Sunday, 13 January 2008

US economic policy shot in the foot #1: The SOMA portfolio

This week’s news of the death of the UK corporate troubleshooter Sir John Harvey Jones reminded RebelEconomist of a piece of advice he gave on his television programme back in the 1990s. The gist of it was that, in business, doing nothing is almost certainly the wrong choice, because the business environment evolves continually so that yesterday’s best practice is today’s handicap. This post is the first in a series of three describing aspects of US economic policy that may have once been reasonable, but, without rigorous review and reform, became ossified and increasingly unsuitable as the economy changed. In each case, I shall argue that failure to update the policy has represented a wasted opportunity for the US.

Low long-term interest rates and their effect on US mortgage finance undoubtedly contributed to the recent US housing boom and the associated development of complex debt instruments, which led to the present disruptive housing bust and financial turmoil. It is commonly argued that long-term interest rates were driven down by the purchase of dollar bonds, especially treasuries, by Asian and oil-producing nations’ central banks investing their foreign exchange reserves. As Brad Setser put it in his blog this week: “the surge official outflow from asia and the oil exporters led to a surge in demand for US debt and specifically "safe" treasuries and agencies. that pushed yields on these instruments down. US investors didn't like the yields and sold, often to foreign central banks. they then invested their funds in higher yielding instruments -- often MBS or CDOs that included repackaged subprime debt.”

While Fed board governors are not known for plain speaking, it does appear that they were aware of and concerned by these developments during the boom. Greenspan famously described falling long-term interest rates during a period of rising short-term interest rates as a “conundrum”, while Bernanke suggested that the explanation for the relatively low long-term interest rates was a “savings glut”. It is not unreasonable to infer that around this time, the Fed would have preferred long-term interest rates to be higher and understood that either less buying or more selling of long-term treasuries would have the desired effect.

In the light of these concerns, it is remarkable that, during the period in which the Fed was raising short-term interest rates from June 30th 2004 to June 29th 2006, the Fed itself was almost certainly the largest holder, and one of the biggest buyers, of US treasuries. As Chart 1 (reproduced from the New York Fed’s latest annual report on domestic open market operations) shows, the outright holdings of its system open market account (SOMA), which comprise exclusively treasuries, grew from about $670bn to $750bn nominal over the tightening period.




















Despite the fuss about currency intervention and reserves accumulation by Japan and China, their central bank holdings of US treasuries appear to be smaller than the Fed’s. Neither country publishes full details of its reserves holdings, but according to the most recent US Treasury survey of foreign holdings of US securities, as at end-June 2006, Japan and China held $706bn and $556bn respectively of non-ABS long-term debt securities and $85bn and $17bn ofshort-term debt securities. Given that it is unlikely that all of these bonds are held by the monetary authorities in each country or that they include treasuries only, the SOMA holding is probably the largest. Moreover, foreign exchange reserves are typically held mainly in short-term securities, whereas the SOMA holdings deliberately represent a roughly even proportion of the outstanding issue of treasuries across the maturity range, as evident in its present (January 2nd 2008) holdings (Chart 2).




















An obvious question is, therefore, why does the Fed hold such a large proportion of treasuries, and why did they continue to increase their holdings even when they were concerned that other buyers were fuelling the boom by driving down long-term interest rates?

In a fiat money system, the central bank supplies, distributes and collateralises its money (mainly banknotes) by buying debt. In order to maintain confidence that the central bank remains solvent and able to redeem banknotes if the demand for money falls, this debt tends to be highly creditworthy and liquid. Clearly, government bonds have these properties, so the Fed buys treasuries, and as bonds mature and the underlying demand for central bank money expands with inflation and real economic growth, the Fed is a regular buyer. These treasuries are held in the SOMA.

But government bonds are not the only suitable monetary asset; the Fed accommodates short-term, seasonal fluctuations in money stock using collateralised short-term bank debt in the form of repurchase agreements (“repos” in Chart 1). In fact, repo is arguably a better asset than long-term bonds for monetary policy operations, for at least two reasons. One reason is that, while trading any asset (eg gold) for money gives the central bank some control of short-term interest rates (since money is a close substitute for bank deposits), which is of course how central banks set the tightness of monetary policy, dealing in short-term debt itself ought to give the closest control. Another reason is that using non-government debt supports central bank independence by separating central bank and government finances. For these reasons, monetary authorities that have more recently (re)developed their monetary policy operations, like the European Central Bank and the Bank of England, use largely repo rather than government bonds.

