One Bear at a Time

Fresh from finishing Summa: The Great Myth, we came across a Dec. 13 blog entry by Doug Noland, “The Prudent Bear”, titled Q3 2013 Flow of Funds. In reading his blog we came across a section that we reproduce below adding numbering in square brackets and emphasis. We then discuss the errors in his thinking.

From his blog:

[1] Federal Reserve Assets this week surpassed $4.0 Trillion. The vast majority of the Fed’s Assets are securities. After liquidating its T-bill portfolio, the Fed currently holds $2.178 TN of Treasury notes and other federal securities, up about $500bn over the past year. The Fed also holds about $1.70 TN of MBS, up more than $500bn from a year ago.

On the Liability side of the Fed’ s Balance Sheet, Currency in Circulation was up $72.8bn over the past year to $1.230 TN. There are a few miscellaneous Liabilities (i.e. reverse “repos” $113bn, Deposits $62bn), but the vast majority of Fed Liabilities are now “Reserve Balances with Federal Reserve Banks.” Reserves were $2.541 TN this week, an increase of over $1.0 TN from a year ago.

[2] This additional Trillion of “Reserves” is the (electronic) “money” the Fed has injected into the securities markets over the past year. [3] These are digital/electronic “Credit” entries in the general ledger balances between the Federal Reserve Banks and its member banks and financial institutions. These electronic IOUs are created in the process of the Fed expanding its balance sheet holdings (purchasing securities in the marketplace with newly created “money”).

[4] There’s great confusion regarding these “Reserves.” It is a popular misconception that, since these balances sit benignly as “Excess Reserves” (surplus “cash”) on bank balance sheets, this “money” is having no impact on transactions or prices. There’s discussion at the Fed to now use the interest-rate paid on these balances as a policy tool. Former Fed vice chair Alan Blinder would like the Fed to charge banks to hold these reserves, thus [5] incentivizing the banks to lend these “reserves” rather than to do nothing with them.

[6] I am these days reminded of when the expansion of short-term GSE liabilities (electronic IOUs) became a powerful marketplace liquidity-creation mechanism back during the nineties – yet it for years remained virtually unrecognized (was it ever recognized?). [7] Importantly, the massive increase in the Fed’s Liability “Reserves” is a direct “money”-creation mechanism with profound effects on securities market prices (and speculative dynamics). [8] Moreover, these “Reserves” must remain banking system Assets until the Fed sells Assets (securities) and uses the proceeds to partially extinguish its Liabilities. Said differently, Fed “Reserves” IOUs will remain in existence until the Fed extracts liquidity from the marketplace – i.e. collapses some of the liquidity it created – and reduces the quantity of its Liabilities.

[9] To claim the Fed’s “Reserves” are large because banks are failing to lend is factually incorrect. Reserves are gigantic for only one reason: The Fed has created enormous quantities of “money” in its misguided quantitative easing program. [10] If these $2.4 TN of “Reserves” are just sitting there innocuously, why then doesn’t the Fed commence the process of “normalizing” its balance sheet? Why is it continuing to add $85bn a month? [11] Because once monetary inflation takes root it is extremely difficult to stop.

Point by Point

Beginning in the paragraph marked [1], he discusses the current state of the Fed’s balance sheet – all perfectly correct and reasonable. Then, in point [2] he succumbs to the myth with the statement statement that the Fed has “injected” a trillion dollars of reserves into the securities markets.

Point [3] is a correct description of the nature and manner of creation of the reserve credits recorded as liabilities on the Fed’s balance sheet.

Point [4] is more complex. He opens with the statement It is a popular misconception that, since these balances sit benignly as “Excess Reserves” (surplus “cash”) on bank balance sheets, this “money” is having no impact on transactions or prices. This is in fact an accurate description of them although we recognize that QE has affected bond markets via interest rates and stock markets through investor psychology. We have shown liquidity is not involved in Summa: The Great Myth and will show it again herein.

