Debtor's Prison

Greetings Fellow Inmates,

On this venerable Winter Solstice, 12.21.09, or 12.19.16.17.2 in the Mayan Calendar, as the Sun traverses its lowest daily course through the celestial horizon, we here at DP staff contemplate the significance of this event and its allegorical importance to what is happening in the financial universe.   Many ancient cultures conceived the Winter Solstice to be the Sun, or God’s, lowest descent in the sky, signalling the end of an era (a year, or otherwise) and a 3-day window of uncertainty about whether the Sun would rise once again, thus renewing the existence of the Universe into a new era.    In the same way, we find ourselves at a financial dusk, when the current financial system will become unstable enough to warrant a massive systemic transition into a new system.   In this spirit, we will expand on the discourse from the last post, Monetary EASING, not tightening awaits us, by looking at Excess Bank Reserves (EBR).   As you know, EBR are part of the Monetary Base, and hence form the most fundamental type of liquidity in the financial system.   EBR are otherwise known as high-powered money due to the fact that it is this money that is supposed to course its way through the financial system and down the economy into people’s pockets.   It is precisely these EBR that are the digital zeros Uncle Benny creates out of thin air with his trusty computer to fund all his emergency lending programs and long-term debt purchases of US Treasury, Agency and Agency MBS.   Bear in mind that the entire focus of the media has been on the credit programs themselves, and we’ve all been dizzied into numb confusion by the endless barrage of the alphabet soup and asset purchase programs (quantitative easing), or in other words, the asset side of Uncle Benny’s Balance Sheet (FedBS).  We find truly astounding the degree to which the main-stream media, so-called economists, and policy makers have ignored the liability side of the FedBS – especially considering that it is precisely there that the problem and major cause of the upcoming fiat currency crisis lie.    Clearly, understanding EBR is of paramount importance not only to all of our own individual personal finances but also to the root causes that will lead to the collapse of the USD-backed global monetary system.  

As in our last post, we begin by introducing you to questionable literature from “reputable” sources; this time from the Federal Reserve Bank of New York.   The December 09 publication of “Current Issues in Economics and Finance”, entitled Why Are Banks Holding So Many Excess Reserves?, “authors” Todd Keister and James J. McAndrews attempt to explain in simple terms the cause and some potential consequences of the vast increase in EBR.   Similarly to our last post, we find much amiss in this publication as arguments are often weak, based on unlikely or nonexistent conditions, backed by little or no evidence and easily proven to be incorrect.   The paper attempts to explain that EBR are nothing but a “by-product” of Uncle Benny’s credit programmes, and dismisses them as largely inconsequential in the long run, with little or no inflationary effects.   We vehemently disagree with these statements and will attempt to demonstrate our refutations below.  The paper uses simple conceptual thought-experiments, which will serve as a good platform to explain how EBR work in practice.  We will use these experiments to highlight some important concepts as well as some uncertainties, unlikely or erroneous assumptions, devious misinterpretations and transparent manipulation/obfuscation in the original paper.   We will only partially use the paper to explain EBR and not quote as much of it as last time in order to not hurt the “authors”’ feelings like we did JEG’s, who apparently did not appreciate the rigour.  We really recommend you read the whole paper, it’s only 10 pages and some of this discussion might be clearer.

Quotes are in bold italics.

The paper’s abstract:

The buildup of reserves in the U.S. banking system during the financial crisis has fueled concerns that the Federal Reserve’s policies may have failed to stimulate the flow of credit in the economy: banks, it appears, are amassing funds rather than lending them out. However, a careful examination of the balance sheet effects of central bank actions shows that the high level of reserves is simply a by-product of the Fed’s new lending facilities and asset purchase programs. The total quantity of reserves in the banking system reflects the scale of the Fed’s policy initiatives, but conveys no information about the initiatives’ effects on bank lending or on the economy more broadly.

From the very onset we realize how vacuous this paper truly is.   Banks are in fact amassing funds, it doesn’t merely “appear” that way, it is a fact.   While reserves or EBR are a “by-product” of Uncle Benny’s credit programmes, they could equivalently be thought of as enablers/facilitators of the programmes.   They are in fact, opposite sides of the same coin.     EBR not only “reflect” the size of Uncle Benny’s initiatives, they are in fact the principal tool through which those initiatives are executed.   The exact level of EBR does in fact convey information about the “effect” of monetary policy on bank lending, as the authors inadvertently assume in their simplified model.  While on its own, the EBR level does not encode information about the economy at large, other well-established indicators do and we will explore them further below to conclude that in fact EBR are NEITHER negligible nor dismissible but rather are unpredictable, significant, inflationary, and difficult to manage.

Let’s begin by taking a look at what has happened with EBR for some perspective.

Notice that the growth was explosive since the collapse of Lehman.   We are currently near all-time highs and are they are likely going to grow even more as we have prognosticated before.   Previous to the Lehman crisis, total bank reserves were about $50bln, almost none of it EBR.   That means that during that time, no banks had any interest in holding EBR and would rather lend all the money out and earn the interest.   Keep this in mind for later.  Today, total reserves are $1.15tr (a 2,200% increase!), the vast majority of which is EBR.   This great increase corresponds to the great increase in Uncle Benny’s monetary adventures.    Below is a visual break-down of how the assets and liabilities on the FedBS break down.

