Brad Setser

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An unlimited guarantee requires unlimited access to financing …

by Brad Setser
October 13, 2008

Over the weekend, the countries of the G-7 indicated that they would do “whatever it takes” to prevent another Lehman-style bankruptcy. They pledged to “use all available tools to support systemically important financial institutions and prevent their failure. ”

Many European banks need access to short-term dollar financing to support their dollar assets, as we discovered after Lehman default’s led to a run on money market funds. Today, the Fed and the major European central banks made sure that any European bank that needs dollars will get dollars:

“The BoE, ECB, and SNB will conduct tenders of U.S. dollar funding at 7-day, 28-day, and 84-day maturities at fixed interest rates for full allotment. Funds will be provided at a fixed interest rate, set in advance of each operation. Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction. Accordingly, sizes of the reciprocal currency arrangements (swap lines) between the Federal Reserve and the BoE, the ECB, and the SNB will be increased to accommodate whatever quantity of U.S. dollar funding is demanded.”

Emphasis added.

Any word, when over-used, loses its impact — but this really is unprecedented.

The US and the major European central banks have effectively agreed to lend without limit to make good on their pledge to avoid a systemic bank failure. All major financial institutions in the G-10 ultimately now have access — through their national central bank — to the Fed. This isn’t quite a global lender of last resort (in dollars) but it is close. Banks are different than countries, so the analogy is imprecise — but back when emerging economies had trouble rolling over their short-term dollar debts during the crises of 97-98, the G-7 never pledged to lend “any amount” needed.

Lending to countries through institutions like the IMF isn’t collateralized — but it also was never unconditional. The G-7’s guarantee of liquidity doesn’t seem to be linked to steps the banks could take to help themselves — like suspending dividend payments on their common stock.

The nature of the global response to the current crisis is beginning to emerge.

Step 1 is to guarantee against failure — or at least the kind of failure that leads to losses for unsecured creditors. If such guarantees are credible — and money market funds stop losing funds, so they have money to lend — that should guarantee that any systemically important institution can borrow the funds it needs to repay its maturing short-term debts, no matter how troubled its balance sheet. Short-term bank debt would be as good as short-term Treasury debt.

A necessary component to this guarantee though is a real effort to recapitalize the financial system, so that the banks will eventually be able to borrow on the strength of their own balance sheets — not on the strength of the government’s guarantee.

France, Germany, and the UK have now pledged a sum substantially larger than the United States’ TARP to backstop their banks — and they have indicated their willingness to take large equity stakes in their respective bank systems. France has pledged a sum of up to 2% its GDP. The UK has already committed 37 billion pounds ($64 billion), or 2.5% of its GDP. Germany has indicated that it willing to use 3.2% of its GDP to buy equity in its banks. Comparable US equity injections from the US government would imply a commitment of between $300 and $500b.

That seems to me to provide a baseline from evaluating the scale of the equity investments the TARP may need to make. The IMF has estimated that the major banks need roughly $700b in new equity capital.

The US government still seems to worry that overly punitive terms would discourage “healthy” institutions from seeking a government equity injection. I understand the need to be reassuring — and to make it clear that the injection of government funds is considered to be reassuring rather than evidence of hidden problems.

At the same time, I would hope that the executives of America’s banks gathering at the Treasury this afternoon recognize that a lack of confidence in the quality of their balance sheets pushed the global financial system to the edge of collapse. Lehman’s default revealed that few large financial institutions can currently borrow without at least an implicit government guarantee. The market isn’t sure about the valuations they have given to their illiquid and opaque assets — and thus isn’t convinced about their solvency in rapidly slowing global economy. No bank executive wants to dilute existing equity investors. But absent unprecedented government intervention first to provide the banks with emergency financing and now to guarantee their liabilities, many banks would have already had to shut their doors.

I am open to be being persuaded otherwise, but I would think that any institution that is now borrowing heavily from the Fed should be expected to receive an equity injection from the government if it cannot quickly raise substantial sums from true sources of risk capital — and by that I mean sources of capital that are investing in the banks without any expectation that the government will protect new equity investment from future losses.

Absent a major equity infusion, it is hard to see how the banking system can be weaned off the need to rely on the government’s implicit — if not explicit — guarantee to borrow. Think of it this way: all the concerns traditionally raised about Fanny and Freddy — privately owned companies borrowing in the market on the back of a government guarantee rather than than the strength of their own balance sheets — now apply to the “private” financial system.

It looks like the G-7’s actions have kept the financial system from falling off the precipice. But a world where the government guarantees the ability of privately owned banks with potentially troubled balance sheets to raise wholesale funding is neither desirable nor necessarily stable for long.

UPDATE: The Treasury has indicated that it will inject $250 billion in the banking system — in a way that in effect leaves the banks no choice but to accept the Treasury’s offer to buy preferred stock. That addresses one of my concerns, namely that the government wouldn’t use the leverage associated with its de facto guarantee of bank liabilities to force the banks to accept actions that are good for the system as a whole even if they are bad for current shareholders. But as Felix Salmon notes, it isn’t clear how much preferred equity the government will get in exchange for its capital and the government is buying non-voting stakes — leaving it to the Fed and other regulators to assure that the capacity to raise funds on the back of the government’s guarantee isn’t abused. And as Yves Smith notes, the government seems to have opted to support all the remaining large players in the system. That helps to explain the stock market rally — but it also potentially leaves some difficult questions unresolved.


  • Posted by Tim Shephard

    “But a world where the government guarantees the ability of privately owned banks with potentially troubled balance sheets to raise wholesale funding is neither desirable nor necessarily stable for long.”

    Why not? As long as they can figure out some good ways to make sure the money is being loaned out in a way that is priced sanely (given then nature of the counterparty, their collateral, and how they plan on using it), I think it will be OK.

    Personally, I think CBs are just replacing the Shadow Banking System, which seems like a good idea given how easily the latter can give way to panic..

  • Posted by John Smith

    Is “guaranteed capitalism” a contradiction in terms, as our Libertarian friends point out?

    But is it not the end result of “peoples’ capitalism”, which tries to turn “workers” into “investors”, and increase the base of people who back the free market uncritically?

    Investment gains are now expected for life by our “investor class” (primarily the top 35% of our population). Government-guaranteed investments are the price they demand for not “acting like workers” on the job and w.r.t normal gov’t programs.

    Wouldn’t the latter be cheaper? Wouldn’t the welfare costs of greater unionization and expanded social security be less than our maniac bubbles and frenzied gov’t guarantees?

  • Posted by moldbug

    Can any Japan experts explain how this differs from the route Japan took? It seems pretty similar to me.

    AFAIK the basic problem in Japan was that the government could lend all the money it wanted to the banks, but the banks if anything wanted to contract their balance sheets. They had few incentives to open new loans in an environment of falling asset prices.

    Today’s Fanny and Freddy are in a slightly different position – they are acting as genuinely nationalized entities, lending because they are forced to lend. To get the rest of the “private” financial system to work this way strikes me as a difficult step. The government is pushing on a string, and the string is the “private” management of the zombie banks – who clog up the pipe between Uncle Sam, who wants to lend, and his faithful subjects, who want to borrow.

    And turning a zombie into a non-zombie is, as you note, difficult. Among other things, in an environment where assets sell for nine cents on the dollar, it takes a lot of recapitalization to make a bank solvent!

  • Posted by Bernardo A

    Ok, but at least it will help rebalancing the US CA deficit. Unless the US will end up lending to their banks more money than will the rest of the world (which is improbable given that also the rest of the world is in trouble).

  • Posted by karen

    welcome to the fiat world: where deficits don’t matter and there is unlimited access to financing.

  • Posted by john

    Comment #2. Fascinating comment. However, “the people” were willing participants in this fantasy too. Part of that “survival of the fittest” mentality combined with the I’m-above-average-dumb-ass-optimism that is present in most Americans. Regardless of how “it caught on”, however, it’ll be a long, LONG time before any American political party can go on TV and tell “the people” that they are hopeless dumb-asses and can’t be trusted with their own money; even if it IS true. If I recall, it was only a few years ago that dumb-asses were clamoring to invest their Social Security funds in the scam-market.

    My own opinion is that this stems from the majority-ethic group still hoping (against hope) that the Republicans will EVENTUALLY help them get even with “those people”, and hence, while they are vainly waiting, will ignore being ripped-off themselves. They’ve cut-off-their-noses-to-spite-their-faces; for the last 20+ years.

  • Posted by Bernardo A

    Brad, please explain: will the FED issue bonds in order to raise the money to give to its lenders? Or will the FED buy banks’ bonds? In other words: will the FED lending represent a net capital outflow or an inflow for the US?

  • Posted by Tony

    Over the two years, I’ve grown accustomed to well-reasoned prognostication from the financial and economics blogosphere. Regular readers have known for a long time — much earlier than commentators in the mainstream media — that asset values inevitably would fall, that major banking institutions’ balance sheets could not withstand the losses, and that the United States current account deficit would be a politically and economically important factor in the unraveling.

    Now that the *real* mother of all bailouts has been proposed, no one seems to be able to look farther out beyond a few weeks. I know that this plan has just been announced, but let the discussion of the unknowns begin already. Yes, it is obvious that a blanket government guarantee of virtually the entire private banking system is certain, for a few weeks or months, to ensure the survival of private banks in the eyes of investors and counter-parties.

    The real question is, then what?

    Why won’t these guarantees turn the banks into zombies? In the absence of direct government control, why on Earth would Bank of America expand mortgage lending, credit card lending, business lending or any other kind of lending in a contracting economy?

    Also, what are the currency effects of these coordinated actions? Will these actions outweigh deflationary pressure of contracting credit, or, somehow, can these governments pay for these actions without printing? Will there be unequal effects among currencies? Do these action increase or reduce the risk of a flight away from the dollar? What is happening to the balance sheet of the Federal Reserve?

    What losses can we expect taxpayers to incur? Asset losses are probably only about halfway over. Many more banks will be pushed into insolvency. Will the currently discussed levels of equity injections be enough to cover the expected loses? Is there a point at which a major Western nation might be expected to default? Is there a point at which a Western nation might politically revolt?

    I don’t know much, but I bet you have some ideas on these issues, Brad.

  • Posted by don

    “Short-term bank debt would be as good as short-term Treasury debt.”
    What is worrisome, I’m afraid the reverse will soon become just as true – short-term Treasury debt will be as good as short-term bank debt.

  • Posted by Cedric Regula

    Part of the USG “toolkit” is guaranteeing money markets and also direct loans to corporations, if I read that right, wherever I read it. So that is how they are side stepping the private banking system.

    But what they are doing with the bank problem at the moment is clearly a stop gap measure(I hope) to buy time. They can’t practically nationalize the entire banking system at once. Ben & Hank don’t have enough minions to run it, and probably don’t want to spend their days and nights approving car loans and credit card apps.

    But there are plenty of problems with leaving things as they are. Like funding zombies, and if moral hazard was bad because of implicit guarantee, explicit guarantee makes it much worse.

    How we ever wean them off of this is a big problem. We have to somehow stop “interest rate engineering” and using leverage to drive GDP growth, commodity prices, stock prices, and government tax receipts. We have taken taken the marriage of Keynesian and Supply Side economics way past the brink.

    But the global economy would have to shrink to get there, and that would probably bankrupt the G10, now that they saved the banks. Next problem….

    This also would eventually be inflationary, if the banking system does start lending all the money they have stuffed in their mattresses, and we do re-cap them and take illiquid loans off the books. So the Fed does have to call the money back someday and not keep replacing it with new swaps and repos.

