It turns out that I may have been unfair to Patricia Croft (chief economist of RBC-whatever-it-is) over here. As Erin Weir points out, she's not the only high-profile professional economist to go from remarking on the relatively small quantity of Canada's official reserves to making the clanging error of concluding that the Bank of Canada's abilities to stop the appreciation of the Canadian dollar are limited.
And now this from the lead editorial in today's Globe and Mail:
The last time that the Bank of Canada intervened to affect the
Canadian dollar's exchange rate, by using the foreign exchange reserves
of the Crown in right of Canada, was in 1998; a once quite frequent
practice has become rare, in this era in which central banking is
highly focused on inflation targeting. But Mr. Carney has never ruled
out resorting to make sales from those reserves, which at present stand
at about $44-billion (U.S.), of which $25-billion is in U.S. dollars;
the bank is not wholly disarmed.Conceivably, the Bank of Canada could increase the money supply by
creating bank deposits in the course of buying government bonds, in
order to devalue the Canadian dollar, without taking the policy
interest rate even closer to zero. At this point, though, that would
amount to a demoralizing statement about the Canadian economy.The Bank of Canada would not be able to resist a sustained rise in demand for the Canadian dollar, but Mr. Carney and his colleagues have effectively reined in a movement toward parity with the U.S. dollar.
Presumably, the person who wrote this for the country's Newspaper of Record did some homework (for example, looking up the latest numbers for the official international reserves), but he never did get a firm grip of how monetary policy works.
But Mr. Carney has never ruled
out resorting to make sales from those reserves, which at present stand
at about $44-billion (U.S.), of which $25-billion is in U.S. dollars;
Indeed he hasn't. But he won't, because using those international reserves to buy up Canadian dollars would increase the value of the CAD in international markets; the problem is that the exchange rate is already too high.
Conceivably, the Bank of Canada could increase the money supply by
creating bank deposits in the course of buying government bonds, in
order to devalue the Canadian dollar, without taking the policy
interest rate even closer to zero. At this point, though, that would
amount to a demoralizing statement about the Canadian economy.
Increasing the money supply is exactly what the Bank of Canada should be doing – and has been doing, for more than 15 years – when inflation goes below its stated target.
The Bank of Canada would not be able to resist a sustained rise in demand for the Canadian dollar,
If the People's Bank of China can do it, so can the Bank of Canada. It's one thing to argue that a policy is undesirable. But that's not the same thing as saying that it is literally impossible.
I'm getting more and more depressed with this file. How are we supposed to have a discussion about what the Bank of Canada should do if no-one seems to understand what the options are?
Worthwhile Canadian Initiative 
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Hello Mr. Rowe,
Let us say that depositor A is in fact the Bank of Canada. For supplying 100 gold coins, it subsequently received 100 ethereal dollars closing out its account. On the BofC’s balance sheet there are liabilities of 100 real gold coins issued as currency and an asset of 100 ethereal dollars which it has since used to buy 100 gold coins of government paper.
Now the BofC wants national interest rates raised from %5 to %6. The markets have determined that 5% is the true market rate wherein both lender and borrower are happy with risks and return. At 6% borrowers will dwindle in number and the supply of funds will grow.
Now it is your argument that the BofC will offer prospective depositors a a higher rate of return than that offered by the Bank. This action will draw funds from the Bank to the BofC. Its liabilities will rise with the influx of money, but its assets will rise only marginally as the number of loan seekers declines. It will also attract the attention of those who will seek to profit by immediately borrowing at %5 and lending to the BofC at 6%. But how can a bank satisfy loan demand when its means disappears into the hands of another. The Bank may have to call in loans.
Engineering a decline in interest rates will cause a reversal of such flows in that many will attempt to borrow a dwindling supply of funds from the BofC.
I do not think that one needs to say what eventually occurs to banks that fail to heed market conditions.
So how will the BofC pay out the depositors when it is not recouping the returns from loans needed to justify a 6% depositor’s rate?
To engineer a decline in interest rates from the market determined rate of 5% to 4%, the BofC must lower its rate paid on deposits, which will drive funds from it, which will hamper its attempt to lend to prospective borrowers and arbitragers and perhaps force it to call in loans.
Regards,
Gary Marshall
Gary:
Under the gold standard, if the BoC raised interest rates above the market, it would attract gold deposits. For every $1 deposit of gold coins, its assets would rise by $1 and its deposits would rise by $1.
