Daily Archives: October 9, 2011

Today’s Modern Money Primer

Check out the latest in the Modern Money Primer series:  The Effect of Sovereign Budget Deficits on Saving, Reserves and Interest Rates.

MMP Blog #19: Effects of Sovereign Government Budget Deficits on Saving, Reserves and Interest Rates

Last week we began to analyse fiscal and monetary policy formation by a government that issues its own currency. We went through a list of false statements about sovereign government spending, and offered a list of general statements that do apply. Let us now begin to examine in more detail the government’s budget and impacts on the nongovernment sector. This week we will look at the relation between budget deficits and saving, and the effects of budget deficits on bank reserves and interest rates. 

Budget deficits and saving. Recall from earlier discussions in the Primer that it is the deficit spending of one sector that generates the surplus (or saving) of the other; this is because the entities of the deficit sector can in some sense decide to spend more than their incomes, while the surplus entities can decide to spend less than their incomes only if those incomes are actually generated. In Keynesian terms this is simply another version of the twin statements that “spending generates income” and “investment generates saving”. Here, however, the statement is that the government sector’s deficit spending generates the nongovernment sector’s surplus (or saving). 

Obviously, this reverses the orthodox causal sequence because the government’s deficit “finances” the nongovernment’s saving in the sense that the deficit spending by government provides the income that allows the nongovernment sector to run a surplus. Looking to the stocks, it is the government’s issue of IOUs that allows the nongovernment to accumulate financial claims on government.  

While this seems mysterious, the financial processes are not hard to understand. Government spends (purchasing goods and services or making “transfer” payments such as social security and welfare) by crediting bank accounts of recipients; this also leads to a credit to their bank’s reserves at the central bank. Government taxes by debiting taxpayer accounts (and the central bank debits reserves of their banks).  

Deficits over a period (say, a year) mean that more bank accounts have been credited than debited. The nongovernment sector realizes its surplus initially in the form of these net credits to bank accounts.  

All of this analysis is reversed in the case of a government surplus: the government surplus means the nongovernment sector runs a deficit, with net debits of bank accounts (and of reserves). The destruction (net debiting) of nongovernment sector net financial assets of course equals the government’s budget surplus.  

Effects of budget deficits on reserves and interest rates. Budget deficits initially increase bank reserves by the same amount. This is because treasury spending leads to a simultaneous credit to the bank deposit account of the recipient and to that bank’s reserve account at the central bank. 

Let us first examine a system like the one that existed in the US until recently, in which the central bank does not pay interest on reserves. Deficit spending that creates bank reserves will (eventually) lead to excess reserves—banks will hold more reserves than desired. Their immediate response will be to offer to lend reserves in the overnight interbank lending market (called the fed funds market in the US).  

If the banking system as a whole has excess reserves, the offers to lend reserves will not be met at the going overnight interbank lending rate (often called the bank rate, but in the US this is called the fed funds rate). Hence the banks with excess reserve positions will offer to lend at ever-lower interest rates. This drives the actual “market” rate below the central bank’s target rate for overnight funds. 

Once the rate has fallen sufficiently far away from the target, the central bank will intervene to remove the excess reserves. Since the demand for reserves is fairly interest inelastic, lowering the offered lending rate will not increase the quantity of reserves demand by very much. In other words, it is difficult to eliminate a position of system-wide excess reserves by lowering the overnight rate. Instead, the central bank must remove them. 

The way that it does this is by selling from its stock of treasury bonds. That is called an open market sale (OMS). An OMS leads to a substitution of bonds for excess reserves: the central bank’s liabilities (reserves) are debited, and the purchasing bank’s reserves are also debited. At the same time, the central bank’s holding of treasuries is debited and the bank’s assets are increased by the amount of treasuries purchased.  

Since the bank’s reserves decline by the same amount that its holdings of treasuries are increased, this is effectively just a substitution of assets. However, it now holds a claim on the treasury (bonds) instead of a claim on the central bank (reserves); and the central bank holds fewer assets (bonds) but owes fewer liabilities (reserves). The bank is happy because it now receives interest on the bonds. 