Let us remind you, as you might notice from the graph that assets must be exactly the same as liabilities on the FedBS.  Therefore, an enormous increase in EBR is in fact necessary to support the great increase in the asset side of the FedBS.   It is not merely a “by-product”, it is a requirement, the only available tool, and co-consequential.   Increases in the asset or liability sides of the FedBS have no causal relationship between them insofar as they are always concurrent and equivalent.   Of course, one could argue that the given intent of a particular monetary policy could target a specific sector of the economy or financial system by employing either side of the FedBS, inevitably forcing the other side to adjust accordingly.  Therefore, manipulations of either side of the FedBS are not the cause of manipulations of the other, nor is either a “by-product” of the other.  They are both used simultaneously every time to achieve a given monetary aim.   In other words, much like our current situation, if the Fed wished to support a given credit market (like MBS) by purchasing bonds or to provide banks with emergency lending (thus using the asset side of the FedBS), it could only do so by increasing EBR (the liability side) by the same amount.   

The authors present a conceptual thought-experiment to illustrate what happens practically and sequentially to bank lending, deposits and EBR during a credit crisis.  We again recommend you read the paper to follow through some of the following details.   Succintly, the paper illustrates through a series of steps how in the case of a “credit crunch”, in which banks refuse to lend to each other and the Fed subsequently steps in to provide liquidity, EBR rise as a result of this liquidity.   Remember, EBR are not the “result”, but rather they are the liquidity.   I any case, the “authors” show in their example that an increase of $74bln in EBR would lead to a $20bln increase in total bank lending and an increase in $60bln of deposits. In other words, each dollar increase in ERB would lead to an increase of $0.27 in bank lending and an increase of $0.81 in bank deposits.  This is completely different than what is actually happening, as seen in the Numbers below.  The authors are careful to argument that the monetary easing through increases in EBR are not intended to increase bank lending, but rather to stop it from contracting.   In other words, as one bank demands repayment (or more collateral) from or refuses to lend to another bank, the Fed provides that liquidity so that the affected bank (Bank B) does not have to demand payment from its customers (the economy).   Let’s examine what has happened to total bank lending and total bank deposits in actual reality.  Below is a table of what has happened in the last 13 months, data courtesy of Uncle Benny.   Here is all the data, in XLS format.

We notice that from November 2008, only two months after Lehman, to December 2009, the Monetary Base increased by 66.6%.   If we take out the cash component of the Monetary Base, we see that EBR increased by 92.7%.   In the same time, total Bank Deposits, more representatively measured by Money of Zero Maturity (MZM) - a broad measure of deposits across the whole system -, grew by only 7.8%.   Meanwhile, bank loans actually declined by 6.3%.   In other words, in reality, for every dollar increase in EBR, there has been a proportional decrease of $0.07 in bank lending and an increase of only $0.08 in total deposits.  Clearly, reality is wholly different than the “authors”’ illustration of the allegedly “workings” of the banking system.   This alone is reason enough to discredit it entirely.   But, we continue on a couple of more points.  

Below is a chart of the Money Multipliers, which are the ratios of the broad monetary aggregates, which are in turn measures of the amount of immediate-term demand deposits in the banking system of swathes of the economy of increasing size.   In other words, in the traditional conception of the money multiplier model, which is supposed to be a repercussion of the fractional reserve banking system we are supposed to have, the banks’ lending of the monetary base money creates an expansion in the broad money supply.   As we have often said, the Money Multiplier Model is in fact disproven by data.  But let’s assume for now that it works.  

Notice the dramatic action!  While the MZM multiplier consistently increased starting in the mid 1990s.   It rose from 6.5 in 1995 to near perfect plateau of 10.0 during the 13 months leading up to Lehman’s collapse.  The value of 10 is curious, as this is the most often used rule-of-thumb in traditional economics textbooks to explain the “multiplying” effect of the fractional reserve banking system.   During the go-go ra-ra years of snake oil selling investment bankers and European, Latin American and Asian suckers, the MZM multiplier really took up.  Then, after Lehman, it collapsed to 4.6 today, and it shows no signs of stopping down this precipice.  In other words, whereas before the crisis, each dollar increase in EBR would coincide with about an $8-10 increase in total bank deposits (as measured by MZM), today, each dollar increase in EBR coincides with only a $4.5 increase in deposits, as measured by MZM.   M1, which measures a smaller section of the economy (excluding savings deposits, small-denomination time-deposits, money market mutual funds and institutional money funds) shows an even more troubling case.  While previous to the crisis each dollar increase in EBR would coincide with an increase of $1.8-3.0 in M1, now a days the ratio is only 0.81.   This means that for every dollar Uncle Benny pumps into the economy through the EBR, less than one dollar comes out into the first next measuring radius of deposits in the economy at large.   Where is this value disappearing into?   Well, good question, and one that the “authors” of this paper don’t even attempt to answer.   One plausible explanation, in our opinion, is that some of the increase in EBR, which are obviously just sitting there, are going simply to cover losses from bad debts.   New credit is still hard to come by to the larger economy.   So, though new debt is not likely to be significant, existing debt is also being ramped down, as evidenced by the lower bank lending.    In other words, Uncle Benny is simply attempting to mitigate the haemorrhage of wealth destruction caused by the falling asset prices underlying most debt.  He is not being entirely successful, when he technically should be perfectly able to; yet for all his wanton monetary looseness, he only manages to paper over 81% of the wealth destruction happening as deposits decline (relatively).  

