I finally had some time to read George Selgin's excellent Floored! over the Christmas holiday.
Some family members saw me reading the book and asked me what it was about. The subject that George is tackling—two types of central bank operating systems—is quite technical, so I wasn't sure how to break it down for them. But in hindsight, here's how I would go about it. I'm going to explain what the issues are in terms of an instrument we all use and understand: good ol' fashioned banknotes.
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Imagine that when you go to your bank this morning to withdraw $200 in cash, you can only get $100 out of the ATM. The bank manager says that it is expecting another shipment of cash later in the day, so come back then. But be early, he warns, since a lineup is sure to develop.
What explains this odd situation? The central bank has started to ration the amount of banknotes it issues. For instance, the Bank of Canada currently supplies Canadians with $85 billion in banknotes. But say it has decided to only provide half that, $45 billion.
A world in which banknotes are rationed would be very different from our actual world. When we march up to an ATM, we are accustomed to getting as much cash as we want. If everyone in my neighbourhood were to suddenly decide that they wanted to cash out their bank accounts, the Bank of Canada will print whatever amount of currency is necessary to meet that demand. Central bank don't keep cash scarce, they keep it plentiful.
Strange things happen in a world with rationed cash. Imagine that everyone wants to hold $200 in banknotes in their wallet but can only get $100 from the ATM. Further, assume that people need to hold a bit of cash because certain transactions can only be consummated with banknotes. To cope with this chronic cash shortage, a spare-cash market will emerge. For a fee, those who have a bit of extra cash on hand will lend to those who are short.
The spare-cash market would look a bit like this. To top her existing cash balance of $100 up to her desired $200, Jill makes a deal with Joe to lend her $100 in cash. She provides security for the loan by transferring $100 from her bank account to Joe's bank account. A day later Jill repays Joe with $100 in banknotes, and he returns her $100 security deposit, less a $1 fee. Jill has effectively paid $101 to get $100. Or put differently, she has paid Joe 1% in interest to get $100 in cash for a day.
We could even imagine informal person-to-person trading posts springing up outside of popular ATMs where those who are short of cash meet up with lenders like Joe who specialize in locating and lending spare cash. An Uber-style app would be created where the credit history of borrowers are documented, reducing the risk to lenders. People might be able to order up cash from home, delivered by bike courier.
The spare-cash market that I've just described is not a market we are accustomed to. As I said earlier, central banks keep cash plentiful. But it's similar to another market we are all familiar with: the secondary market for concert tickets. Tickets are necessarily rationed because there are only so many seats in a concert venue. Professional ticket scalpers line up ahead of time and buy these tickets so they can on-sell them at a premium.
Like the scalped ticket market, the spare-cash market is a natural response to scarcity. Those who can't spare enough time to stand in an ATM queue but need banknotes, like Jill, can pay those with spare time to stand in line, like Joe. Both are made better of. Joe's lot has improved because he earns more standing in ATM lines and lending cash than he did in his previous occupation. Jill is better off because she attains her desired amount of cash.
Once cash stops being a free good, cash payment delays emerge. Say that Jill prefers to go shopping in the morning for groceries and other necessities, before her hair dressing salon opens. But because acquiring cash is costly, she sometimes delays her shopping trip till later in the day, in the hope that someone might walk into her salon and pay with cash. That way she can avoid paying interest to Joe.
However, if over the course of the day no one pays Jill with banknotes, she will have to borrow in the spare-cash market at the last minute. If everyone is following the same strategy as Jill, there will be an end-of-day spike in cash demand. Joe may run out of cash to provide his customers, and so Jill may have to go without food that night.
So now that we've outlined the contours of a world where cash is rationed and ATM lineups develop, would it be preferable to a world in which cash is plentiful and there are no lineups?
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Let me start by arguing why an alternative world in which cash is rationed might be more desirable than our current world with plentiful cash.
