This post is about something I don't understand.
Let's start out simple. There are two parallel imaginary worlds: the green world and the red world.
In the green world people use positively-valued green money as the medium of exchange. If I buy something I give the seller my green money in exchange. Green money flows in the opposite direction from all other goods and financial assets. I am not allowed to take green money from someone without their consent. Only the issuer of green money is allowed to create green money. The borrower of green money undertakes an obligation to give green money to the lender at some future date.
In the red world people use negatively-valued red money as the medium of exchange. If I buy something the seller gives me his red money in exchange. Red money flows in the same direction as goods and financial assets. I am not allowed to give red money to someone without their consent. Only the issuer of red money is allowed to destroy red money. The lender of red money undertakes an obligation to accept red money from the borrower at some future date.
There is a symmetry between the red and green worlds; one is the negative mirror-image of the other. But there is also one asymmetry: the red world has a fundamental problem. Each individual can increase his utility by buying more goods and selling less goods, thereby accumulating an infinitely large stock of red money. The bank that issues the red money needs to put some limit on each customer's holdings of red money, to ensure this does not happen. This is not a problem in the green world, because having zero stock of green money sets a natural limit that stops an individual buying, and the individual is fully aware of that limit.
The real world is a red/green world. It has both green money and red money. A positive balance in a chequing account is green money. A negative balance in a chequing account is red money. If I sell my car to Andy, who gives me a cheque for $1,000, the bank reduces my overdraft by $1,000 and increases Andy's overdraft by $1,000. The bank has transferred $1,000 of red money from me to Andy. IIRC my father nearly always used red money. He nearly always ran an overdraft, paying it off once a year when he sold the harvest, to keep the bank manager happy.
In a red/green world, we can define the stock of "gross money" as the absolute sum of red money plus green money, and we can define the stock of "net money" as green money minus red money.
The Bank of Canada.
Canadian commercial banks have chequing accounts at the Bank of Canada. It's a red/green system. If I bank at BMO, and Andy banks at TD, and I sell my car to Andy who pays by cheque, BMO now has a positive balance of $1,000 at the Bank of Canada, and TD now has a negative balance of $1,000 at the Bank of Canada.
But the Bank of Canada sets a 50 basis point spread between the interest it charges TD on red money and the interest it pays BMO on green money. So BMO and TD can both gain if BMO lends TD $1,000 to eliminate both balances, at a rate of interest that splits the spread between the Bank of Canada's two rates of interest. Which is what Canadian commercial banks normally do. So the gross money stock is small, and normally the same as the equally small net money stock, by the end of each day.
- If the Bank of Canada acted differently, and set the same rate of interest on both red and green money, so the spread is zero, then there would be no incentive for BMO and TD to trade in the overnight market. If BMO's customers always sold more to TD customers than vice versa, BMO's chequing account at the Bank of Canada would become more and more positive, and TD's chequing account at the Bank of Canada would get more and more negative. The gross money stock would rise without limit, though the net money stock would not change.
- Or if TD were a risky bank, and if that risk were bigger than a 50 basis point compensation would warrant, there would be no rate of interest at which BMO would lend to TD that TD would accept. Again it is possible for BMO's account at the Bank of Canada to become increasingly positive, and TD's account increasingly negative.
A red/green world faces the same fundamental problem as the red world. A commercial bank will put a limit on each customer's overdraft. Similarly, the Bank of Canada must, at least implicitly, place a limit on commercial banks' overdrafts.
The European Central Bank.
Eurozone national banks have chequing accounts at the European Central Bank. It's a red/green system. They call it TARGET2. But unlike the Bank of Canada's red/green system, there doesn't seem to be any functioning equivalent to the overnight market that eliminates negative balances every evening. The ECB can hold the net money stock fixed, but the gross money stock can rise without limit. Here is the recent data (pdf).
I think you can see where this is going. I don't understand how it is supposed to work.
Worthwhile Canadian Initiative 
Antti,
My last comment assumed a dual world.
Because naming a green money overdraft as red money implies a dual world.
So I would say the inverse holds in respect of red money overdrafts and green money in a dual world.
I think this is all consistent with Nick’s own approach as identifying the real world as dual. He starts by renaming overdrafts as red money.
