Richard Williamson smackdown watch: Richard Williamson edition
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