Both central banks and commercial banks issue liabilities that function as media of exchange. Why do we say that it is central banks, rather than commercial banks, that determine monetary policy; setting interest rates in the short run, and inflation in the long run? What makes a bank a central bank?
It is true that central banks normally have a legal monopoly on the right to issue paper notes, but so what? We don't have to use paper money; we could use cheques or debit cards instead. If paper money disappeared, would central banks disappear, or lose their special power?
It is true that in some countries commercial banks are required to keep a certain ratio of central bank liabilities in reserve against their deposits, or choose to keep a certain ratio even if they are not legally required to do so. But what happens if they aren't legally required to do so, and don't choose to do so?
Here's the answer. Commercial banks promise to redeem their monetary liabilities for the monetary liabilities of the central bank at a fixed (or at least pre-determined) rate. Central banks do not promise to redeem their monetary liabilities for the monetary liabilities of the commercial banks. This asymmetry of redeemability is what gives central banks their power over commercial banks. But a bank with that power is nevertheless not a true central bank unless it acts like one, and uses that power.
To see the power that flows from asymmetric redeemability, suppose bank A and bank B both issue paper money, but B promises to redeem its notes for A's notes at par, while A makes no such promise. Suppose interest rates are initially at 5%, and A decides it wants to lower interest rates to 4%, while B decides it wants to keep interest rates at 5%. What happens? The interest rate differential creates infinite arbitrage opportunities. Borrow A's notes from A at 4%, convert them into B's notes at par, and lend to B at 5%.
Bank B would end up accepting an infinite quantity of A's notes, which it could only lend out at 4%, while paying 5% on its deposits. It would make infinite losses. To avoid infinite losses, bank B would be forced to lower its rate to 4% too, or else suspend redeemability at par.
Now start at the beginning, with interest rates at 5%, and suppose A decides to raise the interest rate to 6%, while B tries to keep it at 5%. What happens? The arbitrage opportunity now works in the opposite direction. Borrow B's notes from B at 5%, convert them into A's notes, and then lend them to A at 6%.
Bank B would face an infinite demand to redeem it's notes, and it could only satisfy that demand by borrowing notes from A at 6%, while earning 5% on its loans. To avoid infinite losses, bank B would be forced to raise its rate to 6% too, or else suspend redeemability at par.
It's the asymmetric redeemability that gives bank A the power to set interest rates, and forces B to follow A. It's what gives A the power to act as a central bank, while the pursuit of profit (or the avoidance of infinite losses) makes B a commercial bank in A's orbit.
It makes no difference if the paper notes are ink marks on a ledger, or demand deposits recorded on a computer.
It also makes no difference if bank A is in one country, bank B is in another country, and they have different media of account, as long as B promises to redeem its notes for A's notes at some fixed rate, and A makes no such promise. In other words, a central bank that pegs its currency to another country's currency, with free convertibility, no longer has the power to set monetary policy, and isn't really a central bank (though it will look like a central bank to the commercial banks in B's country).
What about under the Gold Standard, where B promises to convert its notes into A's notes, and A promises to convert its notes into gold?
A central bank under the gold standard is like a central bank that unilaterally pegs its currency to the currency of another country; it isn't really a central bank at all (though it will look like one from the perspective of its commercial banks). And it's not a central bank in the modern sense, because it lacks the power to determine inflation rates in the long run. I am very tempted to say that the true central bankers under a gold standard are the gold miners. But gold miners might have the power to act as a central bank, but generally choose to maximise profits instead. They have the power, but lack the will to act like a central bank.
But a large gold mine, willing to lend or borrow gold at an interest rate of its choosing, could act as a central bank, if it had the will to do so.
Suppose that under the gold standard, two large firms controlled gold mining. All banks promise to redeem their paper money for gold at a fixed rate, but the gold miners make no such promise. But since gold from the two mines is identical, gold from one mine is redeemable into gold from the other mine at par. Here we have bilateral, or symmetric redeemability. This is exactly the same as France and Germany immediately before the introduction of the Euro, when both countries bilaterally agreed to the same fixed exchange rate between their currencies. What happens if one gold mine (France) sets a lower interest rate then the other gold mine (Germany)? Again we have infinite arbitrage opportunities. But now both mines (both France and Germany) will be required to redeem the other's gold (currency), and both will make losses. Whichever one has the strongest will, and the deepest pockets, and so cries "uncle" last, will become the central bank.
$1k? Nah!
Update: I'm not claiming any particular originality for these ideas. I got them from three sources (but don't want to claim that I have represented those sources accurately): a working paper from some economist in New Zealand (I think) whose name I have forgotten; conversations with Pierre Duguay, Deputy Governor Bank of Canada; and Willem Buiter's blog.
Worthwhile Canadian Initiative 
. They define what legally counts as paying the debt. But for current exchanges, sellers can presumably choose medium in which they set prices and accept for payment “sorry, but I won’t accept cash for my house, but I will accept payment in bottles of whisky”.
But I think the point of legal tender laws is that you can’t refuse to take the money as payment. You cannot say that I will only take whisky. And the Government has the coercive power because they enforce property rights. I think the G wants a to be widely used by it’s citizens, is so that they can measure and tax economic activity. They want you to buy the whisky bottles off the other guy, and have him buy the house off of you. So they can tax each transaction.
error, I think the “reason” G want’s A’s currency to be widely used.
Basically they are a mob family, who want a cut of everything in exchange for protection.
“But that’s the whole question of the discussion. What makes a central bank central?”
I think it is acting as the banks’ bank that makes a central bank central, but what Nick is really asking, if I may put words on his page, is “how can a central bank control interest rates”. Therein lies madness, because, my conclusion was (like Gary Marshall I think, but I have not seen him explain his argument clearly) that central banks do not have much control of interest rates. Unless, that is, they are prepared to take on pretty much the whole of one side of the market, and probably lose money in the process. I had a long debate with JKH about this on Brad Setser’s blog before the financial crisis. And, when the financial crisis occurred, and the Fed tried to hold down interest rates when the market wanted to push them up, what I had expected happened – the Fed ended up massively expanding its balance sheet.