(I have a problem at origin with this formally because there is no red money payment instrument that explicitly instructs the transfer of red money in the real world (although as I described above it is not difficult to visualize an instruction that does exactly that), and therefore red money is not really a medium of exchange in the real world. That part of the discussion is one of counterfactual equivalence rather than existence. In that sense, I wouldn’t start out by equating real world overdrafts to red money. I would pursue that tweak as an “as if” counterfactual.)
“It’s a non-monetary asset, just like a negative balance is a non-monetary liability in the real world.”
Yes, I think this applies to real, green only, and red only worlds.
E.g. I’d identify an overdraft as a non-monetary liability in the real world.
“Are we now talking about the real world?”
I’m talking about any world where a green money payment instruction is used, by either restriction or choice.
Conceptually or semantically, I have no problem with the idea that a positive green money balance (stock) can be transferred from a starting balance of 0, to result in a negative balance. It is clear that a positive balance ends up at the destination account. So it must be taken from the origin account. It just happens to result in a negative balance at the origin account (or borrowing).
Partly semantics, but partly to have consistency in terms of arithmetic additivity/subtractability. If something called an overdraft or a negative balance or a red money balance is allowed as the result of a green money payment, then it makes sense to me. And one of those things must be allowed for the full balance to end up at the destination account.
Maybe we disagree there.
“not given to thinking too deeply about things unless I think there is something serious at stake”
I prefer serious thinking about intriguing ideas (e.g. green/red utopia) over bad thinking about allegedly serious ideas (e.g. those who mangle the difference between fiscal policy and monetary policy in “helicopter money” discussions)
roughly speaking, a payment instruction in red money might look something like “receive to the order of” instead of instead of “pay to the order of”
that instruction would command the seller to transfer a red liability to the buyer (who “receives” a red money liability balance)
the instruction flows from buyer to seller, but the payment flows from seller to buyer
the instruction flows in the same direction as for a green payment, but the instructed flow is in the opposite direction
The whole red/green conversation has been held with everyone involved explicitly turning a blind eye to the subject of credit risk. I thought that was established pretty much from the start?
Switching quickly to the real world (skip to the end, if you can’t handle it), it seems clear that there is a strong asymmetry between adding to one’s account and subtracting from it, at least beyond the magic of the number 0. In an overdraft only (i.e. no other types of loans) world, there is a hard cap on the negative side for each individual involved and everything account movement below 0 is subject to scrutiny and unilateral action from the bank. Positive balances could all end up in one place and no one (at the bank) would care.
Say everyone has an overdraft limit of 50. All but one could max out their overdraft and while the lucky winner (or loser, if you’re Warren Mosler) would end up with all the positive balances to his / her name. That is very different from a red money world in which there is no control over where the money goes.
Expanding to a more fuzzily constrained world with (perhaps collateralised) loan contracts, it still seems obvious that it is the limit of the loan (the amount subtracted from an account) that has to be negotiated with the credit institute while I’ve never heard of a bank that turned down an incoming payment to one of its customers (correct me if I’m wrong, JKH).
That’s why it’s unproblematic to print green money and have it circulate anonymously but why there’ll never be red bills. The business model of banking says it must be so.
Maybe the ECB is different in that neither it nor its customers are businesses. I would be interested in knowing more about the arrangements in other currency unions and what it is that keeps individual member countries from running off with the loot. CFA franc, anyone? J.P. Koning? Wiki says it is guaranteed by the French treasury.
“with everyone involved explicitly turning a blind eye to the subject of credit risk”
I recall that being covered very early on
i.e.
its a generic problem/challenge, but it hasn’t been ignored in the full discussion
“How about the first real revolution in macroeconomics since Keynes? ;-)”
Which one would that be Antti?
I’m still trying to understand Keynes.
but it hasn’t been ignored in the full discussion
I was having my doubts reading through the comments. But I might well be wrong.
JKH said: “I’d identify an overdraft as a non-monetary liability in the real world.”
Assume a green only world to keep it simple.
I do not get that at all.
Oliver,
“I was having my doubts”
I haven’t gone back, but I think you’ll find reference to it in comments under this post as well as under the “Cunning Plan” post preceding it.
