I have a confession to make. During the financial crisis I secretly bailed out the Bank of Montreal. I was part of a vast conspiracy of millions of other Canadians doing the same thing. It's worse. My personal bailout program for the Bank of Montreal started long before the financial crisis. It started when I first arrived in Canada. It's even worser. The Bank of Montreal still has not repaid me what it owes, and my bailout continues to this day. Without this bailout program, the Bank of Montreal could never have continued in business; it would have gone bust centuries ago. This secret bailout program is far bigger than the total market value of Bank of Montreal shares, so the Bank of Montreal is deeply underwater! It would have been much cheaper for me and my fellow conspirators to have bought the Bank of Montreal outright. And we could have earned a far higher return on our investment if we had done that. The Bank of Montreal eagerly borrowed every single dollar we were prepared to lend it in our bailout program, and made a profit by lending those dollars to other borrowers. We should have just lent our dollars directly to those ultimate borrowers, and cut out the middleman.
Or, to say the same thing more simply: I have a chequing account at the Bank of Montreal, and the Bank of Montreal is a bank.
There are real questions that can be asked about the relationship between government and banks, and between central banks and banks. Should central banks act as lender of last resort to commercial banks? If so, in what circumstances and on what terms? How should monetary and fiscal policy be conducted during a recession and/or financial crisis, and how much and by what methods should central banks try to influence the behaviour of commercial banks in order to attain their monetary policy objectives?
I do not know the answers to those questions, but I think they are important. For what it's worth, my hunch is that the channel between central banks and commercial banks currently plays a far larger role in the monetary policy transmission mechanism than it should. And I am very uneasy about the lack of transparency that seems almost inherent in the role of lender of last resort; it's in stark contrast to the transparency of inflation targeting.
David Macdonald has collected the facts of Bank of Canada lending to the commercial banks during the financial crisis. No worries. But his interpretation of those facts is simply to restate those facts in the same way that I restate my facts in my opening paragraph above.
For example, David says (pages 8 and 9):
"In fact, several banks drew government support whose value exceeded the bank’s actual value. Canadian banks were in hot water during the crisis and the Canadian government has remained resolutely secretive about the details."
And on page 28:
"Total support for CIBC was worth almost one and a half times the value of all the company’s shares in March 2009. In fact, almost every day from mid-January 2009 and the end of April, CIBC was completely “underwater,” receiving support worth more than the value of the company."
All banks always borrow more than the value of the bank. (OK, I expect that's not strictly true, and if I searched I could find a counterexample, where a newly-formed bank had raised capital but hadn't yet got its act together to attract some deposits and make some loans.) That doesn't mean the bank is in "hot water", or "underwater". It means it's a bank. Hell, most homeowners with a mortgage worth more than 50% of the value of the property are "underwater" or in "hot water" and being "bailed out" by the mortgage under that definition. Banks typically borrow more than 90% of what they lend. They always live "underwater" and in very "hot water" indeed. That's where banks live.
Banks borrow and lend. Banks' balance sheets are much bigger than the market value of their shares. That's what banks do. Banks are banks.
(Oh, and the one really interesting and important thing about banks, which is what sets them apart from you and me and other financial intermediaries, is that some of banks' liabilities are used as media of exchange. That is the really important fact about banks.)
What we really need is a counterfactual conditional. What would banks have done instead if the Bank of Canada had not provided those loans? Would they have gone bust? Or would they have just had smaller balance sheets? And that analysis is exactly what I didn't find in reading David's Report.
If I hadn't got the mortgage, what would I have done? Maybe I would have gone bust, or maybe I just wouldn't have bought the house? You can't answer that question just by noting that the mortgage was more than my equity in the house.
[Update: let me make the central point even more strongly. When a recession appears more likely, the central bank may offer loans on easier terms. That's what central banks are supposed to do. And commercial banks may accept those loans. That's what banks are supposed to do. We wanted the banks to accept that "bailout" money, whether they needed it or not. The time to get worried is not when banks act like banks and accept that "bailout". The time to get worried is when banks stop acting like banks and don't accept that "bailout". (Or, like many US banks, they just park the "bailout" money back at the same Fed which lent it out in the first place). It's when banks stop acting like banks that we should start to wonder what use they are in the big scheme of things. We wanted the Canadian banks to borrow the "bailout" money. We wanted them to act like banks. The very last thing we should be doing is criticising them for doing this. The very worst result of this Report would be if it made banks more reluctant to borrow and lend in any future recession. That's the last thing we need.)
