1) A bank is liquid when it is able to exchange its assets for cash rapidly enough to meet the demands made upon it for cash and payments.
2) A bank is solvent when the realizable value of its assets is at least sufficient to cover all its liabilities.
3) A bank at any given time could meet a current test of liquidity (and not be solvent), and it could be solvent, and not have sufficient current liquidity.
4) But to satisfy the legal requirements for an operating bank, to qualify its deposits as money, to satisfy its creditors, and the various corps of examiners, a bank always must be both liquid & solvent.
5) In terms of the balance sheet, net worth is the margin between solvency and insolvency, but a forced and hasty liquidation of assets might result in a bank becoming insolvent whose condition ordinarily could be regarded as sound.
6) It is therefore all important to the banker to keep his bank sufficiently liquid so that its solvency will not be tested under the adverse conditions associated with a hasty and ill timed sale of assets.
7) Banks must balance their assets & liabilities between liquidity and income. Lower yields on bank assets reflect greater liquidity, while higher yields on bank assets reflect reduced liquidity. I.e., there is in the main, an inverse relationship between the yields on a bank’s earning assets & the liquidity of those assets.
8) Banks must also adjust the basis spread, or hedge their positions, with uniquely fitting derivatives, along an ever shifting (rising, flat, inverted), yield curve (amid constantly changing economic conditions).
9) It means arranging the relationship between the different classes of assets in its loan and investment portfolio against the distribution of the bank’s deposit liabilities (transaction & time deposit accounts). I.e., by matching the volume of its current/short-term liabilities (borrowings), against the volume of its long-term loans and investments (e.g., mortgages). They must remain ever cognizant of their current & future (expected cash flows).
10) The bank must match its assets & liabilities between liquidity and period to maturity. Assets should be structured so that the bank will never be forced to sell a security under unfavorable conditions before it matures (duration gap).
11) During 1939 thru 1962 the increase in bank capital ratios had been upward in spite of the continued expansion of bank liabilities,. This rise is almost entirely attributable to retention of earnings.
12) Primary reserves or “working reserves” are those cash assets that consist of due from other banks (excluding the District Reserve Banks), vault cash, and deposits in the Reserve bank that are in excess of the bank’s reserve requirements (currently 800b in member bank excess reserves).
13) In an emergency banks are allowed to dip into their vault cash to meet withdrawals even though this depletes their reserve assets below minimum legal requirements, but such deficiencies must be restored within a short period of time.
14) Under fractional-reserve banking a part of the member bank’s required reserves are available for withdrawals, since the cashing of deposits, or their transfer to other banks, releases required reserves, adding to excess reserves
15) Secondary reserves consist of earning assets which can be converted into cash quickly and without loss, e.g., U.S. Treasury obligations having about one year or less to go to maturity, commercial paper, repurchase agreements, etc.
16) The ratio of a bank’s non-earning assets relative to the proportion of its earning assets, as well as how much income the bank ends up forfeiting, depends on the degree of its reliance on short-term liquid securities. Contra wise banks assume credit risk, interest rate risk, market risk, and liquidity risk by overweighting its investment portfolio with longer-term assets.
17) For a member bank to remain fully “lent up” requires an accurate assessment of the (1) future balance of payments, (2) understanding its customer’s deposit volatility, (3) knowing the trend in interest rates, (4), and estimating the demand for loan funds.
18) It requires arranging its investment accounts by distributing maturing paper against the turnover in its deposit liabilities while maintaining the regulatory capital-asset ratio. It involves maintaining its margin, or its yield spread, along the slope (rising, flat, or inverted), of an ever shifting yield curve.
19) The function of bank capital or the aggregate of capital stock, notes and debentures, surplus, undivided profits, and all net-worth reserves provides a “cushion” to protect bank creditors. It measures the bank’s ability to absorb losses and still maintain solvency.
Wednesday, September 23, 2009
Bank Credit Contraction - Deposit Destruction
The depth of any deposit contraction depends upon the volume and distribution of excess-reserves in the system (especially which banks, their aggregate size, & the volume of each bank’s excess reserves). It is also dependent upon the ability and willingness of the member banks to discount assets, or go into debt with the central bank.
Deposit destruction reverses the steps by which the creation of deposits in one bank is ultimately spread to the other banks in the system.
Bank credit contraction involves both the (1) transfer of deposits, and (2) transfer of excess-reserves, to the bank, or banks, initiating the contraction.
Contraction by any single member bank in the system will force additional member banks to tighten up, (curtail granting new loans, or purchasing new investments).
Since deposit destruction is mutually reinforcing, contraction will ultimately reduce a bank’s earning assets, and the bank’s regulatory capital-to-asset ratios.
In their lending operations, management is forced to reduce and retire bank assets by calling loans and selling securities, letting maturing investments run off without replacement, not renewing existing loans, reducing or not rolling over short term financing (e.g., repurchase agreements &commercial paper, & borrowing federal funds).
If the individual bank’s excess-reserve position is insufficient, or the individual bank is unable to restock its excess reserves through the FED’s liquidity funding facilities, contractions become cumulative. I.e., the effects are soon transmitted throughout the banking system.
The reinforcing nature of bank credit contraction is volatile, disorderly, and cumulative. It eventually results in the respondent banks closing their correspondent accounts.
This was one of the principle reasons that the Federal Reserve System was established, to avoid the reinforcing forces of bank credit contraction. This objective was not achieved until after 1933.
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In the context of their lending operations it is only possible to reduce bank assets, and TRs, by retiring bank-held loans, e.g., for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.
Monetize private debt, and this proportion of the debt has been monetized, and has resulted in a concomitant injection of new money into the economy
Deposit destruction reverses the steps by which the creation of deposits in one bank is ultimately spread to the other banks in the system.
Bank credit contraction involves both the (1) transfer of deposits, and (2) transfer of excess-reserves, to the bank, or banks, initiating the contraction.
Contraction by any single member bank in the system will force additional member banks to tighten up, (curtail granting new loans, or purchasing new investments).
Since deposit destruction is mutually reinforcing, contraction will ultimately reduce a bank’s earning assets, and the bank’s regulatory capital-to-asset ratios.
In their lending operations, management is forced to reduce and retire bank assets by calling loans and selling securities, letting maturing investments run off without replacement, not renewing existing loans, reducing or not rolling over short term financing (e.g., repurchase agreements &commercial paper, & borrowing federal funds).
If the individual bank’s excess-reserve position is insufficient, or the individual bank is unable to restock its excess reserves through the FED’s liquidity funding facilities, contractions become cumulative. I.e., the effects are soon transmitted throughout the banking system.
The reinforcing nature of bank credit contraction is volatile, disorderly, and cumulative. It eventually results in the respondent banks closing their correspondent accounts.
This was one of the principle reasons that the Federal Reserve System was established, to avoid the reinforcing forces of bank credit contraction. This objective was not achieved until after 1933.
================================================================================
In the context of their lending operations it is only possible to reduce bank assets, and TRs, by retiring bank-held loans, e.g., for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.
Monetize private debt, and this proportion of the debt has been monetized, and has resulted in a concomitant injection of new money into the economy
Cartesian coordinates: Contrary to economic theory, monetary lags are uniformly fixed in length. The statistical analysis of these crests and troughs confirm that the rates-of-change in these monetary flows (our means-of-payment money times its rate of turnover) are not random. Specifically, the rates-of-change (roc’s), in the monetary lags (the proxies for real-growth, & for inflation), oscillate unvaryingly along the X axis. Their maximum and minimum reference frames (as demonstrated by the clustering on a scatter plot diagram) correspond to the economic lag, and not to any of our federal government agencies’ weekly, monthly, quarterly, or annual statistics.
These oscillations do however suffer from errant data. Errant data may originate from faulty theoretical interpretations, flaws in defining the data, and errors in the survey, collection, calculation, and publication of the government’s call reports, etc. (for both the (1) seasonal mal-adjusted data, as well as the raw (2) non-seasonally adjusted data). And it is problematic that there are also undetected mistakes in the raw data.
In the first sentence of the Federal Reserve Act of 1913 it calls for the Federal Reserve Banks to “furnish an elastic currency”. The Board of Governors has liberally interpreted this statement to support its policy of seasonal accommodation. The corresponding data is then reported using periodic revisions to seasonal factors (hence the mal-adjustments). The technical staff's economic justification for this practice (using last year’s seasonal factors for this year’s release), has its roots in the fallacious “Real Bills Doctrine”.
The problem with the “Real Bills Doctrine” is that an injection of new bank credit for financing inventories, or any other phase of merchandising, or processing, is obviously inflationary when the theory applied under the assumption that labor and facilities are fully employed, as for example, during the Christmas and New Year’s holidays.
And the raw data may be revised, reconstructed, or spliced, causing noticeable changes and distortions. Geographical statistical areas and sample sizes’ may change. The data might not conform to the data from original release. And when some statistical releases are revised, these time series overlay (wipe out), the original data. I.e., the government’s reporting agencies don’t always keep separate iterations of the old historical data. Reporting may also be delayed, published less frequently, or only available as seasonally mal-adjusted.
It is instructive that the FED has never cooperated by supplying continuous, comparable, and timely data. Supporting data is required for the proper investigation, the subsequent proof, and ending conclusion, for any economic research.
That understood: the roc’s in the Y coordinates for monetary flows (MVt), closely parallel the roc’s in GDP figures. I.e., the roc’s in bank debits closely correspond to the roc’s in monetary flows (for both real growth, & for inflation). Likewise, it is no accident that the roc’s in adjusted member bank “free” legal reserves corroborate these roc’s. The roc’s between both time series is synchronous (what is being compared is the rate-of-change, not the absolute figure).
That given: “reliance on the data compiled by the Government agencies is subject to the limitations of all analyses based upon statistical aggregates, i.e., data cannot be compiled accurately, or by a method which conforms to rigid theoretical concepts”(Dr. Leland James Pritchard, Chicago, Economics, 1933; Masters, Statistics, Syracuse).
It is more likely that statistical calculations are at odds with the real world, estranged from scientific economics, inconsistent with mathematical modeling, not because of faulty economic theories, but because of non-conforming, or non-existent, raw data. (“History is full of bad jokes”).
How accurate is the debit series? It is 100% within the range for any quarter. It is approximately 80% within the range of a single month. And I would guess that it is probably c. 50% within the range for any given week (for the period of time in which statistics were reported. Cartesian coordinates: Contrary to economic theory, monetary lags are uniformly fixed in length. The statistical analysis of these crests and troughs confirm that the rates-of-change in these monetary flows (our means-of-payment money times its rate of turnover) are not random.
======================================================================
If the catalogue of facts and their measurements (1) don’t correlate, (2) consistently compare, or (3) conclusively prove; the validity of a one’s arguments (theory), then there is a higher probability that the FED’s data is wrong, rather than the time series, or the theory supporting it.
These oscillations do however suffer from errant data. Errant data may originate from faulty theoretical interpretations, flaws in defining the data, and errors in the survey, collection, calculation, and publication of the government’s call reports, etc. (for both the (1) seasonal mal-adjusted data, as well as the raw (2) non-seasonally adjusted data). And it is problematic that there are also undetected mistakes in the raw data.
In the first sentence of the Federal Reserve Act of 1913 it calls for the Federal Reserve Banks to “furnish an elastic currency”. The Board of Governors has liberally interpreted this statement to support its policy of seasonal accommodation. The corresponding data is then reported using periodic revisions to seasonal factors (hence the mal-adjustments). The technical staff's economic justification for this practice (using last year’s seasonal factors for this year’s release), has its roots in the fallacious “Real Bills Doctrine”.
The problem with the “Real Bills Doctrine” is that an injection of new bank credit for financing inventories, or any other phase of merchandising, or processing, is obviously inflationary when the theory applied under the assumption that labor and facilities are fully employed, as for example, during the Christmas and New Year’s holidays.
And the raw data may be revised, reconstructed, or spliced, causing noticeable changes and distortions. Geographical statistical areas and sample sizes’ may change. The data might not conform to the data from original release. And when some statistical releases are revised, these time series overlay (wipe out), the original data. I.e., the government’s reporting agencies don’t always keep separate iterations of the old historical data. Reporting may also be delayed, published less frequently, or only available as seasonally mal-adjusted.
It is instructive that the FED has never cooperated by supplying continuous, comparable, and timely data. Supporting data is required for the proper investigation, the subsequent proof, and ending conclusion, for any economic research.
That understood: the roc’s in the Y coordinates for monetary flows (MVt), closely parallel the roc’s in GDP figures. I.e., the roc’s in bank debits closely correspond to the roc’s in monetary flows (for both real growth, & for inflation). Likewise, it is no accident that the roc’s in adjusted member bank “free” legal reserves corroborate these roc’s. The roc’s between both time series is synchronous (what is being compared is the rate-of-change, not the absolute figure).
