Sunday, 1 January 2012

My quibble with the vice-president of the ECB’s speech.

Warning: this post is a bit technical, semantic and arcane.

Vítor Constâncio, vice-president of the ECB makes the following claim:

“Central bank reserves are held by banks and are not part of money held by the non-financial sector, hence not, per se, an inflationary type of liquidity. There is no acceptable theory linking in a necessary way the monetary base created by central banks to inflation.” (Hat tip to Mike Norman.)

I have no quarrel with Constâncio’s attack on the idea that boosting bank reserves boosts bank lending, which is the basic point he makes here. But I don’t fully agree with the above quote from C’s speech.

When bank reserves rise by $X, the amount deposited in commercial banks will most likely rise by the same amount, all else equal. To illustrate, suppose $Y of my govt bonds are QE’d. I get a cheque for $Y from the central bank. I deposit the cheque at my commercial bank, and the latter deposits the cheque at the central bank. Net result: bank reserves rise by $Y and deposits at commercial banks rise by $Y.

The only exception would be where the govt bonds QE’d are bonds owned by some commercial bank.

The result of the above “$Y” operation is that private sector net financial assets do not rise, but they DO BECOME more liquid. In addition, having a central bank buy govt bonds is the classic way of enforcing an interest rate reduction, and it is generally agreed that interest rate reductions are stimulatory, (and if the stimulus goes too far, inflationary.) So, contrary to C’s claims, there certainly are transmission mechanisms via which a rise in reserves could be inflationary.

That can all be put another way – sort of – as follows. The only reason that (quoting C) “central bank reserves are not part of money held by the non-financial sector” is that very few private sector entities are allowed to have accounts at central banks: that is, most private sector entities have to employ commercial banks as agents when those entities come by some central bank money (as in the case of QE). But that is a feeble argument for saying that private sector non-bank entities don’t hold or possess central bank money.

So how should C have phrased the above quoted two sentences? I think he should just have said something like “An increase in bank reserves as such does not encourage extra bank lending”. And that’s it. In trying to broaden the point too much and include ideas about “no acceptable theory linking in a necessary way the monetary base created by central banks to inflation” he tripped up.

He should have me as his speech writer – then he’d REALLY trip up.



  1. Interest rate reductions are only stimulatory when the private sector is looking to expand its borrowing in aggregate.

    That is not the case at the moment. Private sector borrowing is shrinking and that alters the monetary dynamics. And it is not shrinking because money is too expensive. It is shrinking because there are no profit opportunities from asset pump and dimp schemes.

  2. Fair point Neil. I think interest rate adjustments do have a FINITE effect, but my hunch is that it’s a feeble effect.

    Also, in trying to persuade those with conventional views on interest rates about the weakness in Constancio’s argument, there’s no harm in me appealing to conventional ideas on interest rates: there is nothing like confounding people with their own arguments. Totally dishonest, of course!


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