    But there is nothing like a 20% down week in the stock market to turn everyone into a Keynesian, shut up about moral hazard, and even say things like “inflation is better than deflation”.

  • Posted by fresno dan

    I agree that some of our problems have to do with a “freeze” in the credit martket…but not most. Capital was misallocated, and most prudent consumers and bussinesses are not going to borrow now. Who is going to build another Starbucks??? Are we really under premium coffeed? How many more granite countertops can be sold? With HELOC’s being stopped, most consumers simply do not have funds for anything other than gas and food at the current prices.

  • Posted by Don the libertarian Democrat

    day, October 12, 2008
    My Prediction
    I want to make a prediction, just in case it comes true and people will think that I’m very smart for no good reason. Many people are predicting the end of capitalism or saying more sensible things like this:

    “It is possible, then, that the main legacy of the crisis will be some form of corrective to the country’s recent excesses. The economy looks to be heading into a period of more regulated, but still American-style, capitalism, more along the lines of how it operated in the 1950s, 1960s and 1990s. Those three decades happen to have produced the biggest and most widely shared economic gains since World War II.”

    I think that this is wrong, and the end of capitalism is silly.

    I predict the following:

    1) There will be more regulation, but it will focus on keeping crises from occurring, not on micro-managing the economy. ( See this post )

    2) The government will more quickly than many believe get out out of these crisis investments.

    3) A major cause of the crises infecting our current system will turn out to be the implicit and explicit guarantees by the government to intervene in crises such as this. It will be obvious that such interventions are too costly for governments in the future.

    There you have it. We will have more government aid to the truly needy in the future, but the idea that government can manage the economies of the future more efficiently than private enterprise will turn out to be false.

    Don’t say you haven’t been warned!

  • Posted by Stephen

    I agree completely with Tony. Ok already we had to do what has and will be done, but what are the long term effects on economy and currency? I hope Brad can give us some general insights, I truly appreciate his efforts here on this public blogsite.

  • Posted by black swan

    A nice provision I would have liked to have seen added to the Paulson bill, would have kept any directors, who had received any form of bank stock or bonds as part of their compensation packages, from selling that stock until any Government assistance their banks had recieved had been paid back. That would stop the pump and dumpers.

  • Posted by JKH


    “I am open to be being persuaded otherwise, but I would think that any institution that is now borrowing heavily from the Fed should be expected to receive an equity injection from the government if it cannot quickly raise substantial sums from true sources of risk capital — and by that I mean sources of capital that are investing in the banks without any expectation that the government will protect new equity investment from future losses.”

    Without constructing an elaborate argument against it, I’ll have to disagree with this. The emphasis on reprivatisation urgency is misplaced in this instance, in my view.

    If you step back and examine the full architecture resulting from the cumulative sequence of programs, you basically have the following:

    a) Various Fed lending programs directed primarily to the liquidity of institutions
    b) TARP Mach I, directed primarily to the liquidity of asset markets
    c) TARP Mach II, directed ultimately to the solvency of institutions

    Each of the stages noted above is aimed at jump starting corresponding broken counterparts in the private financial sector – liabilities, assets, and capital respectively. Each is aimed at providing support for the eventual re-entry of private sector activity.

    (I think the surprise 6 months from now will be the degree to which TARP Mach I was utilized. Most commentators think it was a mistake and that the authorities should have moved to Mach II directly. I disagree. While direct capital support is necessary and essential, I don’t think it’s sufficient for an optimally balanced program. I think the asset purchase program will end being a useful part of the arsenal.)

    In the case of capital, the idea is to provide an additional insurance cushion at the senior level of equity, while the markets sort out more clearly the effective value of the junior levels. Some institutions will end up being solvent; some won’t. The sorting out process will lead to sources of private capital identifying where the opportunities are, and then coming back in to recapitalize those institutions with prospects, making the eventual retirement of government equity possible in the case of the winners.

    This all takes time. Financial institutions, households, and markets require time for workout. The origin of this crisis is a massive failure of risk management across the spectrum – financial institutions, regulators, and importantly households. But the unusual intensity of it is due to the fact that this is the first time that massive financial claims on household cash flows have been marked to market in triggering such an event – hence the calamity of its accelerated effect on financial markets.

    In short, there is a massive time mismatch between the rollout of the underlying real economic event and its effect on financial markets.

    It’s time to be a little more patient with the rollout of the solution, I think.

  • Posted by moldbug


    I think the expansion of the Fed’s LLR commitment to provide global liquidity is important enough to qualify as a (d) on your series. Obviously, much of the panic selling was coming from Europe, which had been practicing unprotected maturity transformation in dollars. That wound now seems to be closed.

    But we have already seen this battle play out in the struggle to provide liquidity facilities for the US shadow banking system, earlier this year. Providing an infinite supply of short-term loans is a way to prevent banks from liquidating more long-term loans in fire sales. It is not a way to compel banks to use new borrowing to make new acquisitions, whether by making new loans or by buying old ones on the fire-sale market.

    Troubled assets tend to carry high default risks, but the risk-free interest rate in the troubled-asset markets is, while unknowable, extremely high. It seems theoretically possible that once the market is convinced that there will be no further forced asset sales, MT could flip back on extremely fast.

    But it is hard to be sure this is really the case, and there are feedback cycles in the real economy – your time mismatch – that could mimic the effect of further financial liquidation.

    Moreover, even if the financial bleeding is stopped promptly and we don’t end up in Japan, the result is a high level of dependence on political lending that will be very hard to reverse. It certainly does not do anything to resolve the international currency imbalances that this blog is all about.

  • Posted by joebhed

    The problem is either expressed as illiquidity or insolvency, depending on one’s point of view.
    That is, credit, or debt.
    Our total existence to date has been funded via nominally $50 TRILLION in repayables.
    This fact stems from a mighty capitalist truism.
    All money created to “fund” our economic activity is created as a debt, payable with interest.
    As someone said, we have really run out of adjectives to describe the true scale of the problem, a “bubble” of debt that will drown(kill) the nation’s economy if it bursts, i.e.contraction and deflation.

    Yet, the grand sum of ALL of the solutions offered here is another humongous infusion of the cause of the problem – too much debt.
    It might feel good for a minute or two, but it cannot be sustained.
    Repayment, given ALL NEW MONEY is created as debt, is impossible.
    I don’t see ANYTHING that addresses this truism.
    I must be wrong.

  • Posted by JKH


    I agree with you on the importance of the international projection of LLR.

    Also important are FDIC type insurance expansions, including those of the interbank type.

    I would group these within a redefined category a) above, as support directed toward financial institution liabilities in the broadest sense.

  • Posted by James Bowery

    Isn’t the point of all this to let the banks sit on a huge inventory of empty houses shelting only rats and crack house squatters, while evicted families are living in tent cities?

  • Posted by Cedric Regula


    I’ve been thinking banks should set up REIT divisions and manage rentals for people that want to move back from tent cities. Maybe look the other way when evaluating the screwed up credit rating of prospective renters. Like Liar Leases or something.

    But that would be too much work for bankers, and wouldn’t help the balance sheet. Much easier to stick the USG/taxpayer with the problem.

  • Posted by touche

    What everyone is wondering is whether the drastic measures that have been adopted the last few days are a long-term solution to the insolvencies of financial institutions or whether it is just a futile effort to postpone the day of reckoning a little while longer. No one has put any up any sound argument for the former, so it must be the latter.

  • Posted by bsetser

    JKH — good points; I agree that it isn’t necessary or even a good to try to “reprivatize” banks too quickly. For one thing, the regulatory regime for the banking system needs to be reworked first.

    Your argument about the surprise of the next 6 months being asset purchases is interesting. I can see the case for doing so alongside equity injections that allow the banks to sell at a realistic price without becoming insolvent, as it would provide the banks with a bit of needed liquidity to use to pay down debt/ lend out — tho I also still worry that it will be impossible to find a fair way to price enough a very heterogenous pool of assets to make TARP Mark I work all that effectively.

    That said, I probably didn’t explain my motives for seeing the banks recapitalized clearly. Tis true that with a credible guarantee, banks can operate with any capital, or even with assets that are worth less than their liabilities. think of the Chinese state banks in the late 90s!

    So why a desire to see a recap now, rather than just credible governmetn guarantees. Part of it is a desire to stop dancing around the hard issues and make choices. Part of it is a sense of equity — guarantees extended for free are a give away to existing equity investors (tho valuing equity right now is hard, given the difficulties of firesales would be compounded if lots of firesales were going on at once). Part of it is a sense that allowing institutions to borrow on the back of a government guarantee creates incentives for excessive risk taking. And part of it is a sense that without equity injections, lots of institutions will have a strong incentive to hold on to bad assets rather than sell them to avoid booking losses — and thus the underlying problem will fester. it is better it seems to me to write the bad assets down, do a recap and give the bank the option of holding (and booking profits over time if the assets prove to be good) or selling/ moving on rather than basically keeping the current game going by allowing the banks to try to wait it out while borrowing on the back of the guarantee.

  • Posted by jim, fullerton, ca.

    The Government pushes money to banks. The banks will only lend if the lending standards are reduced or eliminated which means they will not get repaid.

    With high unemployment and recessions, there are few qualified borrowers who need financing. Thats the problem!!

  • Posted by LB

    james: that’s a really enlightening comment. at the center of this global spiral of flows is a cash-for-land deal yes?

    tony makes another great point — the end of the rainbow is way past the next 2 weeks, or the next 84 days, or even the next 4 years (or so they think and that might be their achilles heel in the end).

    e.g. the only corporations that are currently in DJ30 that were there in 1932 are 2 — GM & GE.

    cedric: with that platform alone, i hereby nominate you for president —

  • Posted by bsetser

    The swaps are rather complicated in a BoP sense.

    the ECB lends euros to the fed, leading to an increase in the fed’s liabilities and to the united states external liabilities. But the fed holds the euros it borrows on deposit at the say the ECB, so the Fed and the united states external assets also go up. it is a wash. A capital inflow from the ECB finances the buildup of US external assets (an outflow).

    The Fed lends $ to the ECB — leading to an increase in the europe’s external liabilities/ the united states external assets. This is a capital outflow … as it results in a US claim on a non-resident, i.e. the ECB. The ECB then lends the $ to a European bank. that is a new domestic asset for the ECB (the dollar loan)/ new domesic liabilities for the European bank (the need to repay the ECB) — there is no BoP impact. The european bank then repays a US money market fund. That is a capital inflow to the US, or rather a reduction in net US external assets (an existing loan to the world is repaid, leaving the US private sector with fewer claims on the rest of the world). The net result is that a capital outflow from the Fed finances the repayment of a private US loan to the rest of the world, so the fed’s external assets go up/ private external assets go down and the net BoP impact is zero. A fed loan to the ECB that finances a ECB loan to a private European bank replaces a private US loan to the European bank. Net US claims on the world are unchanged.

    At least that is how I think it would scored.

  • Posted by ccm

    The implications of this post and the previous one are huge. Think about it: If (a lot of) financial commercial paper was sold with an implicit government guarantee, then we should come to the same conclusion that we reached with Fannie and Freddie. If they are to be reprivatized, they must be reduced to a size such that a default would be manageable.

    Since I’m pretty sure the long-term goal is to extinguish the government equity position, this implies that any reasonable plan proposed by Treasury should have as one of its goals the reduction in size of the financial commercial paper market — so that a bank default would never again have Lehman-like effects.

