Hoenig falls for the popular myth that bank capital is expensive.

Federal Deposit Insurance Corp Vice Chairman Thomas Hoenig says that requiring banks to fund themselves via more capital or capital/equity like instruments like bonds that can be bailed in will raise bank funding costs and hence force banks to make more risky loans to cover those costs.

Anat Admati, economics prof at Stanford, would be able to explain to Hoenig why capital is no more expensive than debt. But I’ll run thru the argument very briefly for the umteenth time. It’s very simple.

If a given bank is funded ENTIRELY by capital, the risks run by capital holders are EXACTLY THE SAME as if the bank is funded entirely or almost entirely by debt. E.g. if the chance of the bank’s assets declining to X% of book value are 1/Y in any given year when the bank is funded entirely by capital, then the chances of the same thing happening when the bank is funded by debt will be exactly the same. Ergo the charge made by debt holders and capital holders for funding the bank will be the same.

Oxford economics prof not allowed to pay cash for new car.

I’m still scratching my head over this.

Simon Wren-Lewis (Oxford economics prof) says he has enough cash to buy a new car. But when he tried to buy one, the car dealer said new cars could only be acquired via an interest free loan.

I suspect this is plain old trickery. I.e. I suspect if you look at the small print in the “interest free loan” agreement, you’ll find something like the rate of interest suddenly jumps to 10% after two years, but is not charged to car buyers immediately. That is, after three or four years, the car dealer can send car buyers a stonking great bill for interest and if there are any complaints, he just says that was all in the small print.

Banks increase the total amount of debt – what of it?

One function performed by private banks is to intermediate between borrowers and lenders, though they also create a certain amount of new money every year.

If there were no banks, then there’d be a big reduction in intermediation. I.e. while individual lenders would lend to individual borrowers, there’d be a big reduction in the total amount of lending and borrowing: that is, there’d be a big reduction in the total amount of debt. Put that the other way round: banks result in more debt.

Given that the word debt has negative overtones, that might seem like an undesirable outcome. Unfortunately, while overtones fool most of the people most of the time, they don’t prove very much.

A classic example is the phrase “national debt”, which the large majority of people, and possibly even the majority of so called “professional” economists, believe to be undesirable. That’s because (to repeat) the word debt has negative overtones, so the national debt must be bad, bad, bad. Incidentally the overtones are even worse in the German language, which helps explain Germany’s obsession with maintaining an external surplus, i.e. being a creditor rather than a debtor.

In fact, national debt can perfectly well be viewed as a form of saving, and if you like, called “National Savings”. That is (as MMTers keep pointing out), national debt is very much like a deposit account at a bank, with government playing the part of the bank.

Anyway, is there a problem with the increased amount of debt brought about by private banks? Well as long as debtors are able to pay the interest on their debt, there shouldn’t be a problem.

In other words to the extent that there are an excessive number of cases where debtors CANNOT pay the interest, i.e. where the lending is irresponsible, then clearly what private banks do is wrong: i.e. the increased amount of debt they occasion is undesirable.

Now what’s the basic cause of that sort of that irresponsibility (e.g. NINJA mortgages)?

Well one important cause is the fact that governments stand behind private banks. For example there is FDIC insurance for small banks in the US. As to large banks, Uncle Sam dishes out hundreds of billions of dollars at laughably low rates of interest to large banks in trouble, as happened in the recent crisis. And as to the UK, state backing for private banks has been provided free of charge since WWII. That is, unlike the FDIC system where at least banks pay an insurance premium, UK banks have obtained state protection for free until very recently.

But all the latter forms of state protection throw up a problem, namely: if the insurer pays when you lend in an irresponsible manner, why not lend irresponsibly and keep the profits when all goes well, while sending the bill to the insurer when it doesn’t? It’s a heads I win, tails you lose scenario.

Of course we couldn't just abolish all forms of state support for banks and leave it at that. But we could make money lending entities (aka banks) fund themselves in much the same way as any normal corporation, that is with substantially more capital than they currently do. Obtaining a third of funds from equity is perfectly normal for non-bank corporations, and Google is funded 90% by equity. Google, far as I know, is not a disastrous flop.


Conclusion.

It is hard to prove what the optimum amount of debt is. Thus it’s a big over-simplification to argue that just because private banks increase the total amount of debt that the effect of private banks is harmful. In contrast, what does the real harm is the backing for private banks offered by governments.  

Simon Wren-Lewis keeps quiet about pro-austerity academics.

This article by SW-L (Oxford economics prof) portrays the austerity versus anti-austerity argument rather too much as a left versus right argument for my liking. The baddies are the political right, while the goodies are the political left who have been allegedly trapped into buying the pro-austerity argument by devious righties.

SW-L is quite right to say that devious righties have forced many leading lefties to buy the pro-austerity agenda by repeatedly asking the question “What about the deficit?” every time the left proposes any sort of anti-austerity measure. And if the right has to enlarge on that deficit question, it just trots out the old nonsense about a government being like a household in that households have to balance their books.

Of course some righties (perhaps the majority) actually believe that governments can be compared to households. So the truth is that it’s a case of clever righties tricking dumb righties AND well meaning lefties.