I own some BNS shares. The Carleton University pension plan almost certainly holds Canadian banks' shares. I have a chequing account at BMO, as mentioned above. I'm probably biased.
Worthwhile Canadian Initiative 
Bob: was it a simple sale, or was it a repo?
My understanding is that it was a sale: insured mortages for CMHC paper. And since CMHC paper trades at a discount form T-bills (even though they are also guaranteed by the govt), that meant the banks lost money on the exchange. (That’s why my scenario 2 above involved writing a cheque for $1100 to get $1000 cash.)
Bob Smith:
If the government paid the market price for these MBS in the context of the IMPP (as I supposed he did), would you say that the government’s action provided “market support” for these instruments so to avoid a debt-deflation spiral? If you respond yes, would you reconsider your position on “providing the banks with liquidity without bailing them out”?
Bob, the government may have netted $2.5 billion dollars from the program. But that’s not the right way to think about it. Perhaps the government mispriced the liquidity services it was offering the banking system and it should have netted $2.6 billion. Maybe it should have made $10 billion. Maybe just $1.0 billion. We’ll never know if it properly priced the program.
I agree completely with Stephen’s comments and his judgment that “it was a willful misrepresentation to characterize the liquidity support as a bailout”.
In further support, 70% of Cdn bank needs are provided by depositors – the safest, most reliable and cheapest form of finance for a bank (i.e. for CDN banks). And there were no runs on Cdn banks.
AND, Cdn banks have always had much low leverage ratios (required by OSFI – and Cdn banks exceed the OSFI standard) – much lower leverage than US banks and much much lower leverage ratios than the European banks that seem to operate as fonctionnnaires of EU countries’ finance ministries. Cdn banks mostly exceeded the standards of Basel 3 – before Basel 3 existed or was agreed to.
(when I was in the bank in the 1970s and 80s, we characterized ourselves as “prudent balance sheet lenders” while we characterized the American banks as “go-go bankers” for they would lend against cash flow projections (i.e. fairy dust). We never discussed European banks but if we had, would likely have called them Gosbanks – USSR).
Only 30% of Cdn bank needs are borrowed by Cdn banks from short term commercial markets (CBA data and BoC data). And as Carney and others noted tirelessly, it was the commercial money markets that “froze up”. BTW, the credit crunch hit and hurt the shadow banks far far more than the Cdn banks – e.g. leasing stopped almost overnight and some firms exited from Canada back to US.
The GoC and BOC liquidity support was transparently designed to end the credit crunch to get Cdn banks lending again to SMEs which had almost stopped cold – and to announce to the capital, credit, deposit markets to: “calm down, everything is OK, the Bank of Canada and the Govt of Canada are standing behind the Cdn financial system. There is not and will not be a financial meltdown – now – go watch the Maple Leafs lose to whomever” (sometimes a cigar is simply a cigar).
I agree with Nick that this was a pure hatchet job. Good empirical research but interpretations that are simply not sustainable – presumably in pursuit of a larger agenda e.g. “tax the rich greedy banks”.
Stephen: OK, and a sale is even simpler than a repo, or loan.
JP: If a big buyer makes a big purchase, that will move the market price. But we normally say that exploiting that monopsony power to the full, and buying less than you wanted to because you want to keep the price below the competitive equilibrium, is not a good thing. Not sure how well that analysis applies here.
Nick: “I’m not sure whether or not that could work, in a system-wide liquidity crisis, if it wasn’t backed by the ultimate creator of money.”
The CMHC/IMPP plugged much of the Canadian side of the crisis in 2008 by buying NHA-MBS, and the CMHC/IMPP aren’t ultimate creators of money but taxpayer funded.
A counterfactual is a world in which NHA-MBS liquidity options are sold by private actors to holders of NHA-MBS. These options allow NHA-MBS holders to sell all MBS back to the option writer at any time at a liquidity-protected price (some favourable point in the bid-ask spread). In a liquidity crisis bid-ask spreads increase, so the value of these options would quickly rise. The CMHC/IMPP provided MBS holders with a liquidity option, but we’ll never know if they required MBS holders to pay the market price for this option.
Yeah, the goal here wasn’t to maximise govt revenues, it was to provide an incentive to the banks to stop using govt-provided liquidity when markets started functioning again. As it was, only $69b of the $125b made available was taken up. If really were free money, they would have snapped it all up.
Bob, the government may have netted $2.5 billion dollars from the program. But that’s not the right way to think about it.
