Monthly Archives: September 2011

By L. Randall Wray 

This week we addressed denomination of “money things” in the state money of account—for example, the Dollar in the US. We began a discussion of “leveraging”—making one’s IOUs convertible (on demand or on some contingency) into another’s IOUs. Next week we will turn to the notion of a “debt pyramid” with the state’s own IOUs at the apex. For now, on to the questions and comments. As usual I will group them into themes; some commentators actually answered several of the questions (Thanks!) but I’ll briefly repeat some of what they said.

Q1: (Jeff) Can’t the Fed just control inflation by raising required reserve ratios? At the limit, to 100% reserves? And would that affect interest rates?

A: As discussed in a bit more detail below, and in this blog later, required reserve ratios do not control bank lending. To hit its interest rate target, the central bank must accommodate the demand for reserves—whether the ratio is 1% (about where it is now) or 10% (the ratio usually used in textbooks to simplify math). (Note: the required reserve ratio in Canada is a big zip, zero! That is actually the most advanced way to run the system. Hats off to our neighbors to the north.) Since it would not control lending there is little reason to believe raising ratios would affect inflation. Also note that raising the ratio does not affect the overnight rate (fed funds rate in the US)—since that is the policy variable.

Higher ratios do act like a tax on banks—they must hold a very low earning asset. If the ratio is 1% they hold 1% of their assets (more or less—close enough for this analysis) in an asset that earns a very low interest rate (the support rate paid by the central bank on reserves). They need to cover their costs and make profits by earning more than that on the rest of their assets (99%). Raising the ratio to 10% means they only have 90% of their assets potentially earning higher returns. And so on. Will that affect lending rates earned (what they charge borrowers) and deposit rates paid (what they pay depositors)? Well banks live on the spread between those two—that is how they cover costs and make profits. So, yes, raising ratios might cause them to raise loan rates and lower deposit rates—not a good thing for borrowers or depositors. 

Finally, what about 100% reserves? There is a good book by Ronnie Phillips (Google it) on the Fisher-Simons-Friedman proposal to do just that. However, this is usually presented as a way to make banks “safe”—they’d hold only reserves or treasuries against their demand deposits, on the idea that with safe assets, the deposits are always safe (so you do not need deposit insurance, FDIC). Sounds OK so far as it goes. Someone else has to do the lending since the banks are not allowed to do it. A big topic.

Q2: (Jeff) How can China operate domestic policy with a fixed exchange rate?

A: Trillions of dollars of foreign exchange reserves! No George Soros is going to bet against China’s ability to peg its exchange rate. So, yes, there are exceptions to the rule that pegged exchange rates reduce policy space.

Q3: (Neil) What about IMF conversion clause? What makes banks special? (others also asked that)

A: Come on, you are sounding like Ramanan. I answered that already—yes you can tie your shoes together and try to run a marathon. First, this discussion was general. Second, as I showed, in practice the clause has no impact. What makes banks special? We’ll save that for coming blogs. But two characteristics that are very important are: access to central bank, and access to deposit insurance.

Q4: (Godefroy) What does the central bank lend against? How does a bank get cash?

A: Central bank lends against qualifying assets. It’s the boss and can decide. Yes, it lends against treasuries (IOUs of the Treasury); it can lend against “real bills” (short term commercial loans made by banks to good customers); it can lend against toxic waste MBSs (maybe a bad idea?). It can use collateral requirements as a way to supervise/regulate banks: encourage them to make only safe loans by narrowing what it accepts as collateral.

When you go to the ATM to withdraw cash, your bank has a bit on hand—that counts as part of its reserve base. If everyone goes tomorrow, obviously the bank runs out quickly. It orders more from the Fed—shipped in armored trucks—and the Fed debits the bank’s reserves, and when that is insufficient it lends the cash (a loan of reserves) against collateral. The Fed holds the bank’s IOU as an asset; it is of course a liability of the bank.

Q5: Do money center banks influence the FOMC?

A: Is Goldman Sachs a bloodsucking vampire squid that bought and paid for Timmy Geithner’s NY Fed as well as Treasury?

Q6: (Glenn; Jeff) Why does government need to borrow its own IOUs and pay interest? And why pay interest on “fiat money”?

A: Good question! Government cannot borrow its own IOUs. Neither can you! If you give an IOU to your neighbor for a cup of borrowed sugar, you do not go back and ask if you can borrow it. It is a senseless operation.