Another possibility is that George Osborn and his pals seriously believe that households can be compared to governments, in which case the WHOLE OF the political right is dumb!

However, that’s not the whole story. The unfortunate truth is that there are plenty of so called “professional” economists who (like dumb righties) also don’t understand the differences between micro and macro economics: i.e. who don’t get the distinction between households and governments. SW-L as an academic understandably wants to keep quite about those individuals.

Two so called professional economists who quite obviously don’t understand the difference between macro and micro, and who have devoted a large amount of effort to opposing deficit increases are Kenneth Rogoff and Carmen Reinhart of Harvard. But so called professional economists working for the IMF and OECD are equally guilty.

What % of money for loans comes from intermediation?

Commercial banks which want to lend are forced to obtain some of the relevant money from savers, else those banks run out of reserves. At the same time, banks create a certain amount of money from thin air every year. So how much “loan money” comes from each of those two sources?

It could be argued that since the money supply expands at 5 to 10% pa, that the ratio is about 90% intermediation 10% origination. But is ONE YEAR the appropriate period? Probably not. I suspect the appropriate period is the duration of the average loan: say roughly 10 years, during which time the money supply would double roughly speaking (in nominal rather than real terms). So in that case we’re talking about an intermediation / origination ratio of about 50:50. But that’s very much a back of the envelope calculation.

It can be argued that when a loan is repaid, money vanishes, and when a new loan is granted, ALL OF the relevant money is created from thin air. That’s not a totally invalid way of looking at it. But it’s a bit of a silly way of looking at it, and for the reason given above, namely that a bank HAS TO attract some money from savers (including those who repay loans) else it runs out of reserves.

Thus the conventional view of banks adopted by those who have never opened an  economics text book, namely that they are piggy banks which cannot lend until they receive savings, is not totally invalid.

The moral is that if you think philosophy is abstract, you ain’t seen nothing: try working out what banks are and what they do.

How safe is the money you’ve deposited in your bank?

According to Ellen Brown, it’s increasingly unclear how safe depositors’ money is in the US and Europe. Reason is that banks use depositors’ money to place mega derivative bets, and want ever more freedom to do that. Plus banksters run rings round politicians and regulators when it comes to altering legislation so as to enable banksters to do that.

Assuming Ellen Brown is right, that’s just one more argument for full reserve banking. That’s a system under which money which is supposed to be totally safe is lodged with the state, while derivatives, loans to mortgagors and businesses and anything faintly risky is funded just like any normal corporation: that is by shareholders and bondholders who stand to lose everything if the worst comes to the worst.

Ellen Brown more or less says that in her final paragraph which reads, “Meanwhile, local legislators would do well to set up some publicly-owned banks on the model of the state-owned Bank of North Dakota – banks that do not gamble in derivatives and are safe places to store our public and private funds.”

Banks do intermediate.

Richard Murphy, affectionately known in some quarters as “Murphaloon”, wrote an article recently in which he gives advice to the economics Nobel laureate, Joseph Stigligz, on the question as to whether banks intermediate between savers and borrowers. This should be interesting. (I use the word “interesting” advisedly.)

Basically Murphaloon has fallen hook line and sinker for flavor of the month, which is that commercial banks when they lend, create the relevant  money out of thin air RATHER THAN acquire such money from savers. As he puts it, “The reality is that banks technically do not need any deposits to make a loan.”

If that were the case, one has to ask why banks have dished out hundreds of billions over the decades in the form of sweetners designed to attract the money of savers (i.e. shareholders, bond-holders, depositors etc). When I say “sweetners” I mean dividends for shareholders and interest for bond-holders and depositors.

The reality is that commercial banks engage in BOTH ACTIVITIES. That is, it’s beyond dispute that they create a certain amount of new money most years (apart from in the middle of severe recessions). That stares you in the face from the money supply figures. But at the same time, they DO INTERMEDIATE.

In support of his ideas, Murphy cites a recent Bank of England publication. As he puts it, “As the Bank of England conceded in April 2014, the idea that banks act as intermediaries between savers and investors is just wrong.” Well if you word search for “intermediate” in the BoE work you won’t find anything about the intermediation idea being “wrong”.

What the BoE publication DOES SAY (in the summary of its second section) is “…banks do not act simply as intermediaries, lending out deposits that savers place with them…”.

That’s correct. I.e., as I said above, commercial banks do intermediate, but that’s not all they do: in addition they create a finite amount of new money most years.


The intermediation process.

The reason why commercial banks must obtain a certain amount of savers’ money before lending is thus.

Additional loans means additional spending: people borrow specifically so as to spend the money on something. Assuming the economy is at or near capacity or “full employment”, additional loans / spending must be matched by a CUT IN SPENDING elsewhere. That cut could take the form for example of a cut in public spending, but assuming “all else equal” (including public spending), additional loans / spending must be matched by additional “abstinence from spending” somewhere, i.e. additional saving.

It could well be argued that when there’s additional lending, the free market does not raise interest rates by enough to cause an equivalent amount of extra saving. And if that’s the case, the central bank has to step in and boost any naturally occurring rise in interest rates by an artificial rise in interest rates.

