Mish's Global Economic Trend Analysis

Notes From Steve Keen on "Lending Reserves" and "Debt Jubilees"; Mish Proposed Starting Point For Real Solution to Debt Crisis

Posted: 13 Jul 2012 10:30 AM PDT

In response to Can Bernanke Force Banks to Lend by Halting Interest on Excess Reserves?, Australian economist Steve Keen pinged me with the following ...

Cheers Mate

That "increase reserves to increase lending" argument is so hard to shake, but reserves can't be lent from simply from a double-entry bookkeeping point of view.

The way that accountants keep track of the "assets equals liabilities plus equity" rule is to record an increase in assets as a positive and an increase in liabilities as a negative (your liabilities rise, so a negative gets bigger). Reserves are an asset, as are loans, and shown as a positive. Deposits--which are created by a loan--are a liability and shown as a negative

So to lend to a customer, a bank has to show a negative on that customer's accounts. This can be matched by a positive on the loans entry--because the loan has increased in size. No problem.

But if banks were to lend from reserves, they would need to record a minus there--reserves have fallen. And on the liabilities side, they want to ... also show a negative. Whoops! No can do.

The end result of this logic is that reserves are there for settlement of accounts between banks, and for the government's interface with the private banking sector, but not for lending from.

Banks themselves may (if they are allowed--I simply don't know the rules here) swap those assets for other forms of assets that are income-yielding, but they are not able to lend from them.

Cheers, Steve

P.S. On my debt jubilee idea, I'd welcome a debate with you over it. There is an issue, whether you support a "strong money" gold-backed currency system or a reformed credit system, of dealing with the mess left by this one we currently have. My idea is a way to cancel the impact of debt that should never have been lent in the first place (and to prevent speculation taking off again on the other side by reforms to asset markets that make debt much less attractive).

It would be good to have a back-and-forth with you on the dilemma we're in and the alternative ways out of it, whatever our desired end-system might be.

Debt Jubilee Revisited

Steve Keen is looking to discuss what to do about excess debt.

I knocked his "debt jubilee" idea in Steve Keen Goes Off the Deep End With a "Debt Jubilee" (Free Money to Consumers) Proposal.

It's easy enough to tear down ideas without presenting an alternative. So let's take a look at issues that I think need to be addressed.

Structural Issues

Giving money away will not cure any structural issues such as the high cost of education, pension underfunding, medical costs, prevailing wages, student loans, etc., etc.

Indeed, I think it would compound those problems.

Likewise, I think the second part of Keen's idea about controlling debt in the future tied to GDP growth (or anything else for that matter) would fail miserably.

A free market, not government mandated fiat money is the solution. We certainly do not have a free market now. Instead, we have fiat mandate, compounded by fraudulent fractional reserve banking.

It is the fractional reserve banking system that is the very root of the credit expansion problem.

Fractional Reserve Lending Is Fraud

By lending out more money or gold than exists, asset prices reach unsustainably high levels before they crash. Sound familiar?

Greenspan compounded the problem in 1994 by allowing banks to "sweep" checking accounts (unknown to customers) into savings accounts (via accounting entry).

Savings accounts have no reserve requirements. Effectively, money that people think is in their checking accounts is not really there at all. In fact, it has been lent out multiple times over.

This fact exacerbated the run-on-the-bank problems we saw in 2008. As a side note, FDIC insurance is another form of fraud.

Housing Bubble Lending

In the housing bubble, banks lent because they thought they had credit-worthy customers and/or because they thought asset price appreciation would have them covered in case of losses. Banks did not lend because they had excess reserves to lend from.

It turns out that banks did not have credit-worthy customers. It also turns out that asset prices did not cover losses when the housing bubble burst.

Not Just A Duration Mismatch Problem

On March 24, 2011 I wrote a detailed rebuttal to FRL: Central Bank Authorized Fraud; Fractional Reserve Lending Problems Go Far Beyond "Duration Mismatch"

Reflections on "Legitimate" Right-To-Use

Some argue that as long as customers agree to these various banking schemes it is OK. That line of thinking says as long as it's in the agreement for banks to sweep money from checking accounts to savings accounts and lend it out, then it's OK for banks to do so.