Thanks to cash rationing, Joe and Jill are forced to transact with each other. Perhaps a 'citizen-lender' like Joe can get additional
This oversight function that Joe fulfills never emerges in the plentiful cash world since the two aren't forced into an economic relationship. And thus the credit market in a plentiful cash world may be less efficient than it would be if cash were rationed.
Now let me argue the opposite, why the world of plentiful cash may be superior.
There is an underlying logic to rationing concert tickets. A venue has just x seats, and so only x tickets can be sold. But there is no equivalent reason for a central bank to limit the size of its banknote issue. It does not face a capacity restraint, and the extra cost involved in printing new banknotes is tiny. And so any decision to ration cash is a purely arbitrary one.
Under rationing, citizens are forced to engage in a host of time-consuming activities that they wouldn't otherwise have to engage in, including locating a reliable cash lender, providing personal and potentially intrusive credit data to this lender, and then setting up an appointment to settle the debt at a later date. To avoid the hassles and expenses of dealing in the spare-cash market, folks like Jill may try to avoid making cash trades until later in the day, but that means she can't follow her preferred shopping schedule.
If cash were plentiful, the millions of citizen-hours spent in coping with these annoyances would be freed up for alternative uses. Jill might be able to enjoy the extra minutes she now has with her children, or work on upgrading her salon. Instead of paying for Joe to stand in an ATM line-up, she can hire him to help in the construction, surely a much more socially useful activity than lining up.
So which world do you prefer? Joe's extra credit monitoring is certainly beneficial. But does it outweigh all of the costs and nuisances that a cash shortage imposes on people's lives? This is a tough calculation to make. If you support cash rationing because you like the fact that it leads to a secondary market in cash loans (and thus more credit monitoring), why not create shortages in other financial markets, say by forcing banks to also ration deposits?
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Let's wrap this all up. We've explored the difference between a world in which cash is rationed and one in which it is plentiful.
But George's book isn't about cash, it's about another instrument issued by central banks: reserves. Unlike cash, reserves are an exclusive financial instrument. Only banks can hold them. Since reserves aren't part of our day-to-day experience, I've tried to explain things in terms of banknotes, a far more mundane central bank-issued instrument.
George argues in his book for rationing reserves. It would be as-if he were arguing for the rationing of cash in the scenario I sketched out above. Note that I am not saying that George wants cash to be rationed (as a free banker he would probably be against it), but I am saying that many of his arguments in favor of reserve rationing can be recast in terms of a banknote rationing.
In particular, George speaks favorably of the secondary market in reserves that springs up thanks to rationing. In the U.S., this is usually referred to as the fed funds market, but more generally it is known as the interbank market. The interbank market is exactly like the spare-cash market that I've described above. Just as Joe lends to Jill in the spare-cash market, banks lend reserves to each other in the interbank market. George provides much evidence that the self-monitoring that banks engage in by transacting in the interbank market is a valuable function.
What George doesn't touch on is that this increase in the amount of credit monitoring, far from being free, comes at the cost. Like Jill, banks must spend time and resources coping with a perpetual reserve scarcity. If this artificial shortage was removed, banks could stop allocating internal resources to this coping effort and deploy it instead to other uses. In the same way that plentiful money meant that Jill could hire Joe to upgrade her salon rather than paying him to stand in line, a bank can move employees from its defunct fed funds department to bolster its lending department, or customer service, or technology effort.
The question shouldn't be: do we want interbank peer monitoring? Rather, do we want interbank peer monitoring at all costs? I think this makes the calculation much more difficult.
There must be a shortage of reserves other wise the central bank would be scrutinising most loans and would be acting as the lender to the public rather than the facilitator of the lenders, the commercial banks. Reserves are available by the discount window but at a premium price. Banks prefer the lower interbank market rate and when they qualify , demonstrate the "wisdom of the crowd" and their peers in the commercial market , instead of the singular and academic scrutiny of a central bank loan officer.