It’s also a fairly central idea in the text of this post:
“But there is also one asymmetry: the red world has a fundamental problem. Each individual can increase his utility by buying more goods and selling less goods, thereby accumulating an infinitely large stock of red money. The bank that issues the red money needs to put some limit on each customer’s holdings of red money, to ensure this does not happen.”
That’s about credit risk.
Yes, it’s there. There could of course just be a cap on the total stock of red money and not on each individual’s stock. That implies Nick has credit risk and banks at the back of his mind. But anyway, I tend to get lost in the comments and forget what the original post was about. I guess I’m suspicious when commenters claim to be having an epiphany while referring to an imaginary concept. Forget about it.
“I guess I’m suspicious when commenters claim to be having an epiphany while referring to an imaginary concept”
epic
Oliver
An occasional holiday from reality can be pleasant.
But I’m not sure I’d want to live there.
I’m enough of a hippie to agree with that. And it’s been very educational so far.
JKH: “That’s about credit risk.”
Yep. I was just about to copy and paste that section of the post into this comment, then looked up and saw you had already done it.
Oliver: “There could of course just be a cap on the total stock of red money and not on each individual’s stock.”
I don’t think that would work. Each individual would rush to max out and hit that total limit first.
But, the puzzling thing is, I’m not sure whether this actually happens in real world red/green monetary systems like LETS.
Yes, I also imagine that would’t work. I stated that merely as a hypothetical alternative by which a certain amount of symmetry could have been preserved. If that had been your intention.
I’d be interested to know more about such systems and your opinion on why they don’t implode, or at least not as quickly as one might expect.
Ramanan has a good related post on TARGET2.
I must say I personally find the term “accommodating” to be somewhat nebulous and uninspiring. I dislike the way Godley and Lavoie use it, and I dislike it elsewhere such as in the Meade quote provided by Ramanan.
“Accommodation” in this case merely refers to the fact of how net flows of reserves between NCBs are reflected as corresponding TARGET2 offset positions. When the Bundesbank receives net incoming reserve liabilities due to flows from other NCB areas, it needs to be compensated with corresponding value in some way by the rest of the Eurosystem. This is done by reflecting a TARGET2 asset on the books of the Bundesbank.
Similarly, any kind of clearing system that allows net surpluses or deficits on the books of members (e.g. the typical CB system) can be said to be “accommodating” in this very general sense.
“Accommodation” is inherent in the purpose and design of a clearing system. A net clearing position is a residual, and it gets reflected as a residual on the books of the members.
“I must say I personally find the term “accommodating” to be somewhat nebulous and uninspiring.”
JKH,
I think it’s a useful term. It distinguishes balancing official funds flows (essentially flows which settle imbalances) from commercial funds flows (i.e. payments made in the course of ordinary business, which cause the imbalances).
The interesting point Ramanan makes is in his last paragraph. He says T2 balances cannot rise unimpeded. The natural restraint is the amount of collateral banks have to offer their NCBs when borrowing from their NCBs. A point that had escaped me hitherto. (You’ve probably already mentioned this in one of your posts.)
JKH: I’ll get back to my “epiphany” in more length tomorrow, but a few words now:
I know the word should be used very sparingly, but if ever in economics, now we have two paradigms here. You seem to consider a payment or a transfer going in certain direction a fact, but that it is not. It is just a way, specific to certain model/theory, to describe phenomena (which consist mainly of the accounting entries). This is what I meant when I said that you cannot invoke conventional or legal language to prove your point. Someone saying that a credit (or, green money) balance is transferred doesn’t make it so. No matter who that someone is, or how many of those “someones” are out there. You’re free to think in terms of that kind of transfer; conceptually or semantically there is nothing wrong in it. But likewise, Nick is free to think that it’s actually a debit balance of the seller which is being transferred to the buyer. The entries are the phenomena; the rest is just words describing the alleged meaning of those entries.
You said: “It is clear that a positive balance ends up at the destination account.”
Does this mean that if the destination account happens to be overdrawn, then you don’t see a positive balance being transferred?
To another subject:
Your latest comment made me think of the simplest way to put the purpose, or essence, of TARGET2. You say “how net flows of reserves between NCBs are reflected as corresponding TARGET2 offset positions”. I see what you mean (total reserves up in one country, down in another country), but you might have already realized that I don’t like to talk about “flows” of reserves.