So the Fed could have countered the fall in long-term interest rates that occurred as they tightened monetary policy in 2004-6 by substituting repo for SOMA holdings of long-term treasuries, which would have brought the Fed into line with more modern practice anyway. The fact that Bernanke had previously (in 2001) discussed the possibility of the Fed buying more treasuries to reduce long rates if short rates hit zero suggests that the Fed did not doubt that reducing SOMA treasury holdings in 2004-6 would have meant higher long-term interest rates. And by recently running down its treasury bill holdings and expanding its repo operations to temporarily allow banks to raise liquidity against securities of lower quality during the ongoing credit squeeze, the Fed has demonstrated its ability to substitute repo for treasuries. If the Fed had substituted repo for long-term treasuries in 2004-6, US mortgage rates might not have fallen so low, and the housing boom and growth of high-yield debt securities might have been more muted.

The most likely explanation why the Fed did not do this is simply that they are not looking to change what works. The annual reports on open market operations describe how the Fed avoids distorting the market for specific treasury issues, but do not discuss the possibility of responding to changes in the behaviour of other investors and its impact on the yield curve, let alone whether treasuries are the most suitable debt instrument to provide the mainstay of the SOMA. A less favourable explanation might be that the Fed board governors were unwilling to take action that might have been seen as targeting the housing market specifically.

10 comments:

mheck82 said...

Makes sense.

Came here via your comment on Brad Setser's blog.

Flow5 said...

Written 1980: The DIDMCA became law on March 31st, 1980. Considering the paucity and nature of the comments in the financial press, the revolution and disastrous implications of this Act clearly are not recognized. The Act created the legal framework for the addition of 38,000 more commercial banks to the 14,000 we already had, and in the process, the abolition of 38,000 intermediary financial institutions.

Consequently if this act is not revised so that the Fed can get a direct grip on the volume of legal reserves of all of these institutions, then this country will experience a truly disastrous inflation

Commercial banks create new demand deposits when they make loans to, or buy securities from, the nonblank public, including the U.S. Treasury. Obviously the volume of money created is not self-regulatory. Our money has to be managed. The sine qua non of monetary management is total current control by a central monetary authority over the volume of free legal reserves held by all money creating institutions, and over the reserve ratios applicable to their deposits.

The first rule of reserves and reserve ratios should be to require that all money creating institutions have the same legal reserve requirements, both as to types of assets eligible for reserves, as well as the level of reserve ratios. Ideally, monetary policy should limit all reserves to balances in the Federal Reserve banks (IBDDs), and have UNIFORM reserve ratios, for ALL deposits, in ALL banks, irrespective of size.

Legal reserves are no longer “binding/restrictive”. And the money supply is unknown & unknowable largely due to the DIDMCA

Anonymous said...

Simply put, contrary to the impressions they attempt to create, neither the Fed nor the ECB have "injected" material amounts of "liquidity" into the international banking system in recent months. This is not a call for them to do so - to some extent their hands are tied by inflation pressures, currency risks, and profligate government spending (particularly in the U.S.). The problem is that by creating the illusion that they are doing something material - when the problem in the global financial system is not confidence, or liquidity, but solvency - the Fed and the ECB misdirect the attention of investors, provide false hope, and will ultimately do a great disservice to investors and to their own credibility.....

At present, the Fed has injected less than $20 billion in total “liquidity” since March – nearly all of which has been withdrawn from the banking system as currency in circulation. Normally, the Fed would have done a “permanent” open market operation by now, to finance this increase in currency demand (which predictably grows by $30-50 billion annually). But by constantly rolling over temporary repos every week or two instead, the Fed can act as if it is “doing more.”....In short, the Fed is doing nothing more than predictably rolling over its repos, but with great flourish as if something more is going on.....

Last week, the market shot higher on reports that the European Central Bank was injecting 348.6 billion euro (the equivalent of US$500 billion) of liquidity into the European banking system. The truth is that the ECB actually drained liquidity last week.....