Instead, government offers Treasuries as a higher interest paying IOU, exchanged for reserves. When you go down to your bank, you can exchange your demand deposit for a saving deposit on which you earn higher interest. That is really all that a government bond sale is—a substitution of a demand deposit at the central bank for a time deposit.

Note that cash (“fiat money”) does not pay interest. A Chicago Mafioso loan shark might lend you cash at 140% interest. Why? You are desperate. He gets compensated for the risk that you will run with the money. Of course, there is a substantial penalty for nonpayment. But why would the Treasury pay interest on bonds, and why would the Fed pay interest on reserves? There is no necessity of doing that. We’d accept cash and banks would accept reserves without interest—there is no default risk (on sovereign government IOUs on a floating exchange rate), and we need them to pay taxes. But it is nice to get interest, isn’t it? Think of it as a government transfer payment, a form of charity. It might be a bad idea—a topic for later.

Q7: Does a lack of sufficient reserves constrain loans?

A: No. Don’t take my word for it. Here’s a comment from the Fed’s Senior Vice President, Federal Reserve Bank of New York, Alan Holmes. Holmes explained why the then faddish Monetarist policy of controlling inflation by controlling the growth of Base Money had failed, saying that it suffered from “a naive assumption” that the banking system only expands loans after the [Federal Reserve] System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand…

Q8: (unknown) How do banks work? What happens if a borrower goes bankrupt?

A: We’ll look in more detail at how banks “work”. They’ve got assets on one side of their balance sheet and liabilities plus capital on the other. When the assets go bad, the capital is reduced (shareholders lose); once the capital is wiped out, the losses come out of the other liabilities, so creditors lose. Since the FDIC insures depositors, if losses are big enough to hit deposits, Uncle Sam covers those.

Q9: (HadNuff) Don’t you pay taxes with demand deposits? Banks can be illiquid but not insolvent?

A: You write a check to the IRS but your bank pays the taxes for you using reserves, since the IRS sends the check on to the Fed, which debits the bank’s reserves (and increases the Treasury’s deposit). The central bank lends reserves to solve liquidity problems, lending against collateral. Banks do become insolvent, as discussed above. They then must be “resolved”—there are a variety of methods but it comes down to selling the assets, covering insured depositors first, and then other creditors and the shareholders take the loss.

By L. Randall Wray

In the past two weeks we took a bit of a diversion the case of so-called commodity money consisting of precious metal coins. We also briefly discussed the gold standard. I argued that even on a gold standard, the currency is really the government’s IOU backed by taxes. And that remains true even if the sovereign stamps the IOU on a gold coin. So those precious metal coins were really what is often derided as a “fiat money”. The typical dichotomy posed between “fiat money” that has “nothing” backing it versus a “hard money” or “commodity money” with gold or silver behind it is actually false. All “modern money” systems (which apply to those of the “past 4000 years at least” as Keynes put it) are state money systems in which the sovereign chooses a money of account and then imposes tax liabilities in that unit. It can then issue currency used to pay taxes.

In the introduction to this Primer I had promised not to delve too much into history—first because our main purpose is to explain how money works today; and second because the past is admittedly cloudy (“mists of time” as Keynes said). However, I felt it was necessary to explain how things worked on the gold standard and with metal coins (as best as we can determine) in order to argue that those who think that “fiat money” systems are something strange, unnatural, and of recent vintage, are confused. Governments of the past and present can choose to tie their hands, so to speak, by standing ready to convert their currencies to precious metal or foreign currencies. Fixed exchange rate systems stand at one extreme of the modern money continuum. They are a policy choice. There is nothing “natural” about them. They do, however greatly reduce fiscal policy space—in ways to be discussed more later in the primer. The US and other sovereign countries could choose to tie policy in that manner. But they would not thereby return to some mythical utopian past with a natural self-regulating commodity money. In truth, domestic fixed exchange rate systems usually bring on more problems than they resolve, and they are typically short-lived. And international fixed exchange rate systems—such as the sterling system or the Bretton Woods system fared no better.

This week we return to our analysis of the operation of today’s monetary system, examining the denomination of IOUs in the state money of account.

IOUs denominated in national currency: government. In earlier blogs we have noted that assets and liabilities are denominated in a money of account, which is chosen by a national government and given force through the mechanism of taxation. On a floating exchange rate, the government’s own IOUs—currency—are nonconvertible in the sense that the government makes no promise to convert them to precious metal, to foreign currency, or to anything else. Instead, it promises only to accept its own IOUs in payments made to itself (mostly, tax payments, but also payments of fees and fines). This is the necessary and fundamental promise made: the issuer of an IOU must accept that IOU in payment. So long as government agrees to accept its own IOUs in tax payments, the government’s IOUs will be in demand (at least for tax payments, and probably for other uses as well).