What is missing from Nick’s post that would lead towards this conclusion is scale. In normal conditions, central banks are simply too small to have much influence on interest rates. Consider the classic T-account of the banking system. The stock of loans and deposits is normally at least ten times the stock of base money, typically much more. You don’t need much response in the volume of deposits and loans from a change in interest rates to imply a huge change in base money.
Rebel,
I would never argue something as silly as the idea that central banks control interest rates.
What I’ve always argued is that central banks control the target policy rate and the actual rate trend relative to the chosen target at the time, apart from relatively immaterial deviation noise.
There have only been two operational exceptions to this in recent memory.
The first was the massive reserve injection by the Fed following the 9-11 attacks. The Fed was forced into emergency quantitative easing due to system dislocations. This dislocation was very short term and temporary.
The second is an operational glitch associated with the recent massive injection of excess reserves during the credit crisis. The Fed lost some control of the funds rate on the downside for a very specific reason. That is the fact that non-bank institutions who maintain balances at the Fed (e.g. Fannie, Freddie) are not eligible to earn interest on them. So they are willing to lend at below the funds rate. This is a simple architecture problem that the Fed has referenced frequently and plans to remedy at some point. For the time being, it is pragmatically irrelevant, since short rates are at the zero bound.
Anybody who wants to investigate this in a reasonable way can dig up a long term graph of the target rate and the effective rate. If, after looking at that, they want to deny that the Fed exercises control over the short policy rate, they’re welcome to join the flat earth society as well.
(And I hope you will recall that the ON Eurodollar rate is not the same as the policy rate.)
JKH,
Clearly Fed policy is not stated in terms of an overnight eurodollar rate, but I do not understand the difference between them – where does an overnight (I assume you mean today / tomorrow, rather than the spot / next day) eurodollar loan settle if not in a reserve account? While it seems that the Fed funds market is sufficiently narrow for the Fed to control normally, at the beginning of the financial crisis the Fed was obviously more interested in holding down the more economically pervasive term LIBOR rates, hence the TAF etc. How do you – or anyone else still reading – answer my T-account point, that central bank is generally too small not to be overwhelmed by the supply and demand response to a significant change in the interest rate? I would still like to get to the bottom of this conundrum.
original anon: “The central bank in the case of loan repayment has redeemed its monetary liability because it extinguishes the reserve liability used as repayment for the loan. And it has issued a credit to the commercial bank in exchange. The form of credit it has issued is the cancellation of the monetary liability of the commercial bank (the loan).”
I’ve been thinking about this. I see what you mean, but I don’t think it counts as the central bank fulfilling it’s promise to redeem commercial banks’ liabilities at par.
Let me give you another example. I can write “IOU $100 signed Nick Rowe” on a bit of paper, but nobody has promised to redeem my liabilities for anyone else’s liabilities at par. I can’t be sure that anyone will accept my paper and give me a loan.
Now suppose I have a $100 mortgage at BMO, and I also have $100 in my chequing account. If I write a cheque to BMO to pay off my mortgage, you might say that BMO has redeemed my liability. But this is not the same as BMO fullfilling a promise to make me a loan. All the BMO has done is to cancel two offsetting liabilities: their liability to me, and my liability to them.
I need to get my head clearer on this, so I can express what I am trying to say more clearly.
TD (or anyone) can take a cheque written on BMO and demand payment in BoC liabilities (or BoC notes). BMO has promised to fulfill any such demand. TD (or anyone) cannot take a cheque written on the BoC (or BoC notes) and demand payment in BMO liabilities. The BoC has not promised to fulfill any such demand.
Also: “Whether or not Canadian banks can have negative reserves is irrelevant to the issue of discussing redeemability. But since you ask – no they can’t have negative reserves, to the degree that a negative end of day position (or any required accounting period position) forces them to cover that shortfall by borrowing from the central bank. The borrowing brings reserves back to zero.”
I can’t see the difference between that and a negative reserve balance, if the borrowing is automatically extended. I can’t see the difference between a line of credit, an overdraft, and a negative balance in my chequing account. It’s the net position that matters.
Nick, original anon,
I agree that a central bank effectively redeems its liabilities when it accepts reserves to cancel a loan, but it seems to me that this is a quite limited commitment, because it is restricted to the time that the loan matures and the central bank will only pay with the debt of the reserve holder itself (rather than with the debt of a third party such as credit in an account with another bank). The relationship is still very asymmetric.
original anon,
You said “I’d be interested in an example of one (central bank) that isn’t (concerned with controlling interest rates), present day or historic.”
I don’t think that the early central banks such as the Bank of England were. They basically grew out of professional lenders of specie who found that they could borrow a little cheaper if they made their debt securitised and transferrable (and therefore more liquid). Presumably, the interest rates these note issuing lenders charged were in line with the terms prevailing in a traditional market of loans between individuals, which in turn depended on the return to other opportunities to invest capital and credit risk. Eventually, one of this range of note-issuing banks emerged as the dominant one, typically because the government granted it special privileges in return for a cut of the action. In the case of the Bank of England, it specialised in lending to the government, so making its notes legal tender, and, over the years, severely curtailing the ability of the other banks to issue notes at all, allowed the BoE to fund itself more cheaply, and it was expected to pass this advantage on to the government in the rates it charged them. Apart from that, the early central banks were not concerned to influence interest rates, and certainly not for the purposes of macroeconomic control.
“TD (or anyone) can take a cheque written on BMO and demand payment in BoC liabilities (or BoC notes). BMO has promised to fulfill any such demand. TD (or anyone) cannot take a cheque written on the BoC (or BoC notes) and demand payment in BMO liabilities. The BoC has not promised to fulfill any such demand.”
Two preliminaries:
First, you made a general statement which I allege does not hold generally. The onus is on you to prove the truth of your general statement. The onus is on me only to prove that it isn’t true as a general statement, not that it’s generally false. Fair?
