Fractional reserve banking

Fractional reserve banking is sometimes portrayed as a sort of scam; a method by which rich bankers  underhandedly sap the wealth of society. This short video here, How Fractional Reserve Banking Increases Inflation and Steals our Wealth, is fairly representative of a view I hear expressed quite often.

As you might have guessed, I think that this view is somewhat distorted and misleading. Let me explain why I feel this way.

The video starts off with an hypothetical depositor who starts off with $1000 and asks what happens when it is deposited. Right away we are off to a poor start.

Does he mean starting off with $1000 of cash? Or does he mean $1000 of money (say, in the form of a paycheck)? It makes a difference. When was the last time you made a cash deposit? If you are like me, you cannot remember when. Of course, money gets "deposited" all the time in your account. At work, for example, you might be paid by check or by direct deposit. But this is not what the guy means by "making a deposit"--these "deposits" are simply debit and credit operations in a linked system of accounts (your paycheck is credited to your account, and is debited from your company's account). What the guy means by a "deposit" is a cash deposit. The main source of cash deposits in all likelihood originates from the cash registers of retail businesses.

Alright then, evidently there is cash in circulation. These days, cash primarily takes the form of small denomination paper notes issued by a central bank, like the Fed (in the past, cash frequently took the form of specie--gold and silver coin). There is a demand for cash. Cash is useful for purchasing some types of goods and services when no other means of payment is available. (Cash is also used when transactors wish to keep their exchanges anonymous). And so people occasionally visit ATMs to make cash withdrawals. This cash ultimately finds its way in the cash registers of businesses (however, it is estimated that a lot circulates in the underground economy and, in the case of the U.S., outside of the country).

O.K., so where does banking fit in all this? Maybe your ideal view of a bank is simply as a place to keep your cash safe, kind of like your piggy bank. You deposit your cash with the bank, and the bank issues you a receipt, which constitutes a record of your cash deposit and represents a claim for cash (deliverable by the bank). Or the bank may simply record your deposit as a book entry item. Either way, your cash deposit constitutes a liability for the bank. These liabilities are sometimes called "bank-money" because, well, because they can be used as money. Receipts (especially if they are made payable to the bearer) can potentially circulate as money. Similarly, checks can be written ordering the transfer of cash sitting at the bank from one account to another. If the value of liabilities issued by the bank do not exceed the amount of cash it holds as assets, then we call this 100% reserve banking. (The liabilities issued by the bank are backed 100% by cash.)

Of course, banks do not just keep your cash safe and perform debit/credit transactions for you. They also make money loans. And here is where the confusion generally begins. It starts with the idea that the bank might have the temerity to lend YOUR cash out to someone else--at interest, to boot!

Well, that's not quite what happens. Let try me explain (well, to the best of my understanding, of course).

Suppose you want to start a restaurant business. You own the property and building, but nothing else (apart from your human capital). The building needs to be made into a restaurant. You need ovens, utensils, rooms to be made and finished, furniture, staff, advertising, accountants, lawyers, etc. How do you pay for all this stuff? You clearly have wealth (physical and human capital). You just don't have any cash.

But what do you need cash for anyway? Why not pay for all this stuff using your wealth? One way to do this, in principle at least, is to issue receipts representing shares in your wealth. These shares are liabilities against your wealth. Each share represents an IOU against the future income stream generated by your capital. (The IOUs could take a variety of forms. They could, for example, be made into coupons redeemable for food from your restaurant--something very similar to Canadian Tire Money).

Um, one problem. If you're like me, not very many people know who you are. A randomly selected member of society is unlikely to recognize us, or have any idea what we really own, or have any idea how well we might live up to the promises (IOUs) we issue. Basically, most of us are anonymous (except for within a relatively small network of friends and business relations--and even then, we keep a lot of information private). Anonymity renders our capital illiquid (it is not easily or widely accepted as a means of payment).

O.K., so scratch the idea of creating your own money. This is where a bank now comes in. Let's imagine that the bank reviews your business proposal and concludes that it is likely to be profitable. The bank also thinks that your capital is of high quality and that your ownership title is clear (btw, you are now no longer anonymous to the bank). Now, you might think that the bank is then going to lend you the cash you need to finance your operations. Well, you would be wrong (sort of). That is, you do not need cash--what you want is bank-money. And that's what you typically get from the bank: a money loan in the form of bank liabilities (not cash).