JUST AS IN THE U.S., the bulk of the reserves in the European banking system are financed by the continuous rollover of repurchase agreements. In the Euro-zone, the total outstanding amount of these repos has been fairly steady around 450 billion euro. Also, as in the U.S., the ECB has moderately increased the amount of repos outstanding to cover the holiday period through January 4. Still, this increase has only had only minor effect on the 30-day average, and even measured daily, represents only about 38 billion in additional euro to cover the holiday currency demand for the entire Euro-area.

RebelEconomist said...

flow5,

Thanks for bringing the DIDMCA to my attention; I will find out about it. However, I do wonder how important deposit money actually is, as it is matched by debt (ie it is "inside money"). One would expect that central bank money ("outside money") should have a stonger per unit effect on prices (although even banknotes are ultimately a public liability). I do not know as much about monetary economics as I would like, but I doubt that this question has yet been definitively answered.


Anonymous,

Thanks for your comment too (which I also saw on Brad Setser's blog). I agree that commentators have not been sufficiently careful to net off the maturing lending when commenting on central bank operations in recent weeks. However, I do think that, even if the central banks have not increased their net lending much (which I guess would have to go with a large reduction in interest rates), they have done something "material" with these operations:
(1) In an effort to counter the widening in short term credit spreads, the Fed substituted repo operations (in which they take a wider range of collateral than just treasuries) for outright treasury bill purchases. By making non-treasury assets cheaper to finance in repo, this should support their price a bit.
(2) They have also extended the maturity of their repo operations, to address the steep money market yield curve that prevailed in December.

flow5 said...

WRITTEN SEPT 1980:

The DIDMCA became law on March 31st, 1980. Considering the paucity and nature of the comments in the financial press, the revolution and disastrous implications of this Act clearly are not recognized. The Act created the legal framework for the addition of 38,000 more commercial banks to the 14,000 we already had, and in the process, the abolition of 38,000 intermediary financial institutions. The intermediary financial institutions effected were the nation's savings and loan associations, mutual savings banks, and credit unions. Trust companies and stock savings banks have been commercial banks for many years.

Commercial banks, as contrasted to intermediaries, are credit and money creating institutions. The intermediaries are credit transmitters. Savers (contrary to the premise underlying the DICMCA in which CBs are assumed to be intermediaries and in competition with S&L’s, etc.), never transfer their savings out of the commercial banking system (unless they are hoarding currency). This applies to all investments made directly, or indirectly through intermediaries. Shifts from time deposits (TDs) to DDs within the CBs, and the transfer of the ownership of these DDs to the S&Ls, involves a shift in the form of bank liabilities (from TDs to DDs), and a shift in the ownership of DDs (from savers to S&Ls, et al). The utilization of these DDs by the S&Ls has no effect on the volume of DDs held by the CBs or the volume of their earning assets. 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.

In the context of the commercial banking system lending operations it is only possible to reduce bank assets and DDs by retiring bank-held loans. The saver-holder might 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 CB security obligations, e.g., bank stocks, debentures, etc.; or an increase in CB capital accounts through the retention of profits; or by the nonblank public increasing its holdings of currency; or by transferring DDs into (TDs).

Lending by commercial banks is inflationary. Lending by intermediaries is non-inflationary. The lending capacity of the intermediaries is limited by the volume of actual voluntary savings put at their disposal. In contrast, the lending capacity of the member commercial banks of the Federal Reserve System is limited by the volume of legal reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities as fixed by the Board of Governors of the Federal Reserve System. For the nonmember banks the lending capacity at any given time is limited by the rate of expansion of member bank credit since the member banks still hold the major volume of commercial bank assets.

Commercial banks do not loan out existing deposits (saved or otherwise), or the owners equity or any liability item. When commercial banks grant loans to, or buy securities from, the non-bank public, (which includes every institution and every person except the commercial and the reserve banks), they acquire title to earning assets by the creation of NEW money (demand deposits) somewhere in the banking system.

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 legal reserves - and thereby it's lending capacity. But all such inflows involve a decrease in the lending capacity of other banks, unless the inflow results from a return flow of currency to the banking system, or is a consequence of an expansion of Reserve Bank credit.