ReplyDeleteActually banknotes are rationed as the effect of rationing reserves rations bank notes in turn and it has the same affect of peer monitoring of banks, as banks have to demonstrate the quality of their loan book to other banks or the Central bank to get the reserves to convert to bank notes.
"There must be a shortage of reserves other wise the central bank would be scrutinising most loans and would be acting as the lender to the public rather than the facilitator of the lenders, the commercial banks. Reserves are available by the discount window but at a premium price."
DeleteI'm not sure I follow what you're saying. But if a central bank like the BoC were to move to a plentiful reserve system, it would *not* do so by lending via the discount window. It would just buy around $3 billion in treasury bills with $3 billion in new reserves. Voila, job done. No need for a 'central bank loan officer.' It would be a very safe operation.
Well buying treasury bills would only reduce the interest rate, it wouldn't remove the requirement for banks to pass interbank peer monitoring.
DeleteYour question in the last paragraph seems to be about the merits of banks time spent on interbank peer monitoring.
Another feature of banks lending reserves, is that a reduction in Share holders capital of the lending bank, due to a bankruptcy of the borrowing bank , reabsorbs the inflation of deposits that are not repaid by the defaulting borrowers of the bankrupt bank.
"Well buying treasury bills would only reduce the interest rate, it wouldn't remove the requirement for banks to pass interbank peer monitoring."
DeleteNo. The Canadian overnight interbank exists because at the end of the day, some banks don't have enough BoC-issued reserves and need to borrow from other banks. But if the BoC were to purchase $3 billion in treasury bills with $3 billion in new reserves, then each night every bank will now exit the day with a satisfactory amount of reserves, so no overnight interbank lending need occur.
And no, this needn't reduce the interest rate, because the BoC can simultaneously raise its deposit rate (the interest rate that banks reserve if they hold BoC reserves overnight) by 0.25%.
When a bank needs reserves ie when it does not have them or treasuries to sell , that is where your question about the source of them arises, I gave a couple of examples of the merits of the interbank process.
DeleteStrikes me JPK has spotted one of the basic flaws in limiting the supply of base money (aka reserves), namely that if there is a shortage of that money, that can to some extent be made good by credit monitoring, but “this increase in the amount of credit monitoring, far from being free, comes at the cost.” Quite right.
ReplyDeleteAs Milton Friedman said, the real cost of supplying everyone with more base money is zero. Plus full employment can easily be brought about simply by supplying the private sector with whatever amount of base money induces it to spend at a rate that brings full employment. So why not do that, or at least aim to do that? I.e. why bother with the relatively expensive alternative form of money?
But that raises a question: if “credit monitor” money (i.e. commercial bank issued money) is inherently expensive, how does it come into being at all? More particularly, how does it manage to drive base money to near extinction? Ironically, George Selgin himself described the process via which commercial bank money drives out base money in his Capitalism Magazine article “Is Fractional-Reserve Banking Inflationary?”
Far as I can see (and this isn't quite the same as George Selgin’s explanation) what happens is that given a “base money only” system (i.e. full reserve banking), commercial banks can lend at below the going rate of interest because those banks do not need to pay interest to anyone to come by money: they just print the stuff, i.e. create it from thin air. And that forces central banks and governments to impose some sort of deflationary measure, like withdrawing base money.
I.e. the effect of letting commercial banks create money is much the same as the effect of traditional backstreet counterfeiters. In fact the French Nobel laureate economist Maurice Allais described the latter money creation by commercial banks as “counterfeiting”. David Hume said much the same 300 years ago.
"As Milton Friedman said, the real cost of supplying everyone with more base money is zero. "
DeleteRalph, I pretty much stopped agreeing with you after the Milton Friedman line. Like George, I don't have any problem with fractional reserve banking. My blog post is much less ambitious than your comment: I am only trying to map out the pluses and minuses of the existence of one tiny market, the interbank market.
