NY Fed staff: The banking system no longer resembles the fractional reserve banking model

In an article last year, economist Marc Lavoie noted that the financial crisis and the reaction to it have forced monetary authorities to publicly reject some key assumptions of mainstream monetary theory as a way to prevent market participants from misrepresenting and misjudging the effects of recent Fed actions. According to Lavoie, these features of mainstream theory include the notion that increases in bank reserves get "multiplied" into a larger expansion in the broad money supply as banks increase lending, as well as the idea that increases in bank reserves at the central bank result in price inflation.

As these recent blog entry and working paper by NY Fed staff can attest, it's clear that the Fed's public relations campaign to change people's understanding of all this is still underway. No doubt, these efforts are also partly aimed at countering the views recently expressed by certain economists within the Federal Reserve System regarding the potentially inflationary nature of an expanded monetary base.

That being said, I find the title of McAndrews's blog entry misleading. I fail to see how disproving the money multiplier means QE isn't inflationary. In my view, there is a good case to be made that the Fed's asset purchase has ramped up the search for yields, leading banks into speculation resulting in, for instance, commodity inflation. However, the inflationary potential of QE should be viewed as a separate issue given that the resultant inflation would not be a consequence of increased lending caused by the increase in bank reserves.

Here is an interesting excerpt from the working paper by McAndrews et al. explaining how the Fed's authority to pay interest on reserves nullifies the money multiplier process and the notion of fractional reserve banking:

In this note, we present a basic model of the current U.S. banking system, in which interest is paid on bank reserves and there are no binding reserve requirements. We find that, absent any frictions, lending is unaffected by the amount of reserves in the banking system. The key determinant of bank lending is the difference between the return on loans and the opportunity cost of making a loan. We show that this difference does not depend on the quantity of reserves. [...] The current banking system in the United States and worldwide no longer resembles the traditional textbook model of fractional reserve banking. Historically, the quantity of reserves supplied by a central bank determines the amount of bank loans. Through the "money multiplier", banks expand loans to equal the amount of reserves divided by the reserve requirement. However, in many countries, reserve requirements have been reduced either to zero, or to such small levels that they are no longer binding. (p. 1)

May 31 - June 1 Conference on Contemporary Capitalism and its Financial Circuits

There's a conference being held on May 31 and June 1 in Ottawa, Ontario, on “Contemporary Capitalism: Its Financial Circuits, Its Transformation and Future Prospects".

Quite an impressive list of participants.

The conference program contains contact information and other details. In case you're interested in knowing more about some of the conference's sponsoring organizations, you will find links to the websites of ROBINSON and IEPI on the right-hand column of this blog.

The right way to balance the budget: target the corporate surplus, not the government deficit

Deficit reduction is back on the agenda in Canada. And according to recent statements made by Tony Clement, the minister assigned the task of balancing the federal budget, it appears likely that significant cutbacks in public sector spending will occur in the next few years.

This is most unfortunate. At a time when household debt is at a record high and the personal saving rate is near the 40-year low (see chart 1), slashing government budgets is the last thing Canadians need right now. Think about it: for every dollar of reduction in government expenditures, there is one less dollar of income earned in the economy (similarly, if the funds are spent on imports such as US-made fighter jets, the money leaves the domestic economy). The same goes for any tax increase used to balance the budget: each dollar of taxes collected by the government represents one less dollar in private sector bank accounts.

In other words, it is impossible for the government to decrease its deficit in isolation, and any reduction in government spending or tax increase will have an impact on the private sector. In fact, there is a strong argument to be made that the decline in the personal saving rate and the overall weakness in the household sector's financial position during the last two decades is partly the result of the deficit reduction efforts of the federal and provincial governments in years past.

As I've shown elsewhere, public sector deficits are from an accounting standpoint the equivalent of surpluses in the private sector, plus additional net imports. The reason for this is that government deficit spending adds to the net accumulation of private holdings of households and businesses (and/or the foreign sector, where applicable).

Chart 1 (double click to enlarge) proves that this basic principle is supported by the facts*. As you can see, whenever Canada's government sector (all levels of government combined) is in a deficit, the private sector runs a surplus (or reduces its deficit). The relationship is so close to being perfect that it looks as though each financial balance is a mirror image of the other. If you take into account net imports, you get perfect symmetry (see chart 2).

Chart 1

Chart 2

The Corporate Surplus

A much more sensible approach to balancing the federal budget would take into account the fact that Canada right now has a massive corporate sector surplus (see chart 3). The reason for this large accumulation in corporate savings is that during the last decade the corporate sector significantly reduced its share of productive investment in the economy in favour of short-term investments and speculative activity (Baragar and Seccareccia, 2008).

Chart 3

Based on official statistics (and my own calculations), Canada's corporate sector ran on average a net surplus of 3.7 percent of gross domestic product since 2001. This is a huge jump from the previous 40 years when the corporate sector maintained an average deficit of 1.3 percent. If corporations were to invest these funds in productive, job-creating initiatives, the deficits of both the government and household sectors would shrink significantly without the need to make contractionary cuts to public expenditures.