The source of time deposits to the commercial banking system is demand deposits, directly or indirectly via the currency route or through the banks undivided profits accounts. The financial intermediaries are the customers of the commercial banks. Money flowing to the intermediaries actually never leaves the commercial banking system as anyone who has applied double entry booking on a national scale should know. And why, from a systems standpoint, should the banks pay for something they already have. I.e., Interest on deposits? From the standpoint of the commercial banking system, CBs would be more profitable, if our legislators got the commercial bankers out of the savings business. The effect of allowing CBs to “compete” with MMFs and other intermediaries has been, and will be, to reduce the size of the intermediaries – reduce the supply of loan-funds (available savings), increase the proportion, and the total costs of CB time deposits.

CB 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.

Disintermediation for the intermediaries-S&L, MSB, CUs, MMMFs, etc., is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); earning assets with historically lower rate and longer term structures. In other words competition among CBs for time deposits 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 banks to pay higher and higher rates to acquire, or hold, funds.

The monetary authorities of the Federal Reserve System, through their control over the volume of Reserve Bank credit, and the reserve ratios applicable to member bank demand and time deposits (and Eurodollar borrowings) can control the size and rate of expansion of the nonmember banks – as long as the member banks hold a substantial majority of all commercial banks assets. 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.

Under the Act the legal reserves of the member banks remain the same, namely, balances in the Federal Reserve banks plus vault cash. Nonmember banks, S&Ls, MSB, and CUs ultimately (after eight years) were subject to uniform reserve ratios as these pertain to size of institution and type of deposit. But there is this important difference in reserve asset requirements: The nonmember banks can hold a part of their legal reserves in the form of interbank demand deposits (IBDDs) in correspondent member banks; the S&Ls, as IBDDs in the Federal Home Loan Banks; and the Credit Unions, as IBDDs in the National Credit Union Administration Central Liquidity Facility. Presumably in order to prevent the pyramiding of reserves, the Act requires all institutions holding these particular IBDDs to redeposit the funds in Federal Reserve Banks. Unfortunately, pyramiding will not be eliminated unless the Fed imposes a 100 per cent reserve ratio on these accounts. But the Act specifically exempts all except correspondent member banks from any reserve requirements.

There is no possible way for the Fed to get a “handle” on the money supply unless it has (and properly exercises) direct control over the volume of legal reserves, and the reserve ratios, of all money creating institutions. This the Act does not provide. The legal reserves of all money creating institutions should consist of directly held balances in the Federal Reserve banks – that and that alone. This was the original definition of the legal reserves of member banks in the Federal Reserve Act of Dec. 23, 1913 – (Owens Glass Act) and it is still the only viable definition (pre-1959 requirements pertaining to assets).

In due course, under this Act, our means-of-payment money supply (now designated as M1A by the Board of Governors) will approximate M-3.

Does this imply a disastrous inflation, perhaps high double-digit or even triple-digit, is knocking at our door? Hardly. At least not immediately. But in due course the public will think of CU share accounts as money, the customers of S&Ls and MSBs will regard their balances in these institutions as money, and the managers of these institutions will discover savings deposits need not precede loans. They will, as commercial bankers now do, simply credit the account of the borrower. The mangers of the erstwhile intermediaries will then have discovered the joys of “fractional reserve banking”. This assumes the commercial banking system, as a whole, is expanding and that the intermediaries on balance, have excess inflows of funds and not outflows of funds (disintermediation). No individual institution, acting alone at any given time, can create credit (and money) by a multiple – but it can over a period of time if other banks are expanding. Multiple credit and money creation is a system process. Consequently if this act is not revised so that the Fed can get a direct grip on the volume of legal reserves of all of these institutions, then this country will experience a truly disastrous inflation.

Note: We should have learned the falsity of the assumptions underlying the DICMCA during the 1966 period, (when Reg Q ceilings were raised to 5.5 per cent in order to bail out certain large New York commercial banks). All the while, the thrifts did not have interest rate ceilings then, and the intermediaries suffered disintermediation, but the commercial banks did not, and there was a housing crisis.