Commercial banks creating deposits does not allow commercial banks to lend at below the going rate of interest. Whether a deposit is a result of the commercial bank creating it itself, or if it results from attracting a deposit of CB cash, the cost of retaining that deposit, the rate needed to prevent it being withdrawn and deposited elsewhere is the same in both cases. That rate is the cost of paying interest to deposit holders and is the cost of making loans, and that rate comes about by CB policy on short term interest rates. This the topic of a post on Reflections on Monetary Economics blogspot.
DeleteI'm confused about the "incites" here. Do you mean insights?
ReplyDeleteIt is not bank reserves that need rationing, it is the warehouse reserves, how much spare shelf space does a distribution need to cover flow volatility. The bank reserve system is an accounting tool, it works because in the collective, all warehouse managers have a choice, buy more or less now of real goods, and that effects the deposit to loan ratio. Thus, if the deposit and loan queues are slightly congested, they are observable, they are coherent with real goods flow. Managing real goods flow by waling the corridor between deposits and loans is the very definition of fractional reserve banking. It is all done by making the queue transparent, and optimally congested.
ReplyDeleteSome thoughts
ReplyDeleteThe US system proviously functioned something like this:
Banks were required to hold reserves in proportion to their most liquid liabilities. The Fed provided these reserves by purchasing assets from / selling assets to the banks. The amount purchased / sold followed actual needs of banks according to a: regulatory requirements and b: desired reserves in excess of that amount, the indicator being the resulting interest rate in the interbank market. In comparison, in a 0% reserve requirement environment, the amount of reserves would depend only on b. Similarly, in an overdraft system, reserves would never enter the system through active purchases by the CB but rather through borrowing by banks from the CB at a predetermined interest rate. The incentive for banks to economise on reserves under all of these systems is a function of the relative cost of reserves compared to other assets. I don't know whether George Selgin imagines there was an absolute limit on the amount of reserves 'available' at any point? I, in any case, am convinced that that cannot actually be / wouldn't actually work.
The floor system:
Instead of providing reserves as 'needed' (regulatory requirements + extra desired reserves), the CB creates an excess of reserves by purchasing more assets than previously. This drains risk from banks' balance sheets but also the corresponding reward. It also affects the price / yield of the purchased assets themselves. To the extent that the CB pays interest on the reserves provided, the immediate incentive for banks, as far as I can tell, is for them to sell more assets / hold more reserves than they otherwise would. Depending on the difference in risk adjusted interest rates between assets sold and reserves received (IOR), one could characterise such a policy as the public (i.e. the tax payers via the CB) paying banks for doing business relative to the cases above. Whether that translates into an incentive for banks to expand business (fork out new loans), is on another page, I suppose. Or, as you put it, it's a complex calculation.
The difference between the above systems could be reframed as the question of whether banking is actually a public service which banks have incidentally made into their business or whether it is actually a business, the privilege for which, particularly taking into account public guarantees, banks (and thus ultimately bank customers) should be made to pay for. I would argue that the former is what we should have, but that reality is more of an unholy hybrid. Questions that come to mind are e.g.: is there a 'neutral', middle ground? And, considering almost everbody uses banking services / money, does it make much of a difference whether we pay for them with our taxes or via the services we use? The latter is more directed, I suppose, but arguably also more contractionary.
Also, you write:
To top her existing cash balance of $100 up to her desired $200, Jill makes a deal with Joe to lend her $100 in cash. She provides security for the loan by transferring $100 from her bank account to Joe's bank account. A day later Jill repays Joe with $100 in banknotes, and he returns her $100 security deposit, less a $1 fee. (...) This extra bit of person-to-person monitoring may prevent folks like Jill from over- or underborrowing.
When Jill transfers an existing bank depostis balance to pay for cash, she isn't borrowing IMO. She is exchanging one type of credit for another. If anything, the bank is forced to borrow from the CB when the initial $100 is withdrawn. Of course, Jill can borrow from Joe, but that would involve the creation of a 'personal IOU', not a wire transfer.