Now, the commentator in that video claims that this bank-money is created out of thin air. That is both correct and completely irrelevant; see my earlier post here. The bank-money (whether in the form of paper notes or book-entry objects) are backed by the assets you put up as collateral for your loan. As long as the loans officer makes good decisions about which business ventures to lend money to, the bank-money created by the bank is fully backed (and consequently, not inflationary; i.e., the new money issue is not dilutive). What the bank has in effect done here is transform your illiquid capital into a liquid liability. This is hardly an activity that one might reasonably label as being inherently "evil."

But this is not quite the end of the story. I have just made the claim that banks issue fully-backed liabilities that serve as money instruments. If this is true, then what do people mean by fractional reserve banking? Let me explain.

In practice, banks issue a very peculiar type of liability, called a demand-deposit liability. In the lingo of financial wonks, these are liabilities that have embedded within them a contractual stipulation known as an American put option. This option gives the debt holder (the depositor) the right to exercise a redemption option on demand at a fixed price. The redemption option in this case consists of the right to redeem bank-money for cash on demand (and usually at par, but frequently subject to a service charge). This is what happens every time you make a withdrawal of cash from your bank or an ATM.

Why do banks do this? Isn't is a recipe for potential trouble?

I don't know why banks do this. In many jurisdictions, it may constitute a legal restriction (as part of the bank charter). I'm not sure if the restriction is binding, however. That is, it is my understanding that banks used to do this even when they were not legally required to do so. Evidently, the redemption option is valued by those who make use of bank-money.

I am aware of only two (not necessarily mutually exclusive) explanations for this contractual stipulation. One is that consumers value insurance against "liquidity shocks" (events were only cash is accepted). The other is that the redemption option serves as sort of a discipline device for bank managers (see Calomaris and Kahn, AER 1991). That is, the put option makes the bank's liability a very short-term debt instrument, so that depositors can potentially pull out very quickly if they sense any hanky-panky. The threat of mass redemptions (and the bankruptcy it would entail) is presumably enough to dissuade self-interested bankers from absconding with depositor wealth.

Sounds wonderful except that, of course, only a very small fraction of a bank's assets are typically in the form of cash. Most of the bank's assets are tied up in "long-term illiquid" assets, like your house, or your human capital. Consequently, while the bank's liabilities may be fully backed, only a small part of this backing is in the form of cash. This is the true nature of fractional reserve banking.

The potential trouble, of course, comes to play when a bank (or worse, the banking system as a whole) is subject to a wave of mass redemptions. There is simply not enough cash in the banking system to honor all of its short-term debt obligations simultaneously. (This is not fraud or deceit; it is something that everyone is--or should be--plainly aware of.) In this event, banks are compelled to sell off their assets to raise the cash they need. This is not something that all banks can all accomplish simultaneously; at least, not without depressing asset values and creating a deflation (the fall in the price-level reflects an increase in the demand for, hence value of, cash relative to goods and services).

There are basically two (possibly more, as readers have suggested below) ways to eliminate retail-level banking panics (waves of mass redemptions). Neither are without cost. One way is to adopt some sort of national deposit insurance system. This is the system that presently exists in the United States (FDIC plus the Fed discount window). People criticize this system because it allegedly promotes moral hazard (banks are induced to take on excessively risky investments). On the other hand, the U.S. has not experienced a retail-level bank run since the Great Depression.

The other way to eliminate retail-level banking panics is to pass legislation requiring all banks to hold 100% cash reserves. This would, of course, kill the business that transforms your illiquid assets into a liquid payment instruments. But it would not necessarily kill the prospect of bank-run-like phenomena. This is because bank-run-like phenomena can emerge even without fractional reserve banking. The phenomenon is possible whenever short-term debt is used to financed long-term (illiquid) asset purchases, as is the case in the wholesale-level banking sector (the so-called "shadow banking" sector).

The use of short-term debt to finance long-term asset purchases (think of the overnight repo market) is, again, a very peculiar financing structure. Like the demand deposit liability, the structure is likely explained by the need to align incentives. While this structure may enhance efficiency along some dimension, it comes at a cost. The analog to a bank run here is a "roll over freeze." This is an event where creditors (depositors) refuse to rollover their short-term funding en masse. In this event, debtors must now scramble to raise funds or dispose of their assets (at "firesale" prices).

