...against fictions and other tall tales

Saturday, 21 April 2012

A microeconomic perspective on the “loans create deposits” meme

By Joseph Laliberté

A private bank’s “cash and cash equivalent” position as shown on its balance sheet typically includes its deposits with other banks, excess reserves at the central bank and vault cash.  In financial accounting, the cash flow statement illustrates the main elements impacting the cash and cash equivalent position of a business between the beginning and the end of a given period.

Perhaps one of the most fascinating aspect concerning the obsession of mainstream macro economists with banks’ cash and cash equivalent position (excess reserves, in particular) is the near irrelevant status this component has in banking and financial circles.  Below is an extract from a letter of the German Banks Association (Bankenverband) to the International Accounting Standards Board (IASB) that illustrates perfectly the lack of interest that many have in regard to banks’ cash position:
One of the major objectives of the boards' proposals is to provide information which is relevant to predicting future cash flows.  We agree that the issue of liquidity presents a significant challenge for the banking sector.  Nevertheless, cash flow statements cannot help to assess future liquidity in any way.  No financial analyst, for example, has ever queried any of our member banks about, or given any great consideration to, the cash flow statement.  If the IASB has information pointing in another direction, we would be interested in the details. (emphasis added)
Illustrative of the non-importance of a bank’s cash flow statement is that the very definition of “cash and cash equivalent” used for the purpose of building the cash flow statement appears far from standardized across the banking industry.  Some banks, such as Deutche Bank, divide “cash and cash equivalent” on the asset side of its balance sheet into “cash and due from banks” and “interest-earning deposits with banks”. However, for the purpose of its cash flow statement, Deutche Bank defines “cash and cash equivalent” as “cash and due from banks” PLUS “interest earning deposits with banks” MINUS “term deposits with banks”.  For its part, the French bank Société Générale presents on the asset side of its balance sheet two categories (i.e., “cash, due from central banks” and “due from banks”) while for the purpose of its cash flow statement it defines "cash and cash equivalent" as follows: (“cash, due from central banks” MINUS “due to central banks”) PLUS (“due from banks” MINUS “due to banks”).  Closer to home, ScotiaBank defines “cash and cash equivalent” as “cash and non-interest-bearing deposits with banks”, thereby excluding interest-bearing deposits with banks, while National Bank includes cash and all deposits with financial institutions.  Go figure!  One would assume that banks would find it necessary to settle on a common definition of “cash and cash equivalent”, especially since we are often told by the financial press and many economists that this asset component is so critical in analyzing banks’ capacity to extend loans.

That said, even if all banks would settle on a common definition of “cash and cash equivalent”, this asset category would still say very little about a bank’s liquidity.  The reason for this is that any given bank could have a cash and cash equivalent position of zero and still be considered highly liquid thanks to its holding of cash management bills/T-Bills/government bonds. 

Furthermore, the cash and cash equivalent position says nothing about a bank’s capital ratio, the critical element in determining a bank’s capacity to extend credit.  Banks’ capital is allocated to balance sheet expansion through loan and deposit creation, not banks’ cash or reserve position.  As per the cash flow statement of a deposit-taking institution, net additional loans to customers are considered a use of funds, and net additional deposits from customers are a source of funds.  Therefore, once a loan is granted and the customer’s checking account is marked up by the same amount, the cash and cash equivalent position of the bank is left unchanged.  From a microeconomic banking perspective, loans create their own source of funds, or stated differently, "loans create deposits".  Assets-liabilities duration mismatch (interest rate risk) is of course an important consideration, and this is where the discussion ties in with the central bank’s decision on interest rate.

One last point that deserves to be highlighted is that, although a bank’s "cash and cash equivalent" position generally says nothing about its capital position and, consequently, its regulated lending capability, an increase in this asset item may sometimes reflect improved liquidity.  This was arguably the case with QE1 when the Fed purchased mortgage-backed securities (MBS) by crediting private banks’ reserve account at the Fed.  Moreover, if one assumes that with QE1 the Fed engaged in fiscal policy by overpaying for MBS (relative to their market value), then it could be argued that QE1 may have also helped to improve banks’ capital position as well as their regulated lending capability.