Addendum:
One of the principal purposes of the Act was to provide the housing industry with a reliable source of funds. That may be achieved through various governmental and quasi-governmental corporations. But the role of the S&Ls in housing finance will probably diminish significantly. By becoming commercial banks and having a larger spectrum of loans to choose from, the S&Ls will act like banks and whenever possible eschew “borrowing short and lending long”. Sources of mortgage funds will shift from the subsidized rates heretofore provided by the small saver to “bond-backed” sources which will reflect the higher interest rates prevailing in the loan-funds markets. These factors combined with higher trend rates of inflation should result in a pronounced upward trend in mortgage financing costs.

flow5 said...

The Fed has had for many years the power to create any amount of IBDD’s (Interbank Demand Deposits). There are no reserve or reserve-ratio restrictions on the credit-creating capacity of the 12 Federal Reserve Banks.

The newly created IBDD’s can be put at the disposal of any bank in the System through the “discount window” or in the present situation the Term Auction Facility. These borrowed deposits are not only money to the recipient bank, they also become a part of the legal reserves of the System. And therein lies a limitation.

The Fed cannot increase the legal reserves of the System without creating the basis for a multiple expansion of the money supply (multiple in terms of the incremental reserves).

One dollar of borrowed reserves from the TAF provides the same legal-economic base for the expansion of money as one dollar of non-borrowed reserves (vault cash & IBDDs). The fact that advances have to be repaid in 28 days is immaterial. A new advance can be obtained, or the borrowing bank replaced by other borrowing banks.

The importance of controlling borrowed reserves is indicated by the fact that at times during the TAF program (1/16/08) nearly all legal reserves are borrowed, i.e., total legal reserves are approximately equal to total borrowed reserves.

The Fed can, and does, offset domestic borrowings & foreign exchange swap lines with open market selling operations, thus eliminating any net increase in bank legal reserves.

Therefore, with the rescue operation of the TAF’s dimension, it has offset TAF auction credit with open market selling operations of U.S. Treasury Bills, see: (-) 61,659 (H4.1) 1/10/08, as well as Treasury Bill redemptions (which decrease the assets on the Federal Reserve’s balance sheet -- by reducing the SOMA portfolio), and reverse repos (from non-U.S. banks, etc,) to drain the added reserves from TAF borrowings (H4.1).

Note: Commercial banks PAY for excess reserves both in the inter-bank market (direct/correspondent or brokered, etc.), or acquire reserves via open market operations from the “trading desk”.

Commercial banks also PAY the Reserve bank for borrowed reserves from either the discount window or the Term Auction Facility. A significant portion of IBDD's are always bought.

Prior to Jan 2003 the discount rate or adjustment credit, etc. averaged c. 25-50 basis points below the fed funds rate. Then the problem was that the commercial banks flaunted the Board’s rule that advances should not be used for profit. & the profit proclivities of the commercial banks eliminated any stigma to the borrowing.

Afterwards, the discount rate became a penalty rate designed to minimize discount window borrowing in times of rising interest rates and rising inflation.

Hence the new cost differential discouraged excessive advances that are made regardless of (1) their purpose or (2) the reserve position of the borrowing banks. I.e., because all of these institutions are able to borrow in the fed funds market at lower costs.

However, the 1/14/08 TAF auction’s stop-out rate of 3.95% was effectively the same as the “trading desks” one-day target repo rate on Treasuries, i.e., the one-day cost-of-carry on Government Securities, i.e., lower than the (OIS) overnight indexed swap rate (expected FFR the next 30 days). Recognize here that the repo target rate is the true monetary “policy instrument”.

Discount window administration is necessarily concerned with the emergency needs of specific banks. The TAF gives the Fed enhanced surveillance over the short-term liquidity needs of problem banks, e.g., banks that can’t roll over commercial paper, banks unable to redeem counter-party commercial paper, i.e., to prop banks balance sheets, i.e,

Thus the FOMC has maximized the funding supplied to the inter-bank market by (1) accepting a wider variety of “eligible paper” (assumption of risk); using the Federal Reserve’s standard evaluation & haircut procedures, & (2) extending the borrowing period; eventually driving down the market price to counter-parties. Essentially, the “trading desk” substituted virtually all non-borrowed reserves with borrowed reserves at the TAF (injecting its’ maximum liquidity to inter-bank lending). It was a brilliant move by the FED

In contrast the FOMC targets the federal funds rate (at a higher 4.25%), nominally the rate banks charge each other on overnight loans of deposits at the Fed. The FF market is where un-collateralized (unsecured) inter-bank loans (excess reserves) are lent & borrowed for short duration. The daily federal funds transactions in comparison to the Government Securities market are a trivial amount.