“Perhaps the government mispriced the liquidity services it was offering the banking system and it should have netted $2.6 billion. Maybe it should have made $10 billion. Maybe just $1.0 billion. We’ll never know if it properly priced the program.”
True, although that’s a criticism of anything the government does – how do we know that civil servants wages are properly priced? It’s particularly problematic in this context, because there is no market competitor for the liquidity services that can be offered by the government – private parties can’t print money.
In any event, the terms weren’t so favourable that the banks were hopping to make make use of the IMPP, since the government only ended up buying $69 billion of the $125 billion it had offered to puchased. Not conclusive, I admit, but sugestive that the liquidity services weren’t significantly underpriced. An of course, if the CCPA wants to argue that there was a bailout because the the liquidity services were underprised, that might be a reasonable argument, but it’ll require a lot more evidence that they’ve accumulated.
“Would you say that the government’s action provided “market support” for these instruments so to avoid a debt-deflation spiral”?
You’ll have to clarify, what do you mean by “market support”.
Again, agree with Stephen.
The banks were never in jeopardy of failing themselves – they simply stopped lending in order to hoard cash when the crunch hit.
(The small and mid-sized firms account for 75% of employment in Canada).
This caused Catherine Swift (MA, Economics, Carleton) Pres of CFIB and the SMEs put unbelievable pressure on Flaherty to “do something” – to get the banks lending again.
To restate the obvious, the credit crunch was passed on by the Cdn banks to SMEs (and was also passed on to shadow banks who had commercial lines of credit with banks in addition to using the commercial credit markets).
The SMEs responded by shutting down their supply chains i.e. stopped ordering stuff from the mfgs. And the SMEs threatened to start laying off large numbers of employees – a disaster for the Finance Minister if that were to pass.
The shadow banks responded by inter alia, stopping leasing of cars, trucks, industrial equipment and credit to SMEs as well.
These actions would have caused huge increases in unemployment – and would have caused the CAW, CCPA et al to hurl abuse at the GoC for not intervening. And it would have been a disaster for Flaherty.
This is why the CCPA interpretation is “nonsense on stilts”.
Bob Smith:
What I mean by “market support” is, let say, by running the counterfactual simulation of no purchase of MBS whatsoever by CHMC, one find that the price of MBS would have been actually much lower. Would you then still be comfortable saying that IMPP was just about providing liquidity to banks and that it had no “bail out” component?
“one find that the price of MBS would have been actually much lower”
Would it have been? Certainly the offering price for such securities, from financial institutions facing liquidity contraints of their own, would have been lower, but would financial institutions have been willing to sell at those offering prices? Not so clear. They might just have preferred to hoard their cash and not lend, rather than selling safe assets at a hefty discount to free up cash. In that scenario it would not be true to say that the price of MBS would have been lower (or not), there just wouldn’t have been a price. In fact, that’s precisely the scenario that the government was trying to avoid.
You could describe the government’s role here as a market maker, but it’s hard to conclude (at least without a lot more evidence) that they were providing “market support”.
i was remiss.
one cannot mention banks without mentioning the balance shet mechanism that makes recessions worse.
which means a big mechanism torward preventing bailouts is… ngdp targeting.
every post should have a tie in. lol. my bad.
dwb: “which means a big mechanism torward preventing bailouts is… ngdp targeting.”
Bingo!
Looks like Evans at the Fed is now on board too, so we are slowly winning!
Bob Smith:
first, banks do not have to “free up” cash to lend. They might have to free up capital if they are capital constraint, but this is entirely different to freeing up cash.
second, CMHC auction results that yields on MBS were subtantially higher than the risk free rate when the IMPP got started in late 2008, and this yields differential progressively came down thereafter. This suggest that IMPP was quite sucessfull in brining yields on MBS closer to the risk free yield. If anything, this suggest that there was indeed a “bail out” component to the IMPP to the extent that it proped up MBS price, and improved banks’ capital position.
“In any event, the terms weren’t so favourable that the banks were hopping to make make use of the IMPP, since the government only ended up buying $69 billion of the $125 billion it had offered to puchased. Not conclusive, I admit, but sugestive that the liquidity services weren’t significantly underpriced.”
One could just as easily say that the terms were very favourable since the banks ended up selling $69 billion to the IMPP rather than $0. I’ll stay mum on the issue.
“…because there is no market competitor for the liquidity services that can be offered by the government – private parties can’t print money.”