That given: “reliance on the data compiled by the Government agencies is subject to the limitations of all analyses based upon statistical aggregates, i.e., data cannot be compiled accurately, or by a method which conforms to rigid theoretical concepts”(Dr. Leland James Pritchard, Chicago, Economics, 1933; Masters, Statistics, Syracuse).
It is more likely that statistical calculations are at odds with the real world, estranged from scientific economics, inconsistent with mathematical modeling, not because of faulty economic theories, but because of non-conforming, or non-existent, raw data. (“History is full of bad jokes”).
How accurate is the debit series? It is 100% within the range for any quarter. It is approximately 80% within the range of a single month. And I would guess that it is probably c. 50% within the range for any given week (for the period of time in which statistics were reported. Cartesian coordinates: Contrary to economic theory, monetary lags are uniformly fixed in length. The statistical analysis of these crests and troughs confirm that the rates-of-change in these monetary flows (our means-of-payment money times its rate of turnover) are not random.
======================================================================
If the catalogue of facts and their measurements (1) don’t correlate, (2) consistently compare, or (3) conclusively prove; the validity of a one’s arguments (theory), then there is a higher probability that the FED’s data is wrong, rather than the time series, or the theory supporting it.
Forecasting: It's Inviolate & Sacrosanct
(1) Ben S. Bernanke
Chairman and a member of the Board of Governors of the Federal Reserve System. Chairman of the Federal Open Market Committee, the System's principal monetary policymaking body.
At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections.
2) European Central Bank (ECB) Central Bank for the EURO
The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level…
3) Janet L. Yellen, President and CEO of the Federal Reserve Bank of San
Francisco
You will note that I am casting my statements about the stance of policy and the outlook in very conditional terms. I do this because of the great uncertainty that surrounds these issues. Frankly, all approaches to assessing the stance of policy are inherently imprecise. Just as imprecise is our understanding of how long the lags will be between our policy actions and their impacts on the economy and inflation. This uncertainty argues, then, for policy to be responsive to the data as it emerges, especially as we get within range of the especially as we get within range of the desired policy setting.
(4) Thomas M. Hoenig
President of Federal Reserve Bank of Kansas City
Monetary policy must be forward-looking because policy influences inflation with long lags. Generally speaking a change in the Federal funds rate may take an estimated 12-18 months to affect inflation measures….But the course of monetary policy is not entirely certain. & will depend on how the economy evolves in the coming months.
(5) William Poole*
President, Federal Reserve Bank of St. Louis
However inflation is measured, economists agree that monetary policy has at most a minimal influence on the rate of change in the price level over relatively short time periods—months, quarters or perhaps even a year. Central banks are responsible for medium- and long-term inflation—such inflation, as Milton Friedman wrote, is a monetary phenomenon that depends on past, current and expected future monetary policy. As a practical matter, the medium- to long-term likely is a period of two to five years.
(6) Robert W. Fischer – President Dallas Federal Reserve Bank
November 2, 2006:
"In retrospect [because of faulty data] the real funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been. In this case, poor data led to policy action that amplified speculative activity in housing and other markets. The point is that we need to continue to develop and work with better data."
(7) Governor Donald L. Kohn
I think a third lesson is humility--we should always keep in mind how little we know about the economy. Monetary policy operates in an environment of pervasive uncertainty--about the nature of the shocks hitting the economy, about the economy’s structure, and about agents’ reactions. The 1970s provide a sobering lesson in the difficulty of estimating the level and rate of change of potential output; these are quantities we can never observe directly but can only infer from the behavior of other variables.
(8) James Grant (Grant’s Interest Rate Observer)
“Both use quantitative methods to build predictive models, but physics deals with matter; economics confronts human beings. And because matter doesn’t talk back or change its mind in the middle of a controlled experiment or buy high with the hope of selling even higher, economists can never match the predictive success of the scientists who wear lab coats.”
-------------------------------------------------------------------------------------
First, there is no ambiguity in forecasts: In contradistinction to Bernanke (and using his terminology), forecasts are mathematically "precise” :
(1) “Money” is the measure of liquidity; &
(2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, or demand deposit turnover) that matters;
(3) Nominal GDP is measured by monetary flows: (MVt); our means-of-payment money (M), times its rate of turnover (Vt);
(4) The rates-of-change (roc’s) used by economists are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;
Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.
Contrary to economic theory, and Milton Friedman, monetary lags are not “long and variable”. The lags for monetary flows (MVt), i.e. proxies for (1) real-growth, and (2) inflation, are historically, always, fixed in length.
Roc’s in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact; as demonstrated by the clustering on a scatter plot diagram).
Not surprisingly, adjusted member commercial bank “free" legal reserves (their roc’s), corroborate both lags for monetary flows (MVt) –-- their lengths are identical (as the weighted arithmetic average of reserve ratios remains constant).
The lags for (1) monetary flows (MVt), & (2) "free" legal reserves, are synchronous & indistinguishable. Consequently, this makes economic forecasting automatically, mathematically, infallible (for less than one year).
Economic bubbles are astonishingly obvious: including housing, commodity,, dot.com bubbles, etc. This is the “Holy Grail” & it is inviolate & sacrosanct: See 1931 Committee on Bank Reserves Proposal (by the Board’s Division of Research and Statistics), published Feb, 5, 1938, declassified on March 23, 1983.
The BEA uses quarterly accounting periods for real GDP and the deflator. The accounting periods for GDP should correspond to the specific economic lag, not quarterly.
Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP.
Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.
Because of monopoly elements, and other structural defects, which raise costs, and prices, unnecessarily, and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 – 3 percentage points.
I.e., monetary policy is not a cure-all, there are structural elements in our economy that preclude a zero rate of inflation. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.
Some people prefer the “devil theory” of inflation: “It’s all Peak Oil's fault" or it’s all ”Peak Debt's fault". This approach ignores the fact that the evidence of inflation is represented by "actual" prices in the marketplace.
The "administered" prices of the world's monopolies, and or, the world’s oligarchies: would not be the "asked" prices, were they not “validated” by (MVt), i.e., “validated” by the world's Central Banks. Dr. Milton Friedman said it best: “inflation is always and everywhere a monetary phenomenon”.
(like Max Planck's constant in quantum physics).
Chairman and a member of the Board of Governors of the Federal Reserve System. Chairman of the Federal Open Market Committee, the System's principal monetary policymaking body.
At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections.
2) European Central Bank (ECB) Central Bank for the EURO
The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level…
3) Janet L. Yellen, President and CEO of the Federal Reserve Bank of San
Francisco
You will note that I am casting my statements about the stance of policy and the outlook in very conditional terms. I do this because of the great uncertainty that surrounds these issues. Frankly, all approaches to assessing the stance of policy are inherently imprecise. Just as imprecise is our understanding of how long the lags will be between our policy actions and their impacts on the economy and inflation. This uncertainty argues, then, for policy to be responsive to the data as it emerges, especially as we get within range of the especially as we get within range of the desired policy setting.
(4) Thomas M. Hoenig
President of Federal Reserve Bank of Kansas City
Monetary policy must be forward-looking because policy influences inflation with long lags. Generally speaking a change in the Federal funds rate may take an estimated 12-18 months to affect inflation measures….But the course of monetary policy is not entirely certain. & will depend on how the economy evolves in the coming months.
(5) William Poole*
President, Federal Reserve Bank of St. Louis
However inflation is measured, economists agree that monetary policy has at most a minimal influence on the rate of change in the price level over relatively short time periods—months, quarters or perhaps even a year. Central banks are responsible for medium- and long-term inflation—such inflation, as Milton Friedman wrote, is a monetary phenomenon that depends on past, current and expected future monetary policy. As a practical matter, the medium- to long-term likely is a period of two to five years.
(6) Robert W. Fischer – President Dallas Federal Reserve Bank
November 2, 2006:
"In retrospect [because of faulty data] the real funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been. In this case, poor data led to policy action that amplified speculative activity in housing and other markets. The point is that we need to continue to develop and work with better data."
(7) Governor Donald L. Kohn
I think a third lesson is humility--we should always keep in mind how little we know about the economy. Monetary policy operates in an environment of pervasive uncertainty--about the nature of the shocks hitting the economy, about the economy’s structure, and about agents’ reactions. The 1970s provide a sobering lesson in the difficulty of estimating the level and rate of change of potential output; these are quantities we can never observe directly but can only infer from the behavior of other variables.
(8) James Grant (Grant’s Interest Rate Observer)
“Both use quantitative methods to build predictive models, but physics deals with matter; economics confronts human beings. And because matter doesn’t talk back or change its mind in the middle of a controlled experiment or buy high with the hope of selling even higher, economists can never match the predictive success of the scientists who wear lab coats.”
-------------------------------------------------------------------------------------
First, there is no ambiguity in forecasts: In contradistinction to Bernanke (and using his terminology), forecasts are mathematically "precise” :
(1) “Money” is the measure of liquidity; &
(2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, or demand deposit turnover) that matters;
(3) Nominal GDP is measured by monetary flows: (MVt); our means-of-payment money (M), times its rate of turnover (Vt);
(4) The rates-of-change (roc’s) used by economists are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;
Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.
Contrary to economic theory, and Milton Friedman, monetary lags are not “long and variable”. The lags for monetary flows (MVt), i.e. proxies for (1) real-growth, and (2) inflation, are historically, always, fixed in length.
Roc’s in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact; as demonstrated by the clustering on a scatter plot diagram).
Not surprisingly, adjusted member commercial bank “free" legal reserves (their roc’s), corroborate both lags for monetary flows (MVt) –-- their lengths are identical (as the weighted arithmetic average of reserve ratios remains constant).
The lags for (1) monetary flows (MVt), & (2) "free" legal reserves, are synchronous & indistinguishable. Consequently, this makes economic forecasting automatically, mathematically, infallible (for less than one year).
Economic bubbles are astonishingly obvious: including housing, commodity,, dot.com bubbles, etc. This is the “Holy Grail” & it is inviolate & sacrosanct: See 1931 Committee on Bank Reserves Proposal (by the Board’s Division of Research and Statistics), published Feb, 5, 1938, declassified on March 23, 1983.
The BEA uses quarterly accounting periods for real GDP and the deflator. The accounting periods for GDP should correspond to the specific economic lag, not quarterly.
Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP.
Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.
Because of monopoly elements, and other structural defects, which raise costs, and prices, unnecessarily, and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 – 3 percentage points.
I.e., monetary policy is not a cure-all, there are structural elements in our economy that preclude a zero rate of inflation. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.
Some people prefer the “devil theory” of inflation: “It’s all Peak Oil's fault" or it’s all ”Peak Debt's fault". This approach ignores the fact that the evidence of inflation is represented by "actual" prices in the marketplace.
The "administered" prices of the world's monopolies, and or, the world’s oligarchies: would not be the "asked" prices, were they not “validated” by (MVt), i.e., “validated” by the world's Central Banks. Dr. Milton Friedman said it best: “inflation is always and everywhere a monetary phenomenon”.
(like Max Planck's constant in quantum physics).
The "M's"
The net effect (from an accounting standpoint) – snippets/excerpts
“Means-of-Payment” / “Primary-Money-Supply” The money-supply concept has been an area of wide disagreement among economists, and it may well continue as such. It is not something that is fixed and definite. At present it is unknown and unknowable.
There has always existed professional sanction for a variety of bias and ignorance:
Prior to the DIDMC A of March. 31, 1980 both (1) Money transmitters/financial intermediaries & (2) New money & credit creators/member commercial banks, were legally separate financial institutions. In 1980, the DIDMCA legally commingled, and consequently blurred, the inter-relationships between these 2 distinct bank (macro-economic) lending operations, into a single organization, with few, or virtually unrestricted lending regulations (no interest rate ceilings, minimal or no legal reserves; as applied to a declining proportion, & a reduced number, of deposit classifications, as well as increasingly insignificant, reserve ratios, i.e., smaller & smaller fractions were required against new & existing bank deposits).
It was a pyrrhic victory for these bankers, the U.S. economy, and its taxpayers. Coinciding with this new legislation, and this new banking infrastructure, the Fed’s research staff re-named both institutions (combined them), “Depository Institutions”. Thus by edict, the principle financial intermediaries were destroyed, and a money creating System was fostered, which the Fed cannot monitor, and has yet to bring under control.
The framework separating an individual bank’s lending operations can be described and contrasted, using different constructions, of various classifications, of the monetary aggregates, i.e., by the turnover in the ownership of, or the transfer of deposits between, or the transactions velocity of bank debits (money is the measure of liquidity).
Our Depository Institution’s infrastructure is mélange. It’s impossible to uniquely identify the different and shifting types of bank balances. The legislation’s net effect, is that, the new credit and money creators’ deposits/liabilities have been expanding pari passu (in lock step), with the former commercial banking Systems’, expansion of loans-deposits. And during this evolutionary and expansionary process, the preponderance of all Depository Institution’s deposit liabilities are, being diverted, or shifted, by their owners/savers, into highly liquid, interest bearing deposits (or lower rates of return).