If this sounds familiar, it should: it is exactly what happened in our most recent financial crisis. It is also what policymakers currently fear might happen to European banks (who have borrowed USD short-term, to finance longer-term asset purchases; see here). 

This just in from Father Paul's pulpit

The slump in the United States and other advanced economies is the result of a failure of demand -- period, end of story. All attempts to claim that it is somehow structural, or maybe the result of reduced incentives to produce, have collapsed at first contact with the evidence. (link)

You've got to hand it to the man. He has the self-confidence of a Jesuit preacher who believes--really, truly believes in hell--and who fervently wants to share his revelation with us, the poor deprived masses. (Btw, doesn't a "failure of demand" also imply reduced incentives to produce?) I wonder what sort of reply he is expecting from this incredible statement?

Oh, I know, how about....Amen?

P.S. Forgive me Father Paul, for I have sinned. (I have committed the thought-crime of contemplating the possibility that this might not be the "end of the story"...am so ashamed; please prescribe penance.)

Update: This just in (thanks to the Arthurian). Guess he does have a sense of humor! 

What Scott Sumner Knows for Certain

Love TheMoneyIllusion. But does Scott go a little too far with this proclamation?

Here’s what we know for certain about the US business cycle:

1.  If nominal wages are highly sticky, then NGDP slowdowns will raise unemployment.

2.  Nominal wages are highly sticky for at least some workers.

3.  The period after mid-2008 saw the largest NGDP growth collapse since the Great Depression.

4.  The period after mid-2008 saw a huge rise in unemployment.

Points 3 and 4 are empirical statements (and they are true).

Point two sounds like an empirical statement too, but it is not really. The reason is that there are many different theoretical (and empirical) notions of what exactly constitutes a "sticky" nominal wage. Most people have in mind the idea that nominal wage rates do not appear to adjust quickly to changing economic circumstances. But ideally, the concept should be defined more precisely than this (preferably within the context of an explicit economic model). At the very least, we could then be absolutely certain that we were talking about the same thing!

(The other thing I should like to point out here is that people often ignore the huge monthly gross flows of workers into and out of employment. The wages of these workers likely display much more flexibility than those workers employed for some time at a given establishment. I discuss turnover issues here.)

The first point is clearly a theoretical proposition: if X, then Y. As a theoretical proposition, it is likely to remain valid only under a set of specific conditions. Unfortunately, Scott does not provide us with the model he has in mind. And to make matters worse, he seems to want to make us believe that, whatever this model is, it "for certain" applies to the U.S. economy. (Most of what I am complaining about is probably the by-product of loose blogger language, but I think it's important for some things to be more precise.)

Now, I can certainly think of a model that might deliver something resembling the proposition in question. Think of a neoclassical labor market model, where money is somehow necessary, and were nominal price adjustment (or formulating contingent contracts) is costly. Then think of an exogenous decline in the price level (who knows what might have been responsible for that). The implication is that the real wage rises and that this reduces the demand for labor (though why this translates into an increase in unemployment, and not an increase in non-participation, is not usually discussed).

As I have argued elsewhere (The Sticky Price Hypothesis: A Critique), Marshall's scissors (static supply and demand curves) are probably not the best tool we have available to interpret the labor market. The labor market is a a market in relationships, much like the marriage market. The spot wage is irrelevant in enduring relationships; what matters is the time-path of wages and the division of the joint surplus. There are many different wage paths that cost the firm the same in net present value terms. A "sticky" wage (whether real or nominal) need not have any allocative consequences.

I therefore confess that I, for one, do not know "for certain" that if nominal wages are sticky, then NGDP slowdowns will raise unemployment.

It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. Mark Twain

What makes a central bank special?

Nick Rowe over at WCI has an interesting post asking what makes a central bank special; see Currency, Interest, and Redeemability.

According to Nick, what makes a central bank special is not that it can borrow and lend, create money, and set interest rates. All of us can do these things in principle; and in practice, many large private financial institutions do do these things. The difference, as Nick explains, is what he calls "asymmetric redeemability." The Bank of Montreal, for example, issues money redeemable in BoC liabilities; but the reverse is not true.

I think that's right; but let me expand with a few related thoughts of my own.

If one looks at history, a recurring property of monetary economies is the emergence of a "base money" that serves as the redemption object for "broad money" objects. Frequently, the broad money is made redeemable, on demand, and at par, with the base money. (We might even call base money "central" money, as it serves as the focal point for all other monies.)

