Another round of QE: More of the same?

I once had a boss who always asked for briefing material of "no more than 100 words". He'd also say "Give me charts, please. Charts!" Here's a snapshot of what he would get if I was asked to update him on the effect of the Fed's quantitative easing (QE) strategy.

Recall that the Fed implements QE by buying financial assets from banks and other private institutions in the aim of putting downward pressure on yields and thus reducing interest rates. QE as a policy measure is easily identifiable in charts since it increases massively the amount of excess reserves in the banking system.

Given that Chairman Bernanke announced a new round of QE last week, I thought these charts might be of interest.* Not all of these indicators are related to QE's stated objectives. Still, given the centrality of QE in the Fed's overall strategy, I think it's useful to include them.

So, to summarize, since the start of QE, bank lending standards have returned to normal...

 

...business loans have rebounded, though not at pre-QE levels...

...the rate of increase in manufacturers' new orders has normalized...

...corporate profits have continued to rise well beyond pre-QE levels...

...the cost of borrowing for businesses (as reflected in the rate of 10-year inflation protected securities) has come down...

...as did the 30-year conventional mortgage rate...

... and stocks have recovered.
 

On the other hand, home prices have remained depressed...

...the employment-population ratio has flattened...

...and, finally, the rate of unemployment is still stubbornly high.

In a speech earlier this year, the President of the San Francisco Fed, John Williams, called the level of unemployment in the US a "national calamity that demands our attention". From the charts above, it's clear that another round of QE is unlikely to do much to help create more jobs moving forward.

* All charts and data are from the St. Louis Fed, FRED.

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.

Careful with the saving terminology: a reply to JKH

By Joseph Laliberté and circuit. The authors reside in Canada and come from two different heterodox backgrounds, namely, MMT and the post-Keynesian/circuitist tradition.

Introduction

Much discussion took place lately regarding the proper meaning of the term “saving”. The issue surfaced when supporters of “Modern Monetary Realism” (a MMT offshoot) called out supporters of Modern Monetary Theory over the confusion they sometimes entertain when defining this term. Specifically, MMR contends that some MMTers often confuse “saving” with “saving minus investment” or “S-I”. The MMRers stress, correctly in our view, that “S” corresponds to “saving” rather than “S-I”. The anonymous blogger JKH has written extensively about this aspect and has even authored a detailed paper on this issue. We highly recommend this paper, as it provides an in-depth analysis and summary of this whole issue.

That being said, we wish to start off by saying that, while one could blame MMTers for putting too strong an emphasis on “S-I” rather than “S” in their analytical framework, it would be wrong to suggest that MMT’s lead proponents (i.e., Fullwiler, Mosler, Wray, etc) are not aware of the intricacies of the “saving” definition. Also, although it is true that some MMTers may have been sloppy at times in their use of terminology (for instance, we know of examples where MMTers have incorrectly referred to “S-I” as “saving” or “net losses”), it is unfair to characterize MMTers as being the only ones who get the terminology wrong. As Scott Fullwiler repeatedly and correctly pointed out, most of us at one time or another are guilty of using unclear or incorrect terminology, especially when commenting on blogs.

The objective of this post is to clarify terminology and demonstrate that JKH’s own choice of words regarding the notion of “saving” is not entirely without fault and could, as a result, mislead some readers. But before doing so, we wish to stress that we fully support the goal of both MMT and MMR (and JKH) in trying to put forth a more technically-sound approach to macroeconomics and economic policymaking. Indeed, it is our hope that all commentators would settle on a standard set of terminology moving forward.

Net Saving or Net Lending?

It is well-known that MMR and MMT have more or less officially adopted Wynne Godley’s terminology. Accordingly, both MMT and MMR would contend that “S-I” should be identified as “net saving” (of which the origin is most likely shorthand for “saving net of investment”). However, in our view, this terminology is not the most appropriate and could result in significant confusion for readers given that the term “net saving” in the OECD’s System of National Accounts refers to something entirely different from “S-I”. The correct terminology for (S-I) is in fact “net lending” (or “net borrowing”). Blogger Neil Wilson has been explicit on this point in the context of the aforementioned debate. In our view, “net lending/net borrowing” of the private domestic economy could also be appropriately described as the “sector surplus/deficit” of the domestic private economy.