    However, the plan reported on by Yves Smith appears to go in the opposite direction: interest bearing debt is insured for three years, whereas only non-interest bearing deposits over $250,000 are insured. In other words, Treasury’s plan appears likely to result in an increase in financial commercial paper — and an increase in the need for government guarantees!

  • Posted by Cedric Regula

    Yves Smith seems to have the same concerns as me about how TARP Mach 2 is taking off. Could turn out to be Welfare for Bankers, or maybe a really good unemployment plan for working mother….rather than right sizing of the industry with some regard for taxpayer interests.

    “This would not be as bad as Shedlock suggests IF there was also, as in the best-practices model of Sweden, some punitive elements (getting rid of incumbent management, wiping out shareholders, nationalizing banks, which in the Swedish case enabled the taxpayer to profit) and a plan to rationalize (as in shrink in an orderly fashion) the industry. Instead, the Treasury appears to be trying to prop up the industry in place. That is not likely to be a winning formula.”

    “WSJ Provides Sneak Preview of Treasury Bank Salvage Operations”

  • Posted by LB

    bset — on top of everything else you illuminated, the FX swaps give the FED a short-term currency hedge against any possible USD depreciation by adding foreign currency onto its balance sheet, yes?

    if so, brilliant move ben…you just negotiated us americanos 84 more days of dollar hegemony…

    have a holly jolly xmas!
    (don’t forget to use your mastercard)

  • Posted by Frank Gifford

    I am wandering around in these trees, and I keep bumping into this forest I can’t see. Then I step into this puddle of peak oil, but I still can’t wake up:)

  • Posted by Cedric Regula

    Mish takes a peak at implementing TARP Warp 1&2.

    England did their 4 largest banks today, but looks like we may worry about all thousands of ours. No mention of prioritizing the FDIC to gobble up the Fed bad bank list as I had hoped.

    Looks like they did placate Mitsubishi enough to go ahead on the MS deal. They were worried about being a wiped out preferred shareholder next year. These guys can think ahead believe or not.

    Quote from Mr. Kashkari, “interim administrator”.

    “A program as large and complex as this would normally take months — or even years — to establish. We don’t have months or years,” Mr. Kashkari said. “Hence, we are moving to implement the TARP as quickly as possible while working to ensure high quality execution.”

  • Posted by JKH


    “The swaps are rather complicated in a BoP sense.”

    I agree with your explanation, which is in the form of a particular example. I’m sort of intrigued by this stuff, so here’s another way of looking at it, albeit a little more abstractly:

    As mentioned on other occasions, the fundamental mechanics of Fed money creation don’t change even when it extends dollar credit beyond US borders. The swap creates dollar credit on the asset side of the balance sheet which is offset by an increase in bank reserves on the liability side. The reserves are created by the swapped dollars in your example flowing from the Fed to the ECB to the foreign bank to the domestic money market fund to the US bank account of the domestic money fund to the Fed reserve account of that bank. Those reserves are newly created – the final result of the original dollars created and exported via the Fed’s swap. The Fed takes steps to deal with the new excess reserves if required through various sterilization techniques.

    The Fed’s two balance sheet entries – swapped dollar asset; new reserve liability – represent the full round trip of the dollars via the balance of payments. This is a balance sheet management operation that takes place entirely through the capital account. Another way of looking at it is that there is no change in net international claims because the operation is quite independent of the current account, and uninterrupted by it. The dollars that leave the US must therefore come back to the US.

    (I assume that the “swapped dollar asset” is in the form of foreign currency the Fed has received on the swap where a forward contract exists to retire or roll the asset at a specified exchange rate for future US dollars – i.e. foreign exchange risk has been hedged – and therefore what remains is effectively a US dollar asset.)

  • Posted by bsetser

    LB — I don’t think the Fed really has a currency hedge. The fx is collateral against the loan — but there is is little realistic risk that foreign governments won’t pay and the US will seize the collateral. Given that the US is ultimately lending to backstop US money market funds — and lending to allies — if a foreign central bank couldn’t pay the US would almost certainly rollover the swap line.

    Moreover, as JKH suggests, the forward price of retiring the dollar has likely been spelled out in the swap, to the fed still effectively has a dollar asset. It isn’t that different from China’s swaps with the domestic banks in that sense — the PBoC agrees on the price it will buy the dollars back from the banks, giving the banks dollars to invest but leaving the pboc with the exchange rate risk.

    JKH — I agree with your comment. The question I haven’t fully worked out (due to both a lack of time and a lack of understanding) is whether the Fed’s sterilization efforts have matched the scale of the lending to foreign central banks through the swap contracts.

  • Posted by Cedric Regula


    I think you just fix the number of euros for dollars on the date of the swap, then that is how many you get when you unwind the swap. But I’m the type that doesn’t like paying broker commissions if I don’t have to.

    But I also like making up examples illustrating why all these machinations may be necessary. One reason I can think why they need dollars in Europe (besides the obvious one… BP, Total, Eni, Satoil all need real money to buy oil.) is US FDI is pulling out of Euro stocks and bonds and pulls dollars out of Europe. So the ECB and BOE need dollar liquidity for their banks and brokers.

    These dollars do come back, and are not safely in the Feds non-inflationary vault. So it seems the Treasury would need to give the Fed some treasuries to sell for sterilization efforts(since the Fed ran out of everything marketable already), tho with all the other treasury borrowing and money disappearing everywhere the Fed may not worry about it too much and just do their normal thing and watch the inflation index to see if money supply is too loose or restrictive.

    But I still think they have a big incentive to sit on dollars if they can (and dollars even appreciate now) and keep the LIBOR rate high so they rake in the dough on their existing portfolios. Wish I new more about what the nature of their dollar denominated portfolios are, but I don’t. Dollar denominated loans to BRICs, Eastern Europe, and the 3rd world maybe?

  • Posted by JKH


    Nor have I followed the sterilization effect that closely. My rough impression is that, concurrent with the activation of swap activity and the general market meltdown, the domestic fed funds rate has become extremely volatile on the upside (probably for the same type of reason that Libor is high). This would explain why Fed has set a very high actual reserve level according to recent weekly statements. The required system level isn’t much more than $ 10 billion, while actual levels have ranged up to $ 175 billion – extraordinary excess reserve settings for extraordinary times. This is compounded by the fact that standard discount window borrowings result in generally unanticipated increases in excess reserves. But apart from that, the excess position is under the control of the Fed. They wouldn’t be running it as high as they are if they didn’t think it wasn’t required due to the funds rate volatility. The important point is that they have the tools to sterilize when they deem necessary – and now they have even more flexibility by being able to pay interest on reserves. Expanding the swap program won’t be a problem for any required sterilization offset. But for the time being, the funds rate has been getting away from them on the upside, and they need to flood the system with excess reserves in response.

  • Posted by JKH


    Yes, they could also issue treasury bills.

    They may have to do some experimenting to find the best combination of things to do, given the brand new system of paying interest on reserves, particularly in relation to this credit crisis environment and the unusual volatility in actual Fed funds and Libor rates.

  • Posted by LB

    bset — i’d be foolhardy & poundpoor not to defer to your better judgement on this, but if i could take one more stab at clarity:

    i wasn’t suggesting that any foreign CB’s would default and this could be a permanent asset…however, in the short term (<84 days max), as you said earlier, the FX currency is an asset that the FED has on their balance sheet, yes?

    you also said in a prior post that the FED has the option to request more collateral if the value of the USD rises.

    however, what if the USD falls? is it a 2 way street? does the FED give back some of the collateral? if not, why wouldn’t that be considered a hedge for the duration of the term?

    isn’t that what JKH said as well, that the FED is locking in a future price of the swap even if the FX rates are different at the end of the term?

    your example of China is a bit different as their currency is pegged to a basket including the USD, so the FX deviation is more minimal than it could be vs. the Euro.

    the point i’m considering is not who’s right and who’s wrong (as we’re all just searching in the shadows here), but rather reinforcing not only your point that this swap deal is a wash (given sterilization), but also what i think is JKH’s point that it’s also a partial short-term hedge against any possible devaluation of USD.

    emphasis on short-term ONLY…when the loan is repaid and the currency reswapped, those USD’s that were ‘loaned’ out are now in the money supply.

    whether they are in the publicly disclosed M2 or in the non-public M3 is a whole other can of worms.

    bset & JK, please feel free to correct me if i’m misunderstanding either of your positions.

  • Posted by Cedric Regula


    I don’t think sterilization will be happening for a while yet, but I have a nagging suspicion that when it does become necessary, we see another jump voted in the debt ceiling. If I correctly understand how it would have to work now with the Treasury issuing new bonds to the Fed, so the Fed can trade those for cash with a member bank to soak up excess liquidity. Unless we think the Fed can unload the kinds of assets it’s been taking as collateral lately. But they have been acting more like a pawn shop than a central bank.

    The new thing of paying interest on bank reserve requirements is also billed as not needing sterilization, from what I’ve read. That really confuses me. How can paying interest to the banking system be neutral to money supply growth over time?

  • Posted by bsetser

    let me double check — once JKH mentioned it, i started to think that the currency risk in the swap is managed by forward commitments rather than by adjusting the amount of collateral pledged. i know way more about the mechanics of imf lending (a treasury speciality) than the mechanics of the swaps (the fed’s world)

    tis true that the chinese swaps are a bit different – but also remember that the big risk that the banks need insuring against is a change in China’s fx regime that would lead to a sudden big swing, so it isn’t all that different.

  • Posted by JKH


    I’m not certain, but I expect that the currency swap includes an agreed exchange rate at maturity that differs from the exchange rate at inception, where the difference would likely recognize the interest rate differential between similar investments in the two currencies.

    From the Fed’s perspective then, the swap should deliver an all-in rate of return on the Fed’s original US dollars that is similar to the rate of return it might earn by investing US dollars directly. This would be the result of combining the rate of return from investing the upfront foreign currency delivered at the inception of the swap with the exchange rate effect of the currency swap itself.

    From the Fed’s balance sheet perspective, the idea would be to hedge foreign exchange risk – i.e. that assets and liabilities have only US dollar exposure and not foreign currency exposure.

    You may be thinking of a different idea, which is that of an upfront exchange of currencies and no pre-agreed exchange rate at termination. This is just an open exchange rate position, possibly with an agreement to terminate or roll at market rates. This would create a net foreign currency asset exposure for the Fed balance sheet, which if in place would produce a profit in the event of US dollar depreciation (sort of comparable to the international investment position of the US, which is long foreign currency, short US dollars). But I doubt that this is the Fed’s intention. Even if tempting, it wouldn’t be good institutional risk management. But I don’t know if that was your point or not.

  • Posted by JKH


    The whole subject of how the level of reserves affects broader money supply can be fairly contentious, as I discovered last year in one raucous marathon discussion with RebelEconomist.

    My own view in summary is that reserves in fact are not very important in the grand scheme of the broader money supply. This goes against the strong instinct and beliefs of those who are opposed to fractional reserve banking from an ideological perspective, since it would seem to be essential to their case. It is also at odds with textbook explanations of fractional reserve banking. It probably mucks up even more any hope of credible participation in discussions of maturity transformation such as occurred recently. But it is my view.

    In any event, paying interest on reserves is intended to prevent the actual federal funds rate from falling too far below the target rate. This will be helpful to the Fed when for whatever reason the reserve setting is at an excess level and banks would otherwise lend them out at a lower rate. Classic sterilization drains excess reserves when interest rates are too low. Interest rate sterilization directly prevents interest rates from being too low.

    Good night.

