Are central banks still in control?

Krugman Predicts Inflation :-)

Krugman has said that while interest rates are near zero we don't have to worry about inflation:

It’s true that printing money isn’t at all inflationary under current conditions — that is, with the economy depressed and interest rates up against the zero lower bound. But eventually these conditions will end. At that point, to prevent a sharp rise in inflation the Fed will want to pull back much of the monetary base it created in response to the crisis, which means selling off the Federal debt it bought. So even though right now that debt is just a claim by one more or less governmental agency on another governmental agency, it will eventually turn into debt held by the public.

We are living in weird economic times, where many of the usual rules don’t apply and there are big free lunches to be had. But not everything is a free lunch, even now. Sorry.

With a cleaner understanding of economics you don't need to say "the usual rules don't apply".    As interest rates go down the velocity of money goes down and with that you can increase the money supply without causing inflation.  But later, when interest rates start going up, inflation can get out of control.

The interest rate on 5 year bonds has about tripled in the last few months.  We are leaving Krugman's safe zone of "the zero lower bound".

Once the zero lower bound conditions have ended, what does Krugman say we must do again?

At that point, to prevent a sharp rise in inflation the Fed will want to pull back much of the monetary base it created in response to the crisis, which means selling off the Federal debt it bought.

If the Fed started to sell some of its trillions in bonds, then bond prices would crash and interest rates would go up more.  In particular the value of long term bonds would go way down.   The Fed could not sell them for anything near what it paid for them.  So it could not withdraw "much of the monetary base".

Hussman has shown that an increase from near zero interest rates to just 2% would require pulling back half of the monetary base to avoid inflation. The Fed would have to sell off half the bonds on its balance sheet, like $1.5 trillion worth.

However, the most the Fed can possibly imagine is a slight tapering of the $85 billion per month rate at which they are increasing the monetary base.   Even a hint of that caused the markets to freak, which caused the Fed to quickly backpedal on the whole tapering idea.   There is no chance of the Fed pulling back half of the monetary base.  It will not happen.

A comment on a previous crisis seems to hint that Krugman probably does not expect them to withdraw half the monetary base either:

But my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt.

The combination of rising interest rates, the impossibility of the Fed selling half their bonds, and  Krugman's explanation of things (or sound economic theory),  results in a prediction of a "sharp rise in inflation".

Foreigners Selling Treasuries

The total foreign treasury holdings are down about 1% each of the last 2 reports.   In the past foreigners were steady buyers.  The less others buy bonds the more the Fed will have to.

Interest rates have gone up fast.

As interest rates have gone up the value of bonds has gone down.  Below is the bond fund TLT:  When bonds are paying 2% interest and drop 8 years worth of interest in the last 4 months, many people will decide the reward is not worth the risk and sell. 

Hussman showed that when interest rates go up the velocity of money goes up.   The equation of exchange shows if the velocity of money goes up then we can expect higher prices.  Together I think this means the missing inflation is coming.

As John Xeniks said, "it's like we're all watching a dreadful horror movie, but we're locked in the movie theatre and can't get out".

Honest Banking

Fractional Reserve Banking

 Imagine a brand new bank is formed and starts with no money.  Next customer A comes in and deposits $10,000 cash in a new savings account.  Next the bank loans out $9,000 to customer B who takes his borrowed money out as cash.

This loan increases any measure of the money supply that includes both "demand deposit accounts at banks" and cash.    That $9,000 is really counted twice.   Since both customer A and customer B think they can spend this money, economists have decided it is reasonable to count it twice.  Since there are 2 people that think they have this $9,000 it is inflationary. 

So when a bank makes a loan from demand deposits they are increasing some measures of the money supply.  In this sense people say, "banks make money".

This system of telling deposit customers they can take out their deposits on demand while at the same time loaning the money out for many years is called "fractional reserve banking".   This is because only a fraction of the deposit money is actually kept on hand, say 10%.   This type of banking has a terrible flaw.   If a higher fraction of the customers demand their deposits back at the same time than the reserve ratio the bank can not give all of them their money.   This is called a "bank run" and a "liquidity crisis".


The patch for this terrible flaw is to make a central bank that acts as a "lender of last resort" when a bank has a liquidity crisis and temporarily loans the bank some money.  The central bank has a real ability to make new money, either electronic or having it printed.  So the central bank can not run out of money.