But the fact remains that given additional loans, and assuming all else equal, and assuming full employment, there has to be additional saving.

Put another way, given EXCESS unemployment (i.e. plenty of spare capacity), additional loans can indeed be made with no corresponding saving. But unfortunately that point is of limited relevance because given a recession, the one thing that commercial banks DO NOT DO is the save the day by granting more loans. That is, commercial banks act in a pro-cyclical rather than anti-cyclical manner.

The $80 billion gift by taxpayers to banks.

I tried to estimate the total amount of taxpayers’ money effectively given to private banks during the crisis here a month ago. That estimate was way out. Apologies.

The best excuse I can offer is that I DID SPEND a fair amount of time trying to unearth figures for the total amount loaned by the Fed to private banks and what rate of interest was charged. Plus of course the Fed itself (and other central banks) have done everything they can to prevaricate, obfuscate and generally hide the truth about the size of the bailout. However, I’ve now stumbled across what looks like a better set of figures.

The figure often given for the total amount loaned by the Fed is something in the rough order of $15trillion, but that is very misleading because it seems to involve a lot of double counting.

To judge by an article by Mick West entitled “Debunked: The Fed "gave away" $16 Trillion….”, it looks like the total amount ever loaned at one one time was around ONE trillion. As to the PERIOD for which the loan lasted, obviously the amount loaned varied from month to month. But to judge from the chart in West’s article (see below) we’re talking about a loan averaging about $600bn, and lasting from around April 2008 to October 2009 (18 months).

As to the rate of interest, certainly SOME OF the loans were at a zero rate, but West seems to suggest the average rate was around 0.75%, and that’s certainly not the sort of rate that Walter Bagehot had in mind when he said that the central bank should lend at “penalty” rates to private banks in trouble.

As to what a realistic penalty rate is, that’s impossible to say with any accuracy, but Warren Buffet loaned a few billion to Goldman Sachs at the height of the crisis at 10%, so let’s take that as being a realistic penalty rate.

That means (continuing the back of the envelope calculation) that private banks obtained Fed money (i.e. taxpayer money) at 9.25% less than they should have. So I’m claiming the total effective gift by taxpayers to private banks was:

9.25% x $600bn x 1.5years = $83bn

It might seem that $83bn is not taxpayers’ money in that the money was produced from thin air by the Fed, not taken out of taxpayers’ pockets. However, money created by the state is effectively “the peoples’ money”: that is, the recession could perfectly well have been dealt with by using that “thin air” money in a variety of other ways, e.g. to boost public spending or cut taxes. Thus the $83bn is in effect taxpayers’ money.

But there is no reason for taxpayers to simply grin and bear it: that is, private banks could perfectly well be made to pay that money back. But that’s unlikely to happen: after all, banks make large contributions to politicians election campaigns precisely so as to ensure that banks continue to receive large dollops of taxpayers’ money.

_____

P.S. (3rd June 2006).  The opening sentences of this General Audit Office work confirm West's "$1trillion peak" estimate. On the other hand Elizabeth Warren (one of the few intelligent and honest people on Capitol Hill) talks about a $13trillion loan. My guess is she has fallen for the common "double counting" error that plagues this issue. She also confirms the above "negligible rate of interest" point.

Why didn’t QE money printing cause inflation?

When QE was first suggested a few years ago, the doomsayers and inflation-phobes predicted hyperinflation would result from the large amount of money printing involved in QE. One reason inflation didn’t increase was as follows.

As Joseph Huber and James Robertson explain in their work “Creating New Money”, the freedom that private banks have to create money from thin air and lend it out means that those banks can undercut existing savers. As Huber & Robertson put it:
 
“Allowing banks to create new money out of nothing enables them to cream off a special profit. They lend the money to their customers at the full rate of interest, without having to pay any interest on it themselves. So their profit on this part of their business is not, say, 9% credit-interest less 4% debit-interest = 5% normal profit; it is 9% credit-interest less 0% debit-interest = 9% profit = 5% normal profit plus 4% additional special profit.”

But if the existing rate for a zero or near zero risk loan is about 0%, then the scope for the above undercutting is much reduced! Huber and Robertson’s “creaming off” becomes much less profitable.

Put another way, the excess amount of base money currently sloshing around at the start of 2016 will not be inflationary until central banks attempt to impose a significant rise in interest rates. And at that point they may well find their efforts thwarted by the “Huber & Robertson” phenomenon.

A recent article by Christopher Phelan of the Minneapolis Fed deals with the potential for that excess supply of reserves to be inflationary. 
 
George Selgin also wrote an article about the “excess reserves” scenario. He actually considered what would happen if there was an economy where the only form of money was central bank money and privately issued money (i.e. fractional reserve banking) was then allowed. But that comes to the same thing as the above “excess reserves” scenario. Selgin’s conclusion was that there’d be excess inflation for a while – until the stock of reserves (in real terms) was down to the minimum that private banks needed.

One solution to the latter form of inflation would be to force private banks to hold a larger stock of reserves.