In modern economies, the demandable liabilities created by chartered banks (M1, say) constitute broad money made redeemable, on demand, and at par, with government cash (small denomination paper). In the antebellum US, private banknotes were made redeemable on demand at par for specie (gold and silver coin). And so on throughout much of recent monetary history.

Now, there are a lot of interesting questions that arise here that are not the main focus of my post here. For example, why do banks embed their liabilities with what amounts to be an American put option (liabilities made redeemable on demand at a fixed strike price)? Is it the byproduct of a legal restriction, or is it an equilibrium phenomenon?

Either way, it seems obvious that the agency in control of the supply of base money (the object of redemption) is going to be in a position to implement "monetary policy." Whether this is a good or bad thing is the subject of much debate of course (let's not get into that here). And so, I have to agree with Nick's conclusion:

There is something very seriously wrong with any approach to monetary theory which says we can assume central banks set interest rates and ignore currency. It is precisely those irredeemable monetary liabilities of the central bank (whether they take the physical form of paper, coin, electrons, does not matter) that give central banks their special power.

(He is, however, not quite right about private agencies not being able to issue irredeemable objects and get them to be used them as money; see Bitcoin).

Scott Sumner, who runs a very nice blog himself, has an interesting take on Nick's post; see: The Bank of Canada is Important Precisely Because it is not a Bank.  Here is Scott:

Now let’s consider a different monetary system.  Imagine a gold standard and a monopoly producer of gold.  The gold mine company would reduce short term interest rates by increasing the supply of gold.  Like currency, gold is irredeemable.  But no one would call this gold mining company a “bank” because it possesses no bank-like qualities.  Banks don’t create irredeemable assets, gold mines do.

Scott is trying to tell us that a central bank is not a bank; it is the monopoly supplier of base money. He also says that "banking has nothing to do with monetary policy."

I find it difficult to evaluate this view because he does not define "bank" or "monetary policy" here (although I'm sure he does elsewhere). Permit me once again to give my 2 cents worth.

A financial intermediary is an asset transformer. An insurance company, for example, takes "deposits" (premiums), purchases assets, and creates a set of state-contingent liabilities backed by these assets. A pension fund, as another example, takes "deposits" (contributions), purchases assets, and creates a set of time-contingent liabilities backed by these assets. A bank, finally, takes "deposits", purchases (or finances) assets, and creates a set of demandable liabilities backed by these assets.

So a bank is a special kind of intermediary. It is special because the demandable liabilities created by banks are used widely as payment instruments; i.e., money (and the demandable property of these liabilities probably goes a long way to enhancing their acceptability as money, but that's another story).

When a bank accepts your land as collateral for a money loan, it performs an asset swap. It is transforming your illiquid land into a liquid asset (the liability created by the bank). Banks are in the business of transforming illiquid assets into liquid assets. This leads us to ask what the Fed is doing when it purchases (say) MBS or UST assets? In my view it is transforming (relatively) illiquid assets into a very liquid asset (Fed cash). QE is banking; and it falls under the category of monetary policy, in my books at least.

So in some sense, all banks (private and public) are engaged in a form of  "monetary policy." But it still remains true that a central bank with legislated monopoly control over the economy's base money object is "special" precisely for this reason. And any theoretical framework that is to have any hope of ever understanding the role of money and banking in society is going to have to model these objects explicitly; the way this guy does, for example. 

Paul Samuelson on Social Security

Great quote here, via Greg Mankiw's blog, by Paul Samuelson on social security:

Social Security is squarely based on what has been called the eighth wonder of the world--compound interest. A growing nation is the greatest Ponzi game ever contrived.

To the right is a cartoon, via Lones Smith, that is just too funny (and sad) for words.

Burtless: It's *not* regulatory and tax uncertainty

Gary Burtless, an economist at the Brookings Institution, seems pretty sure that the relatively depressed levels of U.S. business investment and employment have nothing to do with the alleged uncertainty over future tax and regulatory regimes. Mark Thoma reports the story here.

The main thrust of the argument is contained in the following paragraph:

Then why was uncertainty about taxes and the future burden of the Affordable Care Act holding back business investment right now? If managers thought taxes or regulatory costs might go up in the future, wouldn't it make sense to take advantage of today's low taxes and lower burdens to invest and hire today? According to the "uncertainty" argument, businesses are fearful they might face high taxes and extra health cost in 2016 and 2018. Shouldn't they expand hiring right now and scale back employment when they actually face higher costs (if they ever do)?