On the other hand, when government promises to convert on demand (to foreign currency or precious metal), holders of the government’s liabilities have the option of demanding conversion. This might in some cases actually increase the acceptability of the government’s currency. At the same time, it commits government to conversion on demand—which as discussed earlier requires that it have accumulated reserves of the foreign currency or precious metal to which it promises to convert. Ironically, while it might be able to find more willingness to accept its currency since it is convertible, it also knows that increasing currency issue raises the possibility it will not be able to meet demand for conversion. For this reason, it knows it should limit its issue of a convertible currency. Should holders begin to doubt government will be able to convert on demand, the game is over unless government has sufficient access to foreign currency or precious metal reserves (either its hoards, or to loans of reserves). It can be forced to default on its promise to convert if it does not. Any hint that default is imminent will ensure a run on the currency. In that case, only 100% reserve backing (or access to lenders) will allow government to avoid default.

We repeat that convertibility is not necessary to ensure (at least some, perhaps limited) demand for the domestic currency. As discussed above so long as government can impose and collect taxes it can ensure at least some demand for a nonconvertible currency. All it needs to do is to insist that taxes be paid in its own currency. This “promise to accept in tax payment” is sufficient to create a demand for the currency: taxes drive money.

Private IOUs denominated in the domestic currency. Similarly, private issuers of IOUs also promise to accept their own liabilities. For example, if a household has a loan with its bank, it can always pay principle and interest on the loan by writing a check on its deposit account at the bank. Indeed, all modern banking systems operate a check clearing facility so that each bank accepts checks drawn on all other banks in the country. This allows anyone with a debt due to any bank in the country to present a check drawn on any other bank in the country for payment of the debt. The check clearing facility then operates to settle accounts among the banks. The important point is that banks accept their own liabilities (checks drawn on deposits) in payments on debts due to banks (the loans banks have made), just as governments accept their own liabilities (currency) in payments on debts due to government (tax liabilities).

Leveraging. There is one big difference between government and banks, however. Banks often do promise to convert their liabilities to something. You can present a check to your bank for payment in currency, what is normally called “cashing a check”, or you can simply withdraw cash at the Automatic Teller Machine (ATM) from one of your bank accounts. In either case, the bank IOU is converted to a government IOU. Banks normally promise to make these conversions either “on demand” (in the case of “demand deposits”, which are normal checking accounts) or after a specified time period (in the case of “time deposits”, including savings accounts and certificates of deposits, known as CDs—perhaps with a penalty for early withdrawal).

Banks hold a relatively small amount of currency in their vaults to handle these conversions; if they need more, they ask the central bank to send an armoured truck. Banks don’t want to keep a lot of cash on hand, nor do they need to so in normal circumstances. Lots of cash could increase the attractiveness to bank robbers, but the main reason for minimizing holdings is because it is costly to hold currency. The most obvious cost is the vault and the security guards, however, more important to banks is that holding reserves of currency does not earn profits. Banks would rather hold loans as assets, because debtors pay interest on these loans. For this reason, banks leverage their currency reserves, holding a very tiny fraction of their assets in the form of reserves against their deposit liabilities.

So long as only a small percentage of their depositors try to convert deposits to cash on any given day, this is not a problem. However, in the case of a bank run in which a large number of depositors tries to convert on the same day, the bank will have to obtain currency from the central bank. This can even lead to a lender of last resort action by the central bank that lends currency reserves to a bank facing a run. In such an intervention, the central bank lends its own IOUs to the banks in exchange for their IOU—the bank gets a reserve credit from the central bank (an asset for the bank) and the central bank holds the bank’s IOU as an asset. When cash is withdrawn from the bank, its reserves at the central bank are debited, and the bank debit’s the depositor’s account at the bank. The cash held by the depositor is the central bank’s liability, offset by the bank’s liability to the central bank.

Next week: we will begin with an analysis of how banks clear accounts among themselves, by using central bank reserves. This also leads to a discussion of “pyramiding”: in modern economies that leverage liabilities, it is common to make one’s own IOUs convertible to those higher in the debt pyramid. Ultimately, all roads lead back to the central bank.