On the Wikipedia page for economist Ricardo Reis we learn he was “Influenced by: Greg Mankiw”, which basically should tell you everything. Everything that is that would lead to the conclusion that his macroeconomics is plain wrong. Yet his connections in the profession are strong and has prestigious academic appointments, is ensconced in senior editorial positions on influential economics journals, advises central banks in the US and has regular Op Ed space in a leading Portuguese newspaper (his homenation). These facts tell you what is wrong with my profession. That someone can write articles that are just so off the mark yet have significant influence in the profession and be held out in the public debate as to be someone who is worth listening to and being reported on. I have received many E-mails in the last few days about the proposal offered by Reis at Jackson Hole last week. Many readers are still confused and actually thought the proposal had credibility. Let me be clear – bank lending is not influenced by the reserve positions of the banks. Without credit-worthy borrowers lining up to access loans, the banks could have all the reserves in the world and the central bank could invoke any number of nifty ‘indexing’ or other support payment schemes on those reserves, and the banks would still not lend. And with those credit-worthy borrowers lining up to access loans, the banks will always lend irrespective of their current reserve position or the nifty support schemes the central bank might dream up. Core Modern Monetary Theory (MMT) 101!



The paper – Funding Quantitative Easing to Target Inflation – was presented to the Jackson Hole Economic Policy Symposium, hosted by the Federal Reserve Bank of Kansas City, which was held last week (August 25-27, 2016).

The theme for the Symposium was “Designing Resilient Monetary Policy Frameworks for the Future”.

Apparently “Some 100 economists and Fed officials — each one able to fill a room if they gave a speech in New York or Washington — attend the two-day event” (Source).

It just goes to show that the neo-liberal Groupthink is alive and well if the ideas that are presented in the Reis paper are taken as worthy of filling a room of high-paid officials.

We shouldn’t be surprised though.

His influence – Greg Mankiw – still teaches students that central banks can control the money supply and that the textbook money multiplier is still a valid concept to learn.

In his Principles of Economics (I have the first edition), Mankiw’s Chapter 27 is about “the monetary system”. In the latest edition it is Chapter 29. Either way, you won’t learn very much at all from reading it.

In the section of the Federal Reserve (the US central bank), Mankiw claims it has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system”. So I suppose on that front he would be calling for the sacking of all the senior Federal Reserve officials given the massive collapse that occurred under their watch.

The second “and more important job”:

… is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).

And in case you haven’t guessed he then describes how the central bank goes about fulfilling this most important role. He says that the:

Fed’s primary tool is open-market operations – the purchase and sale of U.S government bonds … If the FOMC decides to increase the money supply, the Fed creates dollars and uses them buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars it receives for the bonds are out of the hands of the public. Thus an open market sale of bonds by the Fed decreases the money supply.

This is the influence that Mankiw dishes out.

It is completely fictitious account of the way central banks operate.

Central banks cannot control the “money supply”.

In the September 2008 edition of the Federal Reserve Bank of New York Economic Policy Review there was an interesting article published entitled – Divorcing Money from Monetary Policy.

It demonstrated why the account of monetary policy in mainstream macroeconomics textbooks (such as Mankiw etc) from which the overwhelming majority of economics students get their understandings about how the monetary system operates is totally flawed.

The FRBNY article states clearly that:

In recent decades, however, central banks have moved away from a direct focus on measures of the money supply. The primary focus of monetary policy has instead become the value of a short-term interest rate. In the United States, for example, the Federal Reserve’s Federal Open Market Committee (FOMC) announces a rate that it wishes to prevail in the federal funds market, where overnight loans are made among commercial banks. The tools of monetary policy are then used to guide the market interest rate toward the chosen target.

This is practice is not confined to the US.

In reality, in a credit money system, this ability to control the stock of “money” is undermined by the demand for credit. The overall broad money aggregate (‘the money supply’) is determined as the outcomes that follow after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).

The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 is just an arbitrary reflection of the credit circuit. Please read my blog – Understanding central bank operations – for more discussion on this point.

Further expanding the monetary base (bank reserves) as I argued in these blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.

And that brings me to the Reis paper, which was reported on by Reuters (August 27, 2016) – Fed could use reserves payments to stimulate U.S. economy: paper – as if it contained an ingenious new idea.

It is, in fact hard to know where to start discussing this sort of paper, which, sadly, represents the standard understandings in the mainstream of my profession.

There are so many clangers – like:

1. “The interest on reserves controls inflation” – how?

2. In relation to the growing reserves in the banking system, Reis claims “The main risk is that the central bank becomes insolvent … central bank insolvency is equivalent to hyperinflation, which happens often, all over the world.”

To learn why this is such a stupid claim, please read my blogs:

Further, “often” means “frequently”. The record of hyperinflations would suggest the descriptor “rare” is more appropriate.