The H4.1 shows both factors supply & absorbing reserves. Modern Money Mechanics demonstrates both commercial and the reserve banks balance sheet changes which affect the “free” legal reserves owned by the depository institutions on the H4.1.

http://landru.i-link-2.net/monques/mmm2.html

flow5 said...

THERE IS ONLY 1 MAJOR ERROR IN ECONOMICS: Economics is about the rates of change in the flow of funds:

The commercial banks should get out of the savings business (REG Q in reverse). What would this do? The commercial banks would be more profitable - if that is desirable. Why? Because the source of all time deposits is demand deposits - directly or indirectly through currency or their undivided profits accounts. Money flowing "to" the intermediaries 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 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.

From a systems viewpoint, commercial banks as contrasted to financial intermediaries prior to the DIDMCA; (S&Ls, MSBs, CUs), never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing DDs, or 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) and 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-DDs.

The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free legal reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (transaction accounts), 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 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 bank (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 accounts in the “thrifts”, bear a one-to-one relationship to demand deposits. As TDs grow, DDs shrink pari passu, and vice versa. The fact that currency may supply an intermediary step (i.e., DDs 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 CBs to “compete” with S&Ls, MSBs, CUs, MMFs and other intermediaries 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 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-S&Ls, MSBs, CUs, etc., 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 DDs within the CBs and the transfer of the ownership of these DDS to the thrifts involves a shift in the form of bank liabilities (from TD to DD) and a shift in the ownership of DDs (from savers to thrifts, et al). The utilization of these DDs by the thrifts has no effect on the volume of DDs 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 DDs 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 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 DDs 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. CB deregulation created stagflation.

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 of money. Here investment equals savings (and velocity is evidence of the investment process), where in the case of the CB credit, investment does not equal savings but is associated with an enlargement and turnover of new money.

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 (structural changes have reduced the validity of this last conclusion. Under existing institutional arrangements, an increase in time deposits results in an offsetting increase in transactions velocity - therefore no dampening effect results. If there is to be a growth in time deposits there should be an offsetting increase in velocity)...

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.

flow5 said...

You are exactly correct. But remember that most banks no longer face binding statutory reserve requirements -- increasing amounts of vault cash (including ATM networks) plus retail deposit sweep programs (e.g., my articles on this in our Review) have wiped aside such binding requirements. A further advantage of the auction facility is the liberal rules regarding the types of assets that the discount window folks will accept as collateral -- including (gulp) certain CDOs. Such securities are not purchased by the Open Market Desk as it supplies nonborrowed reserves. The difference in the type of securities that the Fed will accept at the Window and at the Desk perhaps is the answer.

Richard G Anderson
Federal Reserve Bank of St Louis

RebelEconomist said...

flow5,

I am afraid I fail to see the wood for the trees in your long comment. You seem to be giving institutional details a lot of weight, but it seems to me that this only matters if you have a rigid idea of what money is. And I am not sure how this is relevant to the SOMA, which is a counterpart to base money only.

flow5 said...

I have no sense of etiquette. I re-read your post & I did go off on a tangent. I bailed on the 3rd paragraph (conundrum & savings glut). If you can delete the comments go ahead.

Substitute repos for SOMA holdings or redemptions between 6/04 & 6/06 to alter the yield curve? That's conceptual & the impact of the policy change you suggest is subjective. But a 15% increase in SOMA holdings over that period should have a substantial impact.

The demand for and the supply of loan-funds (just like the money supply) is unknown & unknowable.

Disecting the sterilization of (1) euro-dollar borrowings or (2) the "payments gap filled by foreigners" is also unknowable.

But as I tried to communicate, the unchecked license to create new money & credit by depository institutions was the dominate factor in the loan-funds market during that period.