"I don't know whether George Selgin imagines there was an absolute limit on the amount of reserves 'available' at any point? I, in any case, am convinced that that cannot actually be / wouldn't actually work."
DeleteThe idea isn't to set an absolute limit of x, but to sufficiently constrain the supply of reserves such that a secondary market emerges. So that instead of sitting on its reserves overnight, a bank can go look for another bank in the secondary market that will pay a premium to hold those reserves.
By injecting a bit more reserves, so that they are no longer scarce, the secondary market disappears and a floor emerges. People call it a floor because it is supposed to illustrate the idea of the interbank rate falling to the interest rate on reserves. But this is a misconception. What actually happens is that the interbank market just disappears, so that there is only one overnight rate, the rate on reserves.
Well, if you ask me, it is about price, not quantity. Under a 'standard' regime, regulatory reserve requirements above 0 are a cost factor vs. performing assets that banks would otherwise hold. And so banks employ people to minimise these costs. Otherwise they could just borrow through the discount window without looking. These are costs to the bank and, ultimately bank customers.
DeleteWith IOR, there is nothing to minimise, so that specific job falls away. But there is still a cost relative to the CB not intervening, namely that of IOR (plus bubble prices of assets bought?). This is a cost to the tax payer.
So you end up having to compare the two.
"But there is still a cost relative to the CB not intervening, namely that of IOR (plus bubble prices of assets bought?). This is a cost to the tax payer."
DeleteYes, a floor system will mean a bit less profit for the central bank, and thus a lower dividend to the government, and this will cost the taxpayer.
But we need to think about this from an overall welfare point of view. Say I have monopolized the nail industry and cap the quantity of nails I produce so that they sell for $1 instead of the market clearing price of $0.10. My decision increases my profits, but society is made worse off--it bears the deadweight loss of the monopoly I've created.
Even if it is the government and not me who runs the nail monopoly, the same logic applies. And it applies likewise to other government monopolies, say like the one over reserves or banknotes. So yes, a corridor may result in less profits to the taxpayer, but it could very well result in a larger consumer surplus.
I agree, it is a type of investment and the return on investment is what counts. Also it is probably the only way a CB can 'act fiscally' if, say, the fiscal authorities themselves can't or won't.
DeleteI don’t buy it.
ReplyDeleteYou’re implying that a bank with excess cash will relax credit monitoring more than a bank without.
But that’s a contradiction. A bank with excess cash in fact has more incentive for credit monitoring.
Because it is in a position to take on a greater volume of credit risk due the presence of the necessary (cash) and therefore a potentially greater exposure to credit risk and losses, if mismanaged.
But it’s nonsense to assume that such a bank would relax its credit risk management function because of that. If anything, it will improve it simply because it has more of the raw material necessary to assume credit risk.
The error here is to assume that the necessary (more money) equals the sufficient (credit risk management). Not so.
This is why a lot of QE is pushing on a string. The string is the resistance from bank capital management functions in pushing back on and controlling the risk of reckless liquidity management.
But then again, the whole monetarism project is a failure to distinguish properly between liquidity management and capital management and the relationship between the two.
It's also important to understand that banks manage their reserve positions not just with interbank lending but with non-bank liquid asset purchases and that the credit risk assessment function covers both banks and non-banks. And there's no reason for banks to suddenly relax their bank credit monitoring in particular in such an excess reserve environment. Having a greater supply of the necessary means more vigilance with respect to the sufficient.
forgot to mention that bank credit also involves the Eurodollar market where the demand side includes the demand for term interest rate sensitivity - the monitoring function for globally operating banks in particular is not limited to the scope of short term sensitivity in the fed funds market under a bloated reserve environment
Delete"You’re implying that a bank with excess cash will relax credit monitoring more than a bank without."