I think it’s important to keep in mind that the purpose of the Eurosystem (ECB+NCBs) is to enable a common banking system for the whole Eurozone (or so I’ve understood). This means that non-banks have to be free to choose in which commercial bank’s ledger they have their liabilities (“loans”) and claims (incl. “deposits”) recorded. This of course applies both within and across countries. Commercial bank reserve balances in NCB ledgers are about non-bank claim flows (if we adopt that language) within the country. TARGET2 is about non-bank claim flows across countries.
So, I’d say this is about free movement of non-bank claims (part of the EU-wide ambition of free movement of capital). If you want to have that, you have to accommodate. If you can’t force private actors to “balance the books” across countries, then you — you being the Eurosystem — have to balance the books (and that’s easy, unless you start putting constraints on TARGET2 balances). (I think I’m partly building on your earlier posts on TARGET2.)
JKH: I’ll get back to my “epiphany” in more length tomorrow, but a few words now:
I know the word should be used very sparingly, but if ever in economics, now we have two paradigms here. You seem to consider a payment or a transfer going in certain direction a fact, but that it is not. It is just a way, specific to certain model/theory, to describe phenomena (which consist mainly of the accounting entries). This is what I meant when I said that you cannot invoke conventional or legal language to prove your point. Someone saying that a credit (or positive, or green money) balance is transferred doesn’t make it so. No matter who that someone is, or how many of those “someones” are out there. You’re free to think in terms of that kind of transfer; conceptually or semantically there is nothing wrong in it. But likewise, Nick is free to think that it’s actually a debit balance of the seller which is being transferred to the buyer. The entries are the phenomena; the rest is just words describing the alleged meaning of those entries.
You said: “It is clear that a positive balance ends up at the destination account.”
Does this mean that if the destination account happens to be overdrawn, then you don’t see a positive balance being transferred?
To another subject:
Your latest comment made me think of the simplest way to put the purpose, or essence, of TARGET2. You say “how net flows of reserves between NCBs are reflected as corresponding TARGET2 offset positions”. I see what you mean (total reserves up in one country, down in another country), but you might have already realized that I don’t like to talk about “flows” of reserves 🙂
This is again a case where I don’t think we disagree, but for what it’s worth:
I think it’s important to keep in mind that the purpose of the Eurosystem (ECB+NCBs) is to enable a common banking system for the whole Eurozone (or so I’ve understood). This means that non-banks have to be free to choose in which commercial bank’s ledger they have their liabilities (“loans”) and claims (incl. “deposits”) recorded. This of course applies both within and across countries. Commercial bank reserve balances in NCB ledgers are about non-bank claim flows (if we adopt that language) within the country. TARGET2 is about non-bank claim flows across countries.
So, I’d say this is about free movement of non-bank claims (part of the EU-wide ambition of free movement of capital). If you want to have that, you have to accommodate. If you can’t force private actors to “balance the books” across countries, then you — you being the Eurosystem — have to balance the books (and that’s easy, unless you start putting constraints on TARGET2 balances). (I think I’m partly building on your earlier posts on TARGET2.)
“I think it’s a useful term. It distinguishes balancing official funds flows (essentially flows which settle imbalances) from commercial funds flows (i.e. payments made in the course of ordinary business, which cause the imbalances).”
I think that’s not really the first order distinction.
The elementary distinction is that of what a clearing system does – how it works.
In the case of TARGET2, changes in central bank reserve liabilities are cleared.
In the case of a single central bank, changes in commercial bank deposit liabilities are cleared.
They’re inter-bank clearings in both cases: inter-central and inter-commercial.
So the essence of the accommodation idea is not in official versus private flows.
That’s just the particular circumstance of the application in TARGET2.
Apart from that, I have an objection to the use of the particular term. Not exactly sure why, but I’ve never liked it.
Obviously a minor, idiosyncratic point that probably indicates I’ve spent too much time on these threads.
P.S.
Somebody else mentioned the collateral point.
I’d say that commercial bank balance sheet expansion and deposit creation is the more elementary constraint – collateral availability being an important part of that.
Let me put it this way:
The “accommodation” whereby the ECB grants a positive TARGET2 balance to the Bundesbank as a result of cumulative net inflows from the rest of the Eurosystem is no different in logic than the accommodation whereby the Bundesbank on a particular day grants a positive reserve balance to Deutschebank as a result of Deutschebank experiencing net inflows from other banks in Germany on that day.