Second, notwithstanding the first, I think I can show your statement also doesn’t hold in a sense that is more general than my first example.
The key to the discussion about symmetry is to recognize that when looking at cases where the CB is counterparty to actual transactions, one must acknowledge that the CB only deals with commercial banks. That’s an asymmetry in itself. But it’s not the asymmetry you’re talking about. In fact, it’s the one that I’m talking about when I say that what makes a central bank central is the fact that it is the bankers’ bank, and that commercial banks must maintain reserve accounts with the central bank. The central bank generally doesn’t deal directly with commercial bank customers. I went on at length about this and the nature of the agency relationship in which commercial banks offer central bank liabilities to retail customers. Your statement of asymmetry isn’t consistent with the known facts of the world, because it doesn’t recognize the fact that the CB doesn’t deal with commercial bank customers as counterparties in transactions, at least not usually. You have to compare relevant counterparty markets in assessing symmetry or asymmetry. At the very least one should be more reluctant to make statements about asymmetry in markets that don’t exist, when transactional symmetry appears in the markets that do exist within the overarching asymmetric institutional structure of the counterparties to actual transactions.
So my initial example was based on the actual market between the CB and the banks. The question effectively is whether symmetry exists in the liabilities that are available to counterparties dealing in this market. And it does. I gave an example of where it does. A CB that accepts reserves in repayment of a loan then extinguishes that loan, effectively providing payment directly in the form of the commercial bank liability.
Now the question is whether that initial example can be made more general within the relevant market – which is the interbank market including the CB and the commercial banks; i.e. ex non-bank counterparties.
In review, suppose in my first example that BMO presents reserves to CB in exchange for CB extinguishing BMO’s liability (loan). CB has effectively made payment with a BMO liability in the sense that it has provided asset value to BMO in an amount equivalent to BMO’s liability. Again, this is a matter of debit-credit accounting, as well as conceptual logic.
Now let’s go wider.
What we need to prove is the case where CB, instead of paying BMO in terms of BMO’s liability, pays BMO in terms of TD’s liability.
I.e. can BMO pay reserves to CB in return for a TD liability?
But that’s exactly what happens when BMO makes an interbank loan to TD and pays for the transaction through the interbank reserve clearings. CB debits BMO for its reserves, and then credits TD with the reserves that it is due. The ONLY way that BMO can make an interbank loan to TD is to have its CB account debited by CB.
And you can be sure that CB is the one that’s actually doing the debiting. That’s the role of the banker to the banks. TD is NOT the one debiting that account. TD is only due reserves – it does not have the debiting power. BMO makes the reserve payment to CB – NOT to TD. And TD receives its reserve payment from CB – NOT from CB. That is the conceptual, logical, and legal nature of clearing arrangements and enforcement.
So the result is that CB receives payment from BMO in the form of reserves, and BMO receives payment from CB in terms of TD’s liability – because without the CB reserve market, that transaction could not take place.
So I believe that proves a symmetric relationship in the markets that exist as opposed to an asymmetric relationship in the markets that don’t. If I were claiming asymmetry between the sun and its planets, I’d suggest it was due to the fact that the planets revolved around the sun, and that there were more of them. I wouldn’t suggest it was because solar eclipses are visible on earth, but the same solar eclipses can’t be observed on the sun.
above:
“And TD receives its reserve payment from CB – NOT from CB”
should read:
“And TD receives its reserve payment from CB – NOT from BMO”
I threw in the solar eclipse analogy as bait.
Could be worth another asymmetry post in itself.
original anon:
Let me approach this another way. Suppose the Fed decided to peg the US dollar to the Loonie (at par), and the BoC shrugged its shoulders and said “whatever”. In that case I believe that the BoC would set monetary policy for the whole of US+Canada. In an important sense, the BoC would become the central bank of the US, even though the BoC is much smaller than the Fed, and even though the Fed and US commercial banks did not use the BoC clearing house.
I want to argue that the relation between the BoC and the Fed in that hypothetical case is the same as the re;ation between the BoC and BMO, TD, etc.
Now, I have tried to say that asymmetric redeemability is what is going on when the Fed unilaterally pegs the dollar to the Loonie. I might be wrong on that. Clearly I don’t understand what it means as clearly as I want to.
Your counterexamples are indeed a fair tactic, and I must be careful not to fall into the “No true Scotsman Fallacy” (changing the definition of “true Scotsman” every time someone comes up with an example where a Scotsman does something I say a true Scotsman would never do).
Modifying your helicentric analogy: we both agree that the planets revolve around the sun, because we see them doing it. When the BoC says it wants higher/lower interest rates, it nearly always gets (roughly) what it wants. But we are trying to explain why the planets revolve around the sun, when (in this case) the sun is so much smaller than the planets.
More later…
I wrote: “Suppose the Fed decided to peg the US dollar to the Loonie (at par), and the BoC shrugged its shoulders and said “whatever”.”
In this analogy to a unilateral peg, the Fed has promised to redeem US dollars for Loonies at par, and do whatever it takes to ensure the exchange rate stays fixed. What does the Bank of Canada’s “whatever” mean? The Bank of Canada replies that that is a Fed decision, and it will continue to target Canadian inflation, raising and lowering interest rates as it sees fit for Canadian purposes, ignoring any effect this might have on the exchange rate, or on how the Fed will need to respond to keep the exchange rate at par. It doesn’t try to help the Fed keep the exchange rate fixed. And I’ve been thinking of this as meaning the BoC does not promise to redeem the Fed’s liabilities.
Now, there is one exception, where the BoC does try to help BMO keep its exchange rate fixed: in the event of a run on BMO, the BoC will lend reserves to BMO freely. But this exception does tend to prove the rule, since we allow that in the case of a bank run on commercial banks, the BoC may temporarily lose control of monetary policy.
original anon,
Since you say “The ONLY way that BMO can make an interbank loan to TD is to have its CB account debited by CB”, perhaps you can explain the difference between the Fed funds and eurodollar loan market I wondered about in my comment of November 01, 2009 at 04:45 PM.