Therefore, on the basis of the Statistics Canada glossary (which is in line with OECD terminology), the following terminology will be used in this post when referring to saving and investment:

•  “S-I” is “net borrowing/net lending” of the domestic private sector (in the three sector model), where “S” is “gross saving” of the domestic private sector and “I” is “gross investment” (or gross fixed capital formation plus investment in inventories) of the domestic private sector. Gross saving does not include a deduction for capital consumption allowance (capital consumption allowance is known at the micro level as “depreciation”). Similarly, gross investment does not include a deduction for capital consumption allowance.
•  “Net saving” of the domestic private sector, unlike “gross saving”, includes a deduction for capital consumption allowance. “Net saving” for the domestic corporate sector (a subset of the domestic private sector) is approximately equivalent to undistributed corporate earnings.

From the above definition, it is quite clear that households/corporations deploy their gross saving, not their net saving. In fact, it could be said that if gross saving is above zero, then it will be deployed in assets (either actively, as in the case of deployments in equipment, or passively, as when leaving it in a checking account) or deployed to reduce liabilities (e.g., repaying loans). If gross saving is above zero, deployment will occur even if net saving is zero or negative due to deduction of capital consumption allowance (i.e., depreciation). Statistics Canada drives this point home when it describes how gross saving is derived from net saving:

Added to this item [net saving] are capital consumption allowances (CCA). The latter are a cost reflecting the reduction in the value of fixed assets used up in production during the period (i.e., depreciation). Even so, they constitute available resources, since in practice, CCA is merely an accounting entry.

This is consistent with the definitions used by the OECD, and fully consistent with the approach used at the micro (business) level. Indeed, a business could in fact generate significant amount of gross saving and deploy them in various types of assets (real or financial) or to reduce liabilities while simultaneously running down its accumulated net savings (i.e., running down its accumulated retained earnings). This is why we argue that JKH’s flow equation S=I+(S-I) is really about gross saving and gross investment, as he himself mentioned when he described this equation as one of “portfolio balance” in which “the two major categories for the application of saving are investment and net financial assets”.

Gross Saving or Net Saving?

On the basis of the above, we would contend that JKH and other MMRers have themselves entertained some confusion over their interpretation of “saving” in two important ways.

First, JKH rarely specifies whether he talks about gross saving or net saving. Second, and more importantly, JKH at times seems to switch from gross saving to net saving in the same paragraph or in the same text. Nowhere is this confusion more apparent as in the comments by JKH that were published on the CNCB website. In those comments, JKH writes that:

Saving is described in proper accounting terms as funds sourced from income by virtue of being saved from income. The eventual deployment of that source of funds is described properly as a use of funds — whether such deployment and use occurs in the form of a bank deposit, a bond, a stock, newly produced residential real estate, or newly produced plant and equipment. The deployment or use of funds is separate from the act of saving itself.

In the paragraph above, JKH is referring to “deployment” and “use of funds” and, as such, ought to be talking about gross savings. Then, in the subsequent paragraph, he states the following:

In summary, the consolidated private sector account obscures, not only the view of saving as it materializes within a given accounting period in bifurcated fashion across household and corporate sectors separately, but also the view of total private sector saving as it is projected fully into the household balance sheet, when captured as a cumulative measure over a sequence of such accounting periods.

In the paragraph above, JKH should really be talking about net saving given that, after all, it is net savings that could be seen as “being projected fully into the household balance sheet, when captured as a cumulative measure over a sequence of such accounting periods”.  On this point, we think that JKH has unfortunately erred in his flow-stock reconciliation.  Flow is about the deployment (i.e., use of funds) of gross saving, as mentioned above. Stock is about cumulative net saving, as capital consumption allowance (depreciation) is netted out from both the asset side and the equity side when reconciling the flow to a balance sheet.  As you can see from the chart below showing corporate gross saving, net saving and net lending, from an empirical standpoint, this is not a minor point. Indeed, using Canada as an example, there is a very significant difference between the level of corporate gross saving and net saving in the national accounts (click on chart to expand).