==============================================================================
1) As there is general agreement among almost all Central Bank economists throughout the world, that legal or statutory reserves are no longer binding/constrained, the money supply will be enlarged, and bank deposits will be transformed, or converted, until our means-of-payment, or primary money supply (currency-deposit structure), approximates the old monetary aggregate M3 - (Feb 2006).
In the beginning there was one M (the “primary” money supply), then three, then five; (M4 & M5), then “L”, “Debt”, & later, NOW, ATS, OCD, MZM, MMDA etc. It would be a burden to enumerate the components of these various concepts of money, the ones in vogue, or otherwise.
1) Since Mutual Savings Bank’s (MS B) inception, it has been illogical that their account balances in the Member Commercial Banks (MCB)were designated as inter-bank demand deposits (IBDD’s –balances maintained by customer banks in correspondent banks), presumably because MSBs were called banks (with the exception of 6 MSB banks that had MCB regulations) and were insured by the Federal Deposit Insurance Corporation (FDIC) and not the Federal Savings & Loan Insurance Corporation (FSLIC), and not counted in M1. At the same time S&L’s deposits were insured by the FSLIC and their balances in the MCBs were not designated as IBDDs (were counted in M1); neither institution had the right to hold deposits transferable on demand, without notice, and without income penalty (the legal basis for becoming a MCB), prior to the Depository Institutions Deregulation & Monetary Control Act (DIDMCA); both were the customers of the MCBs; and neither had Regulation Q restrictions prior to 1965.
2) Thus the M1 figure, even now, increasingly overstates the quantity of the means-of-payment money. This upward bias is the consequence of classifying Savings and Loan and Credit Union Deposits as commercial banks (but not Mutual Savings Bank deposits) as demand deposits, rather than inter-bank demand deposits. M1 thus includes both the Negotiable Order of Withdrawal (NOW) account balances and the thrifts’ balances in the commercial banks – a double counting of our means-of-payment money.
3) What goes for M2 also goes for M3. M2 erroneously includes MMFs in its definition (a sizable #). MMFs are the customer's of the commercial banks. They are financial intermediaries/transmitters. Monetary savings are never transferred from the commercial banks to the intermediaries; rather are monetary savings always transferred through the intermediaries. Whether the public saves or dis-saves, chooses to hold their savings in the commercial banks or to transfer them to intermediary institutions will not, per se, alter the total assets or liabilities of the commercial banks; nor alter the forms of these assets or liabilities.
4) Financial intermediaries (MMFs) lend existing money which has been saved, and all of these savings originate OUTSIDE of the intermediaries (depend on an inflow of savings to finance loans). The utilization of these loan-funds, or the activation of monetary savings held by these financial intermediaries, is captured thru the velocity of their transactions (bank debits/withdrawals), and not thru the volume of their bank deposits. I.e., from the standpoint of the economy, MMF deposits never leave the MCB System. And the growth of the MMFs is prima facie evidence that existing funds/savings have already been saved/invested/spent, i.e., transferred/transmitted by their owners/savers/creditors to borrowers/debtors. I.e., this currently (but not for ever) represents a double counting, and will continue to be so, as long as these intermediary financial institutions don’t operate through transaction accounts.
5) From the standpoint of the individual banker his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, and probably its legal reserves – and thereby it’s lending capacity. But all such inflows involve a decrease in the lending capacity of other banks, unless the inflow results from a return flow of currency to the banking System or is a consequence of an expansion of Reserve Bank credit. That is, the commercial banks “buy their liquidity” by out-bidding other commercial banks for the same fixed volume of deposits. This volume is determined exclusively by the FOMC through it’s control of “free-gratis” bank legal reserves and reserve ratios.
6) From a Systems viewpoint, member commercial banks as contrasted to financial intermediaries, never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits, or time deposits, or the owner’s equity or any liability item. When MCBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, State, and other Governmental Jurisdictions), and every person, (except the commercial and the reserve banks), they acquire title to earning assets, by initially, the creation of an equal volume, of new money-transaction deposits.
7) Any institution whose payments (liabilities) can be transferred/transmitted on demand, without notice, without income penalty, or without equivocation, by data network clearing (under the NACHA rules, Regulation E, Check Clearing for the 21st Century Act, & the Expedited Funds Availability Act – reduce hold periods), for example:
a. debit-card,
b. credit-card,
c. ACH network…automated clearing house,
d. EFTs…electronic funds transfer,
e. Fedwire transfer System,
f. check21 clearing,
g. micro-line payments,
h. RTG real-time gross settlements
i. CHIPs
j. Payments System Risk
8) or similar methods & types of negotiable credit instruments/drafts/debits, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow or balance of payments (Rivlin Committee payment study to assess Fed’s role ).
9) Bank Credit (loans-deposits) increased by a factor of 2.7x from 04/01/89 to 11/01/07. Since commercial banks create new money (demand deposits) why didn’t demand deposits increase by over 764b rather than 15b in this period? The answer is largely because of the massive diversion of approximately 217b of demand deposits into time deposits (less the expansion in bank net worth & the sale to the public of various types of non net-worth securities). Demand deposits were also reduced by an expansion of 547b in the nonblank public’s holding of currency.
10) It is inaccurate (for the cataloguer of economic statistics) to exclude the Treasury’s General Fund Account from the assets included in M1 (with the exception of WWII). No one has established any unique price effect of federal outlays, as compared to state and local government outlays, or expenditures by the private sector. Of course, the shifting of funds to and out of the Federal Reserve banks has a dollar for dollar effect on member bank reserves, but that is another problem that can be, and is dealt with through open market operations.
11) It is a succulent irony that professional economists, (those who confuse the supply of money with the supply of loan-funds), thus conclude that increases in the old monetary figure “L”, (or M2, or M3), are inflationary. The conclusion is tantamount to saying, “don’t save money” as savings (which we don’t have enough of) adds to “L” and therefore has an inflationary bias, when in fact, savings (a large portion of “L”) is evidence of money that has already been saved/spent/invested. Savings-investment accounts have been lumped into the Keynesian inspired concept of money (as are MMF funds).
(Note: “L” measures M3 plus all other liquid assets such as Treasury bills, savings bonds, commercial paper, bankers’ acceptances and Eurodollar holdings of US residents (non-bank).
12) Other mistakes involve the intermittent errors in the reporting by the banks sampled, e.g., (1) as-of adjustments up to 45 days, (2) 4% carry-over provision on reserves, (3) applied, or excess clearing balances, or excess reserves & (4) deposit liabilities (FR 2900 reporting errors).
13) If the “store of purchasing power” attribute of money, when applied to a given asset, is to have significant meaning, it ought to be defined in terms which are applicable to the whole economy. That is, no asset really has a “monetary store of purchasing power” quality unless there can be a net conversion of that asset into money, ceteris peribus. In other words it must be possible to effect this conversion without necessitating that any present money holder reduce/liquidate his holdings/assets. Any other interpretation becomes mired in a futile discussion of relative degrees of confidence and liquidity. But much more than monetary liquidity for the individual holder is necessary if an asset can be said to have the “store of purchasing power” quality; it must be simultaneously monetarily liquid for society as a whole.
14) From the standpoint of monetary authorities, charged with the responsibility of regulating the money supply, none of the current definitions of money make sense. The definitions include numerous items over which the Fed has little or no control (e.g., M2), including many the Fed need not and should not control (currency). The definitions also assume there are numerous degrees of “moneyness”, thus confusing liquidity with money (money is the “yardstick” by which the liquidity of all other assets is measured). The definitions also ignore the fact that some liquid assets (time deposits) have a direct one-to-one, almost unvarying , relationship to the volume of demand deposits (DDs), while others affect only the velocity of DDs. The former requires direct regulation; the latter simply is important data for the Fed to use in regulating the money supply.
15) The essence of a managed-currency System, a System in which the volume of currency in circulation is impersonally determined by the total effective demands of the public. This procedure is in fundamental opposition to a fiat System in which the volume of currency issued is dictated by the deficit-financing requirements of the issuing government.
16) The self-regulatory aspect of our currency supply derives from the fact that in obtaining currency, the public has to give up an equal amount of another type of money, namely, bank deposits. An increase in the volume of currency held by the non-bank public indicates, ceteris paribus, that the public is decreasing deposits, while a decrease in currency held by the public will build up deposits. Thus, whether the public increases or decreases its holdings of currency, the total money supply, per se, remains the same. Obviously in such an arrangement it is impossible to attribute inflationary developments to an expansion of currency (cash drain factor) or (monetary base/high powered money). Actually the issuance of Federal Reserve Notes is deflationary, ceteris paribus, since the issuance diminishes the clearing balances and legal reserves of the member commercial banks. The Fed recognizes this fact and uses its open market power to replenish bank reserves and prevent any unwarranted contraction of bank credit. I.e., a dollar of currency “supports” only one dollar in the money supply, whereas a dollar reduction in bank reserves may force a multiple contraction of deposits.
17) Money should be defined exclusively in terms of its means-of-payment attributes. The present array of interest-bearing checking accounts has confused the distinction between means-of-payment accounts (the primary money supply) and saving-investment accounts and created a dilemma as to what portion, if any, of these interest-bearing accounts should be considered as savings. This dilemma is resolved when the transactions velocity of demand deposits is taken into account; i.e., deposit classifications are analyzed in terms of monetary flows (MVt). Obviously, no money supply figure standing alone is adequate as a “guide post” to monetary policy.
18) In defining the money supply, a distinction should be made between the public and the monetary authorities. From the public viewpoint currency and checkable deposits, credit cards, traveler’s checks, ATS accounts, MMDA accounts etc., serve directly or indirectly as money. From the monetary authority’s point of view, money has to be confined to assets that constitute means-of-payment and are controllable. Currency is not such an asset. Fortunately it is an asset the Fed does not, should not, and cannot control. There is no inflationary bias in an expansion of currency, and the deflationary bias resulting from its growth (the decrease in an equal amount of legal reserves in the System), can, and is, offset through the expansion of Reserve Bank credit.
19) The demand deposit component of our means-of-payment money supply (M1, currency plus checking accounts) is created by private profit financial institutions. The creation process is an inevitable consequence of their lending operations. All currency gets into circulation, directly or indirectly, through the liquidation of time deposits, by the cashing of demand deposits. There is one exception in demand deposit creation: those rare instances when the U.S. Treasury borrows from the Federal Reserve Banks.
20) The bankers, Congress, and most of the banking authorities have simply not been able to dissect and to construct our financial institutions in a System’s context. From a System standpoint the financial intermediaries and the commercial banks are not competitive, but have an inter-relationship that can be mutually beneficial to the economy. The much larger question with which we should be concerned, therefore, is the raison d'etre of an institutional arrangement whose benefits to the banks are dubious and which undoubtedly exerts deleterious effects on the financial intermediaries and the economy. Time-deposit banking arrests the flow of monetary savings into investment because in their time-deposit function the commercial banks are neither intermediaries nor creators of loan funds; they are simply custodians of stagnant money. Monetary savings held in the form of time deposits are not irrevocably lost to investment until destroyed. But they cannot be used to finance investment until their owners (non-bank public) decides, and as long as the non-bank public chooses to hold savings in the form of time deposits, the means-of-payment velocity of these funds is zero and the funds are lost to investment. The expansion of member commercial bank held (impounded/bottled up) monetary savings deposits is prima facie evidence of a leakage which collects in the form of unspent balances.
21) All the devices which have in effect made time deposits an integral part of demand deposits, viz, daily compounding of interest, automatic fund transfers, debit cards, etc., have enabled people to economize on demand deposits, and has resulted in the sharp increase in the transactions velocity since 1967. In other words, under existing institutional arrangements, an increase in time deposits results in an offsetting increase in transactions velocity, therefore no, or limited dampening results. If there is to be a growth in time deposits there should be an offsetting increase in velocity. Our problem has been an excessive increase in both the volume and velocity of money.
22) Time deposits standing alone are not inflationary. In fact, they are the equivalent of demand deposits with a transactions velocity of zero. But they are inflationary when they become in effect interest-bearing demand deposits. Neither the bankers nor the Fed seemed to realize the economics of making time deposits so liquid, that they were, for all practical purposes, a net addition to the effective money supply.
23) It is obvious that demand deposits, which have been saved, cannot be beneficial to the economy unless they are invested. As long as savings are held in the commercial banks in the form of demand or time deposits, these deposits are not financing investment, or indeed anything; their transactions velocity is zero. If, on the other had, these deposits are transferred through the thrifts, or any other financial intermediary, they are invested or otherwise put to work. Such use of deposits does not change the volume of deposits in the commercial banks, merely their ownership. In other words the commercial banks could continue to lend if the public ceased to save altogether. The lending capacity of the commercial banks is dependent on monetary policy, not the savings practices of the public.
24) The unique and inflation-causing changes in monetary policy and the structure of the banking System were the consequence of a universal misconception of the economics of time deposits banking, and the basic differences between commercial banks and the financial intermediaries. The cumulative effect has been to transform virtually all time deposits into the economic equivalent of demand deposits, since the holders of these accounts can on demand, or in the marketplace, convert these holdings without significant delay into demand deposits.