Aren’t there large value payment systems that do not involve the central bank – eg CHAPS in the UK?
“Let me approach this another way. Suppose the Fed decided to peg the US dollar to the Loonie (at par), and the BoC shrugged its shoulders and said “whatever”. In that case I believe that the BoC would set monetary policy for the whole of US+Canada. In an important sense, the BoC would become the central bank of the US, even though the BoC is much smaller than the Fed, and even though the Fed and US commercial banks did not use the BoC clearing house.”
I can work with this example. And I can possibly buy into the idea that the Bank of Canada might set or at least influence monetary policy for the combination. But I can’t buy into the idea that the Bank of Canada becomes the US central bank, simply because US commercial banks would not maintain US reserve accounts with the Bank of Canada. I know what you’re saying, as “in an important sense” but I think you want to be clear on technical limits versus policy influence. There’s a difference between acknowledging that the Fed has great influence on PBOC policy, versus maintaining that the Fed is China’s central bank. The same would hold for the relationship between the Bank of Canada and the Fed in your example. That said, let me work with your example.
In asking the question “What makes a central bank central?” I think you have to maintain a logical context for the positioning of the central characteristic. As suggested above, the question makes sense in the case of the Bank of Canada relative to its position at the center of the Canadian banking system – not in the sense technically of whether the Bank of Canada can be central relative to the Fed, or vice versa. (Also see my closing paragraph below.) That said, it can be demonstrated that the central bank is central with respect to foreign exchange transactions in its own banking system, and that the same type of symmetry exists as illustrated earlier with respect to CB Canadian dollar transactions in the interbank market.
Recall my first example was the case of an exchange whereby BMO paid CB with a CB liability (reserves) in exchange for BMO paying CB with a BMO liability (loan from CB to BMO).
In the second example, BMO paid CB a CB liability (reserves) in exchange for a TD liability (loan from BMO to TD). That transaction in its entirety requires the CB reserve system.
The third example, which corresponds to the issue you raise, would be that where BMO pays CB a CB liability (reserves) in exchange for a TD liability. In this case, the TD liability is a US dollar deposit of BMO with TD. Again, that transaction in its entirety requires the CB reserve system.
Behind this transaction, the role of the relationship between the Fed and the Bank of Canada is only indirect in the symmetry story, which as described above is a symmetry story about a central bank with its own banking system – in this case, the role of the Bank of Canada relative to the Canadian banking system.
E.g. suppose as a PRELUDE to my third example, the Fed buys US dollars and sells Canadian dollars to support its US dollar peg to Canada. Thus, at the margin (i.e. ignoring a cumulative Canadian dollar reserve position), the Fed has ended up long US, short Canadian. Then suppose the Fed “squares up” its resulting FX exposure change in a follow up transaction (sooner or later) by purchasing Canadian dollars and selling US dollars. The counterparty to that transaction could well be TD in my third example, as there TD ended up “long” Canadian dollars and short US dollars (i.e. its liability to BMO).
So that’s how I would position FX transactions generally in the context of why a Canadian central bank is central relative to a Canadian banking system. I think there’s a danger of abstracting to the point of irrelevance, including artificially constructed asymmetry, if one starts mixing it up in the sense of an attempted higher analogy in the relationship between different banking systems with different centers. But I can consider it further if you want to pursue it.
original anon: “I think there’s a danger of abstracting to the point of irrelevance,…”
“danger”? That’s an occupational hazard that academic economists love to court! We call it a feature, not a bug 😉
I think we are partly back to Rebel’s question: what we mean by “central bank”?
There are two questions: 1. what do we mean by “central bank”?; 2. what causes a bank to be central (given that meaning of “central”)?
I come at it as a macroeconomist, so to me the important question is: what causes the Bank of Canada to have so much more power over macroeconomic variables than the Bank of Montreal? By “central bank” I mean one that can control inflation, etc.
But I can appreciate that someone who came at it from a different angle might want to define “central bank” differently, as the “bankers’ bank”, for example.
And my definition is certainly weird, historically speaking, because under the gold standard, for example, there are no central banks in my meaning, though they do exist in other meanings.
Perhaps I should have titled my post: “What gives some banks (typically central banks), so much power over macro variables?”
Will return later.
You’re going in circles here, shifting reference points at whim, with a conclusion (at this point) the same as the title of your post – you can’t possibly know what you “mean” by central bank without understanding what “causes” it to be central. BTW, I meant irrelevance in the context of the rest of the discussion – a higher bar on irrelevance than irrelevance in the context of the rest of the world.
original anon: This was my opening paragraph:
“Both central banks and commercial banks issue liabilities that function as media of exchange. Why do we say that it is central banks, rather than commercial banks, that determine monetary policy; setting interest rates in the short run, and inflation in the long run? What makes a bank a central bank?”
I thought my second and third sentences implicitly defined a “central” bank as one that has power over macro variables.
Insufficiently clear, maybe. But I’m not changing reference points on a whim. I don’t even need to use the word “central”. “Concerning those banks which we believe and observe to have power over macro variables: what is the source of their power? And why don’t other banks have that same power?”
Yep. I definitely wasn’t clear enough about the question I was trying to answer. Another post I should re-write from scratch. Oh well.
Forget CHAPS; I did a bit of investigation and it seems that CHAPS only clears payments, for settlement at the Bank of England. But while I cannot name an example of a non-central bank payment settlement institution right now, I am sure that they could, and probably do, exist. All that is necessary is to establish a mutual company into which settlement members contribute some safe assets in return for a settlement balance, with settlements between members conducted in the accounts of their settlement institution. So I do not think that being the bankers’ bank is necessary to control interest rates (to the extent that the monetary institution can control them of course!).
I know these are arcane issues, but I think that is precisely why understanding them might be very fruitful in terms of understanding, for example, the causes of the financial crisis. Even in a central bank, I never found anyone who really understood the whole picture – the economists avoid such details (especially as many “monetary economics” modules hardly discuss money) and the operations staff tend to have little time for theory.