DeleteI'm not sure if I am implying that or not. Maybe you can explain to me how I'm making this implication?
All I'm saying in this post is that if reserves are made plentiful instead of constrained, then all the work that goes into coping with this artificial shortage no longer needs to occur. And so resources and manpower get freed up for alternative uses.
"You’re implying that a bank with excess cash will relax credit monitoring more than a bank without."
DeleteStated inversely, and equivalently, a bank with constrained cash (i.e. constrained in a relative sense by the supply dynamics of the reserve system under consideration) will be forced to step up its credit monitoring game.
Which is what you're describing (in fact more than implying) Joe as doing:
“Thanks to cash rationing, Joe and Jill are forced to transact with each other. Perhaps a 'citizen-lender' like Joe can get additional incites insights into Jill's capacity to bear credit, the sorts of incites insights that a banker cannot. This extra bit of person-to-person monitoring … this oversight function that Joe fulfills never emerges in the plentiful cash world since the two aren't forced into an economic relationship. And thus the credit market in a plentiful cash world may be less efficient than it would be if cash were rationed … Joe's extra credit monitoring is certainly beneficial. But does it outweigh all of the costs and nuisances that a cash shortage imposes on people's lives?”
Sorry for the delay JKH, have been overloaded with writing duties.
Delete"You’re implying that a bank with excess cash will relax credit monitoring more than a bank without... But that’s a contradiction. A bank with excess cash in fact has more incentive for credit monitoring.."
Sure, once the bank no longer has to cope with the cash shortage then it won't have to monitor counterparties in the cash market--because the cash market disappears when the shortage is alleviated.
More specifically, all resources and manpower allocated to dealing with the shortage are released the moment that the central bank's policy of imposing a shortage is ended. I'm not sure what banks would do with these freed up resources. Maybe they task them to monitor the quality of the bank's consumer loan portfolio, in which case one type of monitoring is substituted by another? Maybe they decide to transfer the resources to the lending department, allowing the bank to take on a greater volume of credit risk? Whatever the case, the resources will be deployed to what the bank perceives to be it's next-best use case.
I should have emphasized what I think is the pertinent point that you may have missed. A large bank’s credit monitoring process for other banks is global – it covers aggregate exposure for all types of instruments issued. The fact that a bank doesn’t need fed funds in a saturated reserve market relates to only one type of interbank lending – overnight fed funds. But that doesn’t mean that banks won’t be looking for other types of funds – funds still most efficiently sourced from other banks. This amounts to banks looking for funds that have an interest rate sensitivity other than overnight. A good example is 6 months fixed rate funds – used to hedge interest rate sensitivity in the case of a Libor loan with a rate reset every six months – either in the Eurodollar market or in the domestic market with a rate linked to 6 month Libor. The point is that this term interbank lending market is an active market with supply and demand – and those on the supply side must continue to do credit risk analysis on counterparties. In fact, the credit risk exposure on a 6 month interbank loan is obviously greater than the exposure on overnight fed funds. A typical global bank will have a large book of term commercial loans linked to Libor and funded in the interbank market in order to manage interest rate risk (often called interest rate “gapping”). It will also have an adjacent component of that book consisting of interbank loans and deposits on both sides – lending and borrowing. In summary, a saturated Fed funds market does not mean the demand from banks to issue interbank liabilities dries up. The credit risk function continues. Overnight fed funds are a subset of total interbank lending and credit exposure. Resources are not necessarily freed up for other purposes in this context.
DeleteGreat piece - thanks JP. I once attended a seminar on the advantages and costs of floor vs. corridor systems and asked why we have a system that creates artificial scarcity and imposes costs which are entirely unecessary on both the CB and the market as a whole. I received the same response about the advantages of interbank monitoring and the role that it plays in market discipline. I was nearly convinced by the speakers point that interbank monitoring can be useful for regulators too by giving advance warnings about what is happening in the economy that they otherwise wouldn't receive.
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