Source: Statistics Canada and authors' calculations

Granted, the difference between gross saving and net saving will vary greatly between industries. For instance, in the service industry such as banking, the difference could be relatively small, but in capital intensive industries such as car manufacturing or oil and gas extraction, the difference could be very substantial.

Similarly, JKH repeats this error in his paper by again not specifying whether he refers to net saving or gross saving and by confusing the act of deployment of gross saving with net saving:

In summary, saving is a subset of income. It is a flow, not a stock. It is the residual of after-tax spending on consumption. (In the case of corporations, it is undistributed profit after the payment of all expenses including taxes and depreciation.) Saving is not the actual deployment of funds into asset acquisitions or liability reductions. Those events are defined subsequent to the fact of saving.

In the above paragraph, JKH is referring to the deployment of gross saving (i.e. use of funds) while also referring to “net saving” when he writes that, for a corporation, saving “is undistributed profit after the payment of all expenses including taxes and depreciation”.

Concluding remark 

Is JKH aware of the conceptual shortcuts he has employed when talking about the term “saving”? He is. At least one of the authors of this post has had exchanges with him on blogs about this issue and he has always been gracious and meticulous in his responses. So we are not about to claim that JKH does not know how to do proper stock-flow reconciliation.

Did JKH simplify his savings terminology so that his message about saving versus net lending is easier to assimilate for a general audience? We would say yes. And herein lies the paradox of academic expression. As a general case, we should always strive to be as precise as possible in terms of terminology or expression. But the necessity to get your message across to a general audience is bound to collide with our utopian goal to be perfectly and academically precise in the use of words.

So, in conclusion, we would argue that in trying to convince us that “saving” is different from net lending for the private domestic sector, JKH ended up using arguments that could be viewed as counter-productive in that they blurred the distinction between gross saving as it is deployed (use of funds) and recorded on a cash flow statement, and net saving as it is accumulated (as a stock) and recorded on a balance sheet.

Eliminating Canada's household sector deficit: A sectoral balances view

Earlier this month, the Governor of the Bank of Canada, Mark Carney, pointed out in a speech that it is important for Canada's household sector to eliminate the net financial deficit it has incurred during the past decade as a result of several years of increased indebtedness*. (For a visual depiction of the interaction between sectoral financial balances and debt-related indicators, refer to Chart 1).

Chart 1 (Click on image to expand)

According to Mr Carney, the most effective way to remedy this situation without hindering economic growth would be for Canadian businesses to increase their level of investment in upcoming years. The intended objective of increasing corporate investment is to offset the gap in the economy that is likely to occur as a result of increased household deleveraging during the next few years.

One commentator applauded Mr Carney for being the only government official at the moment to "speak the truth", that is, to tell Canadians the true state of the country's economy and exhort businesses to take this opportunity to improve their productivity and competitiveness by investing in their operations.

Still, there remains one 'truth' that has yet to be mentioned by anyone, including Mr Carney. And that is the fact that the federal government's commitment to balance its budget is highly incompatible with the objective of seeking to eliminate the household sector's net financial deficit.

To be sure, Mr Carney did mention in his speech that one way to reduce the deficit of the household sector is for governments to increase spending. But given that the speech later implies that this option is not sustainable, it is hard to tell whether Mr Carney would actually endorse the view that government deficit reduction at this time is an impediment to reducing the net financial deficit of the household sector.

The notion that government deficits have a positive effect on the financial balance of the household sector may sound like a far-fetched economic theory. But, in the case of Canada, as I have demonstrated previously, it is a well-supported empirical fact that is statistically (and intuitively) significant.

As you can see from Chart 2 below, based on Statistics Canada's sectoral net lending figures dating from 1961 to present, there is a strong relationship between the (consolidated) government deficit and the net financial surplus of the household sector. The reverse is also true, as government surpluses tend to be associated with household sector deficits.