25) The utilization of commercial bank credit to finance real investment or government deficits does not constitute a utilization of savings, since bank financing is accomplished through the creation of new money. Contrariwise, the activation of deposits within the financial intermediaries increases employment, the demand for varieties of goods and services – and the opportunities of the commercial bankers to make bankable loans. The “loan pie” is not a fixed entity; it grows when the economy grows.
26) Trillions of deposits have been diverted/shifted into time deposits; not because they were saved, but because of the structural changes in the banking System that made most of these time deposits a type of auxiliary money (banks began to manage their liabilities, and corporations began managing (minimizing) their non-interest bearing cash balances). Bank customers were induced to shift out of non-interest bearing demand deposits into time deposits by the introduction of various financial innovations.
27) The DICMCA encouraged a massive shift from transaction deposits, to time deposits, within the newly created depository institutions to the extent that the new money supply’s properties and characteristics, have become obscured or unclear. That is, there has become no logical dividing line.
28) It is impossible for time deposits to grow or shrink without causing, ceteris paribus, an equal and opposite change in our means-or-payment money.
29) From a System standpoint, time deposits that represent savings have a velocity of zero. As long as savings are held (impounded) in the commercial banking System, they are lost to investment. The means-of-payment velocity of time/savings deposits is zero and the funds are lost to investment, to consumption, and indeed to any type of payment. Such a cessation of the circuit income and transactions velocity of funds, funds which constitute a prior cost of production, cannot but have deleterious effects in our highly interdependent pecuniary economy (since 1964, stagflation, as evidenced by bank debits, was the inevitable result). The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.
30) The shifting about in the ownership of deposits will undoubtedly alter the lending ability of particular banks, but the lending ability of the System will not be altered unless deposits are shifted among banks having deferential reserve requirements, or a change in monetary policy by the Reserve authorities.
31) Time deposits, unlike savings accounts in the “thrifts”, bear a one-to-one, almost unvarying’ relationship to demand deposits. An increase in time deposits depletes demand deposits by the same amount, or (1) directly or indirectly via the currency route, or thru (2) the banks undivided profits, and vice versa. I.e., all time deposits are derived from demand deposits. This massive diversion of demand deposits into time deposits was wholeheartedly supported by the bankers, sanctioned by the monetary authorities, and “sanctified” by the Keynesian theories held by virtually all economists. Keynes’ General Theory of Employment, Interest and Money (1936) was their bible. On page 81 of Macmillians’s 1949 edition, Keynes informs us that it is an “optical illusion” to suppose “…that a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking System so that they are lost to investment…”.
32) The principle inflationary pressure on prices in the U.S. occurred from the colossal growth in commercial bank “liquid” time deposits together with bank practices with respect to the acquisition and management of time deposits.
33) The process of “monetizing” time deposits began in the early sixties. Citicorp was the first bank to use the negotiable certificate of deposit in 1961. Soon afterward, Citicorp pulled in deposits (Euro-deposits) from all over the world. But when interest rates finally rose above Reg Q ceilings in 1965, certain large New York City Banks couldn’t replace these borrowings, so the Fed stepped in and raised Reg Q. ceilings to bail out those banks ( & this was the first instance in which ceilings were raised above the levels assigned to thrift institutions. This in conjuction with an excessive expansion of the money supply, created the 1966 housing crisis.
34) Soon, all the major banks were in the act. To this incentive to expand time deposits, the Fed added higher and higher interest rates ceilings on time deposits under their Regulation Q. Today, all interest rate ceilings have been eliminated. Further incentives to time deposit growth were the introduction of ATS accounts, the reduction of reserve ratios against most time deposits, and their removal altogether for some types of time deposits.
35) The drive by the commercial bankers to expand their savings accounts has a totally irrational motivation, since it has meant, from a System standpoint, competing for the opportunity to pay higher & higher interest rates on deposits that already exist in the commercial banking System. This is because the source of time deposits is demand deposits, not the savings held in S&Ls, mutual savings banks or credit unions. But it does profit a particular bank, Citicorp for example, to pioneer the introduction of a new financial instrument such as the negotiable CD until their competitors catch up; and then all are losers. The question is not whether net earnings on CD assets are greater than the cost of the CDs to the bank; the question is the effect on the total profitability of the banking System. This is not a zero sum game. One bank’s gain is less than the losses sustained by other banks.
36) Professional economists have no such excuse for misinterpreting the savings-investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking System, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy. From a System standpoint, time deposits that represent savings have a velocity of zero. As long as savings are held in the commercial banking System, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.
37) In an accounting sense, the Fed has an unlimited capacity to lend. It operates under no reserve or reserve ratio constraints. Nor does it need to be concerned with a new outflow of funds as a consequence of its lending activities. Advances to borrowers simply involve crediting the borrower’s inter-bank deposit account. These accounts are, however, “high-powered money” to use Milton Friedman’s term [sic]. They provide the basis for a multiple expansion of money. Can’t the Fed offset these advances with open market sales? Not on a very large scale without destroying the Treasury’s capacity to manage the national debt. Thus far, the Fed has been able to maintain the liquidity credibility of the banks and thrifts. How long can this necessary degree of confidence be maintained? There is no answer, but it is certain that the crucial test is yet to come.
38) Having the illusions that commercial banks are intermediaries, loaning out the savings of the public, the Fed attempted to “peg” at even higher levels the federal funds rate; allowed time deposits to balloon with no legal restrictions on their growth; and initiated, or allowed, institutional changes which converted an indeterminate, but large, share of time deposits into “primary money”.
39) The Fed and Congress allowed institutional changes which enabled demand deposit holders to shift into interest bearing time deposits with little or no decrease in the liquidity of their assets. These changes took the form of negotiable C.D.’s, ETF (Electronic Transfer of Funds); automatic transfer serves (ATS accounts), NOW (negotiable orders of withdrawal), and MMDA (money market deposit accounts). Since time deposit growth is directly (or indirectly through the currency route) at the expense of demand deposits, the Fed received false signals as to the real means-of-payment money supply.
40) Institutional changes have converted an indeterminate, but large, share of time deposits into primary money. I.e., institutional changes enabled demand deposits holders to shift into interest bearing time deposits with little or no decrease in the liquidity of their assets. With the elimination of Reg Q interest rate ceilings on the time deposits of the member commercial banks and with the elimination of reserve requirements on time deposits, there was both an increased incentive to hold time deposits, and no legal restrictions on their growth. These structural alterations and the practices thereby engendered, (to concentrate and channel loan-funds into narrow segments within our economy) has led to a mélange of excessively destabilizing price changes, especially of those assets, real estate, etc., which serve as loan collateral. The whole brew of ill-advised deregulation and regulatory permissiveness fostered an atmosphere in which greed seemed to triumph, especially if a little fraud was diluted with a heavy does of incompetent supervision by the authorities and their examiners.
41) From the standpoint of the individual banker there is some excuse for opting for negotiable CDs, MMDAs and ATS accounts; and for agitating for the removal of Regulation Q ceilings on interest rates. If other banks are competing for time deposits, the individual banker has to complete or lose deposits and earning assets. Transforming time deposits into an auxiliary money supply, besides having server adverse effects on the economy, has had a devastating effect on bank profits. Interest on time deposits, from the standpoint of the banking System, amounts to paying for something (deposits) the System already possesses. Lacking the interest incentive, holders of “saved” demand deposits would acquire investments outside the banking System. This, contrary to the conventional wisdom, would not result in the diminution of the demand deposits, or earning assets of the banking System. The confusion arises from a unique feature of the commercial banking System; the whole is not the sum of the parts in the money creating process
42) The individual commercial banker performs an intermediary role between savers and borrowers. By attracting an inflow of funds (time or demand deposits or currency), he enlarges his legal reserves and clearing balances plus his legal and economic capacity to expand loans and investments. From the standpoint of the banker, he has simply loaned out the funds acquired; from the System standpoint the added earning assets have been acquired through the creation of new money. To the individual commercial banker, thrifts were obviously competitors. Funds transferred from his bank to a financial intermediary usually resulted in a loss of deposits, and often the opportunity to make a bankable loan.
43) Disintermediation in the “thrifts” may be induced by the rates paid by the commercial banks. However induced, disintermediation results in a diminution of funds in the thrifts, and a transfer of existing deposits within the commercial banking System.
44) Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking System (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries. Shifts from TDs to DDs within the CBs and the transfer of the ownership of these DDs to the thrifts, involves a shift in the form of bank liabilities (from TD to DD) and a shift in the ownership of DDs (from savers to thrifts, et al). The utilization of these DDs by the thrifts has no effect on the volume of DDs held by the CBs or the volume of their earnings assets.
45) Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries; for the funds never leave the commercial banking System.This applies to all investments made directly, or indirectly, through intermediaries. The only way to reduce the volume of demand deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or the purchase from their banks of any type of commercial bank security obligation, e.g., bank stocks, debentures, etc.
46) Sweep accounts are a shift in the form of a commercial bank customer’s money balances. The volume of depository liabilities does not change, only their composition (deposit classification). The balances are swept from deposit liabilities having higher reserve ratios on a specific volume and type of deposit liability (10% on transaction deposits), to nonexistent ones (0% on MMDA accounts). These balances are exchanged and converted by the member banks, and consequently, overnight, these balances circumvent reserve requirements (reserve avoidance), and thereby making the job of monetary management, less effective (because as of 2002 70% + of the banks have become zero-bound).
47) Expanding the money supply essentially requires nothing more than “writing numerically larger figures in the books”.
48) . Monetary policy objectives should not be in terms of any particular rate or range of growth of any “M”, rather policy should be formulated in terms of desired rates of change in monetary flows (MVt) relative to rates of change in real GDP. Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the rate of monetary flows to exceed the rate of change in real GDP by c. 2-3 percentage points.
49) In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels (there is evidence to prove rates of change in Nominal GDP can serve as a proxy figure for rates of change in all transactions. Rates of change in real GDP have to be used, of course, as a policy standard).
50) And lastly the multiplier they use. Multiply total member bank reserves by a multiplier (M1 divided by adjusted total “free gratis” member bank legal reserves). The bi-weekly figure on adjusted reserves is accurate since it involves only adding up member bank balances with the Federal Reserve banks and estimating the member bank’s vault cash. Of course, the multiplier used has to be extrapolated from past data. Alterations in the trend line should reflect changes in reserve ratios (incorporated in (RAM)) and structural changes that would alter the trend ratio of time to transaction deposits.
51) It is impossible for time deposits to grow or shrink without causing, ceteris paribus, an equal and opposite change in our means-of-payment money.
52) The functions of money are: a medium-of-exchange: The exchange of money is brokered into 2 transactions, goods are exchanged for money, and money in turn is exchange for goods. Each transactor indulges in two distinct operations, a sale & a purchase. Goods and serves are being sold for money, and money is used to purchase goods and services. In other words money has a “generalized purchasing power.”
53) Money as a store-of-value: The holder of money that is generally acceptable over time and fixed in price is provided with a store of value providing future purchasing power.
54) A unit-of-account: a “yardstick of value” by which people price commodities and serves exchanged and calculate wealth, income, and debts.
55) Money as a standard-of-value: standard money into which all other types are convertible and, being freely convertible, are thereby kept at a par with the standard money.
56) Money as a guarantor-of-liquidity-and-solvency: substantial quantities of money are held to give assurance that accruing obligations and unforeseen contingencies can be met as they materialize.
57) By raising reserve ratios to 100% the commercial banks would become financial intermediaries no longer able to create money, serving only as conduits between savers and borrowers. The funds for setting up savings accounts would then originate OUTSIDE the banks, just as the funds for setting up share accounts originate OUTSIDE the savings and loan associations. Even if the reserve ratios (minimum ratios of legal reserves to bank deposits) were raised to 100%, the debt would be monetized to the extent to which the Federal Reserve Banks increased their holdings of governments. That is to say, the public’s holdings of money increases pari passu (in lock step) with the expansion of Reserve Bank credit.
58) Gresham’s law is a statement of the “principle of substitution” applied to money or other words, that a commodity (or serve) will be devoted to those uses which are most profitable. It is another one of the paradoxes of money that, unlike articles in the market, the bad drives out the good. E.g., during the Civil War the less valuable paper money drove all types of coins out of circulation. The more valuable money is held, if possible, as a “store of value” and the less valuable is used as a medium of exchange. The demand for money as a store of value thus forces the more valuable types of money out of circulation. E.g., the “vilest die and basest metal” replaced those of “perfect die and metal” in circulation. Noted by Aristophanes (448-380 B.C).