Private clearinghouses have been money printers. But you don’t need to be a “printer” to provide liquidity services. Commercial banks can create deposits with a mouse-click, these deposits serving as back up lines of credit to smaller banks that are liquidity providing. A formal liquidity options market doesn’t exist but it might at some point in time. The more that liquidity services are priced in competitive markets the better.
So the CCPA analysis that got Nick so upset has been called “nonsense on stilts” and “a hatchet job” and generally trashed so hard that the contrarian in me is trying to find something in it to like.
So let me ask, is there any reader of this blog that thinks the govt. and the BoC have done a good job in accounting for the costs (and profits!) of their extraordinary interventions of 2008 and 2009? Do you think that we’ve had a credible accounting by program? Do you think that such a public accounting is part of the BoC’s mandate? Do you think the precedent of clear accounting helps maintain the central bank’s and govt.’s credibility and popular support in times of crisis?
Personally, I’d stop well short of advocating the institution-by-institution breakdown that the CCPA calls for (for reasons others have mentioned above.) But I also can’t shake the feeling that a transparent accounting could have headed off this media “controversy.”
Simon: good question. But I think the answer – what that accounting would look like — might be really weird.
For any normal business, the accounting might be hard to do in practice (if you are dealing with assets of uncertain value) but would be possible in principle. And the answers to that accounting (did the firm benefit? was there a cost to the government?) could tell you the amount of subsidy.
Suppose the Bank of Canada really screwed up, and engineered a recession and financial crisis. And then took absolutely minimal actions to keep the banks just afloat, by overpaying for junk assets. That would meet the accounting definition of a bailout.
“CMHC auction results that yields on MBS were subtantially higher than the risk free rate when the IMPP got started in late 2008, and this yields differential progressively came down thereafter. This suggest that IMPP was quite sucessfull in brining yields on MBS closer to the risk free yield. If anything, this suggest that there was indeed a “bail out” component to the IMPP to the extent that it proped up MBS price, and improved banks’ capital position.”
Let’s deconstruct that. “The yields on MBS were substantially higher than the risk free rate”. An odd result, don’t you think, since the MBS in question were risk free – i.e., they were insured mortgages backed by the full faith and credit of the government of Canada. The banks who used to IMPP weren’t dumping bad assets on the government, they were paying a premium for liquidity – as they should. It doesn’t follow that there was a bailout component to the IMPP. Indeed, the fact that the spread betwween the yields on MBS tendered to the government under the IMPP and the risk-free rate came down as the program extended into 2009 suggests that, as liquidity concerns loosened, the banks were no longer willing to pay a material premium for liquidity.
“One could just as easily say that the terms were very favourable since the banks ended up selling $69 billion to the IMPP rather than $0. I’ll stay mum on the issue.”
Fair enough. Still, if you think of it in terms of the government making $2.5 billion dollars for, basically, shuffling its balance sheet (i.e., issuing debt to purchase government guaranteed debts), that’s a pretty shrewd investment.
I can’t get over this quote:
“CMHC was not providing loans that needed to be paid back, as was the case with the other two aid programs. CMHC was buying mortgages and, as such, the banks did not need to pay this money back. The CMHC program was thus a straight cash infusion for Canada’s banks.”
I just came from giving a straight cash infusion for one of Canada’s grocery chains. Someone should inform the media.
Yikes!
Nick, remember when you said: ” it was reviewed by some very good economists”? I hope you’re wrong. It sounds like it was prepared by the local OPIRG chapter. By an intern.
I don’t understand why demanding a larger haircut on MBS would have been a good idea. The goal of the program was to make sure banks could keep lending during a financial crisis, ideally in a way that didn’t produce moral hazard problems. That’s what the IMPP did. If anything, there’s a stronger case for having a smaller haircut: why would we want banks to restrict lending because they couldn’t get short-term liquidity?
“Fair enough. Still, if you think of it in terms of the government making $2.5 billion dollars for, basically, shuffling its balance sheet (i.e., issuing debt to purchase government guaranteed debts), that’s a pretty shrewd investment.”
I though we already agreed that $2.5 billion isn’t a sign of shrewdness, since we don’t know if the return the government should have earned providing liquidity was $1 billion, $2.5 billion, or $10 billion.
What would be the criteria for making that decision?
“I though we already agreed that $2.5 billion isn’t a sign of shrewdness, since we don’t know if the return the government should have earned providing liquidity was $1 billion, $2.5 billion, or $10 billion.”
Making anything for rejuggling your balance sheet is a sign of shrewdness, whether it’s $1billion, $2.5 billion or $10 billion.