  • Posted by idiot

    I am glad people are so dumb in America that they don’t realize that this “crisis” is yet more creative-destruction…

  • Posted by LB

    JKH: exactly my point but in reverse.

    it would be an open exchange rate position, but from ECB’s, et al’s, perspective and a hedge from the FED’s perspective.

    but this was based on bset’s point a post ago that ECB, et al would have to pledge addt’l collateral if the USD strengthened.

    it was basically a riff on LBnkr’s theory on the FED’s expertise at exporting inflation/deflation and bset’s old old (tho not so old) post title giving the FED some credit.

    i had surmised that this was the implicit exchange: ok, you need some dollars, we’ll loan you dollars but…since that is a risk to us in the long-term (money supply increase), you must bear the short-term risk (FX deviation).

    but if the deal is based on an agreed rate @ maturity, then i’ve given the FED too much credit and my whole point is moot.

    good thought exercise tho…
    thanks for your patience.

    bset: “but also remember that the big risk that the banks need insuring against is a change in China’s fx regime that would lead to a sudden big swing, so it isn’t all that different.”

    given the recent TBTF govt. assistance implicit guarantee discussion, one could also argue that it is at least A BIT different, for a big swing in China’s FX is a game changer and thus in the banks’ eyes (it seems) a remote possibility. in the Euro/pound/et al not so much a game changer (nor a remote possibility…even in the short term) as we have seen these past 7 years and 7 days.

    but since you mentioned it, d’ya think there are derivatives somewhere out there to cover that possibility of a sudden yuan swing?

  • Posted by Kris b

    Can somebody answer the following questions:

    Where do the governments/central banks get the money for this mother of all stick saves? Do they borrow from the capital markets or print? What is going to happen if credit is still locked tight after this plan? What is going to happen if banks are willing to lend but nobody wants to borrow effectively denying authorities the credit transmission? Can they force banks to lend and borrowers to take out loans? Will not these borrowings crowd out the private borrowers around the world. I am just trying to figure our whether we are heading into deflation or inflation and act accordingly.

  • Posted by moldbug


    “My own view in summary is that reserves in fact are not very important in the grand scheme of the broader money supply. This goes against the strong instinct and beliefs of those who are opposed to fractional reserve banking from an ideological perspective, since it would seem to be essential to their case. It is also at odds with textbook explanations of fractional reserve banking. It probably mucks up even more any hope of credible participation in discussions of maturity transformation such as occurred recently. But it is my view.”

    Actually, I agree completely. I don’t see how anyone can differentiate between M0 and MZM with a straight face after today. If you have a dollar, you have a dollar. The intricacies of high-powered versus low-powered money are of interest to those who understand the details of the relationship between the “private” banks, Fed and Treasury. But if all three were consolidated onto one balance sheet, the world would not change at all.

    In particular, the classical explanation of the “money multiplier” is hopelessly outdated in the modern financial world, which has more ways to expand credit than you can shake a stick at.

    If you can violate that little sentence of Mises – “the date on which the bank’s obligations fall due must not precede the date on which its corresponding claims can be realized” – you can import unlimited amounts of money from the future. And if you can persuade a fiat issuer to guarantee your obligations, this structure is actually stable. (Otherwise it is very dangerous.)

    It is those guarantees, CDS really, that permanently expand the money supply. At the very least I’d like to see these tracked on the government’s books somewhere, but of course they won’t be.

  • Posted by jim

    Laughter in middle of stock market madness. Details below:

  • Posted by moldbug

    One more time: the Misesian explanation of the bank crisis. As easy-to-read as I can make it.

  • Posted by sharpemind

    Brad- China reserve data is out. Up $98B in Q3 despite the USD being up 10%

  • Posted by a

    1/ Do the benefits of “too big to fail” not imply that the only banks left standing will be too big? 6 big banks in the U.S., 4 in the U.K., given government support and, whenever their weaker brethen fail, supposed to gobble them up?

    2/ Are we not seeing a rhyming of the Great Depression’s beggar-thy-neighbour tarriffs? Banks in countries which are not big enough and not receiving any guarantees (Switzerland comes to mind) will be in a competitive disadvantage.

  • Posted by DJC

    To avoid systemic bank failure requires that the US government prop subprime Housing prices. Paulson and Bernanke can provide unlimited credit in the economy to elevate subprime housing to the million dollar level and the Dow Jones stock index to 100,000 level, but it will cost you $500 for that gallon of milk.

    From Kunsler,

    I exaggerate perhaps a little, but who really knows where all this leads? Here in the USA, the Treasury, enjoying new and seemingly limitless powers of discretionary spending, has begun shoveling dollars into every truck that backs up to the loading dock. The numbers are staggering. In ten days it’s reached into the trillions in loans and handouts. Most of this money is getting sucked directly into the black hole of debt and margin calls of one kind or another. This is previously-presumed wealth that is now un-presumed. It’s leaving the system, never to be seen again. One useful way of thinking about it is to regard it as our society’s previous borrowings against our own future. Thus, we are seeing our future vanish into a black hole — our future comfort, health, and basic nourishment.

    This is the kind of fiasco that brings down governments, propels societies into revolutions, and starts wars. In a few months, America will be full of angry economic losers. We’re not the same nation that crowded around the old radio consoles for Franklin Roosevelt’s fireside chats. Back then, we were mostly a highly-disciplined, regimented, industrial society full of citizens who mostly did what they were told to do, and mostly trusted in authority. Today we’re a nation of tattooed barbarian “consumers” with no impulse control, a swollen sense of entitlement, ruled by a set of authorities ranging from one G.W. Bush to the grifter-billionaire pantheon of Wall Street CEOs — now heading into secret bunkers with their stashes of krugerrands, freeze-dried veal Milanese, and private security squads armed with XM-8 carbines.

  • Posted by DJC

    US Bailout Plan Will Probably Fail
    11:19 PM ET

    U.S. Treasury Secretary Henry Paulson’s sweeping measures to bailout the financial system will probably fail, Marc Faber, editor & publisher of the Gloom, Boom and Doom Report, tells CNBC’s Asia Squawk Box.

    The proposed $250 billion infusion into financials is meaningless — merely a drop of water on a hot stove, Faber, popularly known as Dr. Doom says. These measures do not address the fundamental problem.

    “What I object to in all the bailout plans in the Western world is (that) they do not address the fundamental problem. And the fundamental problem is overleveraging,” Faber comments.

    He adds that the high gearing needs to be brought down, similar to what the Asian financial system had to go through after the 1997 financial crisis.

    “The U.S. economy’s debt to GDP has grown from 130 percent in 1980, to 350 percent at the present time,” notes Faber. “The leverage has been under the supervision of the Federal Reserve and the Treasury and everybody encouraged it.”

    He adds that these unfunded liabilities, which will surface over the next 20 to 30 years, do not deserve a AAA rating.

    Faber believes the U.S. budget deficit is going to stay at or above $1 trillion level because the government needs to print money in order to meet all the obligations they’ve made to rescue the financial system.

    “U.S. government bonds should be rated as a junk bond,” quips Faber.

  • Posted by JKH


    I feel more empowered, thanks.

    Actually there are several different problems I see in the aspect of bank reserves and their interpretation.

    The first is that bank reserves are empirically enough near 0, relative to the important magnitudes they’re typically associated with, to be found not guilty by reason of lack of meaningful association.

    In normal times, they’re near 0 relative to the rest of the monetary base (CB notes).

    And in any event they’re even nearer 0 relative to the trillions of MZM.

    So a discussion of fractional reserves may as well be a discussion of 0 reserves.

    Yet those (loosely) associated with the right (including Austrians I guess) in general (not you apparently) tend to become quite vexed about the threat of M0 expansion and the impending doom should the multiplier start working on that expanded base. Even if the multiplier worked as those people fear, it would work only on near 0 bank reserves and not on CB notes. The “transmission effect” of reserves is very different than the same for CB notes, but both are lumped into M0. Any indiscriminate focus on the full monetary base is therefore misguided, in my view.

    Moreover, the nature of the transmission mechanism between reserves and MZM is highly misunderstood, again in my view. It sounds as if we’re roughly on the same page here. The mechanism operates in real time in a way that bears no resemblance to textbook portrayals of causality and directionality.

    Legitimate criticism of central bank influence should really focus more directly on its core function of managing the fed funds rate rather than the reserve level. The reserve level is merely a required by-product of short term rate management. The broad financial system generates its appetite and propensity for money expansion through the effect of the interest rate rather than the reserve level. Similarly, the objective of “sterilization” techniques as discussed above is that of direct influence on the interest rate rather than on any alleged multiplier effect of reserves.

    I like your MT post progression, including today’s. But due to the impediment of hands on experience with MT some time ago, I’m having difficulty docking efficiently into your view. The problem will come to me more clearly with time. As I’ve written already, it has to do with the fact that the yield curve includes pricing for risks in addition to pure MT risk. Within any observable yield curve is embedded a pure MT yield curve of MT risk premiums or spreads. (E.g. the corporate yield curve is a spread over the treasury yield curve; each curve includes sub-curves of risk premiums for interest rate and liquidity (MT) risks; the corporate curve includes a sub-curve of risk premiums for credit risk.) While these risks may well be interactive, I’d be more comfortable with your MT framework if I could see the beginnings of this kind of conceptual decomposition. But the real significance of this is that risk premiums obviously correspond to different risks, and therefore my instinct is that the Miseian sentence formulation of the problem is incorrectly precise, and that the “bug” is more submerged than it seems.

  • Posted by bsetser

    LB — I am quite confident that the state banks hedge of their dollar exposure with derivative contracts with the PBoC. that is part of the deal — the state banks are happy to hold $, but only if they aren’t stuck with the exchange rate risk. you can track this through the line item on the balance sheet of china’s banks called “purchases and sales of fx” which seems to correspond with the pboc’s swaps with the banks.

    I want to confirm but I am pretty sure JKH is right about the swaps both having collateral (the fx posted at the fed) and having a built in hedge as there is an agreed exchange rate (and implicit interest rate) for the unwinding of the swap. i suspect i was wrong to think that the collateral needed to be adjusted as the exchange rate moves, but let me check.

    sharpe mind — thanks for the heads up on China’s reserves. I have a lot on that soon …

  • Posted by Twofish

    a: 1/ Do the benefits of “too big to fail” not imply that the only banks left standing will be too big? 6 big banks in the U.S., 4 in the U.K., given government support and, whenever their weaker brethen fail, supposed to gobble them up?

    I don’t think so. Where things seem to be moving is that you have a small number of mega-banks, and then a large number of tiny community banks. The reason that I don’t think we’ll see everything consolidate into mega-banks, is that tiny banks have the advantage that they know their customer in ways that big banks don’t, and this likely will create a symbotic relationship in which the mega-banks interact with the global markets, and then the tiny banks get financiang from the mega-banks.

  • Posted by Twofish

    One thing that somewhat amuses me is how similar the US and the Chinese financial system’s look now. You basically have 4 big state banks, 2 or so investment banks, and then lots of tiny joint-stock commercial banks.

    I don’t think this is a coincidence.

  • Posted by Cedric Regula


    That’s basically what I thought, after trying to reconcile my fading memory of my pre ’80s econ books with the financial reforms happening during the ’80s and beyond.

    So I found a wiki article that explains it quite well. Reserves are basically zero relative to broad money supply. Interest rates are the only thing that influence money supply, at least when the economy and credit markets are working sort of normal.

    I was never quite sure whether interest rates acted on the V (velocity of money) or money creation, but they indicate velocity has only increased by 1% over many decades, so it is money creation that is affected.