Point [5] is an interesting one. Here he pushes on the popular string of encouraging the banks to lend. Addressed in Summa: The Great Myth, and particularly in The Banks Are Not Lending …., we argue that the more important aspect of the binary transaction is that the public is not borrowing. The excess supply is  the binary consequence of insufficient demand which in turn is the result of high consumer debt. And here is a critical fault in his line of reasoning. He has already stated in point [2] that the money created has been injected into the markets. If this is the case, there cannot be reserves to inject into the economy in the form of loans. You can’t spend the same dollar twice. Either it is already in the economy in “securities markets” or it is inside the Fed needing to be moved out into the credit market.

Incidentally, these reserves cannot be moved into the economy as electronic credits. If this were possible, such a credit would have to be convertible into Federal Reserve Notes (FRNs) on demand. Imagine walking into your bank to withdraw $20 to pay the baby sitter and being told that you can only have a nice new shinny Fed credit. This conversion can only happen inside the Fed (unless you want to wear an orange jumpsuit). But it is not possible because exporting an electronic credit would upset the Fed’s balance sheet. These credits can be withdrawn but only in the form of FRNs. The liability on the Fed’s balance sheet moves into a different category and the balance sheet remains in balance.

[6]  In Figure 1 we present a graph of currency in circulation and bank excess reserves. The new beta version of FRED allows us to both vary time frames (drag the vertical handles on the lower time bar) and see the values for the data points on the curves interactively. We see nothing of the GSE-based liquidity he thinks is there.

Figure 1. Currency in circulation (red; billions; left scale) and excess reserves of depository institutions (blue; right scale; billions – the scale self-adjusts as the time scale is altered).

In [7], he appears to reiterate point [2]. But intentionally or unintentionally he doesn’t quite do it. He says that this money creation has profound effects on securities market prices (and speculative dynamics). In fact we are entirely in agreement. Note that he did not say the money moved out of the Fed as liquidity into markets but only that the creation of the money ‘affected‘ markets. And this is the other great Fed tool in operation, communication and mastery over market psychology.

[8] is partly correct. The other option for these “banking system assets” is for them to be withdrawn in the form of FRNs. As a side note, the Fed has an interesting problem in unwinding its balance sheet. Unlike a repo agreement where that acquisition of an asset for a credit is reversed by returning the asset to the lender as a paired transaction, the assets on the Fed’s balance sheet are not paired to any particular primary dealer (PD) account. The Fed buys assets in an auction process. If it tries to sell assets in an auction process, PD ‘A’ with a reserve balance may not buy them. PD ‘B’ that does not have a reserve balance buys them. If A had bought them with reserve money, the money in circulation or the liquidity in the economy would be unaffected. If B buys and uses currency in circulation, the Fed’s balance sheet is reduced in the same way but the liquidity in the economy is reduced and this may not be desirable. We can hardly wait to see how the Fed handles this one. Our guess is a lot of backroom deals where it is made worthwhile for the right party to make the right bid.

[9] We really dealt with this one in the response to [5]. In fact the statement as we have said is partly correct. Lending is a binary transaction. It requires a willing lender and a willing borrower. If one is missing, the transaction does not occur. It is a bank’s business to lend. It is not a consumer’s business to borrow, only to consume in a self-protective framework. There is an asymmetry to the relationship.

The answer to [10] is simple. QE has been wildly successful. It has caused market inflation not by liquidity injection but by positive market psychology. The famous Greenspan Put has become the Bernanke Put. QE is the fabled punchbowl. This is the air in the market balloons. THERE IS NO GOOD OUTCOME.

Finally we respond to [11] by a stepwise argument. For monetary inflation to occur, the reserves must move into the economy as new currency. For this to happen, consumers (remember they are ~70% of the economy) must borrow excessively. For this to happen either money must become much cheaper (but the Fed has broken that tool) or the credit market and the economy must undergo a massive deflation. So massive deflation and then massive inflation. Maybe.

No More Please

We realize that most of the people out there are going to continue regurgitate vast quantities of myth, often with enough odd facts and buzz words to give the resulting porridge some apparent degree of palatability. Unfortunately, it takes several times more time and effort to properly deflate these balloons than it does to blow them up in the first place. This has been a good exercise but we will likely not bother with another.

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