Reis claims that as a result of Quantitative Easing (QE), “the central bank becomes one of the largest individual holders of government debt” and if the government forces “upon the central bank a write-off of the government debt” during a “fiscal crisis” then “the central bank may find itself unable to prevent this loss”.

Which means nothing.

The central bank accountants if they wanted to record positive capital would just type in whatever number they liked into their records.

End of story – after all, as Reis acknowledges the central bank is “the monopoly issuer or the unit of account”. It can never go broke.

3. “Government bonds now carry sovereign risk, which reserves do not, since they are the unit of account”.

Government bonds issued by a sovereign, currency-issuing government are risk free because such a government can always repay liabilities issued in that currency.

4. “An effective helicopter drop would likely require the end of QE, with a dramatic shrinkage of the quantity of reserves” –

What?

We read that a ‘helicopter drop’ (pp 20-21) involves:

… the government sending economic agents checks, just like it does with other social transfers … and issuing government bonds to pay for these. The central bank would then print banknotes to buy these government bonds and immediately write them off from its balance sheet. This leads to the same end result, where private agents receive banknotes from the central bank, but now using the fiscal authority as the distributor. This version is sometimes called overt monetary financing of the deficit. Crucially … the increase in the monetary base must be permanent. With more money chasing the same goods, the argument goes, the price level would have to rise back towards target.

Why would a government expand its deficit to achieve a level of economic activity that Reis describes as the “same goods”?

The increased deficit would increase spending but, presumably, given the logic of wanting to increase the deficit, lead to higher levels of production of goods and service, with no necessary price level effects.

It does not make sense to have a static output side in the face of an expanding nominal demand side.

Further, Reis’ description of OMF (overt monetary financing) is selective.

First, the increase in government spending would not require any debt issuance at all. The government would instruct the central bank to credit its spending account (and a double entry number would spring up somewhere in the debt side of the central bank).

Electronic key strokes.

Second, the government spending would show up as deposits in private bank accounts of the recipients of the government spending. No bank notes (currency) would have to be issued.

Third, the bank reserves (monetary base) would grow accordingly. The central bank could drain those reserves if it chose through open market operations (selling bonds). But at that point there is “no money chasing the same goods”.

Fourth, these deposits were in payment for goods and services or, if they were transfers, were to fulfill income support and other obligations.

In the first case, the recipients presumably responded to the deposit by increasing production. In the second case, the deposits may feed into expenditure fully or partially.

But the increased demand would stimulate further production.

Further, any increase in fiscal deficits increases bank reserves. So if QE was abandoned and the government adopted (sensibly) OMF, then bank reserves would continue to grow unless the central bank chose to drain them.

The claim that there would be a “dramatic shrinkage of the quantity of reserves” reflects an ignorance of the impact of vertical transactions (deficit spending) on the reserve positions of banks – core Modern Monetary Theory (MMT) 101.

Reis also claimed that:

… helicopter drops might be ineffective because the Fed already turns over its profits to the government and might reduce these transfers after such a move, leading the government to cut spending in the future.

Again, one gently shakes one’s head (gently because it would be wrenched off reading a paper like this if it was anything but).

If the treasury side of government can instruct the central bank side of government to shift spending power from one pocket (account) into another pocket, then it doesn’t matter if the central bank stops remitting anything (profits on foreign currency activity, etc) to the treasury.

Once institutional arrangements had reached the sensible point that the both sides of government were actually fully exploiting the currency-issuing capacity, without artificial and voluntary constraints, then the treasury would realise it could always E-mail the operations desk at the bank and instruct it to credit any account it chose, irrespective of anything else!

The other part of Reis’ paper that gained press intention was his proposal to “use bank reserves as a stimulus mechanism, indexing payments to the inflation rate.”

The Reuters report claimed:

That would give banks an incentive to lend when the economy is weak and prices are rising more slowly.

Reis wrote in his paper (p.23):

The central bank is the monopoly issuer of reserves, which are the unit of account. In the same way that in an economy saturated with reserves, the central bank can choose whichever nominal interest rate it wishes to pay on those reserves, it could alternatively choose to remunerate reserves differently.

Which is absolutely correct.

The consequences of the choice of different rates impacts on the capacity of the central bank to sustain its policy target rate.

If it offers no support rate on excess reserves then the short-term interest rate in the Interbank market (where banks lend among themselves to ensure the viability of the payments system) would fall to zero.

This would effectively mean that the central bank loses control of its monetary policy position, unless that position was consistent with a zero policy target rate.

The choice of payment has no direct impact on the capacity of the banks to make loans (more about which soon).

Reis then proposes his ‘pièce de résistance’ (p.23):

Instead of promising an interest rate, the central bank could offer reserves that promised an indexed payment. For each $1 of reserves, the bank could receive a payment tomorrow that was indexed to the price level then.