59) Alfred Marshall, the Cambridge economists, is responsible for developing the cash-balances approach to money. For example, if individuals collectively desire expanding their cash balances (increasing the period over whose transactions purchasing power in the form of money is held), they will initiate a chain of events which will lead to a net reduction in their aggregate holdings of cash. That is, an over-all increase in the demand for money leads to falling prices, a decline in profit expectations, reduced borrowing from the banks -- and therefore a smaller volume of cash balances. Money thus is truly a paradox - by wanting more, the public ends up with less, and by wanting less, it ends up with more. All motives which induce the holding of a larger volume of money will tend to increase the demand for money - and reduce its velocity. Therefore, if there is a flight from the dollar, there will be hyperinflation in terms of dollar denominated assets.
60) Definitions of the money supply are not timeless. The extension of the scope and practices of the Federal Housing's Administration's Authority accompanied by Federal Government guarantees - assures a secondary market for housing - the "store of purchasing power" attribute of money. I.e, there are various types of "tertiary money". These assets possess general liquidity. They do not bear a direct, unit for unit, unvarying relationship, to the primary money supply. And to pass legislation that will establish a new classification of tertiary money is to make these Government guarantees inflationary. Underwritten with the credit of the U.S. Government. Federal insurance, underwriting and guaranteeing,
“Means-of-Payment” / “Primary-Money-Supply” The money-supply concept has been an area of wide disagreement among economists, and it may well continue as such. It is not something that is fixed and definite. At present it is unknown and unknowable.
There has always existed professional sanction for a variety of bias and ignorance:
Prior to the DIDMC A of March. 31, 1980 both (1) Money transmitters/financial intermediaries & (2) New money & credit creators/member commercial banks, were legally separate financial institutions. In 1980, the DIDMCA legally commingled, and consequently blurred, the inter-relationships between these 2 distinct bank (macro-economic) lending operations, into a single organization, with few, or virtually unrestricted lending regulations (no interest rate ceilings, minimal or no legal reserves; as applied to a declining proportion, & a reduced number, of deposit classifications, as well as increasingly insignificant, reserve ratios, i.e., smaller & smaller fractions were required against new & existing bank deposits).
It was a pyrrhic victory for these bankers, the U.S. economy, and its taxpayers. Coinciding with this new legislation, and this new banking infrastructure, the Fed’s research staff re-named both institutions (combined them), “Depository Institutions”. Thus by edict, the principle financial intermediaries were destroyed, and a money creating System was fostered, which the Fed cannot monitor, and has yet to bring under control.
The framework separating an individual bank’s lending operations can be described and contrasted, using different constructions, of various classifications, of the monetary aggregates, i.e., by the turnover in the ownership of, or the transfer of deposits between, or the transactions velocity of bank debits (money is the measure of liquidity).
Our Depository Institution’s infrastructure is mélange. It’s impossible to uniquely identify the different and shifting types of bank balances. The legislation’s net effect, is that, the new credit and money creators’ deposits/liabilities have been expanding pari passu (in lock step), with the former commercial banking Systems’, expansion of loans-deposits. And during this evolutionary and expansionary process, the preponderance of all Depository Institution’s deposit liabilities are, being diverted, or shifted, by their owners/savers, into highly liquid, interest bearing deposits (or lower rates of return).
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1) As there is general agreement among almost all Central Bank economists throughout the world, that legal or statutory reserves are no longer binding/constrained, the money supply will be enlarged, and bank deposits will be transformed, or converted, until our means-of-payment, or primary money supply (currency-deposit structure), approximates the old monetary aggregate M3 - (Feb 2006).
In the beginning there was one M (the “primary” money supply), then three, then five; (M4 & M5), then “L”, “Debt”, & later, NOW, ATS, OCD, MZM, MMDA etc. It would be a burden to enumerate the components of these various concepts of money, the ones in vogue, or otherwise.
1) Since Mutual Savings Bank’s (MS B) inception, it has been illogical that their account balances in the Member Commercial Banks (MCB)were designated as inter-bank demand deposits (IBDD’s –balances maintained by customer banks in correspondent banks), presumably because MSBs were called banks (with the exception of 6 MSB banks that had MCB regulations) and were insured by the Federal Deposit Insurance Corporation (FDIC) and not the Federal Savings & Loan Insurance Corporation (FSLIC), and not counted in M1. At the same time S&L’s deposits were insured by the FSLIC and their balances in the MCBs were not designated as IBDDs (were counted in M1); neither institution had the right to hold deposits transferable on demand, without notice, and without income penalty (the legal basis for becoming a MCB), prior to the Depository Institutions Deregulation & Monetary Control Act (DIDMCA); both were the customers of the MCBs; and neither had Regulation Q restrictions prior to 1965.
2) Thus the M1 figure, even now, increasingly overstates the quantity of the means-of-payment money. This upward bias is the consequence of classifying Savings and Loan and Credit Union Deposits as commercial banks (but not Mutual Savings Bank deposits) as demand deposits, rather than inter-bank demand deposits. M1 thus includes both the Negotiable Order of Withdrawal (NOW) account balances and the thrifts’ balances in the commercial banks – a double counting of our means-of-payment money.
3) What goes for M2 also goes for M3. M2 erroneously includes MMFs in its definition (a sizable #). MMFs are the customer's of the commercial banks. They are financial intermediaries/transmitters. Monetary savings are never transferred from the commercial banks to the intermediaries; rather are monetary savings always transferred through the intermediaries. Whether the public saves or dis-saves, chooses to hold their savings in the commercial banks or to transfer them to intermediary institutions will not, per se, alter the total assets or liabilities of the commercial banks; nor alter the forms of these assets or liabilities.
4) Financial intermediaries (MMFs) lend existing money which has been saved, and all of these savings originate OUTSIDE of the intermediaries (depend on an inflow of savings to finance loans). The utilization of these loan-funds, or the activation of monetary savings held by these financial intermediaries, is captured thru the velocity of their transactions (bank debits/withdrawals), and not thru the volume of their bank deposits. I.e., from the standpoint of the economy, MMF deposits never leave the MCB System. And the growth of the MMFs is prima facie evidence that existing funds/savings have already been saved/invested/spent, i.e., transferred/transmitted by their owners/savers/creditors to borrowers/debtors. I.e., this currently (but not for ever) represents a double counting, and will continue to be so, as long as these intermediary financial institutions don’t operate through transaction accounts.
5) From the standpoint of the individual banker his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, and probably its legal reserves – and thereby it’s lending capacity. But all such inflows involve a decrease in the lending capacity of other banks, unless the inflow results from a return flow of currency to the banking System or is a consequence of an expansion of Reserve Bank credit. That is, the commercial banks “buy their liquidity” by out-bidding other commercial banks for the same fixed volume of deposits. This volume is determined exclusively by the FOMC through it’s control of “free-gratis” bank legal reserves and reserve ratios.
6) From a Systems viewpoint, member commercial banks as contrasted to financial intermediaries, never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits, or time deposits, or the owner’s equity or any liability item. When MCBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, State, and other Governmental Jurisdictions), and every person, (except the commercial and the reserve banks), they acquire title to earning assets, by initially, the creation of an equal volume, of new money-transaction deposits.
7) Any institution whose payments (liabilities) can be transferred/transmitted on demand, without notice, without income penalty, or without equivocation, by data network clearing (under the NACHA rules, Regulation E, Check Clearing for the 21st Century Act, & the Expedited Funds Availability Act – reduce hold periods), for example:
a. debit-card,
b. credit-card,
c. ACH network…automated clearing house,
d. EFTs…electronic funds transfer,
e. Fedwire transfer System,
f. check21 clearing,
g. micro-line payments,
h. RTG real-time gross settlements
i. CHIPs
j. Payments System Risk
8) or similar methods & types of negotiable credit instruments/drafts/debits, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow or balance of payments (Rivlin Committee payment study to assess Fed’s role ).
9) Bank Credit (loans-deposits) increased by a factor of 2.7x from 04/01/89 to 11/01/07. Since commercial banks create new money (demand deposits) why didn’t demand deposits increase by over 764b rather than 15b in this period? The answer is largely because of the massive diversion of approximately 217b of demand deposits into time deposits (less the expansion in bank net worth & the sale to the public of various types of non net-worth securities). Demand deposits were also reduced by an expansion of 547b in the nonblank public’s holding of currency.
10) It is inaccurate (for the cataloguer of economic statistics) to exclude the Treasury’s General Fund Account from the assets included in M1 (with the exception of WWII). No one has established any unique price effect of federal outlays, as compared to state and local government outlays, or expenditures by the private sector. Of course, the shifting of funds to and out of the Federal Reserve banks has a dollar for dollar effect on member bank reserves, but that is another problem that can be, and is dealt with through open market operations.
11) It is a succulent irony that professional economists, (those who confuse the supply of money with the supply of loan-funds), thus conclude that increases in the old monetary figure “L”, (or M2, or M3), are inflationary. The conclusion is tantamount to saying, “don’t save money” as savings (which we don’t have enough of) adds to “L” and therefore has an inflationary bias, when in fact, savings (a large portion of “L”) is evidence of money that has already been saved/spent/invested. Savings-investment accounts have been lumped into the Keynesian inspired concept of money (as are MMF funds).
(Note: “L” measures M3 plus all other liquid assets such as Treasury bills, savings bonds, commercial paper, bankers’ acceptances and Eurodollar holdings of US residents (non-bank).
12) Other mistakes involve the intermittent errors in the reporting by the banks sampled, e.g., (1) as-of adjustments up to 45 days, (2) 4% carry-over provision on reserves, (3) applied, or excess clearing balances, or excess reserves & (4) deposit liabilities (FR 2900 reporting errors).
13) If the “store of purchasing power” attribute of money, when applied to a given asset, is to have significant meaning, it ought to be defined in terms which are applicable to the whole economy. That is, no asset really has a “monetary store of purchasing power” quality unless there can be a net conversion of that asset into money, ceteris peribus. In other words it must be possible to effect this conversion without necessitating that any present money holder reduce/liquidate his holdings/assets. Any other interpretation becomes mired in a futile discussion of relative degrees of confidence and liquidity. But much more than monetary liquidity for the individual holder is necessary if an asset can be said to have the “store of purchasing power” quality; it must be simultaneously monetarily liquid for society as a whole.
14) From the standpoint of monetary authorities, charged with the responsibility of regulating the money supply, none of the current definitions of money make sense. The definitions include numerous items over which the Fed has little or no control (e.g., M2), including many the Fed need not and should not control (currency). The definitions also assume there are numerous degrees of “moneyness”, thus confusing liquidity with money (money is the “yardstick” by which the liquidity of all other assets is measured). The definitions also ignore the fact that some liquid assets (time deposits) have a direct one-to-one, almost unvarying , relationship to the volume of demand deposits (DDs), while others affect only the velocity of DDs. The former requires direct regulation; the latter simply is important data for the Fed to use in regulating the money supply.
15) The essence of a managed-currency System, a System in which the volume of currency in circulation is impersonally determined by the total effective demands of the public. This procedure is in fundamental opposition to a fiat System in which the volume of currency issued is dictated by the deficit-financing requirements of the issuing government.
16) The self-regulatory aspect of our currency supply derives from the fact that in obtaining currency, the public has to give up an equal amount of another type of money, namely, bank deposits. An increase in the volume of currency held by the non-bank public indicates, ceteris paribus, that the public is decreasing deposits, while a decrease in currency held by the public will build up deposits. Thus, whether the public increases or decreases its holdings of currency, the total money supply, per se, remains the same. Obviously in such an arrangement it is impossible to attribute inflationary developments to an expansion of currency (cash drain factor) or (monetary base/high powered money). Actually the issuance of Federal Reserve Notes is deflationary, ceteris paribus, since the issuance diminishes the clearing balances and legal reserves of the member commercial banks. The Fed recognizes this fact and uses its open market power to replenish bank reserves and prevent any unwarranted contraction of bank credit. I.e., a dollar of currency “supports” only one dollar in the money supply, whereas a dollar reduction in bank reserves may force a multiple contraction of deposits.
17) Money should be defined exclusively in terms of its means-of-payment attributes. The present array of interest-bearing checking accounts has confused the distinction between means-of-payment accounts (the primary money supply) and saving-investment accounts and created a dilemma as to what portion, if any, of these interest-bearing accounts should be considered as savings. This dilemma is resolved when the transactions velocity of demand deposits is taken into account; i.e., deposit classifications are analyzed in terms of monetary flows (MVt). Obviously, no money supply figure standing alone is adequate as a “guide post” to monetary policy.
18) In defining the money supply, a distinction should be made between the public and the monetary authorities. From the public viewpoint currency and checkable deposits, credit cards, traveler’s checks, ATS accounts, MMDA accounts etc., serve directly or indirectly as money. From the monetary authority’s point of view, money has to be confined to assets that constitute means-of-payment and are controllable. Currency is not such an asset. Fortunately it is an asset the Fed does not, should not, and cannot control. There is no inflationary bias in an expansion of currency, and the deflationary bias resulting from its growth (the decrease in an equal amount of legal reserves in the System), can, and is, offset through the expansion of Reserve Bank credit.