“I’d say that commercial bank balance sheet expansion and deposit creation is the more elementary constraint”
I think the thing is that refinancing of inter euro zone commercial bank liabilities by the NCBs was a major cause of T2 balance increases – I think it is in that context Ramanan made his point.
JKH,
Thanks for linking.
Henry,
What I meant when discussing the collateral was this: in the late stage of capital flight, such as someone selling Greek securities and transferring funds to Germany, banks become more and more indebted to their NCB. They need to provide collateral. When it’s getting difficult normal lending operations of the NCB no longer works but there’s provision for ELA in which the government provides some sort of guarantee for the banks. Once even this becomes troublesome … something even drastic needs to be done such as capital controls.
Ramanan,
The context is the crisis in the EZ during the early years of the GFC when T2 balances began to rise markedly. OK, you are emphasizing capital flight. There was capital flight but there was also the need to refinance the cross border liabilities of euro zone banks, which from what I have read was a larger problem (?). As the markets had essentially frozen, refinancing became almost impossible. So the NCBs stepped in and provided the refinancing, in the process creating more central bank money. The banks were then able to meet their cross border liabilities – so there was a cross border flow of funds which gave rise to the sharp lift in complementary T2 balances.
Trying it out, to see what it sounds like: “Individuals’ chequing account balances as cumulative accommodating item in their [flow of funds??] accounts”.
Dunno. Not obviously wrong. Dunno how much it helps. I think we need something like “default option” (not in the financial sense, of going bust, but in the computer sense, of what happens unless you make a deliberate choice to change it). Ramanan’s “residual” sorta captures this sense.
Canadian commercial banks have to make a deliberate choice every night if they want their balances at the Bank of Canada to return to (near) zero.
But setting that word aside, what Ramanan says seems right to me. But isn’t it somewhat similar to what we used to call the “official” account on the Balance of Payments? Meaning gain/loss of forex reserves.
“But isn’t it somewhat similar to what we used to call the “official” account on the Balance of Payments? Meaning gain/loss of forex reserves.”
Nick,
I made that point above somewhere. The standard fixed exchange rate system is foreign reserve constrained.
However, in the T2 system, there is no settlement required, so there is no reserve constraint and additionally, NCBs can create “foreign reserves” ad infinitum anyway, because they can create euro to their hearts content, euro both being their internal currency and the currency of cross border eurosystem payments. And as Ramanan points out the only constraint is the collateral available against which NCBs will lend to banks within their national boundaries for the purposes of refinancing cross border liabilities. No collateral, no lending. No lending, no cross border payments. Although this does not necessarily apply where the payments in consideration are related to normal trade and capital flows.
“Although this does not necessarily apply where the payments in consideration are related to normal trade and capital flows.”
To be clear, I should say:
“Although this constraint does not necessarily apply where the payments in consideration are related to normal cross border trade and capital flows.”
Nick:
Canada must have unbalanced money flows between regions, like every other large economy. Groups of individuals, if they are borrowing money, can elect to spend the majority of their borrowed money outside of their local economic area. (Maybe they buy cars.) The macro-economic problem I see is locating the pathway leading to recapture of exported money (for loan repayment) after the money has come to rest out-of-area (in the auto-building locality) .
I think that TARGET2 imbalances reflect the same problem.
Roger: True. And (even though Canadian commercial banks aren’t very regional), there may be one-way flows of money from one commercial bank’s customers to another. And during the day, this would show up on the Bank of Canada’s version of Target2. But, as I explained in the post, the 50 basis point spread between interest rates on positive and negative balances mean that the commercial banks themselves do the recycling every night.
Nick: I was thinking more about the ability of individuals to repay their loans if control of the borrowed money has moved to other areas.
The following is lifted from Godley and Lavoie. I confused the term “accommodation” with their use of the term “compensation”. The passage relates to FX reserve management, so it is relevant to part of the discussion here. It reminds me of the idea of “accommodation” (e.g. the last few sentences). Perhaps Ramanan will have more to say about this.
“The compensation principle asserts that changes in foreign reserves will generally be compensated by endogenous mechanisms that are tied to the normal behaviour of the central bank and to that of the other economic agents in the economy. The compensation principle would also operate in an open economy with private bank money.
