Tuesday, January 20, 2015

Unlearning Money: Part 3

Can commercial banks create "money" as much as they want, or is their ability to do it constrained?

Individual banks face both capital and reserve requirements. But retained earnings from net interest income help in taking care of any increase in capital requirements. This is why capital requirements rarely pose any problems in an environment of economic growth. The economy is growing, credit is growing (the economy makes credit grow and credit makes the economy grow; go figure), and with aggregate credit growth comes usually growth in banks' net interest income. The capital requirement might become a real constraint only when credit, for other reasons, is either growing at a decreasing pace or outright contracting.

Reserve constraints, like capital constraints, pose a smaller problem when the banking system as a whole is increasing lending, i.e. there is aggregate credit growth. When Bank A makes a loan, a deposit created by it might end up being transferred to Bank B, but in similar fashion Bank A is a recipient of deposits created by other banks. This will lead to fairly small net payments between banks.

Let us go a bit further and assume we would like to remove nearly all reserve constraints --including all frictions arising from reserve requirements-- to credit growth. If we are to reduce any friction arising from the netting process itself, we can (in addition to operational and technological improvements) make most of the transactions take place between few "megabanks" in each economic area. If these megabanks view each other more or less "too big to fail", then we have established a large amount of trust (some might rather call it moral hazard) which will make the netting process even smoother and commercial banks more willing to lend reserves to each other. Now that we got started, we could also have the central bank and the government guarantee all loans between these megabanks and any remaining mid-sized banks too, and not only that, but the central bank could create new reserves if the aggregate amount of reserves falls too close to the required level. Required by who? Well, the authorities could simply remove any reserve requirements to start with. Does this mean that the reserve requirements are there only in case the central bank would some day like to resist credit growth, not fuel it? It could be. Someone better ask Paul Volcker -- he might remember.

(Readers familiar with our current monetary system might recognize some familiar aspects in the thought experiment above.)

I would thus argue that in a benevolent economic environment *, the credit supply is not really constrained at all. In a hostile environment, it is mainly constrained by banks' own risk considerations. There are good reasons to believe that the banks can be "irrationally" risk averse, but fortunately this can be countered by bold ("whatever it takes") and firm ("The US government has a technology, called a printing press") action taken by monetary authorities.

If the authorities are even partly successful in their attempt to sustain bank lending during an economic downturn --as currently seems to be the case in many economies--, we can fairly safely conclude that in our current monetary system the real credit growth constraints lie on the demand side. It is the public's, and increasingly the households' --not businesses'-- willingness to borrow that decides the pace of credit growth in most of the advanced economies today. And this in fact is how many academic economists and government officials would like it to be. They have worked hard to achieve this for some decades now. It is easy to track their related actions to the 1980s, and the underlying train of thought probably harks back to academic ideas that emerged in the 1950s.

I will come back to this in my coming posts. For now, I want to suggest the following: We should probably not lump household debt and business debt together in our analyses. They are two distinct forms of debt and taking them apart and studying them separately could be the most fruitful way to proceed in solving our current (scientific) problems in economics.

Some background information:

I have studied money and credit very intensively and, I believe, somewhat independently for about 10 months now and I am looking forward to sharing my major findings in the coming posts. By "intensively" I mean quitting any job you might have, living frugally on some savings, reading economics/philosophy/psychology/history/everything your intuition says you might want to read, thinking, writing, and waking up every morning with "monetary thoughts" racing in your head, making you wonder if those thoughts actually ever had a rest. This can hardly surprise any true monetary economist, a breed that reminds me more of Ludwig Wittgenstein than of Paul Samuelson. For my part, I am happy to say that I feel very good now and during the whole episode I did not use any medication or even professional help, although I have understanding for any colleagues who might have done so...

I consider as my main audience all the like-minded people who just cannot let "money" remain an enigma and are willing to risk their mental health in the name of increased understanding.

* My definition of a "benevolent economic environment": GDP growth fluctuates around its (abstract, and perhaps self-referential) trend and long-term inflation expectations remain well-anchored -- as judged by financial markets. This leaves some room for me to speculate whether half of the investors could be expecting very high inflation and the other half a "Fisherian debt-deflation", and inflation expectations would still seem "well-anchored".

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