    However, the devil is in the details and that’s where we see us borrowing from the future to leverage growth(and government tax receipts) with credit expansion, MT is a problem, and reserves do matter when banks can’t attract the capital to lend and regulatory authorities remind them that they still need to have some reserves.


    “The operative notion of easy money is that the central bank creates new bank reserves (in the US known as “federal funds”), which let the banks lend out more money. These loans get spent, and the proceeds get deposited at other banks. Whatever is not required to be held as reserves is then lent out again, and through the “multiplying” effect of the fractional-reserve system, loans and bank deposits go up by many times the initial injection of reserves.

    However, in the 1970s the reserve requirements on deposits started to fall with the emergence of money market funds, which require no reserves. Then in the early 1990s, reserve requirements were dropped to zero on savings deposits, CDs, and Eurodollar deposit. At present, reserve requirements apply only to “transactions deposits” – essentially checking accounts. The vast majority of funding sources used by private banks to create loans are not limited by bank reserves. Most commercial and industrial loans are financed by issuing large denomination CDs. Money market deposits are largely used to lend to corporations who issue commercial paper. Consumer loans are also made using savings deposits, which are not subject to reserve requirements. These loans can be bunched into securities and sold to somebody else, taking them off of the bank’s books.

    Therefore, neither commercial nor consumer loans are any longer limited by bank reserves. Since 1995 the amount of consumer loans has steadily increased, while bank reserves have generally remained constant:”

  • Posted by Cedric Regula

    Thought I better qualify my comment here before someone else does.

    “and reserves do matter when banks can’t attract the capital to lend and regulatory authorities remind them that they still need to have some reserves.”

    They need reserves for checking accounts only ! Those dry up when banks have a problem balancing assets and liabilities, i.e. bank run.

    MT is one reason they could have a problem balancing assets and liabilities. Lack of investor confidence is another big one.

    So that should be big enough brush stocks to make everyone here right, and no arguments possible.

  • Posted by Cedric Regula

    one more try.

    I meant to type “brush strokes”.

  • Posted by Twofish

    Things work very differently in different places. China has found that interest rates don’t matter but reserve requirements do. This has something to do with the fact that 90% of lending is done through the banks, and there is no commercial paper or money market.

    This illustrate the hazards of treating economics as if it was a platonic science with universal truths.

  • Posted by Cedric Regula


    That would make China more similar to a pre ’80s US, and they have said recently that they intend to tread carefully down the path of financial “reforms and innovation”.

    Tho I think money markets can be made perfectly safe, as they have been for a couple decades, if you just keep the questionable paper away from them, i.e. do junk bond financing elsewhere,if at all, and keep the risk in line with money market yields.

  • Posted by john

    China and the US. Both corporate fascist states. Who was that jaskass that wrote the book about the end-of-history due to the glories of democracy! hahah. The only thing he got right was the title of his book.

  • Posted by Soxfan

    Can anyone explain to me how the heck the FDIC is guaranteeing the debt of the banks? Isn’t the FDIC a self-financed insurance scheme for banks. I don’t see anywhere that FDIC has a call on U.S. Treasury funding in any way, shape, or form (although they could borrow $30bn whicht he banks would remain on the hook for).

    So isn’t a FDIC guarantee equivalent to the banks guaranteeing eachother? I can’t see that working in a systemic situation…

  • Posted by Cedric Regula


    The FDIC “only” had $50 billion in their account that they raised from insurance fees over many years. This fact came into the news this summer when they began siezing banks and paying off depositors. I read a John Maulden newsletter where somehow, someone estimated the FDIC may need 10X that. This is why people began fearing bank runs.

    So lately I’ve been hearing that maybe the USG will back the FDIC with the “full faith and money” of the federal government. So they may feel they have implicitly solved the problem, but I think they need to trumpet the guarantee louder just to make sure Joe 16 ouncer hears it.

  • Posted by Soxfan

    Searching on “full faith and credit” on the FDIC website turns this up:

    Which, if I understand it, says the Fll Fiath and Credit of the United States stands behind FDIC-insured depsoits. It doesn’t say anything about guarantees on bank debts…

  • Posted by moldbug


    There are of course many yield curves, but I think of “the” yield curve as a graph of the risk-free (that is, free from default risk) interest rate. In our present world this can be observed easily with Treasuries.

    The risk-free yield curve is the price of *certain* future dollars in present dollars. I like to think of it as the price of dollars with a “not valid until” stamp, which is of course pretty much what a Treasury strip (zero-coupon bond) is.

    (There is a slight problem in observing the risk-free yield curve in an Austrian utopia, because an Austrian utopia has no Treasury! However, the asymptotic lower bound of default risk should not be too hard to observe with a little clever financial engineering.)

    In an MT collapse, the risk-free curve for Treasuries becomes an ineffective yardstick for measuring the default risk for – say – MBS. The market segments. MT has not collapsed in the Treasury market! And nor will it, while we still have this thing called “China.”

    Thus the observability problem is extremely acute. We know, just by gut feel, that MBS prices against Treasury yields are not an accurate measure of MBS default risk. But we cannot construct an MBS risk-free yield curve by which to measure MBS default risk. Call it Schrodinger’s mortgage.

    As for the risk of an MT collapse, I simply can’t imagine any way in which it could be quantified. The system is intrinsically chaotic.

  • Posted by Cedric Regula

    Soxfan: The full faith and credit on FDIC insured deposits is a big improvement, because they did only have $50B of their own.

    But they got their job expanded again…the inter bank guarantees you mention. It’s officially referred to in todays release of TARP detail, but no fixed amount of earmarked money is referred to in the press release. We have 250B in non voting bank stock, and 100B for buying bad loans. Tarp requires Congress to approve the final 350B , if deemed necessary sometime in the future.

    In addition to the stock purchases, the Federal Deposit Insurance Corp. will temporarily provide insurance for loans between banks, charging the banks a premium for doing so.

    This FDIC program would take the form of providing insurance for new “senior preferred” debt that one bank would lend to another. This debt would be insured by the FDIC for three years, helping to unlock bank-to-bank lending, which has fallen dramatically because of fears about repayment in the face of billions of dollars of bank losses because of bad loans, primarily in mortgages.

  • Posted by moldbug


    I completely agree on the multiplier and the transmission mechanism. For the purposes of monetary dilution, a dollar is a dollar. If the multiplier worked in textbook fashion, the increase in the monetary base would indeed be dangerous. But if the multiplier worked in textbook fashion, we would already be out of the deflation woods! Not so.

    Part of the problem with the fact that Austrians have been marginalized in the academy is that basically anyone (including me) can claim to be an Austrian. No one is excommunicated for heresy or backsliding, and there is no official party line – especially on the inner workings of our present fiat currency system, which is a tool of Satan by definition. So there is a lot of “folk Austrian” wisdom floating around, some of which indeed is terrified by the weird recent appearance of M0 and other Fed data.

    But the works of Mises and Rothbard are so voluminous, and the level of progress since so minimal, that it’s best just to stick with them as a canon. Here’s Rothbard on money supply. I would not endorse this document 100%, but it certainly does not make the mistake of getting het up about the monetary base.

  • Posted by Cedric Regula


    “Thus the observability problem is extremely acute. We know, just by gut feel, that MBS prices against Treasury yields are not an accurate measure of MBS default risk. But we cannot construct an MBS risk-free yield curve by which to measure MBS default risk. Call it Schrodinger’s mortgage.”

    MBS suffer from Schrodinger’s mortgage (inability to observe a potential deadbeat borrower.)

    But CDOs are worse, suffering from both Schrodinger’s mortgage, and Plank’s Constant. We know the smallest measurable piece of collateral is a plank, but the trauch structure poses legalities that separate various CDOs into mortgage instuments that do not wholly own any physical collateral. This is problematic as economic shock waves spread thru time, and makes predicting value rather uncertain.

  • Posted by moldbug


    I’d define “Schrodinger’s mortgage” as the inability to separate illiquidity from insolvency, ie, separate interest rate from default risk.

    There are a whole bunch of problems with complexity and heterogeneity of these instruments. I like the metaphor of a house being broken down into Plancks corresponding to the tranches of a CDO – how are wood prices these days, anyway? Gotta be some money in it…

  • Posted by Roc

    I would absolutely love it if moldy or JKH could briefly go into why the money multiplier does not work as it does in textbooks. I’m sick of hearing tinfoil hat “Austrians” get worked up about that subject (no-one here of course – you guys are great).

  • Posted by moldbug

    roc, I defer completely to JKH on the question. The only reason I don’t think it works is that I don’t see it working – for example, in the Japanese deflation, when the monetary base was pumped up like a whale in a vacuum chamber.

    But I think of USG in terms of a consolidated balance sheet. The banks are on that sheet. And the related-party transactions within it are a black, black mystery to me. Transactions between banks at least have some resemblance to some patterns of trade that might be found in the wild. Once Fed and/or Treasury are involved, I am completely out of my league.

  • Posted by JKH


    Re: the money multiplier

    The theory roughly is that an individual bank can expand its deposit base according to the reserves it keeps. Since the amount of reserves required to back a deposit is a “fraction” of the size of that deposit, a bank can “multiply” the size of its deposits relative to the size of its reserves. At least that’s the way I remember it from the textbooks. You may correct me if I’m wrong on this.

    This sort of thing is true as an observation at a point in time. After all, if the law is that you must keep reserves, and there is a formula for those reserves, then the relationship between reserves and deposits must fit that law, or you have broken the law.

    The problem I have with the multiplier it is that it is useless as an explanation of the dynamic of how the money supply actually grows and what the roles of central and commercial banks are in overseeing its expansion.

    So it is correct as a description of how the world looks, but useless as a description of how the world works.

    This is how the reserve world roughly works, I think:

    First and foremost it is essential to understand that the central bank controls the level of bank reserves available to the banking system. Without going into detail directly, this is evident indirectly when you hear discussions of “sterilization” by central banks. Sterilization refers to the capability of a central bank to view the system reserve effect of its various balance sheet activities as an unintended consequence of those activities, and to offset or “sterilize” that reserve effect with other activities. The fact that the central bank exhibits such dexterity in fine-tuning the reserve impacts of its activities is pretty good evidence that it is aiming to control the level of the final result.

    The idea of controlling the level of reserves is important to a central bank because there is a rule for the amount of reserves that commercial banks are required to keep – i.e. the required reserve ratio. The level of system reserves relative to that rule means there are supply and demand forces at work in the sense that banks compete for their required level of reserves. This competition affects the level of interest rates. The relevant rate in the case of the US is the fed funds rate. The competition results in a daily trading level for the fed funds rate, depending on the level of funds supplied by the Fed and importantly the distribution of that level across various participating banks.

    The primary operating objective of the Fed is to keep that trading level close to the target Fed funds rate, which is the one that is announced whenever the Fed makes such a policy change.

    Two points here.

    First is that this interest rate relationship is the important dynamic around bank reserves – not the relationship between the level of reserves and corresponding deposits.

    Second is that the true causal relationship between reserves and deposits is really the reverse of how it is described in textbooks:

    This relationship is an iterative one over time. Both reserves and deposits may grow in steps or contract in steps. Synchronization is required. But there are short time lags in the required synchronization.

    And the effect of the time lag is that reserves become a function of deposits rather than the reverse as suggested in the old textbook story.

    All banks in a fiat system have the power to create money, including the Fed and commercial banks. If commercial banks expand loans and expand money supply as a result (assets equal liabilities plus equity), the Fed will pick up the new money supply count for next period’s reserve requirement. If the Fed likes the way things are going, it will supply the required reserves. It does so because if it likes the way things are going, it won’t want to change the target funds rate. And if it doesn’t want to change the target funds rate, it will supply the reserves that the banks require according to law.