Mainstream economists usually hold that, whereas otherwise it may be considered to be an exogenous variable, the money supply is endogenous in the case of an open economy with fixed exchange rates. This instance of endogeneity of the money supply process has nothing to do however with the endogenous money supply process that has been presented in this book and by post-Keynesian authors in general. In the Mundell–Fleming approach and in the so-called ‘monetary approach to the balance-of-payments’, the money supply is said to be endogenous in the case of fixed exchange rates, but this endogeneity process is supply-led. There, the stock of money falls or rises because the amount of foreign reserves falls or rises. In the open economy case described by mainstream authors, the money supply increases endogenously, but independently, of the demand for money expressed by the economic agents. Changes in interest rates then adapt the endogenous, but autonomous, increase in the money supply to the unchanging money demand schedule.
This sort of endogeneity of the money supply is totally at odds with the type of endogeneity underlined here. In the post-Keynesian approach and in Model OPEN in particular, the money supply is endogenous because it is demand-led. In Model OPEN, the money supply grows (or diminishes) because more (or less) of it is being demanded by the households of the domestic economy. When agents desire more cash money, the central bank provides the banknotes to the users of the monetary system. Assets are supplied, at given interest rates, on demand and in exactly the right proportions. The number of equations and unknowns in the model is such that there is no way to describe (net) asset supplies other than as passive responses to demand.”
JKH,
I think the compensation principle refers to what happens to the monetary base and the money supply when the central bank buys or sells foreign exchange. Mundell said that if a central bank buys foreign exchange it will increase the money supply since it has to pay by creating bank reserves. In the simplest case … such as France before it joined the Euro … which had what Marc Lavoie calls “overdraft financial system” … in which central bank assets are mainly lending to banks instead of government bonds … lead to banks reducing their indebtedness toward the central bank.
So that I think is different from the accommodation thing which is about transactions between residents and non-residents. Compensation is about transactions which do not enter BOP.
Henry @December 03, 2016 at 05:51 PM
Yeah.
Also the debts between NCBs itself is unlimited by law.
Click to access l_01820060123en00010017.pdf
“The ECB and each of the NCBs shall open an interNCB
account on their books for each of the other
NCBs and for the ECB. In support of entries made
on any inter-NCB account, each NCB and the ECB
shall grant one another an unlimited and uncollateralised
credit facility”
The limit appears because when capital flights are high – as happened in some countries then banks come under severe pressure because they are moving toward the limit reached for borrowing from their NCB.
JKH: I assume you don’t see a positive balance being transferred from the borrower’s loan account to his checking account in the traditional “loans create deposits” case? Or do you? As far as I know, this is commonly seen as creation of two balances “out of nothing”, not a transfer of a balance from one account to another.
Antti, I used the term epiphany. But it seems I misunderstood you – apologies. Within the constraints I reiterated above, I agree with your point, although I’m not sure I’d place it in the category of revolutionary ideas. Reminds me of when my math teacher at school started writing x + (-y) instead of x – y.
Antti, personally I find the idea of bits of paper circulating very much at odds with the idea of marking accounts up and down. Adding another type of paper that ‘flows’ in the other direction does not resolve that particular dissonance. I found it did make me think about the differences between the way accounts are marked up and the way they are marked down, though.
Ramanan,
Thanks.
Agreed.
However, my earlier point was that the substance of the accommodation idea is that of a central bank clearing system. So I see no difference in concept between the ECB as clearer of (changes in) NCB reserve positions and the Bundesbank as clearer of (changes in) commercial bank deposit positions. As I pointed out in the first comment under this post, the difference lies in the natural response of the clearing members to the imbalances that otherwise result. The NCBs make no attempt to adjust their surplus or deficit positions (i.e. they don’t directly respond to them with market transactions), given their arrangement for sharing risk and financial results across the group. Conversely, the commercial banks do respond with market transactions intended to minimize cost inefficiencies resulting from material surplus or deficit positions. They try and manage their “accommodated” position as activity as possible. However, that is just a response to what is delivered otherwise through accommodation. So, given the basic similarity in the so-called “accommodating” nature of the clearing systems, I see the fact that TARGET2 involves international imbalances and the NCB clearing system doesn’t as a secondary characteristic of the conceptual and operational nature of “accommodation”.