If the BoC lowered interest rates below the market, it would lose gold coins, and might eventually run out of gold coins, which would indeed limit its ability to lower interest rates. But we are not under the gold standard. Gold coins have been replaced by BoC paper notes, and the BoC can print as many paper notes as it wants. It’s as if the BoC had a very large gold mine.
There was once a student who hit on a clever way to get individual tuition in a large class. Whenever he didn’t understand something the prof said, he would announce “The prof is wrong!”. If the prof ignored him, he would say “Look, the prof can’t explain it to me; obviously the prof doesn’t understand it!”
When the prof realised the student just didn’t understand the basics, he got a bit pissed off. So did the other students, who sometimes did understand more than the prof.
Nick, it’s quite clear that Gary is not here to learn or discuss. He’s here to teach.
Quite a shame then that he’s so clueless.
Hello Mr. Rowe,
Your latest post confirms exactly what I have said the Bank of Canada would do all along. Fine, dollares, which I believe was some precious metal coin, are no longer interchangeable with the notes. The currency has no gold connection and we can move along.
I said a few times that the only possible means of central bank control would be through its manufacture of currency notes. The currency printing press, which is quite different from the ethereal money printing press, is the only true means of the BofC exerting control over financial markets. Now we are in agreement.
Is this correct?
If we are, then I shall wrap up my argument quickly.
Regards,
Gary Marshall
Gary, during all of your previous diatribes where you writing under the belief that the Canadian dollar currently has a gold connection?
I’d imagine that when Stephen, correctly, stated that “The Bank of Canada has the legal power to create as many Canadian dollars as it wishes”, he was writing under the belief that the Canadian dollar has no gold connection and we can move along.
Hello Mr. Rowe,
The Bank of Canada cannot create as many Canadian dollars as it wishes. It can only create as much currency or Canadian dollar notes and coins as it wishes. There is a great difference.
The BofC is the monopoly issuer of currency in this country accounting presently for 4% of the stock of money. This right to issue currency is then the sole source of all the BofC’s powers: its ability to influence interest rates in forcing them up or down; its ability to influence exchange rates in forcing them up or down.
Are we agreed, Mr. Rowe?
Sorry about the length of the explanation of ethereal money, currency, gold, gold standards, etc. It is all necessary for understanding these abstruse topics. What remains to be said will not take long.
Regards,
Gary Marshall
The ability to print as much currency as it wants, PLUS the fact that commercial banks promise to redeem their liabilities in Bank of Canada currency, is the source of the Bank of Canada’s power to influence macroeconomic variables.
“What remains to be said will not take long.” It has taken far too long already. You could have said it days ago. Say it.
Hello Mr. Rowe,
Sorry about the length Mr. Rowe. Yours is a complaint that students commonly make of their economics’ professors, who often require hundreds of pages and months to explain overly complicated concepts that should blessedly only require several posts spread over as many days.
I said currency is an inferior form of money. It yields no interest. Currency is a dead loss to any holder, especially a bank. It is a store of value, a medium of exchange, and a unit of accounting, but it does not earn interest.
A bank must pay interest to a person having deposited currency notes, but it can earn no interest upon that currency whilst it sits in vaults. The bank requires currency to satisfy its clients needs, and the less it holds for those purposes the better.
Ethereal or inside money does earn interest. Therefore it is preferred about 19 times out of 20 as the established relationship confirms. In other words, the banks will return currency to the depositor or redeem their liabilities in BofC notes 1 out of 20 times.
If the Bank of Canada were to attempt to lower interest rates by creating and lending currency rather than ethereal money, it would have a disastrous effect on the value of the Canadian dollar and on the economy.
By example, Canada’s banks increase the stock of money through the loans process over some term.
After growth in the stock of money of 10%, how much would the demand for currency grow? It should rise proportionally by 10%. If the stock of money moved from $1 trillion to $1.1 trillion, the stock of currency should rise from say about $50 billion to $55 billion.
If the stock of money doubles over some term to $2 trillion, the amount of currency in circulation should also double to $100 billion.
Therefore, if the BofC were to double the amount of currency in circulation by creating and loaning it out, equilibrium in the demand for currency would be restored only when the banks had doubled the stock of ethereal money through the loans process. The inflation rate should be about 100%.
So if the Bank of Canada were to add just $50 billion of currency to the stock of money, the eventual outcome would halve the value of the Canadian dollar.
The Bank of Canada has never dared push currency into the financial markets in absence of demand. Any hint of such a threat would send the financial markets into a panic.
I think Jean Chretien as the finance minister oversaw a borrowing of $40 billion in 79 in a $300 billion economy. Thank God they borrowed only ethereal money and did not print currency; for the inflation rate would have been 200%, not 18%.