It is easy to see that the same process would be triggered even if the central bank paid interest on reserves—as is now done in the US. Once banks have accumulated all the reserves they want, they will try to substitute for higher-earning treasuries. They will not push the overnight rate below the central bank’s “support rate” (what it pays on reserves)—since no bank would lend to another at a rate below what it can receive from the central bank. Instead banks with undesired reserves will immediately go into the treasuries market to seek a higher return. 

The impact, then, will be to push rates on treasuries down. In this second case, the central bank need not do anything—it does not need to sell bonds since it maintains its overnight interest rate by paying interest on reserves. 

In practice, a central bank that adopts this second procedure usually pays a slightly lower rate on reserves than it charges to lend reserves. As discussed earlier, in the US the central bank lends “at the discount window” and at the “discount rate”. It might charge 25 basis points (0.25 percentage points) more on its lending than it pays on reserves. For example, it might charge 2% on loans and pay 1.75% on reserves. The “market” interest rate on interbank lending will remain approximately within that band since a bank needing reserves has the option of borrowing at the central bank at 2%, while a bank having extra reserves can earn 1.75% simply by holding them at the central bank.

That’s enough for today—just about over my 1000 word target! Send your comments and questions.

The Divine Right of Bank Profits: A Reading from the Book of B of A

By William K. Black

Bank of America’s (B of A’s) customers are furious at B of A’s $5 monthlyfee on debit cards.  The normal business’mantra is: “the customer is always right.” B of A, however, is a Systemically Dangerous Institution (SDI), so it ison a heavenly plane transcending the normal rules of business, markets, ormorality.  For B of A, the customer isalways slight(ed).  “I have aninherent duty as a CEO of a publicly owned company to get a return for myshareholders,” Brian Moynihan said.

BofA chief: We have a ‘right to make aprofit’

Moynihan’s statement demonstrates two of the verities of the ongoingfinancial crisis.  First, the CEOs of ourSDIs are terrible bankers, but they are superb at standup.  Second, much of the business press is sobrain dead or sycophantic that it now plays the role of the Washington Generalsas the hapless faux opponents of theHarlem Globetrotters (the SDIs’ CEOs). None of the reporters asked Moynihan the obvious questions:

·     Is that “return for my shareholders” supposed tobe positive?
·     Given that you and your predecessor (Ken Lewis)combined to cause your shareholders a 90% loss on their investments – nearlyone-half trillion dollars, when can we expect your resignation and return ofyour compensation in accordance with your “inherent duty” to thoseshareholders?

I found myself davening in awe atMoynihan’s chutzpah.  Only a handful of CEOs in history haveravaged “my” shareholders worse than the Lewis/Moynihan tandem.  How he had the nerve to sing a hymn ofself-praise to his devotion to those shareholders – and how the business presslet him get away with his sanctimonious chorus – is beyond my Midwesternsensibilities.

Bankof America once stood for the “little fellows”

Today, “Bank of America” is only a name appropriated by anacquirer for its marketing value.  In1904, Mr. Giannini founded the Bank of Italy in San Francisco, California.  The Bank of Italy was a radical departurefrom traditional commercial banking.  Itspecialized in making loans to the Italian-American entrepreneurs that ran manysmall businesses in California and in serving working class customers, many ofthe recent immigrants. Giannini eventually changed its name to Bank of America.
The real B of A was acquired in 1998 by NationsBank, aCharlotte, North Carolina bank founded by Southern elites to cater to Southernelites.  NationsBank changed its name toBank of America because of marketing considerations, but its managers – basedin Charlotte – control B of A.  The B ofA that Giannini proudly boasted was created to serve “the little fellows” wastransformed by the Charlotte-based CEOs into a typical SDI. 

 Lewis and Moynihan’s “One-Two” Knockout Punchagainst B of A’s Shareholders

Moynihan is a lawyer. His annual base salary is around $2 million.  He is CEO because his predecessor exercisedhis “inherent duty … to get a return for my shareholders” by producing aspectacularly negative return.  Moynihanwas named B of A’s CEO on December 16, 2009, replacing Ken Lewis, whose 2007compensation was roughly $20 million. Lewis was the man of massive ego and minimal talent and ethics whodecided that what would ensure B of A’s winning the race to the moral bottomamong the SDIs was acquiring the most notorious lender in the world –Countrywide – in 2008 for $4.1 billion. Banking has such an exceptional sense of irony that he was named “Bankerof the Year” in 2008.  If he had admittedto being a pedophile, would they have named him Banker of the Decade?     