Rebel: agreed. I find it very hard to get my head around the details myself. It’s like cutting through pea soup.
“Yep. I definitely wasn’t clear enough about the question I was trying to answer. Another post I should re-write from scratch. Oh well.”
It’s really not that difficult to describe the functions of the typical modern central bank. The Bank of Canada is a reasonable example. More importantly, and indicatively, I see little difference between the Bank of Canada and the Fed from a functional point of view (something like inflation targets is not critical to a discussion like this), or between those two and other central banks for that matter. From there, you zero in on the function that you think is central. It’s not rocket science.
The question posed in the title of your post is straightforward in that context. As I said, I think the answer is the reserve account and the clearing function that goes along with it. This mirrors the typical deposit account service that a commercial bank offers when they agree to make sure your deposits and withdrawals (cash or cheque) are reflected accurately in your balance. You were fairly clear in that you thought a specific redeemability relationship was the criterion for centrality. So we had a discussion.
I think the question is reasonably clear provided you make some reasonable assumptions about the nature of the modern central bank. If you want to go off and dispute what the typical central bank looks like, that really is a waste of time, given the similarities of institutions like the Bank of Canada, the Fed, and the others. Hell, I see nothing of note even in the Chinese central bank that makes it unqualified to be part of a “typical” modern central bank discussion. Its foreign exchange activity and its peg is just a question of degree in running an FX fund (even the Bank of Canada might consider the idea of intervention, although it doesn’t like it).
So if the question and the assumptions about what the words in the question mean are reasonably straightforward, it’s really the answer that counts.
Anyway, good discussion.
RebelEconomist posted this question as a comment on another post. Since I wanted to answer it, but we were all wandering off topic on that other post, I asked him to move it over here. But he’s on UK time (I think), and maybe down the pub, or at tea, so I couldn’t wait! So I’m re-asking it here.
“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?”
I associate this way of thinking about monetary policy and interest rates with inter-war British monetary theory; and you see it today in some Austrian analyses, I think. The interest rate is determined by the supply and demand for loanable funds (both flows), and central banks’s monetary policy affects interest rates by increasing the supply of loanable funds — effectively printing a flow of money and lending it out.
Notice first how very different this way of thinking is from the Keynesian liquidity preference theory, where the interest rate is determined by the stock supply and demand for money, rather than the flow supply and demand for loanable funds. I know the ISLM can integrate liquidity preference and loanable funds, but the ISLM allows real income to adjust to make liquidity preference and loanable funds give the same answer for the rate of interest. That begs the question, since income won’t increase until you get the rate of interest down and investment and consumption respond. And what happens in the very short run, before output and income have had time to adjust (it takes time to increase employment and output)?
To simplify, let’s delete the banking sector initially, then bring it back in later. And delete government bonds too. There’s just paper money printed by the central bank, and commercial bonds.
Initially the flow demand for commercial bonds (desired savings) equals the flow demand for commercial bonds (desired investment). And the stock demand for currency equals the stock supply. So we start in equilibrium. Now hold output and income constant, because we are in the very short run, and firms won’t have time to hire more workers and increase output and income yet (we can’t move along the IS curve, in other words).
What happens with a once and for all helicopter increase in the STOCK of money? Specifically, what happens to the FLOW demand and supply of loanable funds?
To be continued later, because I’ve got to teach public goods. But if anyone wants to have a go, go for it.
Nick,
As already noted, I don’t plan to enter the debate further.
But fyi, the post Keynesians would say your analysis is entirely wrong in its loanable funds foundation, which applies to a fixed but not a floating rate system.
Enough said by me. I don’t want to disrupt what might otherwise be an interesting discussion.
(P.S. Chartalism/MMT is effectively a branch of post Keynesianism. E.G. Australian blogger Steve Keen is a well known post Keynesian, but not a Chartalist.)
Oh, and assume the price level is fixed, because we are in the very short run.
JKH: The loanable funds theory works great in the long run closed economy. In the long run open economy you need to add the supply or demand for loanable funds from the rest of the world, regardless of whether nominal interest rates are fixed or flexible, because real exchange rates are flexible.
Nick, I hope you have the opportunity to have a healthy debate about this with the Chartalists!
Thanks Nick, I was at tea. I look forward to reading your explanation tomorrow.
If you find yourself covering the same point several times, JKH, you need a blog!
RebelEconomist @ 5:23 p.m.
No doubt an informed suggestion, Rebel.
And an intriguing one – thanks.
Hi Nick (this is the first time to write a comment here),
Thank you very much for the interesting discussion; it gave me a good food for thought – during my working hours (and, as a natural result, I had to work overtime!).
I think, the key to make the “CB” in your model is the commitment to exchange A’s money ANYTIME AT PAR, rather than the one-way redeemability itself. For example, in the former case of the two banks model, if bank B purchases A’s notes (A$) in exchange of B’s notes (B$) at par, but if B re-purchases B$ at the rate of 104/105 (A$/B$), then the investors obtain only 4% yields in A$ – there is no arbitrage opportunity. The same argument applies to the latter case. B can sell A$ at par and buy it back at 106/105 (A$/B$). Again no arbitrage profit.
This implies that, I think, B’s losses in the two-bank model come from the lack of interest rate parity, rather than the asymmetric redeemability. Of course, the idea of the asymmetric redeemability is still very interesting (rather than simply assuming infinite supply of money) – and I am interested in the reason why. A possible interpretation is “A is a risk-free bank and B is a risky bank”, because A never want to accept B’s debts as a part of A’s assets while B is happy to accept A’s debts infinitely. This may be an acceptable (and therefore, boring!) interpretation of the asymmetric redeemability.
Again, thank you for the interesting idea!
Nick’s post said: “So, what is the price of a central bank’s currency that makes no promise to redeem?” Price in terms of goods? For the US and Canada, $1 buys you about 3/4 of a cheap cup of coffee, so that’s the price of $1.”