Well, guess what everyone? CBC radio’s The Current will be talking about this tomorrow morning, and I’ve been drafted for the show. First segment, 8:30 local time. I promise to be as boring as possible, with heavy use of jargon and unexplained acronyms.
Well done Stephen. It’s good you are doing this.
JP and Bob: Milton Friedman said (Optimum Quantity of Money) that the government should earn precisely $0 from providing liquidity, since the marginal cost of the government providing it was $0, and Marginal Cost pricing maximises total surplus. (That’s the 0% nominal interest rate solution, with negative inflation equal to the natural rate of interest.) I would have to think a bit before translating that into a world of a 2% inflation target.
Just shows that the accounting goes all weird once you get into this sort of monetary question.
Bob Smith:
Ever held an illiquid asset? Ever refrained from selling it because you are afraid that putting it on the market will be enough to make the clearing price collapse? Would you not find nice in such situation if the government would give you a helping hand by offering to purchase your asset at a given maximum price through an auction process? Would you not find it nice also if the government progressively increase its maximum price offer in each passing weekly auction (so that minimum rate offered decrease from 3.9% to 3.4% in a matter of three weeks)?
Hi Joseph,
you need to make your illiquid asset 100% govt guaranteed for your example to be analogous.
Also, why is it a good idea for the govt to be extracting rents from banks during financial crises?
NR: “Milton Friedman said (Optimum Quantity of Money) that the government should earn precisely $0 from providing liquidity, since the marginal cost of the government providing it was $0, and Marginal Cost pricing maximises total surplus”
That was my intuition, but it’s nice to know that there’s some basis for it.
SG: “I promise to be as boring as possible”
You’ll fit in perfectly on the Current.
JL: “Would you not find it nice also if the government progressively increase its maximum price offer in each passing weekly auction (so that minimum rate offered decrease from 3.9% to 3.4% in a matter of three weeks”.
Keep in mind that the offered rate reflected the government’s underlying cost of borrowing (plus a spread). Since the MBS are government guaranteed bonds, it would make sense for their price to track the price of direct government bonds.
Kevin Mulligan:
Got your point. However, my broader point is that banks do not need liquidity to lend; they need capital. The paradox in this whole discussion is that the guys arguing that IMPP helped banks extend loans are also the ones arguing that IMPP only helped banks on the liquidity front (not on the capital front).
“What would be the criteria for making that decision?”
Dunno. I’m just taking an agnostic stance between the CCPA’s story of a banking subsidy/tax-payer penalty and its mirror image (Bob Smith’s point) that the government’s canniness led to a tax-payer subsidy/banking penalty. Both arguments are wrong because without a market price to use for comparison, it’s impossible to know if the “liquidity services” provided were subsidized or not. We’d only know if we could compare the price the government set for the IMPP liquidity-option to a competitively-priced liquidity-option on NHA-MBS, but those options don’t exist. Unhelpful, I know.
“However, my broader point is that banks do not need liquidity to lend; they need capital.”
It’s not so cut and dry, you need both. A bank facing liquidity concerns isn’t going to lend, or isn’t going to lend as much. It’ll hoard cash. That was the concern in 2008.
“Both arguments are wrong because without a market price to use for comparison”
Don’t we have a market price for the typed of government guaranteed debt being purchased by the government? We have government debt being issued by the government on the market (subject to the caveat, I suppose, that the BoC is a player in that market). And the price being offered by the government here was linked to its underlying financing cost (I.e., the price of government debt). There’s a spread – which I suppose contradicts Friedman’s prescription, but which hardly constitutes a bail out.
Does anyone know if the identities of purchasers of T-bills at the Bank of Canada’s auctions are made public, along with the quantities purchased? That information doesn’t appear on the Bank’s site:
http://www.bankofcanada.ca/markets/government-securities-auctions/calls-for-tenders-and-results/
Nick
Friedman was forced to conclude that because he didn’t envision a world with non-zero interest on reserves. With interest on reserves, free liquidity only means that the IoR = interbank rate = discount window rate. It does not translate into interbank rate = 0.
Also, the whole price of liquidity = marginal cost = 0 is a classic partial equilibrium with no strategic benefits or agency problems considered. In the Perry Mehrling worldview (the ‘Money view’) it is the central bank giving up the discipline part of its function, trying to make things ‘perfectly elastic’. The Friedman rule is by default inflationary for asset prices, at all levels of IoR.
Ritwik: Fair points. Or, Friedman assumed 0% interest on currency. And yes, if the Friedman rule were followed, it would mean that the central bank would take over (pretty much) the whole economy, and buy up all the assets. (It’s a commie plot!) Because if you can get the same return on holding cash as you could on any other asset, you would rather hold cash.