B of A’s latest closing share price was $5.90 (10/7/11) v.the closing price of $15.10 on December 16, 2008 when Moynihan was namedCEO.  Endemic criminal conduct by B of Ain the mortgage foreclosure process, combined with the massive accounting fraudinherent in Countrywide’s operations combined to cause a loss of slightly over60% to the B of A shareholders. Moynihan’s claim that B of A’s losses were caused by the Dodd-Frank Actare false and pathetic.  If a juniorteller refused to accept responsibility for her $50 cash error and offered sucha lame excuse blaming others Moynihan would fire her on the spot. 

On September 4, 2004, the FBI testified in open session before Congressabout an “epidemic” of mortgage fraud and predicted that it would cause afinancial “crisis” if it were not stopped. Countrywide because the epicenter of this epidemic, which was allowed torage and cause the ongoing U.S. financial crisis and the Great Recession.  On the first trading day (September 6, 2004)after the FBI’s testimony gave B of A’s managers (particularly Lewis andMoynihan) ample notice of the risk of endemic mortgage fraud, the closing pricefor B of A shares was $43.61.  From thatdate, B of A stock lost slightly over 85% of its value because of Lewis andMoynihan’s leadership. On May 24, 2006, the Mortgage Bankers Association (MBA)got around to sending to each of its members the 8th Periodic Report(dated April 2006) of its anti-fraud specialist contractor (MARI).  MARI reported that stated income loans were“an open invitation to fraudsters,” had a fraud incidence of “90 percent,” andthat “the stated income loan deserves the nickname used by many in theindustry, the ‘liar’s loan.’”  On the daythe MBA warned each of its members of this endemic fraud B of A’s stock priceclosed at $48.48.  The current stockprice represents nearly an 88% loss from May 24, 2006. 

These stock prices and percentage losses come from B of A’s site.  B of A, according to its most recent financial report, has 10.13 billionshares outstanding.  Using that figure,the loss to B of A’s shareholders from the three dates I have discussed (the2004 FBI warning, the 2006 MBA/MARI warning, and the date on which Moynihan wasappointed CEO) to the most recent close was, respectively, over $426 billion,$480 billion, and  $103 billion.  (See this source for shares outstanding.)

In plainer English, B of A’s CEOs have led the bank in amanner that has wiped out around 90% of the shareholders value – a loss ofnearly a half trillion dollars.  Lewisleft B of A as a wealthy man despite destroying shareholder wealth at aprodigious rate.  Moynihan is being madeever wealthier despite continuing that destruction of shareholder value. 

Worse, the destruction was avoidable.  It was ego, incompetence, and moral blindnessthat caused Lewis to acquire Countrywide and Merrill Lynch.  Both were notorious – before B of A acquiredthem – for their suicidal lending and investing.  It was Moynihan’s incompetence and moralblindness that allowed B of A to commit tens of thousands of felonies in thecourse of foreclosing through perjury on those who were often the victims ofCountrywide’s underlying fraudulent mortgages. Moynihan and Lewis are fitting leaders of the 1% (actually the top0.0001%). 

Don’tforget about Hans-Olaf Henkel – B of A’s Racist Adviser for Germany

On February 6, 2010 I sent“AnOpen Letter to Dr. Walter E. Massey Chairman,Bank of America President, emeritus, Morehouse College” regarding “Hans-OlafHenkel, Bank of America’s Senior Advisor in Germany.”  I have never received a response to thisletter, though Randy Wray and I did receive a response from a B of Arepresentative to another article we did on B of A’s foreclosure fraud.  I am not aware of any U.S. reporter followingup on the points I made in that letter. My web search indicates that Herr Henkel is still B of A’s senior Germanadviser.  Few Americans know HerrHenkel.  He is the most prominentbusiness elite in Germany and perhaps all of Europe.  His racist views, which I note below, arewell known to B of A’s senior officials throughout Europe.