Finally, we end this discussion with another strong disagreement with the paper’s affirmations.   The following quote is one of the main premises of the paper:

A large increase in the quantity of reserves in the banking system need not be inflationary, since the central bank can adjust short-term interest rates independently of the levels of reserves.

As we have said before, most lately in the last post, we completely disagree with this idea.  In fact, we go as far as to say that Uncle Benny has rendered the Fed Funds Rate effectively powerless to affect broad money supply and longer term interest rates by increasing the size of his balance sheet.    Remember, again, while the authors try to pull a switcheroo and focus on the liability side now, this is in fact that SAME THING as the asset side increase.  In other words, due to the composition of the increase in the asset side of the FedBS, which is mostly made of long-term debt securities, then the liability side (which is inherently short-end) is equally important and thus hindered.    More specifically, the authors suggest that Uncle Benny will be able to affect short-term interest rates in spite of having a long-term portfolio of assets because he now pays interest on EBR.   In other words, if the Fed raises the interest rate it pays on reserves (which is pegged to Fed Funds), then banks will not be encouraged to lend, thus preventing inflation from becoming rampant.    This is of course, how they say it is allegedly supposed to happened, and not like it actually happens.    

The authors greatly omit the fact that the Fed would thus incur losses on its portfolio, which would easily spiral and reveal its effectual insolvency.   This would happen because Uncle Benny would have a portfolio of long-term bonds (average maturity of about 10yr, including MBS) that would earn him the low interest rates of today (less than 4.5%), whereas he would be paying high interest rates (likely in excess of 5%, see Grandpa Volcker) if inflation does become a problem.   Given that the balance sheet is quite hefty and suppose we have $1.25tr of EBR, each basis point difference between the average yield on the Feds asset portfolio and the interest paid on EBR would result in a $125mm loss for Uncle Benny.   In other words, supposed Uncle Benny raises short term Fed Funds to 5.0% (a perfectly normal pre-crisis level), then using the long-term yields prevalent today, he would incur a loss on the FedBS of $6.25bln.   Trust us, if there is one thing Uncle Benny is proud of is that in its 99-year history, the Fed has never lost money.  

So, clearly, Uncle Benny is severely limited in his ability to fight inflation as he is limited to a ceiling for the Fed Funds, determined by the weighted average yield of the long-term asset portfolio, which is currently 4.5%.   What if inflation gets as bad as it did in the 70’s (which did not have the gargantuan, untested, and unprecedented monetary experiments of today), and we predict it will get worse, and Uncle Benny needs to raise the Fed Funds to 15%?   Well, he would lose $131bln.   This is an enormous amount to lose on a central bank balance sheet.   He wont do it, trust us, we know him.    Even moreso, these are purely cash-flow losses from the incoming and outgoing interest payments, and they don’t even reflect the “mark-to-market” losses incurred as the long-term portfolio losses value as the bonds drops in prices.   We are being rather generous and assuming they are held until maturity only because we think the point has been made.

In this way, we thus explain our objection to any notion that Uncle Benny's long-term purchases are independent of short-term interest rates.   Remember as well that he is effectively locked in since he can't sell the long term bonds without incurring losses and potentially causing/fueling a massive exodus from US debt.  The fact that he must now pay interest on EBR means that Uncle Benny is capped to how much he can raise Fed Funds, mainly the weighted average yield of his long-term asset portfolio, without incurring losses.   If one thing the Fed is averse to doing and has never before done is lose money.

So, in conclusion, the great increase EBR is very significant.   It is likely to be very inflationary, if only for the effective cap it places on the Fed Funds, let alone the eventual deterioration in faith in the system.    The latest issue of “Current Issues in Economics and Finance” from the New York Fed really illustrates a couple of key points.   One is that The Powers That Be, and their appendant mouth/bodies, of which the NY Fed is one of the biggest, are very interested in disseminating faulty research and misinformation.   It also begs the question of who is actually reading this material?   This paper has been shown to have many easily deconstructed assumptions, fallacies, results and arguments and in general plagued by an all-around lack of corroborating evidence and much contradictory one.   Presumably, it is “economists” that read the NY Fed’s “Current Issues in Economics and Finance”.   If so, we pity the discipline!

As we watch the sun rise into its lowest daily trajectory in the sky, we also wonder if it will rise in the next three days.   Chances are overwhelmingly that it will, as it always has.    Other cyclical things, such as financial systems, might not be so lucky.

May your capital be safe and your investments prosperous,

MAAA