Zimbabwe recently and Germany in the 20’s were disastrous examples of inflation caused by nations printing and distributing currency notes. It is just as easy to print a $1 million dollar note as it is a $1 note. The comparatively modest inflation plaguing the western nations of the 70’s was caused by governments borrowing large amounts of ethereal money on the financial markets and squandering it.
As the Bank of Canada has never functioned in the manner you described and for the sake of the financial health of the country never will, I can only conclude that it has no power to influence interest rates or exchange rates.
The BofC does not have the means of influencing institutions and markets many times its size because it must acutely limit the use of that one instrument it alone possesses. The BofC does possess ethereal money, received from the member banks for the currency notes proffered, but $50 billion is not a great sum and it is presently fully invested in interest bearing Government securities.
Redemption is a 2 way street. A temporary drop in demand for currency notes will draw an excess back to the Bank of Canada’s doors. A liability in the currency note is erased as is an asset in that the ethereal dollar must be returned. Each must part with something of value, though the greater value will rest with the money that earns interest.
Are we agreed Mr. Rowe?
Regards,
Gary Marshall
Gary: after all that great song and dance, I expected at least you would provide some sort of interesting fallacy. Instead you offer…… (blare of trumpets)………..ECON1000, Economic Principle #8 (or whatever): “If central banks print too much money, the result is inflation”. The Quantity Theory of Money, version 1.0. David Hume knew this, 250 years ago.
Except, David Hume understood the difference between the short and long runs, and real and nominal variables (like the real and nominal exchange rate).
So Gary, do we all agree that Ms. Croft was wrong and Stephen was right all along?
Wow! There was I, making a similar argument on another post, when all the action was elsewhere (sorry Stephen, I do not normally read your posts about Canadian issues, but I was attracted to this one like a rubbernecker by the comment activity). I more or less agree with Gary Marshall, and occasionally have done so on other blogs (which usually ends the discussion like raising a taboo subject in polite company). And no, I am not Gary Marshall’s civil alter ego under another name. Even Ben Friedman and Michael Woodford have both wondered how central banks can control interest rates with such a small balance sheet.
You have to cut Gary some slack, because he is in the difficult position of trying to demonstrate that many others who are content with what seems to be a reasonable understanding are in fact misguided (as was Copernicus). As Gary says, it is difficult to see how the tiny amount of central bank money (and I don’t think it matters whether the marginal amount is reserves or currency) can give the central bank sustainable control of any meaningful interest rate. The banking system’s stock of loans and deposits is so large in relation to the central bank’s balance sheet that even a small supply / demand response to a significant change in interest rates should simply overwhelm the central bank. Clearly the central bank can in theory supply an infinite amount of base money to lower interest rates, but any increase that is large in the context of the banking system balance sheet seems likely to generate an unacceptable level of inflation. And if the central bank restricts the supply to raise interest rates, then people can be expected to reduce their holding of currency, perhaps by making greater use of other types of money. If there is an answer, it might be something like that the supply and demand for deposits and loans is extremely inelastic. My position is that I don’t know, but I feel that at least realising that represents progress.
“… civil alter ego under another name …”
In the year or so that I’ve been frequenting this blog, I’ve noticed that Nick is very generous with his time when discussing monetary issues – even ‘out there’ ideas. There’s no need for anyone to behave like a bull in China shop to get noticed.
Rebel: I think you are being too generous to Gary: reading more into him than is there.
In the long run, a doubling of the stock of paper currency simply doubles total stock of money, doubles the price level, leaving real interest rates and real exchange rate unchanged.
That’s all he’s saying (except he’s a bit confused about the distinction between real and nominal exchange rates). If he had just come out and said that at the beginning, no problem. I would have said I basically agreed with him, politely corrected his confusion between real and nominal exchange rates, and also said that short and long run effects are different because of sticky prices in the short run. But instead he gives this silly song and dance performance, that just ended up wasting a lot of my time that I could have spent more productively thinking about and responding to your comments, for example. So I am very pissed off at him.
I should have ignored him, as some commenters recommended I do.
Rebel: regarding what you say Gary is saying: it sucks as an interpretation of Gary, but otherwise is an interesting question in its own right. It’s the question I was trying to address in my post on asymmetric redeemability.
Rebel,
Responding here to your comment from somewhere else in this jungle war of monetary give and take…
Eurodollars are a different credit risk than fed funds. But I doubt I could explain it convincingly enough to persuade you, so I won’t attempt to.