Nick : Interesting. But wouldn’t that happen only in an economy with zero risk appetite and a central bank that accepts all forms of collateral – a weird Friedman-Bagehot mongrel central bank(incidentally a reasonably accurate descriptor of the pre crisis Greenspan-Bernanke Fed!)
Friedman rule only makes the price of liquidity zero, not the price of default or the price of the term structure. And when risk appetite does crash to zero, the central bank of course has the option of making the price of liquidity non-zero (if it is indeed accepting all forms of collateral).
Though, Mehrling’s point is also that a roughly Friedman rule following central bank (which is incidentally also a very Tobin-esque central bank)encourages a downward trend in default premia as well and is over-sensitive to declines in asset prices. All this is of course tangential to the original Friedman rule, which is only supposed to apply to a central bank that does not accept default risk or term structure risk of any kind on its balance sheet.
A Bagehotian central bank (liquidity manager) is conceptually very different from a Friedmanite central bank (macroeconomic manager) and in the money view, one of the fundamental reasons of the fuelling of a financial crisis (or the lack of prevention of a financial crisis)is the mongrel hybrids that developed economies have, esp. in the US.
Ritwik. My old thoughts here.
Ah, Nick. But the trick in that post was not deflation, which was a veil. The trick in that post was increasing the real rate of interest on money while implicitly assuming that the real rate of interest on other assets would remain ‘constant’ over the long run, in the extreme case assuming that it was greater than the real rate on all assets in the economy. It was to take away the ‘moneyness’ of money. Obviously you ended up with freaky results when the most liquid and most short term asset was assumed to be yielding the highest premium.
If this kind of a scenario were to ever happen, you would have to drop the assumption of constant convertibility. You cannot assume high deflation and zero interest bearing money at the system. That’s just assuming the conclusion. Your thought experiment was overdetermined.
banks are banks but canadian banks are strong:
http://www.bloomberg.com/news/2012-05-02/canadians-dominate-world-s-10-strongest-banks.html
The Friedman rule takes the desired rate of interest as a given and then wants inflation to be the negative of that. In the Friedman rule framework of your thought experiment, deflation would merely the sign of a very high risk free rate of interest. The zero interest on money would put a floor on the interest rate on all other assets and the size of the central bank would be indeterminate or a matter of other policy goals.
Hey Nick if you’re casting about for something to write about, I’d love to hear your thoughts on this:
Lavoie is interesting, and the circuit matrix approach has been around for a while, but the model seems to assume what it seeks to prove. There are only firms and consumers. Banks are just a link. Everything borrowed is spent in production. All proceeds from production go to consumers as deposits. Consumers keep some of this as residual deposits and spend some on consumption goods, which closes all the circuits.
This matrix model is exactly the type of model Keen uses to reach quite different conclusions, so these conclusions clearly aren’t inherent in the use of a matrix model (hardly surprising, the matrix is just a tabular representation of a set of equations. Use different entries, and you get a different model). Lavoie says:
“The fact that these mechanisms appear to be totally independent has led some authors to claim that there could be a discrepancy between the amount of loans supplied by banks to firms and the amount of bank deposits demanded by households. This view of the money creation process is however erroneous. It omits the fact that while the credit supply process and the money-holding process are apparently independent, they actually are not, due to the constraints of coherent macroeconomic accounting. In other words, the decision by households to hold on to more or less money balances has an equivalent compensatory impact on the loans that remain outstanding.”
This doesn’t in any way prove that the model is a model of the real economy, and I’m afraid an appeal to “the constraints of coherent macroeconomic accounting” doesn’t persuade me. In particular money flows through production, whereas in the real economy a great deal of activity has nothing to do with production. Much of it goes into asset transfers.
Banks create money and use it to purchase claims on collateral – mortgages. These claims can be securitized and sold to homeowners, who may pay by using as collateral the increased value that mortgage enabled purchases have created. This may just look a bit familiar. It doesn’t however appear to be representable in the model.
All the complications of the relationship between credit and money are ignored, yet the supply of broad money is vastly larger than that of base money.
BTW it looks like here as in other places the term GDP is used to mean GDP after I’ve adjusted it for my model (GDP has something like $3 trillion of imputed production and ignores at least as much other economic activity. There’s plenty of motive for adjustment). This is quite common and has caused a lot of confusion.
It’ll be interesting to here what other people here have to say about this.