19) The demand deposit component of our means-of-payment money supply (M1, currency plus checking accounts) is created by private profit financial institutions. The creation process is an inevitable consequence of their lending operations. All currency gets into circulation, directly or indirectly, through the liquidation of time deposits, by the cashing of demand deposits. There is one exception in demand deposit creation: those rare instances when the U.S. Treasury borrows from the Federal Reserve Banks.
20) The bankers, Congress, and most of the banking authorities have simply not been able to dissect and to construct our financial institutions in a System’s context. From a System standpoint the financial intermediaries and the commercial banks are not competitive, but have an inter-relationship that can be mutually beneficial to the economy. The much larger question with which we should be concerned, therefore, is the raison d'etre of an institutional arrangement whose benefits to the banks are dubious and which undoubtedly exerts deleterious effects on the financial intermediaries and the economy. Time-deposit banking arrests the flow of monetary savings into investment because in their time-deposit function the commercial banks are neither intermediaries nor creators of loan funds; they are simply custodians of stagnant money. Monetary savings held in the form of time deposits are not irrevocably lost to investment until destroyed. But they cannot be used to finance investment until their owners (non-bank public) decides, and as long as the non-bank public chooses to hold savings in the form of time deposits, the means-of-payment velocity of these funds is zero and the funds are lost to investment. The expansion of member commercial bank held (impounded/bottled up) monetary savings deposits is prima facie evidence of a leakage which collects in the form of unspent balances.
21) All the devices which have in effect made time deposits an integral part of demand deposits, viz, daily compounding of interest, automatic fund transfers, debit cards, etc., have enabled people to economize on demand deposits, and has resulted in the sharp increase in the transactions velocity since 1967. In other words, under existing institutional arrangements, an increase in time deposits results in an offsetting increase in transactions velocity, therefore no, or limited dampening results. If there is to be a growth in time deposits there should be an offsetting increase in velocity. Our problem has been an excessive increase in both the volume and velocity of money.
22) Time deposits standing alone are not inflationary. In fact, they are the equivalent of demand deposits with a transactions velocity of zero. But they are inflationary when they become in effect interest-bearing demand deposits. Neither the bankers nor the Fed seemed to realize the economics of making time deposits so liquid, that they were, for all practical purposes, a net addition to the effective money supply.
23) It is obvious that demand deposits, which have been saved, cannot be beneficial to the economy unless they are invested. As long as savings are held in the commercial banks in the form of demand or time deposits, these deposits are not financing investment, or indeed anything; their transactions velocity is zero. If, on the other had, these deposits are transferred through the thrifts, or any other financial intermediary, they are invested or otherwise put to work. Such use of deposits does not change the volume of deposits in the commercial banks, merely their ownership. In other words the commercial banks could continue to lend if the public ceased to save altogether. The lending capacity of the commercial banks is dependent on monetary policy, not the savings practices of the public.
24) The unique and inflation-causing changes in monetary policy and the structure of the banking System were the consequence of a universal misconception of the economics of time deposits banking, and the basic differences between commercial banks and the financial intermediaries. The cumulative effect has been to transform virtually all time deposits into the economic equivalent of demand deposits, since the holders of these accounts can on demand, or in the marketplace, convert these holdings without significant delay into demand deposits.
25) The utilization of commercial bank credit to finance real investment or government deficits does not constitute a utilization of savings, since bank financing is accomplished through the creation of new money. Contrariwise, the activation of deposits within the financial intermediaries increases employment, the demand for varieties of goods and services – and the opportunities of the commercial bankers to make bankable loans. The “loan pie” is not a fixed entity; it grows when the economy grows.
26) Trillions of deposits have been diverted/shifted into time deposits; not because they were saved, but because of the structural changes in the banking System that made most of these time deposits a type of auxiliary money (banks began to manage their liabilities, and corporations began managing (minimizing) their non-interest bearing cash balances). Bank customers were induced to shift out of non-interest bearing demand deposits into time deposits by the introduction of various financial innovations.
27) The DICMCA encouraged a massive shift from transaction deposits, to time deposits, within the newly created depository institutions to the extent that the new money supply’s properties and characteristics, have become obscured or unclear. That is, there has become no logical dividing line.
28) It is impossible for time deposits to grow or shrink without causing, ceteris paribus, an equal and opposite change in our means-or-payment money.
29) From a System standpoint, time deposits that represent savings have a velocity of zero. As long as savings are held (impounded) in the commercial banking System, they are lost to investment. The means-of-payment velocity of time/savings deposits is zero and the funds are lost to investment, to consumption, and indeed to any type of payment. Such a cessation of the circuit income and transactions velocity of funds, funds which constitute a prior cost of production, cannot but have deleterious effects in our highly interdependent pecuniary economy (since 1964, stagflation, as evidenced by bank debits, was the inevitable result). The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.
30) The shifting about in the ownership of deposits will undoubtedly alter the lending ability of particular banks, but the lending ability of the System will not be altered unless deposits are shifted among banks having deferential reserve requirements, or a change in monetary policy by the Reserve authorities.
31) Time deposits, unlike savings accounts in the “thrifts”, bear a one-to-one, almost unvarying’ relationship to demand deposits. An increase in time deposits depletes demand deposits by the same amount, or (1) directly or indirectly via the currency route, or thru (2) the banks undivided profits, and vice versa. I.e., all time deposits are derived from demand deposits. This massive diversion of demand deposits into time deposits was wholeheartedly supported by the bankers, sanctioned by the monetary authorities, and “sanctified” by the Keynesian theories held by virtually all economists. Keynes’ General Theory of Employment, Interest and Money (1936) was their bible. On page 81 of Macmillians’s 1949 edition, Keynes informs us that it is an “optical illusion” to suppose “…that a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking System so that they are lost to investment…”.
32) The principle inflationary pressure on prices in the U.S. occurred from the colossal growth in commercial bank “liquid” time deposits together with bank practices with respect to the acquisition and management of time deposits.
33) The process of “monetizing” time deposits began in the early sixties. Citicorp was the first bank to use the negotiable certificate of deposit in 1961. Soon afterward, Citicorp pulled in deposits (Euro-deposits) from all over the world. But when interest rates finally rose above Reg Q ceilings in 1965, certain large New York City Banks couldn’t replace these borrowings, so the Fed stepped in and raised Reg Q. ceilings to bail out those banks ( & this was the first instance in which ceilings were raised above the levels assigned to thrift institutions. This in conjuction with an excessive expansion of the money supply, created the 1966 housing crisis.
34) Soon, all the major banks were in the act. To this incentive to expand time deposits, the Fed added higher and higher interest rates ceilings on time deposits under their Regulation Q. Today, all interest rate ceilings have been eliminated. Further incentives to time deposit growth were the introduction of ATS accounts, the reduction of reserve ratios against most time deposits, and their removal altogether for some types of time deposits.
35) The drive by the commercial bankers to expand their savings accounts has a totally irrational motivation, since it has meant, from a System standpoint, competing for the opportunity to pay higher & higher interest rates on deposits that already exist in the commercial banking System. This is because the source of time deposits is demand deposits, not the savings held in S&Ls, mutual savings banks or credit unions. But it does profit a particular bank, Citicorp for example, to pioneer the introduction of a new financial instrument such as the negotiable CD until their competitors catch up; and then all are losers. The question is not whether net earnings on CD assets are greater than the cost of the CDs to the bank; the question is the effect on the total profitability of the banking System. This is not a zero sum game. One bank’s gain is less than the losses sustained by other banks.
36) Professional economists have no such excuse for misinterpreting the savings-investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking System, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy. From a System standpoint, time deposits that represent savings have a velocity of zero. As long as savings are held in the commercial banking System, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.
37) In an accounting sense, the Fed has an unlimited capacity to lend. It operates under no reserve or reserve ratio constraints. Nor does it need to be concerned with a new outflow of funds as a consequence of its lending activities. Advances to borrowers simply involve crediting the borrower’s inter-bank deposit account. These accounts are, however, “high-powered money” to use Milton Friedman’s term [sic]. They provide the basis for a multiple expansion of money. Can’t the Fed offset these advances with open market sales? Not on a very large scale without destroying the Treasury’s capacity to manage the national debt. Thus far, the Fed has been able to maintain the liquidity credibility of the banks and thrifts. How long can this necessary degree of confidence be maintained? There is no answer, but it is certain that the crucial test is yet to come.
38) Having the illusions that commercial banks are intermediaries, loaning out the savings of the public, the Fed attempted to “peg” at even higher levels the federal funds rate; allowed time deposits to balloon with no legal restrictions on their growth; and initiated, or allowed, institutional changes which converted an indeterminate, but large, share of time deposits into “primary money”.
39) The Fed and Congress allowed institutional changes which enabled demand deposit holders to shift into interest bearing time deposits with little or no decrease in the liquidity of their assets. These changes took the form of negotiable C.D.’s, ETF (Electronic Transfer of Funds); automatic transfer serves (ATS accounts), NOW (negotiable orders of withdrawal), and MMDA (money market deposit accounts). Since time deposit growth is directly (or indirectly through the currency route) at the expense of demand deposits, the Fed received false signals as to the real means-of-payment money supply.
40) Institutional changes have converted an indeterminate, but large, share of time deposits into primary money. I.e., institutional changes enabled demand deposits holders to shift into interest bearing time deposits with little or no decrease in the liquidity of their assets. With the elimination of Reg Q interest rate ceilings on the time deposits of the member commercial banks and with the elimination of reserve requirements on time deposits, there was both an increased incentive to hold time deposits, and no legal restrictions on their growth. These structural alterations and the practices thereby engendered, (to concentrate and channel loan-funds into narrow segments within our economy) has led to a mélange of excessively destabilizing price changes, especially of those assets, real estate, etc., which serve as loan collateral. The whole brew of ill-advised deregulation and regulatory permissiveness fostered an atmosphere in which greed seemed to triumph, especially if a little fraud was diluted with a heavy does of incompetent supervision by the authorities and their examiners.
41) From the standpoint of the individual banker there is some excuse for opting for negotiable CDs, MMDAs and ATS accounts; and for agitating for the removal of Regulation Q ceilings on interest rates. If other banks are competing for time deposits, the individual banker has to complete or lose deposits and earning assets. Transforming time deposits into an auxiliary money supply, besides having server adverse effects on the economy, has had a devastating effect on bank profits. Interest on time deposits, from the standpoint of the banking System, amounts to paying for something (deposits) the System already possesses. Lacking the interest incentive, holders of “saved” demand deposits would acquire investments outside the banking System. This, contrary to the conventional wisdom, would not result in the diminution of the demand deposits, or earning assets of the banking System. The confusion arises from a unique feature of the commercial banking System; the whole is not the sum of the parts in the money creating process
42) The individual commercial banker performs an intermediary role between savers and borrowers. By attracting an inflow of funds (time or demand deposits or currency), he enlarges his legal reserves and clearing balances plus his legal and economic capacity to expand loans and investments. From the standpoint of the banker, he has simply loaned out the funds acquired; from the System standpoint the added earning assets have been acquired through the creation of new money. To the individual commercial banker, thrifts were obviously competitors. Funds transferred from his bank to a financial intermediary usually resulted in a loss of deposits, and often the opportunity to make a bankable loan.
43) Disintermediation in the “thrifts” may be induced by the rates paid by the commercial banks. However induced, disintermediation results in a diminution of funds in the thrifts, and a transfer of existing deposits within the commercial banking System.
44) Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking System (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries. Shifts from TDs to DDs within the CBs and the transfer of the ownership of these DDs to the thrifts, involves a shift in the form of bank liabilities (from TD to DD) and a shift in the ownership of DDs (from savers to thrifts, et al). The utilization of these DDs by the thrifts has no effect on the volume of DDs held by the CBs or the volume of their earnings assets.
45) Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries; for the funds never leave the commercial banking System.This applies to all investments made directly, or indirectly, through intermediaries. The only way to reduce the volume of demand deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or the purchase from their banks of any type of commercial bank security obligation, e.g., bank stocks, debentures, etc.
46) Sweep accounts are a shift in the form of a commercial bank customer’s money balances. The volume of depository liabilities does not change, only their composition (deposit classification). The balances are swept from deposit liabilities having higher reserve ratios on a specific volume and type of deposit liability (10% on transaction deposits), to nonexistent ones (0% on MMDA accounts). These balances are exchanged and converted by the member banks, and consequently, overnight, these balances circumvent reserve requirements (reserve avoidance), and thereby making the job of monetary management, less effective (because as of 2002 70% + of the banks have become zero-bound).
47) Expanding the money supply essentially requires nothing more than “writing numerically larger figures in the books”.
48) . Monetary policy objectives should not be in terms of any particular rate or range of growth of any “M”, rather policy should be formulated in terms of desired rates of change in monetary flows (MVt) relative to rates of change in real GDP. Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the rate of monetary flows to exceed the rate of change in real GDP by c. 2-3 percentage points.
49) In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels (there is evidence to prove rates of change in Nominal GDP can serve as a proxy figure for rates of change in all transactions. Rates of change in real GDP have to be used, of course, as a policy standard).
