The textbook model is obsolete because banks don't make lending decisions based on how many reserves they have. They can always get the reserves they need. If customers don't walk in the door with new deposits, the bank can borrow deposits from other banks, something they can now do at the very low Fed funds rate of .2% (1/5th of 1%). And if those deposits are not available, the Federal Reserve itself will supply the reserves. This was confirmed in a BIS working paper called "Unconventional Monetary Policies: An Appraisal", which observed:
"[T]he level of reserves hardly figures in banks' lending decisions. The amount of credit outstanding is determined by banks' willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. . . .
"The aggregate availability of bank reserves does not constrain the expansion [of credit] directly. The reason is simple: . . . in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost . . . of loans, but does not constrain credit expansion quantitatively. . . . [A]n expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. Given the very high substitutability between bank reserves and other government assets held for liquidity purposes, the impact can be marginal at best."
Again, one form of liquidity is just substituted for another, without changing the overall level in the pool.
If bank reserves do not constrain bank lending, what does? According to the BIS paper, "the main . . . constraint on the expansion of credit is minimum capital requirements." These capital requirements, known as "Basel I" and "Basel II," were imposed by the BIS itself. It is interesting that the BIS knows that the main constraints on bank lending are its own capital requirements, yet it is talking about raising them, in an economic climate in which lending is already seriously impaired. Either the BIS is talking out of both sides of its mouth, or its writers don't read each other.
A Solution to the Federal Debt Crisis?
Another interesting aside arising from all this is the suggestion that the government could actually print its way out of debt it could print dollars and buy back its bonds -- without creating inflation. As Roche observes:
"[Quantitative easing] in time of a balance sheet recession is not actually inflationary at all. With the government merely swapping assets they are not actually "printing' any new money. In fact, the government is now essentially stealing interest bearing assets from the private sector and replacing them with deposits. . . . [T]his policy response would in fact bedeflationarynot inflationary."
Roche concludes, "the inflationistas have been wrong and the USA defaultistas have been horribly wrong." The "inflationistas" are the pundits screaming that QE will end in hyperinflation, and the "defaultistas" are those insisting that the U.S. must eventually default on its debt. Representing both camps, for example, is Richard Russell, who writes:
"In my opinion, the US MUST default on its debt. There are two ways to default. One is simply to renege on the debt. . . . The other way to default on the debt is to inflate it away. I'm absolutely convinced that this is the path that the US will take. If the US inflates enough, then over time (many years) the devalued dollar will tend to reduce the power of the debts."
The failed QE experiments in Japan and the U.S. suggest, however, that there is a third alternative. Printing dollars to pay the debt (referred to by Russell as "inflating the debt away") might actually eliminate the debt without creating inflation. This is because federal bonds and Federal Reserve Notes are interchangeable forms of liquidity. Government securities trade around the world just as if they were money. A $100 bond represents a claim on $100 worth of goods and services, just as a $100 bill does. The difference, as Thomas Edison said nearly a century ago, is merely that "the bond lets money brokers collect twice the amount of the bond and an additional 20%, whereas the currency pays nobody but those who contribute directly in some useful way. . . . Both are promises to pay, but one promise fattens the usurers and the other helps the people."
The Fed's earlier attempts at QE involved swapping $1.25 trillion in mortgaged-backed securities (MBS) for dollars created on a computer screen. As noted in the NPR segment, many of those securities have come due and have gotten paid off, putting cash in the Fed's till. The Fed now proposes to use this money to buy long-term Treasury debt rather than MBS. That means the Fed will, in effect, be buying the government's debt with dollars created on a computer screen. The privately-owned Federal Reserve is not actually an arm of the federal government, but if it were, the government would thus be printing its way out of debt just as Helicopter Ben proposed in 2002. Recall that he said, "the U.S. government has a technology, called a printing press" the U.S. government, not the central bank that has done all the QE to date.
Running the government's printing presses to pay its bills has not seriously been tried since the Civil War, when President Lincoln saved the North from a crippling war debt at usurious interest rates by printing Greenbacks (U.S. Notes). Other countries, however, have tested and proven this model more recently. They include Germany, which pulled itself out of a massive financial collapse in the early 1930s by printing a form of currency called "MEFO bills"; and Australia, New Zealand and Canada, all of which successfully funded public works in the first half of the twentieth century simply by advancing the credit of the nation. China, Malaysia, Guernsey, Jersey, India, Argentina and other countries have also revived their economies at critical times by this means. The U.S. government could do this too. It could print dollars (or type them into electronic bank accounts) and spend the money on the sorts of local public projects that would put people back to work and get the economy rolling again.
Do a Helicopter Drop on the States
The government could pay its bills by issuing Greenbacks as Lincoln did, but it probably won't, given the current deadlock in Congress. Today only the Federal Reserve Chairman seems to be in a position to act unilaterally, without asking anyone's permission. Chairman Bernanke could execute his own plan and generate the credit needed to get the economy churning again, by aiming his "quantitative easing" tool at the states. After all, if Wall Street (which got us into this mess) can borrow at .2%, underwritten by the Fed as "lender of last resort," then state and local governments should be able to as well. Chairman Bernanke could credit the Fed's account with money created ex nihilo (out of nothing) and swap it for state and municipal bonds at the Fed funds rate.
A "state" might not qualify as an "individual, partnership or corporation" under Section 13(3) of the Federal Reserve Act, but a state-owned bank would. Bruce Cahan, an attorney and social entrepreneur in Silicon Valley, California, proposes that the Fed could diversify its role by buying long-term bonds in existing or newly-chartered state-owned banks. These banks, which would have a mandate to serve state and local communities, would more quickly and accountably lend for in-state purposes than private banks do now. They could be required to use accepted transparency accounting standards to trace how the proceeds of their loans flowed into the economy. Local needs would thus determine how best to jumpstart and keep alive businesses and households that the "too big to fail" megabanks no longer want to fund on fair credit terms. Adding a state-owned bank would also bring competition to regional banking markets such as that of the San Francisco Bay area, which are now dominated by out-of-state megabanks. By funding state-owned banks, the Fed could inject "liquidity" where it is most needed, in local markets where workers are hired and real goods and services are sold.
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