just don’t know.

    While I hesitate to invoke the simplistic catch-all solution-for-everything called “equilibrium,” I tend to think that lending is demand driven, and that when all the chips landed we’d have roughly the same amount of debt outstanding.

    Without the bank runs.

    But the whole complex of incentives — the whole ecosystem — would be different, with different emergent properties. So It seems impossible to guess without some kind of dynamic simulation model(s).

    • January 30, 2012 at 10:09 pm

      Steve,

      My point was all based around the central bank controlling the marginal cost of loanable funds, and as long as there was no change to ‘the amount of money chasing goods and services’ it shouldn’t affect that cost. That $5tn does become “un-lendable”, and I surmised the central bank would just step in to prevent a massive collapse in M1. I failed to see the *obvious* implications of this change in the source of loanable funds.

      None of this is to invalidate any arguments that anyone is making as to why it might be better if we did it one way rather than the other. It may be better if people can’t earn interest on ostensibly risk-free “super-safe” assets (see post on Gorton). But I don’t feel sufficiently compelled by anything (yet) to have a horse in the race as I’m not currently comfortable that I grasp the implications.

    • Max
      January 30, 2012 at 10:38 pm

      “Right. It would make $5 trillion in bank deposits un-lendable.”

      So what? It just means that banks have to sell more bonds. But remember, creating $5 trillion in reserves requires that the central bank buy $5 trillion of bonds.

      So at least from 30,000 foot view (normal economist perspective), there’s zero effect on the credit market.

      • January 30, 2012 at 10:49 pm

        “So at least from 30,000 foot view (normal economist perspective), there’s zero effect on the credit market.”

        …I’m now starting to think that may be right, but I need to work through it in my head. Appreciate your patience, all of you.

  3. January 30, 2012 at 10:16 pm

    “the *obvious* implications of this change in the source of loanable funds”

    So I’m sure I understand: basically what I outlined in my post and nick suggested? That banks would have to charge for holding people’s savings because they couldn’t lend the funds and make money that way?

  4. Max
    January 30, 2012 at 10:56 pm

    “Deposit insurance doesn’t apply to all deposits and is currently backed up by premiums paid to the FDIC, not the printing press.”

    That’s not what the FDIC tells the public. Deposits are backed by the “full faith and credit” of the U.S. government, they say.

    Yes, there are non-insured deposits. But how much of that is at large, too-big-to-fail banks?

  5. JKH
    January 31, 2012 at 4:46 am

    Max is right.

    Here’s a way of doing it:

    Use Steve Roth’s number of $ 6 trillion in reservable deposits.

    Start from scratch, ignoring the small amount of existing required reserves, for simplicity.

    In order to create $ 6 trillion in reserves, the Fed must acquire $ 6 trillion in assets.

    So the Fed acquires $ 6 trillion in Treasury bonds.

    That creates $ 6 trillion in reserves AND $ 6 trillion in new bank deposits.

    So deposits now total $ 12 trillion, which is a problem, because the newly created deposits are also reservable. Starting to look like Groundhog Day at the Fed.

    The commercial banks issue $ 6 trillion in non-reservable debt to absorb the newly created deposits.

    Customers pay for $ 6 trillion in new bank debt with deposits.

    (Such a process would have to occur in phases, to avoid chaos in reconciling the new liability structure of the banking system with reserve requirements, etc.)

    The banking system balance sheet has now blown up by $ 6 trillion – new reserves and new debt.

    But the new reserves carry no risk and generate no new capital requirement.

    And the existing loan book of the banks is still intact.

    From a balance sheet management perspective, the deposits are essentially matched against reserves, and the new debt is essentially matched against the loan book. (This total effect is the mechanism that fits the Austrian prescription for 100 per cent reserves as the driver of “maturity matching” in the funding of loans.)

    The loan book hasn’t changed, so risk and capital requirements haven’t changed in a fundamental way.

    There would be some adjustments required for interest rate risk management both by the commercial banks (loan/debt mismatches) and the government, but that would be manageable.

    The government could choose whether or not to pay interest on reserves. That might depend on how it expected the banks would want to price deposits in higher interest rate environments – they might want to start paying interest on a good chunk of the $ 6 trillion in higher rate environments – but they wouldn’t be able to if reserves weren’t compensated. All of that could depend on expected customer behaviour in higher rate environments.

    The effective arrangement in total starts to look a little bit like massive Fed QE or MMT “no bonds”, combined with deposit draining debt issuance by the commercial banks.

    Importantly, banks would rely on the appetite of those who sold their Treasuries to the Fed to replace that with somewhat higher risk bank liabilities. But these would rank up the capital structure and so be of relatively good risk quality for investors.

    In general, increases in required un-compensated reserves shouldn’t affect risk or capital requirements, or the required return on capital or the cost of capital. But they DO almost certainly affect the pricing of loans, because increases in uncompensated reserves will reduce bank interest margins, particularly at higher general levels of interest rates, unless the interest rate on loans is increased as an offset. In such an environment, uncompensated reserve requirements are a tax in the sense that they are an incremental expense that must be recovered through other means of asset-liability (or possibly equity) pricing. In this case, new bank debt issuance could also have interest margin consequences, requiring further pricing adjustments.

    • January 31, 2012 at 6:59 am

      JKH,

      Great comment. Here’s an even simpler way of doing it: the Fed does $5tn worth of repos with commercial banks at the FFR. No new deposits are created, the just go straight into their accounts at the Fed. If you didn’t want to be doing those repos forever (understandable), you can then gradually up outright purchases whilst simultaneously reducing repos. Provided there was enough suitable collateral to repo, and the government paid interest on regulatory (rather than excess) reserves at the FFR (which goes to depositors minus a bank service fee, H/T Max), everything looks exactly the same to me – except there are now 100% reserves. If depositors were earning the same rate now as they were before, the only think that has changed is that their deposits are ‘safer’.