However, it's not OK because such lending is nothing more than a gigantic kiting scheme. Moreover, it affects others by cheapening the value of money, pushing up asset prices for the benefit of those with first access to money, the banks and the wealthy.

Logically, two people cannot have the right to use the same money at the same time, whether they agree to such a scheme or not!

Please read that above article if you have not done so. It will open your eyes as to what is happening and why.

Rothbard Chimes In

For more on the case against Fractional Reserve Lending please see

Fractional Reserve Banking by Murray Rothbard.
Case Against The Fed by Murray Rothbard

On page 46 of the book Case Against The Fed Rothbard says "By the very nature of fractional Reserve Lending, banks cannot honor all its contracts".

Since that is known upfront, in advance, how is that not fraud?

Solutions

Before we can address solutions to the debt problem, we have to understand what caused the debt problem in the first place. In this case, FRL is at the heart of it.

Since FRL is at the heart of it, any permanent solution must address that problem.

I welcome further discussion from Steve Keen on these ideas, and I have a follow-up post in mind on student loans, showing just how distorted the system is when government gets in the way of the free market.

Regardless of what the solutions are, the notion that $1.5 trillion in excess reserves is about to come pouring into the economy 10 times over in the form of $15 trillion in new credit is complete economic silliness, a point on which Steve Keen and I are in complete agreement.

Actually, Steve and I are in agreement on many things, just not solutions.

Final Comments

I appreciate these discussions with Steve Keen. He has taught me a lot. I welcome the opportunity to present views to the public about what needs to be done. It's easy enough to tear down ideas without presenting an alternative.

I propose we start by addressing the root cause of the debt problem which I state is fractional reserve lending.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Can Bernanke Force Banks to Lend by Halting Interest on Excess Reserves?

Posted: 13 Jul 2012 12:38 AM PDT

Several readers have ask me to comment on a King World interview of Michael Pento.

Before I offer my comments on Pento's thoughts, let me say upfront that Eric King is a world-class interviewer. King lets his interviewees have their say, no matter what it is.

It is up to listeners to decide whether the message makes any sense or not. King merely wants the position to be well stated.

Email Request From US

Hello Mish:

Have you listened to Mike Pento's scenario where the FED will cease to pay interest on reserves held at the FED, as a result, forcing banks to loan out the money to seek some return. He believes that they will be encourage to purchase US treasuries:

Is this viable and/or probable?

Thanks for providing us with such a great blog.

All the best,

Dan

Email From Down Under

Dear Mish

I follow your work from Australia with great interest. I was impressed with your argument that the creation of new money will not lead to price increases because it is deposited with the Fed, and does not make it into the real economy.

You will no doubt be aware of recent comments by Michael Pento on King World News that the Fed is about to eliminate the incentives for the banks to deposit excess reserves with the Fed, and that this will force the banks to lend in the economy and cause significant inflation, and presumably a drop in the USD.

I would be greatly interested in your views on this, as a deflationist, because if Pento is right then the reason for deflation over inflation might be eliminated. Furthermore, the worsening in key stats such as auto sales and official unemployment might just be the trigger that forces the Fed to squeeze the money out into the economy.

Best regards
Henry

Primer on Bank Lending

With that background out of the way, my first thought is "Here we go again. How many times does such silliness have to be rebutted before it stops?"

Banks lend if and only if both of the following are true.

They are not capital impaired
They have credit-worthy borrowers willing to borrow.

That is not an opinion. Rather, that is a statement of fact. I discussed this at length many times.

Excess Reserves Yet Again

Here is a discussion from BIS Working Papers No 292, Unconventional monetary policies: an appraisal.

Note: The above link is a lengthy and complex read, recommended only for those with a good understanding of monetary issues. It is not light reading.

The article addresses two fallacies

Proposition #1: an expansion of bank reserves endows banks with additional resources to extend loans

Proposition #2: There is something uniquely inflationary about bank reserves financing

From the article....

The underlying premise of the first proposition is that bank reserves are needed for banks to make loans. An extreme version of this view is the text-book notion of a stable money multiplier.

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 main exogenous constraint on the expansion of credit is minimum capital requirements.