Chart 2

 
The only important exception to this longstanding economic reality surfaced in 2008 when the net financial position of the government sector fell back into a deficit (after several years of surpluses) as a result of the sharp drop in Canadian exports, a situation that enabled the foreign sector to return to a considerably large surplus position (see Chart 3). And against the backdrop of a massive and persistent corporate sector net financial surplus starting in the year 2000, the current government sector's deficit has not proven sufficiently large to return the household sector to its traditional net financial surplus position (see Chart 3).

Chart 3

So, given the above, what should the federal and provincial governments do to help eliminate the net financial deficit of the household sector?

First of all, although it now appears likely that the federal government may be headed in that direction, the federal and provincial governments should immediately abandon or, at a minimum, postpone their plans to reduce their deficits and/or balance their budgets. At present, as explained above, the government deficit is actually enabling the household sector's net financial deficit from increasing any further.

Second, governments should take immediate steps to cut down on public expenditures that result in an outflow of funds away from the Canadian economy. As the above analysis suggests, large scale spending on foreign goods has the effect of both increasing the surplus of the foreign sector while simultaneously increasing the size of Canada's public sector deficit. In this regard, there is a strong case to be made for the federal government to cancel its planned purchase of American-made fighter jets.

Similarly, provincial and local public transit authorities should aim, as much as possible and in a manner consistent with established principles of economy and efficiency, to purchase equipment produced in Canada. It should be stressed that the cost-efficiency criterion for choosing among different bids for these public works projects should not be cast aside so as to ensure minimal impact on the tax burden imposed on households and businesses.

Third, as recommended in a previous column, the government should encourage firms to undertake productive investment by imposing a small, yet noticeable tax on retained earnings or on the turnover of corporate financial instruments. These measures would create incentives for firms to reinvest their profits in business operations by increasing the cost of undertaking unproductive activities (e.g., speculative investment) with profits.

Finally, the federal government should reconsider the decision taken in 2008 of requiring the Employment Insurance (EI) fund to balance within a given period. As it stands, when the fund goes into a deficit (as it has been since 2008 due to the rise in unemployment), the government must seek to eliminate the deficit in the short- to medium-term by increasing employer and employee contributions. While such a mechanism may help to reduce the size of the government deficit, it should be emphasized that this policy is highly pro-cyclical given that it acts as an impediment to reducing the net financial deficit of the household sector by decreasing the disposable income and purchasing power of households at a time when they most need it.

To conclude, Mr Carney was right in highlighting the urgency of addressing the current net financial deficit of the household sector. However, it is similarly urgent for government officials in Canada to realize that the objective of balancing public sector budgets is self-defeating and will make matters worse for households given that it reduces a source of employment and revenue. Now, it is very likely that officials of the Bank of Canada are aware of this fact but feel it is not their role to make such an observation. The purpose of the above analysis is a modest attempt to get the word out. Such is my hope and recommendation for 2012. So, on that note, I leave the reader with an excerpt of a letter by John Kenneth Galbraith addressed to President John F. Kennedy dated March 1959 summarizing the point of this column quite nicely:

I have always found that the most useful answer to [those who believe the government must balance its budget] is that the Federal Government, by unbalancing its budget, can help the man who needs a job balance his budget. (1998:29)

* A sector's net financial balance is the difference between its quarterly sectoral savings and investment as a share of gross domestic product. The sum of all sectoral balances must add to zero, which explains why the surplus of one sector is always offset by the deficit of at least one other sector.

References

Eisner, R., How Real is the Federal Budget? (New York: Free Press), 1986

Galbraith, J.K., Letters to Kennedy (ed. James Goodman) (Boston: Harvard University Press), 1998

Godley, W. and A. Izurieta, "The US economy: weaknesses of the strong economy", PSL Quarterly Review, vol. 62, nn. 248-251 (2009), 97-105

Seccareccia, M., "Growing household indebtedness and the plummeting saving rate in Canada: an explanatory note", Economic and Labour Relations Review, Vol. 16, no. 1, July, 2005, pp. 133-51

BoC Governor Mark Carney: Growth in exports, government spending or business investment needed to eliminate the household net financial deficit

A quick post. The Governor of the Bank of Canada, Mark Carney, gave a speech today on the risks facing Canada and the world economies. While the speech contained many of the same themes covered in the December edition of the Bank's Financial Stability Report released last week (see here), a noticeable emphasis was placed on the issue of Canada's household indebtedness. This is not surprising given that Canada's 2011Q3 National Balance Sheet figures are expected to be released tomorrow.