      I’m struggling to see why this would affect interest rates very much, except that you’d probably see a move into deposits away from money market mutual funds and the like.

      Will have more time to think about it when I get home from work later today. Sorry if I missed something important (really wish I could do this full time)

      • JKH
        January 31, 2012 at 7:58 pm

        That’s an interesting point on repos.

        Banks hold a certain amount of prudential liquid assets now – according to regulation and self-imposition. Qualifying liquid assets could be repo’d as you suggest, although there wouldn’t be sufficient to cover the full deposit base – maybe something like $ 1 trillion, compared to $ 6 trillion in deposits. I think that’s initially why the Fed would have to provide a more permanent injection of reserves, with associated deposit creation (because most of the bonds it buys would be sold by non-banks). And the banks could respond to that permanent injection by issuing non-reservable debt to drain the additional deposits.

        The Fed could phase in permanent reserve injection over time.

        Banks could retain a repo buffer at the margin, along the lines of what you described, to accommodate liquidity demands when their liability mix and reserve requirement level changed. The interesting thing is that banks would benefit from keeping some additional liquidity like this, just to accommodate changes in the operating level of their 100 per cent reserve requirement – a seeming paradox of 100 per cent reserves as liquidity. E.g. If bank customers shift from bank deposits to non reservable bank debt, banks could unwind repos with the Fed to shrink their reserves. Conversely, they might hold liquid assets to repo with the Fed in the event of increases in reservable deposits. Given the large mass of required central bank reserves that would exist in such a system, and the potential for commercial bank liability mixes to shift around from time to time, the central bank would likely need to be active in adjusting available reserves to required reserves on a continuous basis, and the repo mechanism would be helpful in doing this.

  6. January 31, 2012 at 6:51 pm

    JKH, thanks as always.

    Another way to think about full reserve:

    Imagine the Fed is America’s (all Americans’) banker. Each person has a checking account.

    The Fed The Bank is backed by the full faith and credit of the U.S. government (or even simpler: it’s merged with Treasury), which can print money as needed. As safe as it gets in this universe.

    Even imagine no reserves: just government:

    1. Transferring money between people’s accounts when they spend,

    2. Issuing more money by spending it into people’s accounts

    3. Retiring money by taxing it out of their accounts

    No reserve here is equivalent to full reserve.

    Does the Fed charge each American to 1. hold their money, and 2. provide transaction (i.e. check writing, online bill pay) and reporting services (i.e. a web site and Quicken downloads)?

    If they don’t charge, that service is a public good, or a subsidy, depending on your point of view.

    If they do charge, you might want to call it a “tax” depending on whether you think safe and convenient money storage is something people have a natural right to. In this world it would start to feel like they did have that right.

    Meanwhile there are private “lending banks” that don’t take deposits (the Fed’s got that covered). They just raise capital and lend against it at an allowed multiplier (with appropriate regulation etc.).

    (Wasn’t there a law at one point that split off banking services from risky lending activities? Seems like, long ago…)

    If we move depositors one step away, to fed-chartered banks, we could say that interest on reserves would be a way for government to provide that public good (or “subsidy,” depending…) in a second-hand way.

    Which is exactly what it does today by allowing banks to lend out 90% of depositor’s money, and issuing the interest-bearing risk-free bonds that are (??) necessary to that system. Free or even interest-bearing checking accounts for all!!

    “The effective arrangement in total starts to look a little bit like massive Fed QE or MMT “no bonds”, combined with deposit draining debt issuance by the commercial banks.
    Importantly, banks would rely on the appetite of those who sold their Treasuries to the Fed to replace that with somewhat higher risk bank liabilities. But these would rank up the capital structure and so be of relatively good risk quality for investors.”

    I think this answers my question: yes, the ecosystem would probably result in enough bank capital and associated lending that credit outstanding would end up being approximately the same.

    • JKH
      January 31, 2012 at 8:15 pm

      Yes, if the Fed were to become THE bank, reserves would be eliminated as a balance sheet item. The main reason for them now is to allow interbank settlement in a competitive banking system. No need for that with a single bank.

      As you say, if the Treasury/Fed is issuing all deposits, then they are fully reserved in the fiat sense, simply because the issuer of deposits is THE currency issuer, in the MMT sense.

      BTW, I’ve always regarded what you allude to here as the purest MMT-type model, although I don’t think I’ve seen anybody from MMT per se describe it that way.

      The Treasury function essentially becomes a bank – THE central bank and THE commercial bank.

      The Treasury function as a bank undertakes both central bank asset swaps, and government deficit spending.

      Because “the bank” in its deficit spending function has issued a positive NFA position to the non government sector, it has itself a negative equity position (LHS equity instead of RHS equity).

      So the difference between this bank and normal private sector banks is that it is allowed to run negative equity.

      And it can do so because it is “the currency issuer”.

      I like to think of it this way, because all the accounting adds up then.

      (P.S. “negative equity” is either a negative RHS entry or a positive LHS entry, although neither representation is a financial claim or financial asset – as per previous discussions.)

      • January 31, 2012 at 11:23 pm

        @JKH:

        Thanks for confirming that the thinking made sense. Of course I’m not proposing this; just using it to think and understand.

        “(P.S. “negative equity” is either a negative RHS entry or a positive LHS entry, although neither representation is a financial claim or financial asset – as per previous discussions.)”

        Yeah: I got that as I read it, even before I got to this PS. Must have been doing my pushups! Thanks.

  1. January 30, 2012 at 8:29 pm

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