On what I now remember as the “compensation” principle, I agree it’s sort of an orthogonal issue. However, the text I quoted describes a way in which central banks accommodate the demand for domestic reserve settlement balances when that suddenly changes due to FX intervention (contrary to how Mundell-Fleming models it). I think you might agree that the way in which G&L understand that is that this is necessary, given that the central bank sets the domestic policy interest rate, and requires that the demand for domestic reserve settlement balances be in “equilibrium” with that target (although I’m not sure they included an example of compensation from a starting QE reserve position where interest is paid on reserves).
Ramanan,
“Compensation is about transactions which do not enter BOP.”
You are far more up to speed than me on the details of balance of payments accounting.
But doesn’t a change in the FX reserve position enter into BOP?
I.e. at least gross if not net?
As in Nick Rowe’s last comment above?
Compensation as described is in response to such changes.
Antti
I agree with the concept that “loans create deposits” from both an operational and accounting perspective
I don’t believe in either simultaneity or the reverse from a causal logic perspective, because the bank has to do credit risk on the loan prior to granting the deposit
While it may be argued that the entries are temporally simultaneous, causal logic order trumps temporal operational order in this case, IMO
I also agree with the flow of funds accounting framework whereby deposits fund loans
I see no contradiction in the language or the concept
(If a bank is competitively short funds on its existing asset base, and is otherwise forced into CB LLR, but finds a private sector source of funds to prevent that, then we can say from a common sense perspective that the private sector source is “funding” the asset base at the margin. or replacing the funding that might otherwise have come from LLR. The creation of deposits from loans at origin is just a quirk of the particular kind of liability issued at origin. It doesn’t change the appropriate framing for flow of funds accounting IMO.)
JKH,
The compensation part is not the central bank buying or selling FX reserves itself. It’s what happens after that – between banks and the central bank. Hence I made the distinction on whether it appears in BOP or not.
I agree about your point about clearing.
But the reason I went into this is because of historic reasons on how this came about. I think you may have seen this paper by Peter Garber: http://www.nber.org/papers/w6619.pdf
Earlier the Euro Area countries had agreements on how to deal with cross border flows and how central banks had facilities with each other. However the central banks probably lacked confidence in giving each other unlimited credit and TARGET2 achieves that.
Ramanan
right
if the CB drains domestic settlement reserve balances by selling FX reserves, then the “compensation” is considered to be the follow up OMO to resupply reserves
(I was just associating the two things jointly)
Nick,
Official account also seems fine. But not all transactions in the official account are accommodating. One can think of autonomous transactions on the official account.
Antti
Maybe you’ll find this of interest:
http://monetaryrealism.com/loans-create-deposits-in-context/
“One can think of autonomous transactions on the official account.”
which might reinforce my point about not associating the particular TARGET2 form of accommodation in too general a way with the idea of international imbalances ?
JKH,
What do you mean by that?
Ramanan,
same point as before
accommodation has to do directly with clearing systems
TARGET2 is a clearing system
it just happens to be directly associated in its particular form with international imbalances
i.e. the NCBs don’t actively manage their “accommodated positions”
i.e. TARGET2 is essentially clear of autonomous flows in that sense
so the accommodated position is the net international position, more or less
but in a counterfactual – if the NCBs did undertake autonomous transactions
then the net accommodation wouldn’t reflect the net international position, because part of the official flow would be autonomous rather than accommodating
so … don’t associate the particular case of TARGET2 as a general rule for the general meaning of accommodation
i.e. generally speaking:
accommodated position does not necessarily = net international position
e.g this is specifically not the case for the plain vanilla case of domestic clearing systems, as per my earlier point on the essential abstracted meaning of accommodation
When an individual sees the balance in his chequing account getting too positive or too negative, he takes deliberate action to stop it. There is a negative feedback loop.
Same with commercial banks’ positions in their chequing accounts at the Bank of Canada.
In David Hume’s price-specie flow mechanism, or in the Monetary Theory of the Balance of Payments with fixed exchange rates, there is also a negative feedback loop, though without deliberate action by the central banks.
There doesn’t seem to be a similar negative feedback loop with TARGET2.