Similarly, on central bank influence relative to balance sheet size, we went over that several years ago. I haven’t changed my views. No disrespect, but I wouldn’t want to revisit it here, and your probably wouldn’t want to listen to me.
You keep mentioning you used to work in a central bank. I wouldn’t expect and would find it hard to believe that you worked on the CB reserve management/money market desk; my guess is that you were in the economics department, although I could be wrong. Economists in central banks are not much different than economists in commercial banks as far as their operational knowledge of their respective institutions and markets is concerned (Although, Patricia Croft seems to be an unusually extreme outlier). Working at a central bank is not necessarily an automatic ticket to comprehension. That goes for understanding Chartalism as well.
I’m as sure in my beliefs regarding these various issues as you are sure of your scepticism about them. We each have that right. But I’m disappointed, because I detected some sort of conversion to what I believe to be the right path on such issues from reading the long post on your own blog.
Best,
JKH
And Rebel, Gary did not say “Clearly the central bank can in theory supply an infinite amount of base money to lower” the CAD exchange rate (which was our original topic) but “they wouldn’t because of…”.
He accused Stephen of making a ridiculous assertion and dismissed Stephen’s response when Stephen offered a perfectly reasonable and correct explanation.
Off topic: JKH: “That goes for understanding Chartalism as well.”
I feel a post attacking Chartalism welling up inside me. Can you (or anyone) recommend any particular good source describing it?
“I feel a post attacking Chartalism welling up inside me. Can you (or anyone) recommend any particular good source describing it?”
Holy smokes.
I feel the mother of all blogosphere economic battles welling up on the horizon.
What fun.
I’ll be back in a bit with some suggested sources.
Nick,
IMO the Australian professor/blogger Bill Mitchell is the best one to zero in on for source material. He’s a very clear thinking analyst and excellent writer. And he writes a lengthy post on something daily.
Here’s his list of “debriefing” primers on “Modern Monetary Theory”, or “MMT”, which is about the same as Chartalism, or at least includes the essentials of Chartalism in its core. Look at the third category down, called “Debriefing 101”, in the following complete list of his entries:
http://bilbo.economicoutlook.net/blog/?page_id=1667
You can get a feel for it by scanning the “Debriefing 101” topics. There are many other pertinent entries beyond that as well.
What I’ve found is that it helps one’s objectivity to distinguish between the purely analytical foundations of MMT, as opposed to the ideological options and/or prescriptions that tend to flow from it. The analysis of the monetary system is the prerequisite to the analysis of the policy options; some of the policy options considered/recommended may seem quite extreme.
The analysis of the monetary system is unusual for a branch of economics, in that it analyzes – well – the monetary system, as it actually works, not as it’s written up in textbooks.
For what it’s worth (objectively nothing), I would vouch personally for the accuracy of the analytical foundation.
Warren Mosler is another key source; as is the Kansas City School. They have their blogs. But I would recommend focusing on Mitchell initially for continuity of material.
Should you post with zeal, I would alert both Mitchell and Mosler so that the games may begin.
P.S.
The Wikipedia entry on Chartalism is near useless.
Hello Mr. Rowe,
I said very early on that the only way that the central bank could ever achieve its disruptive ends is by currency creation. I did not hear any agreement at that time. But currency creation is not an option to be used because of its ruinous effects. The central bank has never used the tool to raise or lower interest rates and never will. It has never used it to raise or lower exchange rates and never will. If the only way for the central bank to raise or lower interest or exchange rates is to actually go out into the markets and issue currency in amounts double or triple the current stock, and the doomsday tool has never been used, then I conclude that the central bank is powerless to impose its will in the financial markets.
If we are agreed that increasing $1 of currency in the country will be 20 times more inflationary than increasing $1 of inside or ethereal money, assuming the increase has no purpose; That such an action is detrimental to the financial health of the economy, why is it that everyone in the economics business keeps telling me that the central bank is so powerful, that its printing press is running full out, that it can drive exchange rates up or down or interest rates up or down? It is pretty much an impotent organization and its printing press is rarely running.
When Ms. Croft argues such a point, she supposedly gets it wrong. Why is she wrong?
If everyone considers my observations commonplace, then why do many keep repeating the line about the omnipotence of the central banks?
Why is there even such a field of study known as monetary policy when the means of implementing such policies do not exist, or at least would destroy the financial system?
Increasing the quantity of money is not automatically inflationary. It depends upon the purpose of the loan. In the 70’s governments borrowed without regard to returns adding enormous sums to the existing stock of money without any beneficial outcome. The result was chronically high rates of inflation.