Burtless raises some good questions here, but I don't think they are the nail-in-the-coffin he makes them out to be. Why not more investment now, if taxes might go up in 2016 or 2018?

First of all, I'm not sure that those are the only dates businesses have to consider (governments can raise taxes anytime). Second, many large capital projects take a lot more than just a few years to complete. Think about the act of committing a large amount of capital (belonging to you, your friends, your creditors, your shareholders) destined to payoff (if at all) sometime in the distant future. Once committed, this capital is almost completely irreversible and--significantly--it is easily appropriated, since capital cannot run away once it is built). Is it completely crazy to imagine that those contemplating such investments in the current economic climate might want to worry (among other things) the possibility of future changes in tax regime?

Well, maybe my argument does not work so well for employment. As Burtless suggests, why not hire people now and then lay them off if and when taxes rise? One response to this is: How does he know for sure that the future regulatory climate will allow firms to lay off people in this easy manner? If the U.S. is moving to a more European-style economic model (and I'm not saying here whether this is good or bad), then firms may at some point in the future face large penalties for letting workers go.

So what is the problem, according to Mr. Burtless. Predictably, it is this:

The odd thing is, when businesses are asked why they're not expanding, "high taxes" and "heavy regulatory burdens" and "tax uncertainty" don't feature as prominent answers. They mostly say they don't see good prospects for extra sales. But right-wing economists have their talking point, even if they make little sense, and they're sticking to them.

Ah yes, those evil right-wing economists (one can see the halo hovering over his head as he says this).

I've tackled the issue of how firms reply to these business surveys here: Deficient Demand: The Deflated Balloon Hypothesis. Basically the idea is as follows. Consider any shock that leads to a contraction in one sector of the economy. Imagine that sectors are characterized by an interlinking network of demands for intermediate goods and services. A collapse in residential construction can now be expected to reverberate throughout the economy. A decline in the demand for housing also leads to a decline in the demand for all the products that go into making houses. It would not be surprising for someone in the business of producing (say roof shingles) to report that his or her main problem appears to be a "lack of demand" for their product.  But that by itself does not constitute evidence that the macroeconomic problem is a "lack of aggregate demand."

Burtless may very well end up being correct in his assessment. I'm just not sure how he knows for sure that what he says is true.

Updates: September 06, 2011

Regime Uncertainty: The Real (Option) Deal, Craig Pirrong
This is a direct rebuttal to Burtless (h/t Prof J)

Other related links:
Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War, Robert Higgs
The Great Recession and Government Failure, Gary Becker (h/t Alex Karaivanov)

Krugman on Gross

We have to give Bill Gross some credit for admitting his mistaken call on the U.S. Treasury market; see here.

Gross's call was based largely on the fact that the Fed's Treasury purchase program was about to expire. The idea is that with a large component of the demand for Treasury debt removed from the market, bond prices should fall once the program is terminated.

This is what you get when you apply the static Marshallian scissors toward understanding an economic phenomenon. It often works well. But not always. And in any case, we know that forecasting the path of security prices is a tricky business. This is what the efficient markets hypothesis tells us.

Gross's intuition was shared by a few of the macroeconomists I bumped into earlier this year at a macro conference in Konstanz. I remember one of my Fed colleagues and myself suggesting to a sceptical audience that one should not expect any dramatic bond price movement once the Fed's purchases ended, largely because the market had already discounted that event. I don't think we were very successful at persuading people. Well, we turned out to be right about that (maybe we got lucky). [Actually, I did give my view of Gross' predictions here in March 2011].

Subsequently, of course, the price of US Treasuries have risen substantially. We did not make that prediction (nor did we try). But evidently, Paul Krugman seems to think he did; see Who You Gonna Bet On?

Yep. All we need is the Econ 101 macro model to understand this crisis and predict bond prices. (Oh, and gold prices have shot up too...where do those appear in that model?)

Do we really need an IS-LM model to tell us that when two assets with similar risk properties and similar returns are swapped in the Fed's portfolio that nothing much is likely to happen? (And as I explain here, standard monetary models deliver "flight to quality" phenomena quite easily.)

Krugman's article gives the impression that simple IS-LM analysis could have predicted the recent fall in Treasury yields. Do people actually find this credible?