    And so on …

    So reserves when fed to the system this way are a function of deposits, not vice versa.

    And for example when the Fed wants to tighten monetary policy, it may well drain reserves in conjunction with or just prior to announcing a policy rate change. But this action is not directed immediately to forcing some change in deposit levels. It is directed at the trading level for the funds rate. The Fed will then hope that the new funds rate affects the financial system and the economy as intended over the longer term. But any change in money supply that comes out of this will mostly be a function of the effect of higher interest rates on the economy – not a function of the effect of a temporary reserve drain on deposits as transmitted through a “multiplier”.

    Bottom line is that reserves are important as a Fed tool in controlling interest rates.

    They aren’t important in the sense of a “multiplier”. That multiplier simply specifies the rule for Fed supplied reserves when the world is OK according to the Fed.

    The corollary is that the chosen reserve ratio itself is economically irrelevant to the Fed’s desire to control short term interest rates. The ratio could be 10 per cent or 1 per cent or lower. The effective reserve ratio (if we choose to view it as spread over the $ trillions in US banking system deposits) is almost infinitesimally small now in the US. The reserve ratio could even be 0. The Fed could still control interest rates by penalizing banks who end up with negative reserves in their own account.

    The economically important aspect of reserve ratios relates more to the implicit taxation effect on banks and their effect on bank interest margins – particularly non-interest bearing reserves.

    Finally, the entire subject of the reserve multiplier is outdated and prioritized incorrectly in my view. People should really be focusing on capital requirements and capital ratios as the driving force in bank balance sheet behaviour. Capital ratios determine leverage. And leverage in the case of commercial banks determines a constraint for the generation of money supply as a consequence of banking lending and asset expansion.

    Focus on capital rather than liquidity reserves if you really want to understand money supply dynamics.

  • Posted by Roc

    Brilliant. Thanks for the response. That makes way more sense than what you’ll find most places.

  • Posted by Cedric Regula


    That is also how I believe it works. But being a servo guy and not an economist, I have a slightly different take on it.

    What you have described in very good detail, I would call the inner loop of a control system. And the only thing banks are required to have reserves for is checking accounts. Everything else is exempt, including CDs and savings accounts. Beyond that banks have funding sources for their capital structure like common and preferred stock, maybe bonds, various kinds of money market instruments and these are all of course exempt from reserve requirements.

    So the reason that reserves are near zero relative to broad measures of money supply is because our checking accounts are so tiny. No offense intended.

    But this explains why the money multiplier seems to do nothing. It is so tiny compared to all the other capital making up the financial system.

    The good news is there is an outer loop in the control system. If the Fed can influence the cost of money in the inner loop thru fed funds, which is really the short term risk free cost of money, then they exert influence on costs of all the other kinds of capital, and costs of borrowing. Banks and markets do have to sort of play along for it all to work. And someone does have to want to borrow money at the going rate.

  • Posted by JKH


    I agree.

    I’m saying that the textbook “multiplier” logic should be questioned, while you’re saying more pragmatically that the scope over which it now operates has declined – not inconsistent points.

  • Posted by Sundblad

    Big thank you to JKH for the money supply explanation!

  • Posted by Blissex

    «And the effect of the time lag is that reserves become a function of deposits rather than the reverse as suggested in the old textbook story.
    All banks in a fiat system have the power to create money, including the Fed and commercial banks. If commercial banks expand loans and expand money supply as a result (assets equal liabilities plus equity), the Fed will pick up the new money supply count for next period’s reserve requirement. If the Fed likes the way things are going, it will supply the required reserves. It does so because if it likes the way things are going, it won’t want to change the target funds rate. And if it doesn’t want to change the target funds rate, it will supply the reserves that the banks require according to law.

    We’ll, what you are describing here (minus the zero-reserve policy from 1995) may well be what happens in practice.

    But it is an explosively subversive thesis: because it amounts to saying the either USA capitalism is entirely driven by the authorities, or that there are no checks and balances.

    The reason is that in your model the Fed and the Treasury are in effect the main controllers of the free market, bar a liquidity/investment trap.

    The key here is:

    «If the Fed likes the way things are going, it will supply the required reserves.»

    Now there are almost only two cases in practice:

    * The Fed only likes where things are going when they go up. After all, who would ever want below-average growth? As Greenspan has argued, no central banker can ever recognize a bubble but after the fact. Every time growth declines then the Fed will increase the leverage ratio to make sure that growth is always above trend. In this Lake Wobegon system, the Fed’s only policy is “whatever it takes”, and in effect the USA has reverted to pre-Fed days, and USA banks like BS, Lehman, etc. are latter-day wildcat banks. Except that they get bailed out by the Greenspan Put or the Bernanke Swap. What some commenter in a blog called a “laissez fairy” system, with the fed in the role of Reagan’s fairy.

    * The Fed has a policy stance other than “whatever it takes” and it determines (and in effect creates) the overall level of financial capital in the system by expanding or restricting its supply of reserves to the financial system in order to make sure it sees what it would like to see. In this case the USA is in effect a state corporatist capitalism version where the Fed engages in fine tuning current levels of capital and to a very large extent who gets it (friends of Paulson for example). China or Germany would seem to have freer and less rigged financial markets than that.

    My impression is that the USA have got a system in which both of the above apply, depending on which way the interests of the republican donor class lean: wildcat banking when it benefits republican campaign donors, fine tuning when it benefits republican campaign donors.

    Indeed the oscillations in the MOAB plan by Paulson are between those two alternatives, and the compromise reached has been to try them both.

  • Posted by Twofish

    Blissex: wildcat banking when it benefits republican campaign donors, fine tuning when it benefits republican campaign donors.

    They are actually republicrat or demopublican donors. As far campaign donations and the fundamental nature of the system, the economic elite of the United States makes sure that campaign donations are spread evenly among the major parties so that they keep influence no matter who gets elected.

    The interesting thing is that the latest financial mess is hardly a “Republican plot” since it has greatly benefited Obama, and the strongest opponents of Paulson and Bernanke have been conservative Republicans.

    Personally, I’m voting for Obama, since the latest episode reveals how utterly clueless the Republicans are over economics and markets. One thing that I find interesting is that people who are “free market idolitors” are often the people that are the most clueless about how financial markets actually work. I’ve read some recent essays from University of Chicago professors who obviously have no idea what exactly a bank does.

    My guess is that they are so determined that things *should* work in a certain way, that they ignore how things actually *do* work. But people in “laissez-faire markets” are in serious trouble because what has happened should have been impossible, and when the impossible happens, then you find extreme difficulty in explaining what happened and what to do about it.

  • Posted by Blissex

    «Finally, the entire subject of the reserve multiplier is outdated and prioritized incorrectly in my view. People should really be focusing on capital requirements and capital ratios as the driving force in bank balance sheet behaviour. Capital ratios determine leverage.»

    Ahhh this bit is so amused. What’s the difference between reserves (whether deposited with the Fed or not) and capital? After all they all there to guarantee creditors.

    JKH’s argument on reflection seems to omit an important detail: that the primary purpose of reserves deposited with the Fed is not to constrain lending, but to ensure that there is a minimum “reserve” of funds to pay bank creditors; the effect on credit expansion is a necessary consequences, but in the crazy world of the USA political system that has got lost.

    So both banks own capital and reserves deposited with the Fed have exactly the same purpose: provide a buffer for losses.

    The reason why some of a bank’s reserves have to be deposited with the Fed is just to ensure that they are protected from being “vanished” by the bank’s management.

    Following JKH’s logic, the reverse of his conclusion seems more relevant: that the bank reported capital is entirely irrelevant, because it is just an accounting entry that can “vanish” at any time, and the only leverage that matters is the ratio with the bank’s funds deposited with the Fed.

    The fractional reserve requirement used to be in effect a requirement on how much “safe” capital had to set aside to guarantee creditors.

    This seeming unawareness of the historical role of CB-deposited reserves vs. capital by JKH tallies well with the leverage, “make money fast” culture of the USA financial system.

    I know that this will shock Usians, but in some countries off-balance sheet vehicles have been used for a long time to hide *positive* reserves. That is, financial entities would salt away large amounts of safe assets into off-balance sheet entities as “hidden reserves” in order to be able to draw them down in lean times. Sometimes hidden reserves would be many times larger than declared capital.

    Of course USA companies do precisely the reverse: they (like the Fed) salt away losses in “hidden unreserves” in order to be able not to drawn down the declared capital.

    Why this difference? Well, in systems where companies create hidden reserves, executives have a stake in the *solvency* of their employers: they longer the employer stays solvent, the longer the milk and honey in the form of salary and perks and power flows. Thus hidden *positive* reserves, which may depress stock prices but cushion bad times.

    Viceversa USA executives have a stake in the *stock growth* of their employer, and very little in the solvency, as their potential lifetime earnings and power and perks are minuscule compared to stock price related bonuses and options. Thus hidden *negative* reserves, which will make insolvency much likelier but keep the stock price up.

  • Posted by Blissex

    «They are actually republicrat or demopublican donors. As far campaign donations and the fundamental nature of the system, the economic elite of the United States makes sure that campaign donations are spread evenly among the major parties so that they keep influence no matter who gets elected.»

    Well, the Democrats are quite corrupt too, in a sort of “Republican lite” way; but while most are corrupt, there is a big difference in the depth of corruption (including the amount of money used to reward favours) and the fervour with which it is pursued.

    In particular for Republicans it is often dressed up as righteous redress for the cruel exploitation of the productive rich by the parasitic poor (via predatory taxes, minimum wage extortion and other crimes); the fancy themselves (like Greenspan I guess) to be inspired by the Ragnar Danneskjöld character in Atlas Shrugged.

  • Posted by warren mosler

    this discussion has gotten totally confused

    it shows little or no understanding of ‘monetary operations’ when reserves and capital are discussed, for just one example.


    and then read ‘Soft Currency Economics’ under ‘mandatory readings’

  • Posted by Cedric Regula


    That is exactly how we do it and why. We have essentially a zero reserve fractional banking system. We hide negative capital. We have negated effective regulation of the lion’s share of money supply, which is capital.

    That is why we sell phoney “insurance” (CDS) because everyone does think there is no shock absorber in the system.

    We have under capitalized insurance guarantees, like the FDIC and the private mortgage insurers like MBIA.

    We have “implicit” government guarantees for F&F and “too big to fail banks”. These of course just became explicit.

    Now the USG/taxpayer is a “stockholder” in the banks, but a minority, non voting one in the interests of “Freedom”.

    And I suspect a big part of the reason we get away with it in the sizable scope that we do is because funding for the twin deficits always seems to come from somewhere else, and this funding comes “cheap”. i.e. returns for real private investors suck, so we are pushed into the game taking higher, if not ridiculous risk, trying to chase just mediocre returns. Sort of works until we get the unraveling, which is what appears to be what is happening as of late.

    So if it appears the system is nuts, it’s because it is.

  • Posted by Blissex

    To summarize something I have written above in a somewhat imprecise but cute way:

    «executives have a stake in the *solvency* of their employers: they longer the employer stays solvent, the longer the milk and honey in the form of salary and perks and power flows.»

    In some countries executives rewards depend on alpha.

    «USA executives have a stake in the *stock growth* of their employer, and very little in the solvency,»

    In the USA (and the City of London) executive rewards depend on beta.