A good way to achieve this would be for the government to encourage firms to undertake productive investment by imposing a small, yet noticeable tax on retained earnings or on the turnover of corporate financial instruments, as suggested last year by Yves Smith and Rob Parenteau in relation to the case of the US. Marshall Auerback also makes an excellent case here in favour of imposing a tax on the corporate sector to achieve this purpose. As for the idea of a financial speculation tax, economist Dean Baker recently explained the benefits of this policy here.**

According to Smith, Parenteau and Auerback, these measures would create incentives for firms to reinvest their profits in business operations by increasing the cost of speculating with profits.

In a context where the potential for large export growth is weak (due to the current strength of the Canadian dollar and the challenges facing the US, Canada’s major trading partner), enticing firms to increase productive investment is likely to be the only way to balance the federal budget without further causing the household sector’s deficit to grow. 

So next time you're concerned over the size of the federal government's budget deficit, keep in mind that the more pressing matter at the moment is to reduce the massive corporate surplus. Such a policy would not only help to reduce the size of the federal government's deficit, but it would also go a long way in eliminating the current financial deficit of the household sector.

Baragar, F. and M. Seccareccia, Financial restructuring: Implications of recent Canadian macroeconomic developments, Studies in Political Economy, Vol 82 (2008).

* All charts were produced using official Statistics Canada sector accounts/net lending data and my own calculations. 

** This sentence was added on May 28, 2011.

Krugman is right: now is the time to invest

It's nice to know that what I say is supported by a Bank of Sweden Nobel laureate. Here's Paul Krugman arguing the same thing I did in an earlier post:

It’s truly amazing that Washington debate is dominated by fear of the bond market. And it’s also truly amazing that nobody is suggesting that a government able to borrow long term at a real interest rate of 0.7 percent really should be taking advantage of those rates to finance some much-needed infrastructure investment. (my emphasis)

On the other hand, it's also quite sad.  I'm convinced that one day, say, thirty or forty years from now, economists will look back at today's policymakers and be astonished by the lack of action on their part. Talk about a missed opportunity.

That being said, if you agree with Prof. Krugman but believe that, unfortunately, the US government is already overburdened with debt and therefore should refrain from spending any further, I suggest you read this recent brief by economist James Galbraith on the myth of the unsustainability of US government debt. The brief does an excellent job at exposing the flawed assumptions used in the economic forecasts of doomsayers such as the US Congressional Budget Office who claim that US federal government expenditures are on a "reckless" and unstainable path. According to Galbraith, 

[t]he CBO’s assumption, which is that the United States must offer a real interest rate on the public debt higher than the real growth rate, by itself creates an unsustainability that is not otherwise there. It also goes against economic logic and is belied by history. Changing that one assumption completely alters the long-term dynamic of the public debt. By the terms of the CBO’s own model, a low interest rate erases the notion that the US debt-to-GDP ratio is on an “unsustainable path.” (my emphasis)

I also leave you with this excerpt from economist Abba Lerner's classic piece, "Functional finance and the federal debt". In my opinion, it offers one of the most powerful explanation for why, barring the improbable event of a complete breakdown of the economy due to hyperinflation or other catastrophic occurence, it is very unlikely that US government debt will grow infinitely if focus is placed on promoting full employment and growth:

"...as the national debt increases it acts as a self-equilibrating force, gradually diminishing the further need for its growth and finally reaching an equilibrium level where its tendency to grow comes completely to an end. The greater the national debt the greater is the quantity of private wealth. The reason for this is simply that for every dollar of debt owed by the government there is a private creditor who owns the government obligations (possibly through a corporation in which he has shares), and who regards these obligations as part of his private fortune. The greater the private fortunes the less is the incentive to add to them by saving out of current income. As current saving is thus discouraged by the great accumulation of past savings, spending out of current income increases (since spending is the only alternative to saving income). This increase in private spending makes it less necessary for the government to undertake deficit financing to keep total spending at the level which provides full employment. When the government debt has become so great that private spending is enough to provide the total spending needed for full employment, there is no need for any deficit financing by the government, the budget is balanced and the national debt automatically stops growing." (my emphasis)

Lerner, A.P. (1943), ‘Functional finance and the federal debt’, Social Research, 10: 38–57.

FRB gets a new look

I finally got around to making a few changes to the site. I'll be adding a profile and a few additional features soon.

Music break 3

The news out of the White House last night contains all the elements to give rise to a lasting conspiracy theory. Mind you, I'm not into that stuff at all. However, whenever I hear about such stories I think about this great track by DXT. It contains samples of a guy rambling on about the supposed invasion of a handful of California communities back in the early 1950s by a squad under the covert command of the United Nations. The story has now found a home in the tired and annoying NWO litany that permeates the internet. As it turns out, the story is from a sci-fi novel or something.

Enjoy the music but don't spend too much time digging into the inspiration for the track. Go biking or sailing instead.