So if the price of currency that makes no promise to redeem is price inflation/deflation of good and services, why does the fed use currency denominated debt to fight price deflation from positive productivity growth and cheap labor (assuming lower interest rates lead to more currency denominated debt)?
Here is another way to look at it. What if lower interest rates do not get excess savers to spend in the present and do not get excess debtors to go further into currency denominated debt (because they already have too much of it) to spend in the present?
edeast said: “. They define what legally counts as paying the debt. But for current exchanges, sellers can presumably choose medium in which they set prices and accept for payment “sorry, but I won’t accept cash for my house, but I will accept payment in bottles of whisky”.
But I think the point of legal tender laws is that you can’t refuse to take the money as payment. You cannot say that I will only take whisky. And the Government has the coercive power because they enforce property rights. I think the G wants a to be widely used by it’s citizens, is so that they can measure and tax economic activity. They want you to buy the whisky bottles off the other guy, and have him buy the house off of you. So they can tax each transaction.”
Doesn’t the fed have monopoly control over the amount of currency?
If debt could be paid off in whiskey, what would happen if someone started increasing whiskey production by 20% or more per year?
By the way, JKH, I would be interested in your explanation of the difference in credit risk between Fed funds and a eurodollar deposit, because I once had to consider it for the purposes of a contract. My counterparty suggested that cash derivatives collateral be remunerated at Fed funds, and I wondered why they preferred that to LIBOR. As I recall, there was something different to do with FDIC insurance.
I’m not 100 per cent sure on this, but I believe it’s because repayment settlement for overnight fed funds occurs prior to reserve account settlement on repayment of anything comparable in the Eurodollar market, where the initial transaction in both cases occurs at the same time, as per the rate comparison. The elapsed timing difference equals credit risk difference.
Please correct me if I’m wrong.
Whether or not my point on timing is exactly correct, another possible contributing factor is that the set of survey banks for Eurodollar quotes is a lower average credit risk group than the weighted average credit risk of the banks that by volume determine the Fed effective rate. Again, I’m not sure on that, but it seems plausible.
The FDIC insurance aspect may make sense as well. It’s conceivable that the Fed or FDIC guarantees repayment of ON fed funds when a bank is shut down, but not settlement for comparable Euro contracts. I really don’t know on that one.
Continued from Nov 3 1.10pm:
How can a change in the small stock of currency cause a significant change in the large supply and demand for loanable funds?
First, because the first is a stock, and the second is a flow. If the people who want to get rid of the helicopter money want to get rid of the excess stock of money instantly, by lending it out (i.e. buying commercial bonds) that creates an infinite excess flow demand for commercial bonds (an infinite excess flow supply of loanable funds). (And remember that even though each individual can get rid of currency by buying bonds, they can’t do this in aggregate, so the infinite excess flow supply of loanable funds continues until the rate of interest falls and people decide to hold the extra currency instead).
Second, even if we convert the stock into a flow, by assuming that those who pick up the helicopter money try to get rid of it slowly over time, we need to think about the elasticity of demand and supply for loanable funds in the very short run, when real output, income, and price level are fixed. If Y, C, and I are all fixed in the very short run (Y=C+I in this simple model), then the demand for loanable funds from investment is fixed, and the supply of loanable funds from savings is fixed too. In other words, the supply and demand curves of loanable funds from savings and investment are perfectly interest-inelastic in the very short run. Any extra supply of loanable funds from an excess flow supply of currency can create an indefinitely large fall in the equilibrium interest rate in the very short run. Increased borrowing for increased investment, and decreased lending from decreased savings, take time to happen. And when they do happen, income increases, creating the extra savings and flow supply of loanable funds.
Now add a banking system, so currency is only a small proportion of the stock of money.
To be continued…
Continued from 2.58:
Forget the helicopter. Assume instead the central bank lends out the new currency, adding it to the flow supply of loanable funds, offering to supply an unlimited quantity of currency at a lowered interest rate. As we have seen, with the supply of loanable funds from savings and demand for loanable funds from investment being perfectly inelastic in the very short run, the increase in the stock of currency needed to lower the interest rate depends not on the elasticities of savings and investment, but on the interest elasticity of the demand for a stock of currency.
Now just add in what I wrote in the original post, about the infinite arbitrage opportunities opened up if the commercial banks try to keep their interest rates constant, when the central bank lowers its interest rate, and the infinite losses that commercial banks would face, given asymmetric redeemability. The commercial banks will lower interest rates too.
So even if we start out with a loanable funds theory of the rate of interest, we end up with a liquidity preference theory, in the very short run when Y is fixed.
Workhorse: Welcome, and thanks!
I agree with your comment. For my argument to work, it is not enough for the commercial banks to promise to redeem their liabilities at par today. They must promise to do so in future as well. (Or, the rate, if not par, must be fixed. Or if not fixed, at least pre-determined to adjust at some particular rate, like a crawling peg. Definitely not flexible exchange rates between the commercial and central banks’ monetary liabilities.
Too much Fed: the question at issue here is to explain how it is that central banks can raise or lower interest rates. The extent to which interest rates affect aggregate demand is a separate question, that I don’t want to get into here.
Nick said: “Now add a banking system, so currency is only a small proportion of the stock of money.”
Let’s call that “stock of money” the fungible money supply, the money supply that can purchase either financial assets or goods and servies.
If currency is only a small proportion of the fungible money supply, what is the large proportion?
Nick said: “If the people who want to get rid of the helicopter money want to get rid of the excess stock of money instantly, by lending it out (i.e. buying commercial bonds) that creates an infinite excess flow demand for commercial bonds (an infinite excess flow supply of loanable funds).”
What if the helicopter money is bank reserves?
If not bank reserves but currency, why give it to the lenders (your statement above leads me to that assumption)?
I think I need a definition of helicopter money.
Nick said: “What happens with a once and for all helicopter increase in the STOCK of money? Specifically, what happens to the FLOW demand and supply of loanable funds?”
If by STOCK of money, you mean the fungible money supply, then I don’t believe there is an exact, direct relationship.
Once again, I need a definition of helicopter increase and who gets the drop.