In the case of Canada, a QE1 style program was put in place, but since reserves were “mopped up” with the issuance of Canadian government bonds, there was no impact on banks’ “cash and cash equivalent” position, a situation that led to an improvement in their liquidity position (as it did in the U.S).  As for the matter of bank capital, contrary to the U.S., there was no direct injection of public funds to recapitalize the banking sector in Canada.  However, just like what happened in other jurisdictions, accounting authorities proved accommodative.  Changes to the Canadian Institute of Chartered Accountants Handbook in October 2008 allowed banks to re-classify financial assets from “held-for-trading” to “held-to-maturity” under specific circumstances.  Use of this re-classification put some banks on stronger regulated capital footing than would have been the case otherwise.

The FRB blog invites your comments. Please share your thoughts below.

Monday, 16 April 2012

Canada's fiscal stimulus: an interpretation

In a previous post, I suggested that Canada's fiscal policy response to the last recession consisted of an effective set of counter-cyclical economic measures.  To support this idea, I highlighted the fact that, as a result of these measures, Canada's level of public fixed investment increased to the highest level in three decades (see graph 1, click on graphs to enlarge).  Also, I suggested that this increase in fixed capital expenditures helped to mitigate the recession's effect on the level of employment.

Graph 1: Consolidated government fixed capital, 1961-2011, Source: Statistics Canada

This view appears to have caught on.  In his recent budget plan, Canada's Minister of Finance, Jim Flaherty, links the labour market's performance during the downturn to the federal stimulus put forth by Stephen Harper's Government after the last recession (see here):
Economic developments since the introduction of the stimulus phase of Canada’s Economic Action Plan underscore its success in protecting Canadian jobs through strong support to the domestic economy.  As a result...Canada has posted the strongest growth in employment among G-7 countries...
[G]overnment investments in infrastructure were key to the success of the Economic Action Plan...
The budget plan includes the following graphs to support the Government's case that its stimulus was effective in mitigating the impact of the recession:

Graph 2: Improvement in employment during recovery

Graph 3: Unemployment rate, Canada and United States, 2006-2011

Graph 4: Growth in real per capita disposable income, 2006-2010

In graph 2, we see that the improvement in Canada's rate of unemployment during the recovery was the highest among the G7 economies.  In graph 3, we see that the unemployment rate fared better in Canada than in the US.  In graph 4, we see that disposable income rose faster in Canada than in the other G7 countries during the recovery.

But is the increase in fixed capital expenditures really the result of federal government action?  In my earlier post, I was very careful not to associate the increase in fixed public investment in recent years solely with the policy measures put forth by the federal government.  Rather, I specified that it was the "combined success of the federal and provincial governments' stimulus measures" which contributed to the effectiveness of Canada's response to the recession.  In my view, suggesting otherwise would be misleading given that the data from the National Income and Expenditures Accounts shows that the largest share of fixed public investment in recent years has come from provincial and local governments (see graph 5).

Graph 5: Public fixed capital, all levels of government, 1961-2011, Source: Statistics Canada

That said, it would be equally incorrect to suggest that the federal government had no role to play in the recent increase in fixed public investment given that, in Canada, a large share of the income of provincial governments consists of fiscal transfers from the federal government to provinces.  As shown in graph 6, federal transfers represent an important source of income for provincial governments.  And interestingly enough, in recent years there has been a considerable increase in the amount of federal transfers to provincial governments.

Graph 6: Provincial government income from federal government, 1961-2011, Source: Statistics Canada

Does this suggest that the Harper Government is justified when it claims responsibility for the boost in capital expenditures in recent years?  It's hard to say for sure, but there is a good argument to be made that the Harper Government is partly responsible given this increase in federal transfers to provinces since the Tories took office.

Better yet, another explanation would be to propose that responsibility for the significant increase in public fixed investment in Canada in recent years rests instead with the fact that, between 2004 and 2011, the governments in power at the federal level were all minority governments, during which "concessions" were made to opposition parties on budget-related matters (i.e., in terms of additional program funding and increased federal transfers to provinces) as a way for these governments to remain in power. 