Any central bank could clearly do that. So what?

Reis then claims that “if the price level was running below target” (pp.23-24):

… the central bank could lower the payment on reserves, and in doing so raise prices. The intuition for how this works is the following. When the central bank promises a smaller payment on reserves are a less attractive investment, so banks will not want to hold them, and their real value must fall. But since their real value is the inverse of the price level, prices must rise. As banks initially move away from reserves and into loans, the movement in savings and investment caused by a change in the promised payments will give firms the incentive to change their prices until equilibrium is restored. By promising a payment on reserves, the central bank gains a new tool with which to control the price level.

Intuition is a dangerous guide to anything if it is not backed by knowledge of how the monetary system actually works.

The Reuters report understood this as saying:

The fluctuations in bank lending due to price changes could help the Fed keep inflation on target.

The problem is that Reis’s “somewhat radical” (his words) proposal is nonsense and belies an understanding of what constrains commercial bank lending.

I outlined what actually happens in this blog – Building bank reserves will not expand credit.

Here is a brief summary (you can read the full exegesis if so motivated).

One of the myths of QE is that by increasing bank reserves (in exchange for central bank purchases of financial assets held by the banks), the banks’ capacity to lend would increase.

Reis clearly falls into that mistaken understanding as does Paul Krugman, Gregory Mankiw and a host of New Keynesian mainstream economists.

The Bank of International Settlements admitted in this paper – Unconventional monetary policies: an appraisal – that:

… we argue that the typical strong emphasis on the role of the expansion of bank reserves in discussions of unconventional monetary policies is misplaced. In our view, the effectiveness of such policies is not much affected by the extent to which they rely on bank reserves as opposed to alternative close substitutes, such as central bank short-term debt. In particular, changes in reserves associated with unconventional monetary policies do not in and of themselves loosen significantly the constraint on bank lending or act as a catalyst for inflation.

Got it!

Those who think that an expansion of bank reserves provides banks with additional resources to extend loans assumes that “bank reserves are needed for banks to make loans” (quote from BIS paper).

The BIS then say:

In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly.

This is a core MMT position that has been in the literature for more than 20 years now – long before the central banks or New Keynesians started turning their attention to the existence and meaning of excess bank reserves.

The core MMT explanation goes as follows.

Loans create deposits which can then be drawn upon by the borrower. No reserves are needed at that stage. Then, as the BIS paper says, “in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system.”

The loan desk of commercial banks have no interaction with the reserve operations of the monetary system as part of their daily tasks. They just take applications from credit worthy customers who seek loans and assess them accordingly and then approve or reject the loans. In approving a loan they instantly create a deposit (a zero net financial asset transaction).

The only thing that constrains the bank loan desks from expanding credit is a lack of credit-worthy applicants, which can originate from the supply side if banks adopt pessimistic assessments or the demand side if credit-worthy customers are loathe to seek loans.

The reason that Reis’ “radical plan” is nonsense is thus very simple – bank credit will be extended when there are demand for funds from the private sector.

Reserves will be added later if needed to sustain the payments system if required.

Richard Koo in his 2003 book Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications (John Wiley & Sons) provided another angle on this:

The reason why quantitative easing did not work in Japan is quite simple and has been frequently pointed out by BOJ officials and local market observers: there was no demand for funds in Japan’s private sector. In order for funds supplied by the central bank to generate inflation, they must be borrowed and spent. That is the only way that money flows around the economy to increase demand. But during Japan’s long slump, businesses left with debt-ridden balance sheets after the bubble’s collapse were focused on restoring their financial health. Companies carrying excess debt refused to borrow even at zero interest rates. That is why neither zero interest rates nor quantitative easing were able to stimulate the economy for the next 15 years.

It is also why indexed payments on bank reserves will also have no impact of the type that Reis’s textbook understanding would imply.

Conclusion

Once again we see that the Jackson Hole Symposium dominated by dumb papers trying to defend the dominance of monetary policy as the primary counter-stabilisation tool.

This is the same old neo-liberal line – eschewing the use of fiscal policy – and promoting monetary policy.

They do this because they want to reduce the democratic oversight on macroeconomic policy and they think that these amorphous central bankers will be immune from political pressures to increase employment etc when there is very high unemployment.

They claim this gives policy more inflation-fighting credibility. It doesn’t at all.

A Job Guarantee run by the treasury would be a highly credible anti-inflation policy tool – because the government would be sending a signal that this powerful automatic stabiliser would always buy off the bottom at a fixed price and shift workers away from any inflating sector.

That would be the most powerful and least destructive anti-inflation tool that a government could use.

That is enough for today!

(c) Copyright 2016 William Mitchell. All Rights Reserved.