However, if a company selling 10 units of some product in an economy with an existing stock of money of $100 borrows $100 to expand production to 25 units, is this inflationary? Not at all, the former selling price would be $10 per unit. The subsequent price would be $8 per unit with a stock of money of $200 and 25 units for sale.
Yes, increasing the quantity of money can cause inflation especially when governments are borrowing, but it need not be that way.
Many will speak of the gold standard as something to be prized. Well, there never was such thing as a gold standard. If there are 100 pounds of silver in some nation, let the central bank take in those pounds and issues notes on them for circulation. The banking system increases the quantity of inside money to 1000 pounds through the loans process. The relationship between the currency notes and the stock of money is 1:5, so the central bank now has to print up more notes for silver they do not have and cannot mine fast enough.
This is the history of a precious metal standard of money. At first it covers all money. With the completion of one loan and the creation of ethereal money, the 1 to 1 relationship is rent forever. Then the demand for and consequent manufacture of currency notes rises with the increasing stock of money and without regard to the quantity of silver. Convertibility at first is guaranteed, then it is restricted, then denied. Then the precious metal standard is abandoned. A precious metal standard could never been maintained and never has. Yet, so many will argue for the return to the mythical precious metal standard given these facts.
The Rebel Economist sees some value in the things I have said or at least my contrariness because he is disatisfied with the current explanations of central bank omnipotence. I am sure there many others.
Regards,
Gary Marshall
Thanks JKH!
For what it is worth, JKH, I used to work in foreign currency market operations, alongside the domestic market operations people, but I think that logical argument supported by facts should be what matters. I will always consider any new information that you are patient enough to offer. I really do want to get to the bottom of this.
But no-one is answering what I think is a simple point. If the central bank provides 5% of the banking system assets, and wishes to, say, lower the level of interest rates by 100bps, if this results in deposits shrinking by about 2.5% and loans increasing by about 2.5%, one would think that the central bank would have to roughly double the base money supply to achieve its objective. Clearly, interest rate changes are not associated with huge changes in base money supply, so is deposit supply and loan demand inelastic, or is the central bank influencing the interest rate by means other than being the marginal player in the money market?
Rebel: I would love to have a shot at answering that question. But I would much rather answer it in context of my post on central banks and asymmetric redeemability, where it belongs, rather than here, where we have been led totally off topic. Would you mind re-posting it there? Sorry.
One last thing Mr. Rowe,
Creating $1 dollar of currency will cause the same amount of inflation as borrowing $20 of ethereal money, yet their exchange value is the same.
Why on earth would any Government have the central bank print up currency notes in some amount when borrowing the same funds will get them just as far with a small fraction of the attendant harm?
The Government of Canada could wade out into the markets and borrow $50 billion, squander it, and devalue the monetary unit by about 5%.
It could print up currency notes in the same amount, squander the sum, and devalue the existing monetary unit by 100%.
The consequences are very different in obtaining the same value of goods.
Speak of nominal and real interest rates and easy calculations all you like, inordinate and unnecessary inflation destroys economies. Germany did not fare too well and neither have those poor Zimbabweans. The real interest rate in Zimbabwe may have been 5%, but the nominal rate at some point must have been above 1 million percent.
Regardless of what the real rate may be, if Canada’s nominal rate were in in the triple digits, I have no doubt that many would just abandon the unit in favor of the more stable US currency until order returned.
Generating so much disorder and inflation runs counter to central bank policies, does it not?
Regards,
Gary Marshall
Rebel,
I feel as if I’ve answered that question a thousand times over the past several years; I really don’t want to do it again at any length.
But the last time in short form was in this very post above, in the first sentence at:
Posted by: JKH | October 28, 2009 at 02:14 PM
Personally, I find dwelling on “elasticities” not to be helpful. This is just a common sense matter of supply and demand in a legally enforced system of competition for economically optimal reserve positions – i.e. at requirement, no more, no less.
In a normally functioning system, a bank that has excess reserves to go on its “day of reckoning” for required reserves will drive the market rate down to get rid of those reserves. That’s what happens generally when the Fed eases. In fact the announcement effect does it right away because markets are anticipatory about the effect otherwise.
Finally, this is not a normally functioning system, with $ 800 billion in excess reserves at the zero bound. I have absolutely no patience for arguments that start generalizing about how things work based on the first zero bound experience in the better part of a century.
Rebel: my answer will be very different 😉
I’m shocked!