This view appears to be supported by the facts.  As you can see in graph 7, federal transfers to provinces increased significantly starting in 2005 following the election of Paul Martin's minority government.  The increase in federal transfers to provinces is especially noteworthy given that it resulted in the first significant increase in federal transfers to provinces (viewed as a ratio of total federal expenditures) since the early 1970s

Graph 7: Ratio of transfers to provinces/federal expenditures, 1961-2011, Source: Statistics Canada

Recall that, in 2005, the Martin Government required the support of the NDP to pass its budget, and that the "compromise" budget significantly increased the amount of funding for programs under provincial jurisdiction such as social housing and education.  But regardless of the nature of these transfers, this additional source of income increased the amount of financial resources available to provinces, enabling them to undertake increased investments in infrastructure and other fixed capital projects.

Now, the above is a very rough sketch.  A more detailed look at the data is necessary to get a better picture of the fiscal dynamics underlying these figures.  Still, I think it's fair to say that the increase in public fixed capital investment in recent years is not solely the result of the stimulus measures put forth by the federal government during and after the last recession.  Rather, as I wrote in my earlier post, it is more likely because of the combined efforts of the federal and provincial governments.


Courant, P., E. Gramlich, and D. Rubinfield. "The stimulative effects of intergovernmental grants: Or why money sticks where it hits", Fiscal Federalism and Grants-in-Aid, P. Mieskowski and W. Oakland (ed.), Washington: The Urban Institute, 1979.

Monday, 9 April 2012

Europe! It's not too late to reverse austerity

The following article was written by the author of the Classic Indeed blog.  The article is cross-posted on both blogs.  Readers are invited to post comments on either blogs.

Months ago we outlined the challenges that presented themselves to Italy and Greece, and to Germany, France and the United Kingdom.  We opted against austerity, trusting that the technocratic appointments of Messrs Monti and Papademos could transform governments in Italy and Greece, and enable their respective legislatures to both recommend alternative and optimal public expenditure policies and to restrain policymakers from endorsing imposed fiscal restrictions while constraining budgets any further.

Unfortunately for the global economy and markets, Messrs Monti and Papademos initiatives did the contrary.  They aspired towards the heroic in adhering to a sub-optimal detriment and have now emerged as the scapegoats for political and investment désenchantées.

More ironic is that both men had very little to do with the original debacle.  They were recommended to their nation’s legislatures to clean up a mess.  Instead, as a result of attempting to implement austerity measures, they have generated more anxiety in world markets than expected.

Unfortunately, the recent economic deterioration and rising social tensions within their respective economies has become their responsibility, and the political disenchantment surfacing within the electorate is also their responsibility.  Worse still, the time for apologetics is long past and is now irrelevant.  At jeopardy is their leadership, the credibility they endorse for their visions of the future and the overall well-being of their citizenry.

Mr. Draghi and Mrs. Lagarde have voiced a redemptive message.  Both had professed that the worst was over.  For instance, in a speech on March 26 of this year, Mr. Draghi said the following:
“I would like to take this opportunity to provide you with my assessment of the current situation in the euro area and shed light on recent signs of improvements in the overall outlook.  I would particularly like to draw your attention to the effectiveness of the policy measures implemented by the Eurosystem, the EU institutions and national authorities.  And to remind you of the measures that we all must continue to pursue over the coming months and years with great diligence in order to continue on this path of stabilisation.”
As for Mme Lagarde, on March 18 of this year, the Managing Director of the IMF sought to reassure the audience of the 2012 China Development Forum with the following statement:
“There are signs that strong policy actions—especially in Europe—are making a difference. Financial markets have become a little calmer…”
Yet, Spanish yields are rising, as are those of Italy and Greece, and there is more and more talk of a potential third bailout for Greece although the IMF and the ECB have reassured the investment communities that changes in Greece are being introduced as promptly as possible and will be enacted effectively.