    Good luck with all that beta! :-)

  • Posted by flow5

    “There is general agreement that, for almost all banks throughout the world, statutory reserve requirements are not binding. Banks need central bank deposits for clearing checks and making other interbank payments, which gives the central bank leverage over money and bond markets.”

    As I tell many audiences, the FOMC targets the federal funds rate, nominally the rate banks charge each other on overnight loans of deposits at the Fed. In fact, what the NY Open market Desk sets each day is the one-day repo rate on Treasuries, that is, the one-day cost-of-carry on government bonds. This is the true policy instrument — and it affects huge amounts of money (essentially, the one-day return on all government securities), while fed funds transactions daily, in comparison, are a trivial amount. Folks who actually deal in money markets know this; others usually do not.”


    Richard G Anderson
    Federal Reserve Bank of St Louis

  • Posted by flow5

    “The low capital ratios of the commercial banks…are not due to low earnings or low retention of earnings. Bank earnings and net profits retained have been at record levels….The low capital ratios of banks are the direct result of monetary policies which have allowed the banks to create a vast superstructure of credit.” Note: “Bank capital as a percentage of total liabilities has declined, with minor reversals of the trend…from a percentage of approximately 35 in 1875 to about 7 as of the present time (1953)”

    “If we are concerned about low capital ratios, there are two principal methods by which they can be raised: (1) minimize further expansion of bvank credit, and (2) minimize bank expenses” — Leland Pritchard PhD Chicago Economics 1933, Masters Statistics Syracuse

    “Neither the supervisory staff of the Comptroller of the Currency nor that of the Federal Deposit Insurance corporation adhere at present to any mechanical or fixed standard or ratio in gauging the adequacy of bank capital structures. Their practices, which are borne out by various public statements, indicate that they believe that a uniform standard would be applicable to only a few banks, and that the test of capital adequacy for any given bank should give consideration to the (1) quality and nature of its assets, (2) the quality of its management, and (3)the general manner in which the business of the bank is conducted”.

  • Posted by Twofish

    Blissex: Why this difference? Well, in systems where companies create hidden reserves, executives have a stake in the *solvency* of their employers: they longer the employer stays solvent, the longer the milk and honey in the form of salary and perks and power flows. Thus hidden *positive* reserves, which may depress stock prices but cushion bad times.

    The reason the United States doesn’t do this is that if you have a lot of corporate reserves, then your company will then be a target for a leveraged buyout and corporate raid. Also US securities laws makes it very difficult for a company to have hidden cash reserves, and provide very few incentives for companies to do so.

    The result of this is that US corporations tend to be leveraged with using debt as a means of maintain corporate control, and depending on financing from the securities markets and banks to maintain a reserve against crisis.

    The trouble with this is that if the banks don’t have a reserve then when things break then you end up having to rely on the government as the final reserve provider.

    It’s a crazy system, but even with the latest crazy it more or less works, and I don’t buy into conspiracy theories about how people have manipulated the system, because the economic system as it stands is too bizarre and complex to have been designed. It’s more of an example of evolution in action.

    Also before we get too nostalgic about the old system, you have look at the down sides and why the old system fell apart. The pendulum swings back and forth, and I’m looking forward to a generation from now when what every new system comes up is faced with some new crisis, and people will look nostalgically at the economic system under George W. Bush (people are very forgetful, and someday now will be the “Good old days”).

    flow5: Neither the supervisory staff of the Comptroller of the Currency nor that of the Federal Deposit Insurance corporation adhere at present to any mechanical or fixed standard or ratio in gauging the adequacy of bank capital structures.

    This is because if you created a fixed standard or ratio then someone will develop a clever way of keeping up that standard or ratio while in practice maintaining zero capital. There are dozens of ways of doing that, and so you have to have very sharp regulators trying to keep track of all of the tricks and schemes.

  • Posted by flow5


  • Posted by flow5

    Formally, all payments were cleared through bank debits. I.e., the purchase & sale of houses cleared through bank debits (the transactions that encompass the speculation in housing).

    Since all commodity & real-estate cleared through bank debits, the rate-of-change in bank debits would have diverged (widened) from the rate-of-change in real-gdp.

    Therefore the FOMC would have shifted to a more restrictive monetary policy and there would not have been the rampant speculation which is always characteristic of an excessively easy money policy.

    There are duplicative transactions, financial transactions, etc. Even so, these payments have never skewed the resultant rates-of-change in the volume of money & it’s rate of expenditure relative to real GDP.

  • Posted by RebelEconomist

    I hate to disturb people’s comfortable ideas of how monetary policy works, but it is actually difficult to see how central banks control interest rates at all. If you think that sounds crazy, read this, by Ben Friedman:

    Essentially, the central bank’s involvement in the banking system balance sheet is just too small. This was the subject of the discusson (referred to above at 12.01 on October 14th) that I had with JKH on Brad Setser’s rge blog in May of last year.

    My understanding has not changed since our discussion, and I would interpret the Fed’s difficulty with getting interbank rates down as evidence that supports my case. Hopefully, the issue of the implementation of monetary policy will now get more attention.

  • Posted by STF


    B Friedman was completely wrong in this paper and in his follow up in 2000. A number of authors have pointed out since that the qty of reserve balances held overnight or the size of the cb’s operations have NOTHING to do with whether the cb can affect rates. Canada has NO rbs circulating overnight, for instance. Also, just because the Fed’s operations were historically small relative to the size of private market trades, there is no operational limit to its ability to expand its balance sheet if it deems necessary–case in point being the $1 trillion expansion over the past few weeks.

    As Warren Mosler noted above, the discussion on this blog of central bank operations and bank deposit creation is completely confused. See if you want to understand how the monetary system really works.

  • Posted by Twofish

    The main method by which the Fed actually controls monetary policy is through repurchase agreements in the overnight lending market. The short term interest rates that get established through the federal funds rate then gets transmitted to the commercial paper and money markets that that has an immediate impact on the rate of business activity. Commercial bank interest rates really don’t have that huge of an impact on the rate of business activity and certainly not an immediate one. Most money flows in the United States go through the credit markets, with the commericial banks having somewhat of a passive role.

    This is very different from how monetary policy works in China where there is no linkage between short term interest rates and commericial activities, and the method of controling the economy is through reserve requirements which impact how much the large banks can lend out to the big corporations. The current mechanism of trying to control the economy through reserve rates was developed late-2005/early-2006. The PBC raised interest rates. Nothing happened. They increased reserve requirements, things happened.

    One consequence of this is that the Fed can control short term interest rates, but not long term interest rates, and between 2005-2006 the combination of the Fed trying to keep interest rates down combined with a war in Iraq resulted in a really, really steep yield curve, and this led to all sorts of silliness as people used short term borrowing to fund long term loans in things like real estate. The combination of near zero short term interest rates and 6% long term rates is what led to “teaser rates.”

    However the game book has changed over the last month. One reason I think that both Paulson and Bernanke were alarmed at the short term credit markets freezing is that frozen short term credit markets means that the Fed and central banks no longer have any control over monetary policy, which is why the Fed and Treasury are basically forcing banks at gunpoint to lend.
    The fear is that you will end up with a situation in which you set interest rates at zero, and then nothing happens.

    The result of this is that I think that the tools that the Fed will be using to manage monetary policy six months from now, may be very, very different than they were six weeks ago.
    The only thing that I do know is that the financial world in August 2009 will be very, very different than in August 2008. What the differences are, I do not know.

    The thing about finance textbooks is that they often have information that is years out of date, and they give the very false impression that everything has been worked out. One thing that is fascinating about the current episode is that you are watching people literally rewriting the textbooks day by day. Part of the reason I’m in a harsh mood against the pundits is that a lot of things that happen in finance are people making things up as they go along and figuring things out by trial and error. There are things that we know now that we didn’t know in early September, and policy makers are going to certainly do things right now that we will know to be stupid in six months or even in six days. I wouldn’t be surprised if at the end of next week the Dow is at 10,000 or if it at 6.000. I wouldn’t be surprised if at the end of next week, it turns out that everything that was announced thus far seem to be working perfectly. I also wouldn’t be surprised if there is some crisis tomorrow that causes everything to fall apart and we’d be tossing Plan C, for Plans D, E, and F.

    Given the difficulty of what is being done, and the stakes, I think it is just a little rude to be screaming at the supposed incompetence of the fire fighters as they are trying to put out the fire.

  • Posted by JKH

    I’m in general agreement with Twofish’s comment above. Mosler’s paper cited by STF just before that looks pretty much on the mark as well.

    Quite frankly, The Friedman paper on quick perusal looks like garbage.

  • Posted by Cedric Regula


    I put the chances at better than 50-50 that next year we follow Japan’s playbook. ZIRP for short rates, then “quantitative easing” to push down long rates. That is done by having the Fed buy lots of long term treasuries at high prices, pushing yields down. They admit this makes gov debt go up, and they never say where the CB gets the money. They just leave that to our confused imaginations.

    But Wolf goes thru the blow by blow in this article. If it works in the US, it works in the US. If not, we go supernova.

  • Posted by Judy Yeo

    The temporary mechanics of credit seem to have been resolved (c’mon unlimited dollar financing is about as close to a fiat guarantee as anyone is about to get), the question on most people’s minds are when and how the life support goes off, it’s not a long term solution, just a resuscitation effort.

    Furthermore, the stock market volatility ( funds who capitalise on volatility ought to be making loads) should trigger the question: will central banks, treasuries and all manner of banks be forced to “stabilise” the situation by becoming the buyers of last resort? at least temporarily.

    BTW congrats brad, at least there’s something sensible to read in this day and age?!

  • Posted by Cedric Regula


    I learned a lot about fed operations in the Mosler article and it helped clarify and fill in the gaps in my fuzzy understanding of what they do. Like targeting fed funds means the fed can inject unlimited funds into the banking system thru either repos or reverse repos, and unlike the commercial variety of those used by banks and corporations, the Fed can just issue them without T-Bill collateral. Unfortunatley these are very short term instruments, and the move by the USG to have the patient taxpayer plow long term capital into banks indicates the Fed was not happy with doing a one way flow of 1-90 day repos, only to have to do it for another 5,10,20 years.

    So up until reading this I was under the impression that maybe a shortfall in banks meeting reserve requirements, which have been whittled down to 8% of checking accounts had some relationship to maybe a few too many people closed out their checking accounts one day and the bank needed to borrow to comply with reserve requirements in the Fed’s capacity as lender of last resort.

    Not so…the banks problems can be unlimited, creating unlimited demand for Fed borrowings and the Fed’s response is to supply unlimited credit in order to get fed funds back to the target rate.

    I’m glad I understand that now.

    Then at the end of the article there are a number of additional discussions where Warren Mosler has some rather rosey sounding explanations about how it’s impossible to monetize debt, the USG can’t cause hyperinflation, reflating prices works, and other good news. I was wondering if we could get an update on those views in light of current events.

  • Posted by Blissex

    «unlike the commercial variety of those used by banks and corporations, the Fed can just issue them without T-Bill collateral.»

    This was what JKH was trying to express above, saying that in effect instead of banks making reserve deposits with the Fed, the Fed is depositing (imaginary) reserves with the banks, and the banks in effect regulate the Fed (via the Republican party machine, let me add).

    «Not so…the banks problems can be unlimited, creating unlimited demand for Fed borrowings and the Fed’s response is to supply unlimited credit in order to get fed funds back to the target rate.»

    Yes, that’s precisely wildcat banking, and even worse, thanks to derivatives and in particular default swaps, it is wildcat insurance as typified by the AIG case.

    USA finance has become the Wild West since 1995, and all sorts of financial indicators have grown exponentially since then.