Helicopter money: the central banker prints some currency, loads it into a helicopter, and flies around the country throwing it out for people to pick up.
Ha! Would I be right in suspecting that you are having trouble explaining how central banks set interest rates Nick? After some perambulation around the difference between loanable funds and liquidity preference flow / stock ideas (which I am not sure matters in the context of an overnight loan market), and a dead end (helicopter money; this is so rare as to be practically irrelevant since, as Mike Sproul says, central banks supply base money by trading it for another asset such as a loan), you eventually say that commercial banks will follow the central bank because they know that its ability to supply base money is infinite and that therefore they would face infinite losses if they did not adjust their rates in line. That is the point that Gary Marshall tries to make – to get interest rates down by supplying base money, the central bank has to be ready to supply such a large amount of base money that they would generate an intolerable rate of inflation. And you picked the slightly easier case where the central bank’s objective was to ease, in which its infinite capacity to trade money for debt (assuming that it will not be deterred by the inflationary consequences) is not in question.
By the way, more respected analysts than Gary Marshall and I have noted this conundrum. The clearest statement of it by a famous name that I know of is Ben Friedman’s “The future of monetary policy: the central bank as an army with only a signal corps” (originally published as NBER WP 7420) – it is sufficient to read the first half-dozen pages or so.
All good suggestions, JKH. Some other ideas that I had written in the margin of page 87 of my copy of Meulendyke (“US Monetary Policy and Financial Markets”) are:
(1) Fed funds payment settles later in the day (ie similar to your first point, but at the opening of the transaction).
(2) The ranking of such a deposit in the creditor hierarchy.
(3) No FDIC fee is payable on a Fed funds deposit, which Meulendyke argues would mean that Fed funds trades above other deposits (not sure I agree).
In the end, I never was able to get to the bottom of it; I think I just insisted on treasury collateral!
Such issues illustrate the level of detail that is needed to understand how monetary policy works. In this case, the more experienced back office staff are probably better placed to know than either the economists or the dealers.
I don’t know how many times I have to say this, but the central bank does not “set interest rates”.
It sets the target policy rate and guides the market rate that corresponds to it through reserve management.
Friedman doesn’t address the mechanism. He probably doesn’t know about it or understand it, like most economists who have no knowledge of reserve accounting and operations.
BTW, Nick, when I informed Mosler by comment that you were planning on a post “attacking Chartalism”, he said something to the effect “It can’t be attacked. It’s accounting.” Which is very much to the point on the policy interest rate issue, as part of MMT/Chartalism.
Rebel: Central banks do helicopter money a lot. Whenever a central bank gives its seigniorage profits to the government (and they do this all the time), and whenever the government uses those profits to finance a deficit (and they do this all the time), the helicopters are flying. The people who work in central banks never see the helicopters, of course, because they are too close to the action to see the woods for the trees. They also don’t see the vacuum cleaner bond market operation, when government and central banks work together to vacuum bonds out of people’s pockets. All central bankers ever see is the combined results of those two operations, and they call it an “open market operation”.
Whenever a central bank increases the supply of currency, of course the long run result will be a price level that is equi-proportionately higher than it would be otherwise. And all real things (including the rate of interest) will be the same as they would be otherwise. That’s the standard Quantity Theory/Neutrality of Money result. What we seek to understand is how central bank printing of currency can have such powerful effects: on interest rates in the very short run; on interest rates and output in the short run, and on the price level in the long run.
The following is a note put out by Goldman Sachs, posted on Mosler’s site. In the main article, the first paragraph is Chartalism. The rest is standard post Keynesianism. The micro and macro analytical framework for all of it is mostly about understanding bank reserve accounting.
“Since March I have been arguing that the world was a better place than people thought. I am now shifting my core view, which still might take several months to develop in the marketplace.
Skipping to the Conclusions
1. Deflation will be the surprise theme of 2010, when Congress will go into a pre-election deadlock; elections have only underscored this is the public direction
2. Excess Reserves will neither generate new lending nor generate inflation; actually, the quantity of reserves (M0) basically has no real economic effect
3. ZIRP and QE actually CONTRIBUTE to the deflation mostly by depriving the spending public of much-needed coupon income
4. When Federal Tax Rates increase in 2011 this problem will become even more severe
5. The overall level of public indebtedness (vs GDP) will not put upward pressure on yields in this backdrop and there will be a reckoning in the high-rates/‘deficit hawk’ community
6. Strong possibility that QE will actually be upsized next year rather than ended when the Fed observes these effects (and this might actually make things WORSE)
The Explanation (a Journey)
It seemed fairly intuitive and obvious for thousands of years that the Earth was at rest and the Sun moving around it. Likewise, it has ’seemed’ that the Fed controls the money supply, balances the economy by setting interest rates and fixing reserves which power bank lending, that more ‘Fed’ money means less buying power per dollar (inflation), that the federal government needs to borrow this same money from The People in order to be able to spend, and that it needs to grow its way out of its debt burden or risks fiscal insolvency. I have, in just a fortnight, been COMPLETELY disabused of all these well-entrenched notions. Starting from the beginning, here is how I now think it works:
1. The first dollar is created when Treasury gives it to someone in exchange for something – ammo, a bridge, labor. It is a coupon. In exchange for your bridge, here is something you – or anyone you trade it with – can give me back to cover your taxes. In the mean time, it goes from person A to person B, gets deposited in a bank, which then deposits it at the Fed, which then records the whole thing in a giant spreadsheet. Liability: One overnight reserve/demand deposit/tax coupon. Asset: IOU from Treasury general account. Tax day comes, Person A pulls his deposit, ‘cashes in’ the coupon, the Treasury scraps it, and POOF, everything is back to even.