From a Canadian standpoint, the most important part of the speech was when M. Carney's discussed the different ways in which the net financial deficit of Canada's household sector can be eliminated. According to M. Carney, the deficit of the household sector could be eliminated through a combination of export growth, government spending and business investment.

But it is clear from the speech that M. Carney would prefer that Canada's business sector, which is currently running a significant net financial surplus, take a leading role in helping to stimulate the economy while households are seeking to reduce their level of debt. This approach may sound familiar to regular readers of this website. Here is the relevant excerpt of the speech:

To eliminate the household sector’s net financial deficit would leave a noticeable gap in the economy. Canadian households would need to reduce their net financing needs by about $37 billion per year, in aggregate. To compensate for such a reduction over two years could require an additional 3 percentage points of export growth, 4 percentage points of government spending growth or 7 percentage points of business investment growth.

Any of these, in isolation, would be a tall order. Export markets will remain challenging. Government cannot be expected to fill the gap on a sustained basis.

But Canadian companies, with their balance sheets in historically rude health, have the means to act—and the incentives. Canadian firms should recognize four realities: they are not as productive as they could be; they are under-exposed to fast-growing emerging markets; those in the commodity sector can expect relatively elevated prices for some time; and they can all benefit from one of the most resilient financial systems in the world. In a world where deleveraging holds back demand in our traditional foreign markets, the imperative is for Canadian companies to invest in improving their productivity and to access fast-growing emerging markets. (emphasis added)

S&P cuts the US ratings outlook to negative

So the rating agency is cutting the US's fiscal outlook to negative? It appears that the reason behind S&P's decision is that the US failed to follow the likes of Canada, the UK and France, among others, in concocting a "credible" plan to achieve a balanced budget within a completely arbitrary and meaningless time period.

If you're interested in learning why the US cannot face insolvency (or "go bankrupt", as Davos and D.C. types like to claim), I recommend you read "True Sovereigns will not default" by Steve Major of HSBC Global Research (January 2010, p. 3). Essentially, the article explains why the notion of default risk is a non-starter for countries such as the US, Japan and the UK where governments have full sovereignty over their own currency. In the case of these "true sovereigns", the risk to investors stems from interest rates and inflation.

Also, I strongly recommend the comments made here by Ed Rombach on Reuters Insider, who describes S&P's decision as a "non-event". According to Mr. Rombach, the US cannot default on its debt given that it issues its own currency. Also, Mr. Rombach discusses the remote possibility that the US could choose to default for political reasons rather than for financial ones as a result of Congress not raising its debt ceiling. Bottom line for Mr. Rombach: sell 5-year credit default swaps on US government debt.*

* The last paragraph was added on April 19, 2011.

The Governor of the People's Bank of China discusses Chinese savings and the global trade imbalance

The Banque de France recently published an interesting article by the Governor of the People's Bank of China, Dr. Zhou Xiaochuan, in its Revue de la stabilité financière. The article discusses the causes of high Chinese savings, as well as provides some interesting insight on how to address the current global trade imbalances. It also presents an interesting view of US-China trade dynamics.

The point I found most interesting in the article was Dr Xiaochuan's refutation of the common claim which holds that the increase in US consumer credit was fueled by the high level of Chinese savings. According to the Governor, Chinese savings could not have caused US consumption to increase given that the high consumption in the US commenced in the mid-1990s whereas "the savings ratio of East Asian countries only surged after the Asian financial crisis and China’s savings ratios did not begin to increase until 2002" (p. 168). Dr. Xiaochuan's take on this matter is in line with the point I made here regarding the causes of the high household debt burden in the US.

US 2010Q4 Flow of Funds Accounts released

One of the more important elements in the US Flow of Funds Accounts is that consumer credit has increased significantly, rising from a negative rate in 2010Q3 to a positive one in 2010Q4. Business credit has also risen, signalling the start of an improved momentum for expansion in the remaining part of the year.