Here are the two takeawayson B of A’s choice of senior advisers. He blames the U.S. economic crisis on the end of “redlining” – making itillegal to discriminate against blacks in housing finance.  Henkel’s open racism and embrace of fantasyabout the causes of the U.S. crisis instead of facts demonstrates the kind ofadvice B of A is receiving. 

Henkel also explicitlyembraced (using a German phrase meaning “without any quibble”), the followingbigoted rants Dr. Sarrazin (then a member of Germany’s central bank):    

DrThilo Sarrazin, a member of the executive board and head of the bank’s riskcontrol operations, told Europe’s culture magazine Lettre International thatTurks with low IQs and poor child-rearing practices were “conqueringGermany” by breeding two or three times as fast.

A large number of Arabs andTurks in this city, whose number has grown through bad policies, have noproductive function other than as fruit and vegetable vendors.
 Forty per cent of all birthsoccur in the underclasses. Our educated population is becoming stupider fromgeneration to generation. What’s more, they cultivate an aggressive andatavistic mentality. It’s a scandal that Turkish boys won’t listen to femaleteachers because that is what their culture tells them. 

I’drather have East European Jews with an IQ that is 15pc higher than the Germanpopulation. 

It is an obscenity that abank that was formed to loan money to small, immigrant entrepreneurs of anoften hated religion (Catholicism), particularly Italian “fruit and vegetablevendors” is now choosing as its “senior adviser” in Germany a man who embracesthe vilest hates and lies that caused so much world misery.  Of course, this is modern German racismvariant in which Turks are so bad that even Jews (G-D forbid!) are preferable.

Here is how I ended my openletter:

Mr.Henkel is not simply a bigot.  Hissubstantive policy advice – deregulation and far higher executive compensation– makes him one of the principal German architects of the crisis.  He gave Bank of America awful advice. 

ButMr. Henkel’s saddest trait is hypocrisy. He is a serial hypocrite because his bigotry trumps the things hepurports to stand for.  His speakerbureau bio (self) describes him as “courageous.”  (He applauds Mr. Sarrazin’s screed asexemplifying courage.)  In the policycontext, courage is speaking truth to power when power does not want to hearthose truths.  Mr. Henkel flatters powerthrough the gospel of Social Darwinism. Mr. Henkel claims to be the champion of the “entrepreneur” – but treats“fruit and vegetable” entrepreneurs with contempt.  Mr. Henkel denounces “smears” against the“market system” but launches, and cheers, the vilest smears that have producedthe most monstrous crimes against humanity in world history.

Bankof America must not simply announce some face saving retirement (particularlyone thanking him for his service and paying him severance).  Bank of America needs to make a clearstatement about what it stands for.  DoesMr. Giannini or Mr. Henkel represent Bank of America?

Ioffer the following recommendations for your board’s consideration.  Mr. Henkel should be terminated for cause.  Immediately. Bank of America should review all policy advice it has received from himand his team and seek outside guidance from experts that (1) foresaw thecrisis, and (2) are not bigots.  Bank ofAmerica should review why its senior managers in Europe and the United Statestook no action while its “senior advisor” spread his hate for months.  Bank of America should announce a new $10million scholarship program for college and graduate students of limited financialmeans.  I suggest naming the program theGiannini awards. 

Given B of A’s failure totake any timely action even after my open letter made clear the urgent need toget rid of Henkel, I now urge B of A to fund the Giannini awards at a level of$100 million annually.  (That’s abouthalf the aggregate compensation B of A paid Ken Lewis for destroying hundredsof billions of dollars in shareholder value and ruining the lives of millionsof defrauded home borrowers.)

I urge the protestorsoccupying Wall Street and other financial centers to demand that B of A fireits racist-in-chief adviser, help the homeowners it defrauded, and stop allforeclosure fraud.  I ask businessreporters to rediscover their canines. Get a good grip, don’t let go, and tear into the real “mobs” that areattacking the American economy – the accounting control frauds likeCountrywide. 

Bill Black is an Associate Professor of Economics and Law atthe University of Missouri-Kansas City. He is a white-collar criminologist, a former financial regulator, andthe author of The Best Way to Rob a Bankis to Own One.  He can now befollowed on Twitter:  @WilliamKBlack