2. For various reasons (either a gold-standard relic or a conscious power restraint, depending who you ask), we ‘make’ the Treasury cover its ‘shortfall’ at the Fed and SWAP one type of tax-coupon (a deposit or reserve) for another by selling a Treasury note. Either the Fed (in the absence of enough reserves – we’ll get to this) or a Bank (to earn risk-free interest) or Person A (who sets a price for his need to save) is ‘forced’ out his demand deposit dollar and into a treasury note at the auction clearing price. What about the fact that treasuries aren’t fungible like currency? On an overnight basis, that doesn’t really constrain anyone’s behavior. A reserve or a deposit means you get your money back the next day. Same thing with a treasury. Functionally it’s cash and won’t influence your decision to buy a car. Likewise for the bank. In the overnight duration example, it does NOT affect their term lending decisions if they have more reserves and few overnight bills, or more bills and fewer reserves. It’s even possible to imagine a world (W.J.Bryan’s dream) where the Fed, with its scorekeeping spreadsheet, combines the line-items we call treasuries and reserves.
3. Total “public sector dissavings is equal to private sector savings (plus overseas holdings)” as a matter of accounting identity. This really means that the only money available to buy treasuries came from government itself (here I am being a bit loose combining Tres+Fed), from its own tax coupons. If there aren’t enough ready coupons at settlement time for those Treasuries, the Fed MUST ‘supply’ them by doing a repo (trading deposits/coupons for a treasury by purchasing one themselves at least temporarily). They don’t really have a choice in the matter, however, because if the reserves in the banking system didn’t cover it, overnight rates would go to the moon. So in setting interest rates they MUST do a recording on their spreadsheet and the Fedwire and shift around some reserve-coupons (usable as cash) for treasury-coupons (usable for savings but functionally identical).
4. Thus ‘monetizing the deficit’ is actually just the Fed’s daily recordkeeping combined with its interest rate targetting, just ‘keeping the score in balance.’ However, duration is real, as only overnight bills are usable as currency, and because people (and pensions!) need savings, they need to be able to pay taxes or trade tax-coupons for goods when they retire, and so there is a price for long-term money known as interest rates. The Fed CAN affect this by settings rates and by shifting between overnight reserves, longer-term treasuries, and cash in circulation. When the Fed does a term repo or a coupon sale, they shift around the banking and private sector’s duration, trading overnight coupons for longer-term ones as needed to keep the balance in order.
5. But all this activity doesn’t influence the real economy or even the amount of money out there. The amount of money out there dictates the recordkeeping that the Fed must do.
6. This is where QE comes in to play. In QE, aside from its usual recordkeeping activities, the Fed converts treasuries into overnight reserves, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it ‘needed’ to do all along. Again, they force people out of treasuries and into cash and reserves.
7. The private sector is net saving, by definition. It has saved everything the Treasury ever spent, in cash and in treasuries and in deposits. In fact, Treasuries outstanding plus cash in circulation plus reserves are just the tangible record of the cumulative deficit spending, also by IDENTITY.
8. So when QE is going on, there is some combination of savers getting fewer coupons – which constrains their aggregate demand just like a lower social security check would, and banks being forced out of duration instruments and into cash reserves. I do not think this makes them ‘lend more’ – their lending decision was not a function of their ‘cash flow’ but rather a function of their capital and the opportunities out there (even when you judge a bank’s asset/equity capital ratio, there is no duration in accounting, so a reserve asset and a treasury asset both ‘cost’ the same). If they had the capital and the opportunities, they would keep lending and ‘force’ the Fed to give them the cash (via coupon passes and repos, which we then wouldn’t call QE but rather ‘preventing overnight rates from going to infinity’). As far as I can tell, excess reserves is a meaningless operational overhang that has no impact on the economy or prices. The Fed is actually powering rates (cost of money) not supply (amount of money) which is coming from everyone else in the economy (Tres spending and private loan demand).
9. I’ll grant there is a psychological component to inflation phenomenon, as well as a preponderance of ignorance about what reserves are, and that might result in some type of inflationary event in another universe, but not in the one we are in where interest rates are low and taxes are going up and the demand for savings is therefore rising rather than falling.
10. One can now retell history through this better lens. Big surpluses in ‘97-’01, then a big tax cut in ‘03. Big surpluses in ‘27-’30, then a huge deficit in ‘40-’41. Was an aging Japanese public ’shocked’ into its savings rate or is that savings just the record of the recessionary deficit spending that came after ‘97? It will be interesting to watch what happens there as the demographic story forces households to live moreso off JGB income – will this force the BOJ to push rates higher or will they never ‘get it’ and force the deflation deeper?
11. There are, as always mitigating factors. Unlike in the Japan example, a huge chunk of US fixed income is held abroad, so lower rates are depriving less exported coupon income which is actually a benefit. There is of course some benefit from lower private sector borrowing rates as well – MEW, lower startup costs for new capital investment, etc. Also, even if one denies that higher debt/gdp ratios are what weakened it (rather than China’s decisions – again something unavailable to Japan), the dollar IS weaker now which is inflationary. But this is all more than offset, I think, by ppl’s expectation that higher taxes are coming, and that’s hugely deflationary and curbs aggregate demand via multiple channels.
12. Additionally, there seems to be a finite amount of political capital that can be spent via the deficit, and that amount seems to be rapidly running out. See https://portal.gs.com/gs/portal/home/fdh/?st=1&d=8055164 . The period of deficit stimulus is mostly behind us. Instead, people are depending upon ZIRP and the Fed to stimulate the economy, and in fact there is marginal, and possible negative, stimulation coming from that channel. The Fed is taking away the social security checks knowns as ‘coupon interest.’
13. Finally, there is a huge caveat that I can’t get around, which is whether we are measuring inflation correctly. It happens that I don’t think we are – strange effects like declining inventory will provide upward pressure and lagged-accounting for rents providing downward pressure in the CPI. This is an unfortunate, untradeable fact about the universe that I think will be offset by other indicators (Core PCE) sending a better signal. But this is part of the reason this whole story will take time to develop in the marketplace. As a massive importer of goods and exporter of debts we are not quite Japan, but the path of misunderstanding is remarkably similar.”
* Credit due Warren Mosler and moslereconomics.com for guiding my logic.
J.J. Lando”