Any remnant stress in markets, according to the institutional duo is a result of the misperception by the interested communities that the consolidations proposed by the ailing economies cannot be achieved.

The emerging doubt on behalf of investment communities and investors in general should not be surprising.  After all, it’s their money and it’s their perception that underscores investment decisions.

One daresay that the investment community saw the collapse of the system much earlier than either the IMF or the ECB, although the leadership of the latter two has been proactive in attempting to stabilize investor sentiment and mitigate between some form of restraint and investment in growth and employment.  Notwithstanding, the reassessment that further bailouts will be necessary is now the swan song of European austerity politics.

Unfortunately, European policymaker perceptions of the bond markets are completely skewed as a result of their own biases.  What is difficult for them to appreciate is that there is no basis left for growth.  Unemployment is up, with Spain leading at 23.6% followed by Greece at 21.0%.  And in those Eurozone countries where unemployment rates are low, many of the employed are part-time workers and, as such, susceptible to labour volatility during these turbulent times.

Moreover, capacity utilization in the manufacturing sector over the last four quarters is dropping across the Eurozone at alarming rates.  Order books are not being filled as quickly as desirable, and their durations and size are shorter than required to support additional investments.  As a result, business investment is stalling as management constrains expenditures and saves its liquidity for dividends in lieu of growth to stabilize share values, foreboding that equity markets react adversely to this dilemma and possibly falter.

What most pundits expected from the emerging markets may not be realized: trusting that BRIC plug the slowdown in Europe, with China leading the way.  Unfortunately, there is no plug.  Most informed observers now mitigate between a slowdown and an ease in aggregate demand, with China’s future growth rates in question.  Projections for the region suggest that China’s growth potential could be in the midst of a major contraction with rates dropping to 7.5% from anticipated 8% and over.

Given the above, the most difficult challenge in domestic politics is for any Government to admit that it followed the wrong track.  There is no shame in being part of a bigger bloc of nations that propound fiscal consolidations even if austerity is showing itself as being the ineffective solution to the Eurozone’s financial crisis, a crisis which is now becoming an economic and political crisis.

It actually takes great courage in admitting that the austerity programs recommended may not work out.  The experiences of other nations in the matter, elicit danger signals that can’t be overlooked.  In such a case, the consolation is that if one’s admission is timely, the Government may come out of an unfortunate situation looking respectful and remarkably diligent.  There is still time for Europe to turn back its political agendas before turning the wrong corner.

The FRB blog invites your comments. Please share your thoughts below.

Thursday, 5 April 2012

Canada's unemployment rate falls to 7.2%

The March edition of Statistics Canada's Labour Force Survey brought some good news today.  Canada's unemployment rate fell 0.2 percentage points in March and is now at 7.2 percent.  The Survey indicates that employment increased by over 80,000, with most of these being full-time positions (approx. 70,000).

From a national standpoint, this is good news, especially considering that the majority of these gains come from the private sector.  Also, it's important to note that there was a positive pick-up in new jobs stemming from the manufacturing sector (approx. 12,000).  Increased private sector job creation is a welcome trend, especially given the upcoming public sector job cuts in the coming months and years.

Notwithstanding this good news, Canada's labour market is still facing some significant challenges ahead.  The rate of government spending is growing at the slowest pace in nearly a decade, and may even turn negative as a result of public sector spending cuts.  Also, consumer spending and credit are slowing significantly, suggesting that overall growth is unlikely to come from households in the near term.  And, finally, with increased exports unlikely to give a boost to Canada's economy in the near-term, it's not at all obvious that today's good news marks the start of a positive and sustainable new trend for the Canadian labour market.

Sunday, 1 April 2012

Music break: FRB anniversary edition

I wish to mention that a few weeks ago was FRB's first anniversary. To mark this occasion, I want to extend my gratitude to readers for their continued support and contribution to this site by dedicating this music break to all FRB readers. I hope it is inspiring.

It's another selection from Miles's '67 Tour. Make sure to check out Williams on drums: "he was a babe at the time", as one of my very first followers once astutely remarked. NOD to you...