    Why would politicians, central bankers, and their paymasters on Wall Street ever vote for below-average financial growth?

  • Posted by flow5

    “someone will develop a clever way of keeping up that standard or ratio while in practice maintaining zero capital” — good reason to Nationalize the banks & revert to a “command economy”.

  • Posted by flow5

    The crux of the cause of our monetary mismanagement, especially since 1965, is the assumption that the money supply can be managed through interest rates, specifically the federal funds rate, (or via the federal funds “bracket racket”, or thru a series of temporary “pegs”, or via a Taylor-like rule).

    We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about.

    The effect of tying open market policy to a fed Funds bracket is to supply additional (and excessive legal reserves) to the banking system when loan demand increases.

    The Fed’s technical staff either never learned, or forgot, how Roosevelt got his “2 percent war”. This was achieved by having the Fed stand ready to buy (or sell) all Treasury obligations at a price which would keep the interest rate on “T” bills below one percent, and long-term bonds around 2-2 1/2%, and all other obligations in between.

    This was achieved through totalitarian means, involving the control of total bank credit and the specific rationing of that credit. Plus there were controls on prices and wages that kept the reported rate of inflation down.

    There are only 3 interest rates that the Fed can directly control in the short-run; the discount rate charged to bank borrowers & the primary credit rate for both the PDCF & ABCP. The effect of Fed operations on all other interest rates is INDIRECT, and varies WIDELY over time, and in MAGNITUDE.

    As any monetarist knows, the money supply can never be controlled by any attempt to control the cost of credit.

    The only tool at the disposal of the monetary authorities in a free capitalistic system through which the volume of money can be controlled is free/gratis legal reserves.

  • Posted by flow5

    “explanations about how it’s impossible to monetize debt”

    Just raise reserve ratios. Reserve requirements have been as high as 91.1 (in 1941).

  • Posted by Cedric Regula


    No servo guys I know would ever design a servo system like that.

    Besides, the first prototype would blow up in the first five minutes of bench testing, and we get in trouble for that.

  • Posted by RebelEconomist

    To be clear, I am not disputing that banks lend first and then acquire reserves. Nor I am disputing that the Fed can control interest rates if they are willing to lose money in the process – even I can control interest rates for a microsecond if I am willing to lose money.

    The key problem, which Warren Mosler’s article, which I see was originally written in 1994, glosses over, is the elasticity of banks’ demand for reserves. He seems to argue that reserves demand is inelastic because of reserves requirements, but other countries do not always have reserve requirements and are still supposed to control interest rates using similar techniques. Anyway, this idea clearly needs to be reconsidered in the light of recent events. For example, he says “added reserves in excess of required reserves drive the funds rate to zero”. See the first chart in

  • Posted by STF

    Rebel economist writes: The key problem, which Warren Mosler’s article, which I see was originally written in 1994, glosses over, is the elasticity of banks’ demand for reserves. He seems to argue that reserves demand is inelastic because of reserves requirements, but other countries do not always have reserve requirements and are still supposed to control interest rates using similar techniques.

    Good questions.

    Mosler’s point does not rely on reserve requirements. He’s well aware of, say, Canada’s lack of reserve requirements and zero overnight balances. There’s no inconsistency there with his paradigm, though full explanation would require a bit of space here. Essentially, the Fed already credits reserve accounts at a penalty rate WHENEVER banks go into overdraft or miss on reserve requirements–the point is that the Fed’s operations (or any other central bank’s) are necessarily about the price of reserves, not the quantity, since the Fed (or any other central bank) is the monopoly supplier of net balances.

    The Fed has a particularly strange way of setting the target rate, but the far simpler method is to set the rate paid on reserve balances and the penalty rate very close (if not equal) to the target rate, and the rate would not deviate from this corridor.

    Under current circumstances, setting the both rates equal to the target (as Mosler and Charles Goodhart have proposed) would again make obvious the Fed’s ability to hit the target rate. Mosler further proposes that the Fed to lend unsecured to member banks at the target rate, since their assets are already signed off on by regulators and the Treasury is already on the hook, and pay the target rate to bank reserve accounts, all to help reduce counterparty risk in interbank markets.

  • Posted by RebelEconomist


    You glossed over what was meant to be my main point, which is that the demand for reserves appears not to be inelastic. As far as I can see (this is something that I am trying to work out myself), if the demand for reserves is not inelastic, the Fed has no special power to control interest rates. As I said above, I can believe that the Fed or any other institution with deep pockets can control interest rates, simply by becoming one side of the market (which is I think what Goodhart is effectively suggesting), but that is not a sustainable situation (assuming, in the Fed’s case, that inflation is kept under control). It seems to me that what we are seeing now is exactly that. In an attempt to hold interest rates down at a time when the natural price of loanable funds is higher due to risk, the Fed is tending towards becoming one side of the entire money market.

  • Posted by flow5

    Reserves are not a tax. The tax is inflation.

    From a systems viewpoint, commercial banks as contrasted to financial intermediaries: , never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time/savings deposits (TDs) or the owner’s equity or any liability item.

    When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) & (every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (TRs) — somewhere in the banking system.

    The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free/gratis legal (excess) reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (10% on transaction accounts in excess of the low-reserve tranche), as fixed by the Board of Governors of the Federal Reserve System, etc., etc.

    Thus, it’s not possible to compare the non-banks to the commercial banks when talking about “funding” or the supply of loan-funds. The commercial banks (as a system of banks) pay for something that they already have (interest bearing deposits). The (CBs & intermediaries) modus operandi is diametrically opposed.

    The member CBs could continue to lend if the public ceased to save altogether.

  • Posted by flow5

    “Banks have long contended that the costs of reserve requirements (i.e., forgone earnings) put them at a competitive disadvantage relative to non-bank competitors that are not subject to reserve requirements – Testimony of Treasury

    “These measures should help the banking sector attract liquid funds in competition with non-bank institutions and direct market investments by businesses” Testimony of Treasury

    A commercial bank only becomes a financial intermediary when there is a 100% reserve ratio applied to all its deposit liabilities. Reserve ratios were at 84% in 1942.

    Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, by data networks, checks, or similar types of negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

    From a systems viewpoint, commercial banks as contrasted to financial intermediaries: , never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity or any liability item.

    When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) & (every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (TRs) — somewhere in the banking system.

    The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free/gratis legal (excess) reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (10% on transaction accounts in excess of the low-reserve tranche), as fixed by the Board of Governors of the Federal Reserve System.

    Since 1942, money creation is a system process. No bank, or minority group of banks (from an asset standpoint), can expand credit (create money), significantly faster than the majority banks expand. If the member banks hold 80 percent of all bank assets, an expansion of credit by the nonmember banks and no expansion by member banks will result, on the average, of a loss in clearing balances equal to 80 percent of the amount being checked out of the nonmember banks.

    From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, and probably its free/gratis legal reserves, not a tax [sic] – and thereby it’s lending capacity. But all such inflows involve a decrease in the lending capacity of other commercial banks (outflow of cash and due from bank items), unless the inflow results from a return flow of currency held by the non-bank public, or is a consequence of an expansion of Reserve Bank credit. Hence, all CB liabilities are derivative.

    That is, CB time/savings deposits, unlike savings-investment accounts in the “thrifts”, bear a direct, virtually one-to-one, unvarying relationship, to transactions accounts. As TDs grow, TRs shrink pari passu, and vice versa. The fact that currency may supply an intermediary step (i.e., TRs to currency to TDs, and vice versa) does not invalidate the above statement.

    Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries, for the funds never leave the commercial banking system.

    Consequently, the effect of allowing member CBs to “compete” with financial intermediaries (non-banks) has been, and will be, to reduce the size of the intermediaries (as deregulation did in the 80’s) – reduce the supply of loan-funds (available savings), increase long-term interest rates, increase the proportion, and the total costs of CB TDs.

    Contrary to the DIDMCA underpinnings, member commercial bank disintermediation is not, and has not been, predicted on interest rate ceilings. Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of currency withdrawals. The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its “open market power”, to prevent any outflow of currency from the banking system.

    However, disintermediation for financial intermediaries- (non-banks), is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); earning assets with historically lower fixed rate and longer term structures.

    In other words, competition among commercial banks for TDs has: 1) increased the costs and diminished the profits of commercial banks; 2) induced disintermediation among the “thrifts” with devastating effects on housing and other areas of the economy; and 3) forced individual bankers to pay higher and higher rates to acquire, or hold, funds.

    Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries. Shifts from TDs to TRs within the CBs and the transfer of the ownership of these TRs to the thrifts involves a shift in the form of bank liabilities (from TD to TR) and a shift in the ownership of (existing) TRs (from savers to thrifts, et al). The utilization of these TRs by the thrifts has no effect on the volume of TRs held by the CBs or the volume of their earnings assets.

    In the context of their lending operations it is only possible to reduce bank assets and TRs by retiring bank-held loans, e.g., the only way to reduce the volume of demand deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.

    The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can make loans (if monetary policy permits and the opportunity is present) which amount to server times the initial excess reserves held.

    Financial intermediaries (non-banks) lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the CBs lend no existing deposits or savings; they always, as noted, create new money in the lending process. Saved TRs that are transferred to the S&Ls, etc., are not transferred out of the CBs; only their ownership is transferred. The reverse process, which is called “disintermediation”, has the opposite effect: the intermediaries shrink in size, but the size of the CBs remains the same.

    Professional economists have no excuse for misinterpreting the savings investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.

    From a System standpoint, time deposits represent savings have a velocity of zero. As long as savings are held in the commercial banking system, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.

    From a system standpoint, TDs constitute an alteration of bank liabilities, their growth does not per se add to the “footings” of the consolidated balance sheet for the system. They obviously therefore are not a source of loan-funds for the banking system as a whole, and indeed their growth has no effect on the size or gross earnings of the banking system, except as their growth affects are transmitted through monetary policy.

    Lending by intermediaries is not accompanied by an increase in the volume, but is associated with an increase in the velocity or turnover of existing money. Here investment equals savings (and velocity is evidence of the investment process), whereas in the case of the CB credit, investment does not equal savings but is associated with an enlargement and turnover of new money (bank credit & the money stock).

    The difference is the volume of savings held in the commercial banking system is idle, and lost to investment as long as it is held within the commercial banking system. Such a cessation of the circuit income and transactions velocity of funds, funds which constitute a prior cost of production, cannot but have recessionary effects in our highly interdependent pecuniary economy. Thus, the growth of time deposits shrinks aggregate demand and therefore produces adverse effects on GDP and the level of employment.

    It began with the General Theory, John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

    In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make the statement correct. Perhaps this is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, Reg Q, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, etc.

    How does the FED follow a “tight” money policy and still advance economic growth.? What should be done? The commercial banks should get out of the savings business — gradually (REG Q in reverse-but leave the non-banks unrestricted). What would this do? The commercial banks would be more profitable – if that is desirable. Why? Because the source of all time/savings deposits within the commercial banking system, are demand/transaction deposits – directly or indirectly through currency or their undivided profits accounts. Money flowing “to” the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of the intermediaries/non-banks cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.

    Dr. Leland James Pritchard (MS, statistics – Syracuse, Ph.D, Economics – Chicago, 1933) described stagflation 1958 Money & Banking Houghton Mifflin,

    “The Economics of the Commercial Bank Savings-Investment Process in the United States” — “Estratto dalla Rivista Internazionale di Scienze Econbomiche & Commerciali “ Anno XVI – 1969 – n. 7
    “Profit or Loss from Time Deposit Banking” — Banking and Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.