50) And lastly the multiplier they use. Multiply total member bank reserves by a multiplier (M1 divided by adjusted total “free gratis” member bank legal reserves). The bi-weekly figure on adjusted reserves is accurate since it involves only adding up member bank balances with the Federal Reserve banks and estimating the member bank’s vault cash. Of course, the multiplier used has to be extrapolated from past data. Alterations in the trend line should reflect changes in reserve ratios (incorporated in (RAM)) and structural changes that would alter the trend ratio of time to transaction deposits.
51) It is impossible for time deposits to grow or shrink without causing, ceteris paribus, an equal and opposite change in our means-of-payment money.
52) The functions of money are: a medium-of-exchange: The exchange of money is brokered into 2 transactions, goods are exchanged for money, and money in turn is exchange for goods. Each transactor indulges in two distinct operations, a sale & a purchase. Goods and serves are being sold for money, and money is used to purchase goods and services. In other words money has a “generalized purchasing power.”
53) Money as a store-of-value: The holder of money that is generally acceptable over time and fixed in price is provided with a store of value providing future purchasing power.
54) A unit-of-account: a “yardstick of value” by which people price commodities and serves exchanged and calculate wealth, income, and debts.
55) Money as a standard-of-value: standard money into which all other types are convertible and, being freely convertible, are thereby kept at a par with the standard money.
56) Money as a guarantor-of-liquidity-and-solvency: substantial quantities of money are held to give assurance that accruing obligations and unforeseen contingencies can be met as they materialize.
57) By raising reserve ratios to 100% the commercial banks would become financial intermediaries no longer able to create money, serving only as conduits between savers and borrowers. The funds for setting up savings accounts would then originate OUTSIDE the banks, just as the funds for setting up share accounts originate OUTSIDE the savings and loan associations. Even if the reserve ratios (minimum ratios of legal reserves to bank deposits) were raised to 100%, the debt would be monetized to the extent to which the Federal Reserve Banks increased their holdings of governments. That is to say, the public’s holdings of money increases pari passu (in lock step) with the expansion of Reserve Bank credit.
58) Gresham’s law is a statement of the “principle of substitution” applied to money or other words, that a commodity (or serve) will be devoted to those uses which are most profitable. It is another one of the paradoxes of money that, unlike articles in the market, the bad drives out the good. E.g., during the Civil War the less valuable paper money drove all types of coins out of circulation. The more valuable money is held, if possible, as a “store of value” and the less valuable is used as a medium of exchange. The demand for money as a store of value thus forces the more valuable types of money out of circulation. E.g., the “vilest die and basest metal” replaced those of “perfect die and metal” in circulation. Noted by Aristophanes (448-380 B.C).
59) Alfred Marshall, the Cambridge economists, is responsible for developing the cash-balances approach to money. For example, if individuals collectively desire expanding their cash balances (increasing the period over whose transactions purchasing power in the form of money is held), they will initiate a chain of events which will lead to a net reduction in their aggregate holdings of cash. That is, an over-all increase in the demand for money leads to falling prices, a decline in profit expectations, reduced borrowing from the banks -- and therefore a smaller volume of cash balances. Money thus is truly a paradox - by wanting more, the public ends up with less, and by wanting less, it ends up with more. All motives which induce the holding of a larger volume of money will tend to increase the demand for money - and reduce its velocity. Therefore, if there is a flight from the dollar, there will be hyperinflation in terms of dollar denominated assets.
60) Definitions of the money supply are not timeless. The extension of the scope and practices of the Federal Housing's Administration's Authority accompanied by Federal Government guarantees - assures a secondary market for housing - the "store of purchasing power" attribute of money. I.e, there are various types of "tertiary money". These assets possess general liquidity. They do not bear a direct, unit for unit, unvarying relationship, to the primary money supply. And to pass legislation that will establish a new classification of tertiary money is to make these Government guarantees inflationary. Underwritten with the credit of the U.S. Government. Federal insurance, underwriting and guaranteeing,
Tuesday, September 15, 2009
The Equation of Exchange
For those who need a reminder, the equation of exchange is an algebraic way of stating a truism; that the product of the unit prices, and quantities of goods and services exchanged, is equal (for the same time period), to the product of the volume, and velocity of money. Velocity is the rate of speed at which money is being spent. It is self-evident from the equation that an increase in the volume, and or velocity of money, will cause a rise in unit prices, if the volume of transactions increases less, and vice versa. This is merely algebra, but it has an important economic application.
The economic question arises from differing opinions as to whether the monetary authorities (The Board of Governors of the Federal Reserve System and the Federal Open Market Committee) can control both the volume and velocity of money, and the effects of changes to the volume and velocity of money, in production and employment, as well as on prices:
Alan Greenspan’s profligacy ended with Ben Bernanke’s appointment to the Chairman of the Federal Reserve in February 2006. Coinciding with Bernanke’s instatement, the FOMC reversed Greenspan’s extremely “easy” money policy, and initiated a “tight” money policy (one aimed at reducing chronic inflation). At that point, correcting the Central Bank’s past excesses, required that the “trading desk” drain the existing volume of required (legal), reserves (thereby reducing the growth rate of the money stock).
From Feb. 2006 until July 2008, the FOMC pursued a consistently tighter money policy. In fact, the rate-of-change in the volume of legal reserves (the proxy for inflation), fell for 29 consecutive months (out of a possible 29, or sufficient to wring inflation out of the economy). It’s only been in the last 10 successive months (since Sept. 2008), that it was necessary for the FOMC to switch from its “tight” monetary policy, to the extraordinarily “easy” monetary policy in force at present. Easy money is here defined as a growth rate of aggregate monetary demand (money times velocity) in excess of the growth rate of product, and service output.
Coterminous with the economic contraction during the past 12 months, the money multiplier has varied (it collapsed) from 209 to 114. It collapsed because the rate of expansion in loans and investments plunged, as (1) credit worthy customers, and (2) investment grade securities – both disappeared. Interpreted, at this stage it means, that if the Manager of the Open Market Account, operating from his office in the Federal Reserve Bank of New York, bought $1 billion of Treasury bills, for the accounts of the 12 Federal Reserve banks (or if there was any other type of expansion of Reserve Bank credit by 1 billion), the money supply would expand almost immediately, by approximately $114b.
All of the data necessary to correctly estimate the 3 links (multiplier), that exist between the member bank’s “source base” and either (1) bank credit proxy, or (2) the 60 largest CBs on the Board’s H.8 release or (3) commercial bank credit -- are available to the FED’s technical staff. From these data the necessary computations can be made.
The basic expansion coefficient for the banking system as a whole (the correct source base), is obtained by dividing commercial bank credit, by the sum of the member bank’s (1) required reserves, plus (2) contractual clearing balances (reductions in required reserve balances have predominantly been accompanied by “offsetting increases” in the member bank’s contractual (required), clearing balances. Required reserves, and vault cash, can be used for deficits in contractual clearing balances used (as long as they are quickly replenished).
Contractual clearing balances are prudential reserves (1) reserves necessary for posting debits and credits resulting from both intra & inter-bank transactions, (2) reserves to meet the public’s demand for currency or (3) reserves to avoid deficits in the bank’s balance of payments). Contractual clearing balances function as “reserve requirements against debits to deposits”. They are reserve requirements based both upon the turnover of deposits, as well as upon their volume (See the 1931 Committee on Bank Reserves Proposal (by the Board’s Division of Research and Statistics). This study was declassified in March 1983.
Any changes (use of deposits), will trigger automatic adjustments in a bank’s requirement for either additional (1) contractual clearing balances (required), and or in, (2) supplemental reserves (daylight overdraft credit). Daylight credit is constrained by (1) “net debit caps” and (2) “interest rate charges on daylight overdrafts. Net-debit-caps are the bank’s maximum allowable daylight overdraft positions. Daylight credit figures (legal reserves), should be incorporated in the banking system’s source base (but the data on daylight credit is unavailable on an up-to-date release). Daylight credit & or overdrafts occur when a bank operates with negative legal reserves (not the same as borrowed reserves).
The number of small and medium sized banks which are “bound” (those banks where the expansion of “loans-deposits” are regulated, or constrained, by required (legal) reserves, has continued to decline (beginning with the Garn-St Germain Depository Act of 1982, and accelerating thereafter (in the 1990’s). However, even as the number of banks that are designated as “non-bound” continues to grow, the largest banks still hold the greatest percentage, (and number of), deposits and customers. And large banks are continuing to expand their market share (percentage of deposits), relative to the medium and small banks.
But even as the number of “non-bound” banks continues to grow, the “non-bound” banks will continue to need Central Bank deposits, for clearing (bank debits), and making other interbank payments, which notwithstanding, gives the Central Bank leverage (albeit limited control), over the money and bond markets. Nevertheless, over time, increasing amounts of vault cash (including ATM networks), plus retail deposit sweep programs, have effectively eliminated legal reserve requirements (for most medium and small size banks). I.e., reserve requirements for the banking system as a whole are not “binding” (emasculating the hard and fast correlation with the money multiplier).
The “trading desk” conducts their open market operations through the primary securities dealers. These government securities dealers have accounts at member clearing banks (money creating depository institutions). So when the “trading desk” buys and sells securities from the dealer’s accounts at their clearing bank, the “trading desk” adds or drains legal reserves in the banking system.
What the Federal Open Market Committee targets is the uncollateralized, interbank, federal funds rate, the rate banks charge each other on overnight loans, for their excess deposits, held at their District Reserve Bank. This is accomplished by the “trading desk” setting the daily, collateralized, repurchase agreement rate (repo) on Treasuries (effectively the one-day cost-of-carry, or one day return on, all government securities). This is how the FED actually (albeit temporarily), controls short-term money market interest rates.
The multiplication factor (for fractional reserve banking), can be altered by a number of variants, e.g., shifts in the ratio of M1 to total bank deposits; shifts in the cash drain factor, changes in the number of member banks in each size group (i.e., legally bound vs. non-bound banks); and the reserve ratio applicable to each size category (0% for the reserve exemption, 3% for the low reserve tranche, and a 10% reserve ratio on all other transaction accounts).
The validity of the multiplier as a predictive device is also predicated on the assumption that the commercial banks will immediately expand credit and the money supply (if they are supplied with additional excess legal reserves). Prior to August 2008, the inconsequential volume of excess legal reserves held by the member banks (ever since 1942), provided documentary proof that the banks exploited virtually all of their lending, and investment, opportunities.
Actually, during this period, the bankers realized that if the aggregate of their bids for federal funds pushed the rate above the bracket (or target level), set by the “trading desk”, this would automatically trigger buy orders; thus expanding Reserve Bank credit, and bank legal, and excess reserves. What the Central bank “plugged in” (the Federal Funds “Bracket Racket”), amounted to an open ended device through which the commercial banks could decide whether or not there should be an expansion in the legal lending capacity of the banking system – the capacity to create credit (money) and to acquire additional earning assets.
In the current environment, the enormous volume of excess reserves held by the member banks function as the bank’s secondary liquidity reserves (regardless of their volume or volatility). I.e., an increase in excess reserves under the FED’s new “interest on reserves regime” functions just like raising reserve ratios would. I.e., the volume of excess reserves increases, when the interest on reserves increases, & vice versa. Likewise, the volume of excess reserves increases, when reserve ratio requirements increase & vice versa.
The volume of idle excess reserves depends primarily upon how yields are set (by the FOMC), on the banking system’s excess, required, and supplemental (daylight credit), reserves. Thus, the volume of excess reserves held by the member banks depends upon how these yields compare to, the returns on all other money market interest rates. Interest on reserves is a mechanism, which was chosen by the FOMC, to both (1) lower an individual bank’s operating expenses vis a vis the global money & lending markets, and (2) to carry out monetary policy objectives (i.e., the buildup of excess reserves (due to the current remuneration rate -- which is .25% & above the .15% FFR), has been used to offset the expansion of reserve bank credit (assets on the FED’s balance sheet).
In the current environment, a bank’s secondary liquidity reserves consist of earning assets which can be converted into cash quickly and without loss (e.g., U.S. Treasury obligations having about one year or less to go to maturity, commercial paper, repurchase agreements, contractual clearing balances, supplemental, required, excess reserve balances, etc.). Excess, required, & supplemental reserves are now earning assets (via interest on reserves), and thus should be included in a bank’s secondary reserves (excess reserves now total $794.5b -- H.3).
Also in this environment, a bank’s primary liquidity reserves or “working reserves” are those cash assets that consist of vault cash, cash items in process of collection, and balances due from depository institutions. The H.8 release shows that commercial banks currently hold $970.3b cash assets. (During the Great Depression excess reserves were roughly 50% of the volume of required reserves (at their height in 1935). This compares to c. 90% at present. (excess reserves represented a bank’s unused lending capacity). Because (during the Great Depression), the volume of excess reserves remained idle for a long period, this led economists to coin the phase “pushing on a string” (because the banks were reluctant to assume new risks, when making new business or consumer loans, & purchasing private-sector investments).