A striking recent illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan's "quantitative easing" policy in 2001-2006.

Japan's Quantitative Easing Experiment

click on chart for sharper image

Despite significant expansions in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly (Figure 4).

Is financing with bank reserves uniquely inflationary?

If bank reserves do not contribute to additional lending and are close substitutes for short-term government debt, it is hard to see what the origin of the additional inflationary effects could be.

Lending Theory

There is much additional discussion in the article, but it is clear that money lending theory as espoused by many did not happen in Japan, nor is there any evidence of it happening in the US, nor is there a sound theoretical basis for it.

In fiat credit-based economies, lending comes first, reserves come second.

Fed's Next Move

Pento was preaching the same thing on IB Times FX in The Fed's Next Move

As I predicted as far back as June of 2010, the Fed will soon follow the strategy of ceasing to pay interest on excess reserves.

Since October 2008, the Fed has been paying interest (25 bps) on commercial bank deposits held with the central bank. But because of Bernanke's fears of deflation, he will eventually opt to do whatever it takes to get the money supply to increase. With rates already at zero percent and the Fed's balance sheet already at an unprecedented and intractable level, the next logical step in Bernanke's mind is to remove the impetus on the part of banks to keep their excess reserves laying fallow at the Fed. Heck, he may even charge interest on these deposits in order to guarantee that banks will find a way to get that money out the door.

Commercial banks currently hold $1.42 trillion worth of excess reserves with the central bank. If that money were to be suddenly released, it could through the fractional reserve system, have the potential to increase the money supply by north of $15 trillion! As silly as that sounds, I still hear prominent economists like Jeremy Siegel call for just such action. If they get their wish, watch for the gold market to explode higher in price, as the U.S. dollar sinks into the abyss.

Emphasis his.

Facts of the Matter

Money supply has already soared by any number of measures.
Credit expansion has been anemic except for student loans and FHA (both with government guarantees)
The Fed did not cease paying interest on excess reserves as predicted in 2010.
It would not matter from a lending perspective if the Fed did.
The idea that excess reserves will come pouring into the economy, multiplied 10 times over is widely believed nonsense. In practice, lending comes first, reserves second. (see "The Roving Cavaliers of Credit" by Steve Keen for further excellent discussion).

Inflationary Nonsense

The simple fact of the matter is Pento has no idea how bank lending works in the real world.

There is no other way to state it. If banks thought they had good credit risks, they would lend (provided of course they were not capital impaired).

Moreover, by paying interest on reserves, Bernanke is slowly recapitalizing banks over time. Would Bernanke easily give that up? Well he hasn't so far. Nor has he even dropped a hint of it.

Even if Bernanke did cease paying interest on excess reserves, it would not impact bank lending for reasons stated.

What If?

For the sake of argument let's play "What If"?

What if the Fed were to reduce interest rates on excess reserves to -3%. Would that do it? Well, it sure would get banks to do something, but that something might not necessarily be lending!

For example, banks might bet against the US dollar, bet on gold, plow into the stock market, etc., etc., etc., but there is no reason to assume banks would extend credit to unworthy borrowers.

Moreover, Bernanke (as foolish as he is), is at least bright enough to figure that out.

Thus, the idea that Bernanke can get banks to lend by reducing interest rates on excess reserves is 100% without a doubt, fatally flawed nonsense from both theoretical and practical standpoints.

ECB Cuts Reserve Rate to Zero

As a practical matter, the ECB just cut interest on reserves to zero. The result is reduced liquidity as banks shut down money market funds rather than lose money.

Please consider How Money Market Funds Were Wounded by European Interest-Rate Cuts

The cut in the interest rate was meant to convince banks to stop parking money, to lend more, to get more money into the system and make it more stable - in Wall Street parlance, to add "liquidity."

But the backlash from banks shows that they're willing to close money market funds rather than lose profits. The effect, ironically, is to reduce liquidity in the financial system.

JP Morgan alone pulled $29 billion in assets.
It's supposed to be different here?
Why?

Additional Discussion of Excess Reserves and Constraints on Bernanke

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

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Mish's Global Economic Trend Analysis

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