Back to the equation: A commensurate increase in the velocity of money may well offset a corresponding decline in the volume, or rate-of-change, in legal reserves (e.g., the proxy for real growth). Any increase in the rate of turnover (in our primary money supply) - will also increase aggregate demand (or nominal GDP). I.e., a dollar bill which turns over 5 times can do the same “work” as one five dollar bill that turns over only once. It is the real means-of-payment money actually changing hands that affect price levels, price trends, interest rates, employment, production, etc.
Once prices start increasing, especially housing prices, it will be necessary for businessmen to secure larger commercial loans (just to carry on the same volume of business). And other commercial loans will need to be obtained in order to hold larger inventories, finance new trade, engage in more forward buying, support higher production, additional purchasing, new carrying, or extra marketing, of goods and services.
However, all such activity promotes higher prices, with no necessary concomitant expansion in the production of “real” things. Bernanke’s price supports increase the probability of stagflation (business stagnation accompanied by inflation), because of the FOMC’s current extraordinarily “easy” monetary policy (i.e., will cause an increase in the unit prices of unsold inventory, as opposed to increase the production of quantities of goods and services exchanged), (e.g., Costco).
Since 1996, only the trend rate of the money stock is available to use as a variable in the equation of exchange. I.e., the current figure for the transactions velocity of money is unknown and unknowable. But if the rate of turnover of the money stock is relatively constant (in the equation of exchange), then the volume, and rate-of-change in M1 (as a predictor of future economic activity) is superior to even the monetary “source base”. But be watchful, because historically, the transactions velocity of money has accelerated given any rapid expansion of the money stock. In any event, accurate economic forecasts (for stocks, bonds, or the exchange value of the dollar, etc) are that much harder to project.
Note that "Cash assets" on the H.8 :Assets & Liabilities of 60 Commercial Banks in the United States include excess reserves.
This is its explanation on the H.8: 14. Includes vault cash, cash items in process of collection, balances due from depository institutions, and "balances due from Federal Reserve Banks".
The economic question arises from differing opinions as to whether the monetary authorities (The Board of Governors of the Federal Reserve System and the Federal Open Market Committee) can control both the volume and velocity of money, and the effects of changes to the volume and velocity of money, in production and employment, as well as on prices:
Alan Greenspan’s profligacy ended with Ben Bernanke’s appointment to the Chairman of the Federal Reserve in February 2006. Coinciding with Bernanke’s instatement, the FOMC reversed Greenspan’s extremely “easy” money policy, and initiated a “tight” money policy (one aimed at reducing chronic inflation). At that point, correcting the Central Bank’s past excesses, required that the “trading desk” drain the existing volume of required (legal), reserves (thereby reducing the growth rate of the money stock).
From Feb. 2006 until July 2008, the FOMC pursued a consistently tighter money policy. In fact, the rate-of-change in the volume of legal reserves (the proxy for inflation), fell for 29 consecutive months (out of a possible 29, or sufficient to wring inflation out of the economy). It’s only been in the last 10 successive months (since Sept. 2008), that it was necessary for the FOMC to switch from its “tight” monetary policy, to the extraordinarily “easy” monetary policy in force at present. Easy money is here defined as a growth rate of aggregate monetary demand (money times velocity) in excess of the growth rate of product, and service output.
Coterminous with the economic contraction during the past 12 months, the money multiplier has varied (it collapsed) from 209 to 114. It collapsed because the rate of expansion in loans and investments plunged, as (1) credit worthy customers, and (2) investment grade securities – both disappeared. Interpreted, at this stage it means, that if the Manager of the Open Market Account, operating from his office in the Federal Reserve Bank of New York, bought $1 billion of Treasury bills, for the accounts of the 12 Federal Reserve banks (or if there was any other type of expansion of Reserve Bank credit by 1 billion), the money supply would expand almost immediately, by approximately $114b.
All of the data necessary to correctly estimate the 3 links (multiplier), that exist between the member bank’s “source base” and either (1) bank credit proxy, or (2) the 60 largest CBs on the Board’s H.8 release or (3) commercial bank credit -- are available to the FED’s technical staff. From these data the necessary computations can be made.
The basic expansion coefficient for the banking system as a whole (the correct source base), is obtained by dividing commercial bank credit, by the sum of the member bank’s (1) required reserves, plus (2) contractual clearing balances (reductions in required reserve balances have predominantly been accompanied by “offsetting increases” in the member bank’s contractual (required), clearing balances. Required reserves, and vault cash, can be used for deficits in contractual clearing balances used (as long as they are quickly replenished).
Contractual clearing balances are prudential reserves (1) reserves necessary for posting debits and credits resulting from both intra & inter-bank transactions, (2) reserves to meet the public’s demand for currency or (3) reserves to avoid deficits in the bank’s balance of payments). Contractual clearing balances function as “reserve requirements against debits to deposits”. They are reserve requirements based both upon the turnover of deposits, as well as upon their volume (See the 1931 Committee on Bank Reserves Proposal (by the Board’s Division of Research and Statistics). This study was declassified in March 1983.
Any changes (use of deposits), will trigger automatic adjustments in a bank’s requirement for either additional (1) contractual clearing balances (required), and or in, (2) supplemental reserves (daylight overdraft credit). Daylight credit is constrained by (1) “net debit caps” and (2) “interest rate charges on daylight overdrafts. Net-debit-caps are the bank’s maximum allowable daylight overdraft positions. Daylight credit figures (legal reserves), should be incorporated in the banking system’s source base (but the data on daylight credit is unavailable on an up-to-date release). Daylight credit & or overdrafts occur when a bank operates with negative legal reserves (not the same as borrowed reserves).
The number of small and medium sized banks which are “bound” (those banks where the expansion of “loans-deposits” are regulated, or constrained, by required (legal) reserves, has continued to decline (beginning with the Garn-St Germain Depository Act of 1982, and accelerating thereafter (in the 1990’s). However, even as the number of banks that are designated as “non-bound” continues to grow, the largest banks still hold the greatest percentage, (and number of), deposits and customers. And large banks are continuing to expand their market share (percentage of deposits), relative to the medium and small banks.
But even as the number of “non-bound” banks continues to grow, the “non-bound” banks will continue to need Central Bank deposits, for clearing (bank debits), and making other interbank payments, which notwithstanding, gives the Central Bank leverage (albeit limited control), over the money and bond markets. Nevertheless, over time, increasing amounts of vault cash (including ATM networks), plus retail deposit sweep programs, have effectively eliminated legal reserve requirements (for most medium and small size banks). I.e., reserve requirements for the banking system as a whole are not “binding” (emasculating the hard and fast correlation with the money multiplier).
The “trading desk” conducts their open market operations through the primary securities dealers. These government securities dealers have accounts at member clearing banks (money creating depository institutions). So when the “trading desk” buys and sells securities from the dealer’s accounts at their clearing bank, the “trading desk” adds or drains legal reserves in the banking system.
What the Federal Open Market Committee targets is the uncollateralized, interbank, federal funds rate, the rate banks charge each other on overnight loans, for their excess deposits, held at their District Reserve Bank. This is accomplished by the “trading desk” setting the daily, collateralized, repurchase agreement rate (repo) on Treasuries (effectively the one-day cost-of-carry, or one day return on, all government securities). This is how the FED actually (albeit temporarily), controls short-term money market interest rates.
The multiplication factor (for fractional reserve banking), can be altered by a number of variants, e.g., shifts in the ratio of M1 to total bank deposits; shifts in the cash drain factor, changes in the number of member banks in each size group (i.e., legally bound vs. non-bound banks); and the reserve ratio applicable to each size category (0% for the reserve exemption, 3% for the low reserve tranche, and a 10% reserve ratio on all other transaction accounts).
The validity of the multiplier as a predictive device is also predicated on the assumption that the commercial banks will immediately expand credit and the money supply (if they are supplied with additional excess legal reserves). Prior to August 2008, the inconsequential volume of excess legal reserves held by the member banks (ever since 1942), provided documentary proof that the banks exploited virtually all of their lending, and investment, opportunities.
Actually, during this period, the bankers realized that if the aggregate of their bids for federal funds pushed the rate above the bracket (or target level), set by the “trading desk”, this would automatically trigger buy orders; thus expanding Reserve Bank credit, and bank legal, and excess reserves. What the Central bank “plugged in” (the Federal Funds “Bracket Racket”), amounted to an open ended device through which the commercial banks could decide whether or not there should be an expansion in the legal lending capacity of the banking system – the capacity to create credit (money) and to acquire additional earning assets.
In the current environment, the enormous volume of excess reserves held by the member banks function as the bank’s secondary liquidity reserves (regardless of their volume or volatility). I.e., an increase in excess reserves under the FED’s new “interest on reserves regime” functions just like raising reserve ratios would. I.e., the volume of excess reserves increases, when the interest on reserves increases, & vice versa. Likewise, the volume of excess reserves increases, when reserve ratio requirements increase & vice versa.
The volume of idle excess reserves depends primarily upon how yields are set (by the FOMC), on the banking system’s excess, required, and supplemental (daylight credit), reserves. Thus, the volume of excess reserves held by the member banks depends upon how these yields compare to, the returns on all other money market interest rates. Interest on reserves is a mechanism, which was chosen by the FOMC, to both (1) lower an individual bank’s operating expenses vis a vis the global money & lending markets, and (2) to carry out monetary policy objectives (i.e., the buildup of excess reserves (due to the current remuneration rate -- which is .25% & above the .15% FFR), has been used to offset the expansion of reserve bank credit (assets on the FED’s balance sheet).
In the current environment, a bank’s secondary liquidity reserves consist of earning assets which can be converted into cash quickly and without loss (e.g., U.S. Treasury obligations having about one year or less to go to maturity, commercial paper, repurchase agreements, contractual clearing balances, supplemental, required, excess reserve balances, etc.). Excess, required, & supplemental reserves are now earning assets (via interest on reserves), and thus should be included in a bank’s secondary reserves (excess reserves now total $794.5b -- H.3).
Also in this environment, a bank’s primary liquidity reserves or “working reserves” are those cash assets that consist of vault cash, cash items in process of collection, and balances due from depository institutions. The H.8 release shows that commercial banks currently hold $970.3b cash assets. (During the Great Depression excess reserves were roughly 50% of the volume of required reserves (at their height in 1935). This compares to c. 90% at present. (excess reserves represented a bank’s unused lending capacity). Because (during the Great Depression), the volume of excess reserves remained idle for a long period, this led economists to coin the phase “pushing on a string” (because the banks were reluctant to assume new risks, when making new business or consumer loans, & purchasing private-sector investments).
Back to the equation: A commensurate increase in the velocity of money may well offset a corresponding decline in the volume, or rate-of-change, in legal reserves (e.g., the proxy for real growth). Any increase in the rate of turnover (in our primary money supply) - will also increase aggregate demand (or nominal GDP). I.e., a dollar bill which turns over 5 times can do the same “work” as one five dollar bill that turns over only once. It is the real means-of-payment money actually changing hands that affect price levels, price trends, interest rates, employment, production, etc.
Once prices start increasing, especially housing prices, it will be necessary for businessmen to secure larger commercial loans (just to carry on the same volume of business). And other commercial loans will need to be obtained in order to hold larger inventories, finance new trade, engage in more forward buying, support higher production, additional purchasing, new carrying, or extra marketing, of goods and services.
However, all such activity promotes higher prices, with no necessary concomitant expansion in the production of “real” things. Bernanke’s price supports increase the probability of stagflation (business stagnation accompanied by inflation), because of the FOMC’s current extraordinarily “easy” monetary policy (i.e., will cause an increase in the unit prices of unsold inventory, as opposed to increase the production of quantities of goods and services exchanged), (e.g., Costco).
Since 1996, only the trend rate of the money stock is available to use as a variable in the equation of exchange. I.e., the current figure for the transactions velocity of money is unknown and unknowable. But if the rate of turnover of the money stock is relatively constant (in the equation of exchange), then the volume, and rate-of-change in M1 (as a predictor of future economic activity) is superior to even the monetary “source base”. But be watchful, because historically, the transactions velocity of money has accelerated given any rapid expansion of the money stock. In any event, accurate economic forecasts (for stocks, bonds, or the exchange value of the dollar, etc) are that much harder to project.
Note that "Cash assets" on the H.8 :Assets & Liabilities of 60 Commercial Banks in the United States include excess reserves.
This is its explanation on the H.8: 14. Includes vault cash, cash items in process of collection, balances due from depository institutions, and "balances due from Federal Reserve Banks".
Saturday, June 27, 2009
The "Regulators"
I am inclined to the opinion that regulatory and supervisory decision-making processes should lie entirely with the Board of Governors, and that the Board should be reconstituted to include the Secretary of the Treasury, the Comptroller of the Currency, the Chairman of the Federal Home Loan Bank Board, the Director of the Federal Deposit Insurance Corporation, the Director of the Office of Thrift Supervision, the National Credit Union Administration, the Securities Futures Commission, and the Chairman of the Securities and Exchange Commission
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