A private bank can have a solvency crisis when the loans that it made are not paying.   In this case the bank has a bigger problem that just a liquidity crisis.   A temporary loan from the central bank will just delay the inevitable bankruptcy and not really fix the problem.    The central bank is supposed to decide which banks just have a liquidity crisis and which have a solvency crisis and shut down the insolvent ones.   It is sometimes not easy to decide if a bank is having a solvency crisis or a liquidity crisis.

If the central bank has the job of bailing out troubled banks then it opens itself up to being tricked by dishonest bankers.   It is possible to make it look like they have a liquidity crisis, get a bunch of money from the central bank, and then run with the money.  Of course the central bank tries not to get conned too often. 

The current system with this "bank made money" can have deflation when lots of people are just paying down loans and not getting new loans.   The overall money supply can go down.   Then there is a patch for this.  The central bank can print more money.   But this has risks of inflation or even hyperinflation if the government gets out of control debt and deficit.  So this deflation/inflation/hyperinflation trouble is another drawback of the current type of banking.

This type of bank can run into trouble if they make long term loans at current interest rates and then interest rates go up.  Imagine they were paying depositors 2% and loaning money for 20 years at 5%.  This is a healthy profit margin.  But then imagine that short term interest rates move up to 6%.  If they don't pay their customers this rate the customers can just take out their money and move someplace else.  But if they pay depositors this much then they will lose money on their loans.   There is a patch for this.   They can have adjustable rate loans.   But then if interest rates can change people who were credit worthy at the starting rate may not in fact be able to pay once rates have moved up.   So adjustable rates loans have their own bad side-effects and were part of the recent crisis.   So rising interest rates is yet another problem with this type of banking.

 

Honest Banking

An alternative to fractional reserve banking is to always match the duration of deposits with the duration of the loans.  To do this banks would sell 10 year bonds to raise money which would then be used to make 10 year loans.   They would sell 20 year bonds to get money for 20 year loans.   Since there are no "demand deposits" in this type of banking the banks are not "making money".

Since depositors can not just take out their money on demand, there is no danger that too high a fraction would all want their money at the same time that the bank would have a crisis.   Avoiding the regular banking crisis of fractional reserve banking seems a big win.

It is also possible to loan out all of the money taken in and not just 90% of it.   So this type of banking could in some sense be more efficient.    If we are matching duration on deposits and loans then we will have real market pricing information on what interest rates should be at different durations.  In the current system with most deposits short term and loans long term we are not letting the market tell us what long term interest rates should be.


I also think is more honest.  If you tell all your depositors that they can take money out on demand, anytime they want, but really your bank is not operating in a way that it can do that then there is a bit of fraud going on.   Even if the central bank can often patch up this problem it is still not clean.   If I were in charge it would be illegal to do fractional reserve banking.


This type of bank still has to be careful to make good loans.  But that is all.   It does not have to get lucky about never getting a "bank run".  It does not have to get lucky about interest rates not going up.  It does not change the money supply, so does not contribute to the inflation and deflation problems.   Avoiding the regular banking crisis of the current system can not be stressed enough.

Criticisms of my View

There are those who say that currently banks are not limited in their ability to loan by their reserves.  This is certainly true for many banks.   Since Bernanke came up with his new trick of paying interest on excess reserves, reserves are acting very different. 

There are those that think banks make real money "out of thin air".   To me these people don't seem to understand the simple example above where the bank making a $9,000 loan increases measures of the money supply.   They think there is some other power to make money that banks have.  So far these people have not been able to explain with sufficient clarity any other type of "bank making money" than my example above.  If anyone can give a very simple example, like my $9,000 loan, where a bank has some different type of money making power, please do.  If in your example you can not take out cash, then your bank is not like a real bank.   Given that my example clearly works, it is not even clear why they think a bank needs any other power to make money.   Isn't the ability to grow the money supply enough of a power?

I can not find a single example where "bank made money" is a real factor in hyperinflation.   If private banks had some magical power to make money, and huge numbers of private banks, why is it that hyperinflation always involves central banks?   Also, to get to run central bank you have to be far more qualified than to run a regular bank.  Also, there are far fewer central banks.   So if it was just a matter of making mistakes, we should expect private banks to do it far more often due to both larger numbers and lower qualifications.  But it is always the central banks.  

Another criticism of my view on banking is about statements I have made similar to "the $2 trillion in excess reserves flooding out into the real economy and cause inflation".    Excess reserves is money that the bank holds above its reserve requirements.  It could withdraw this money from the Fed as paper money if it wanted.   The bank might loan the money out or maybe use it to for some other type of investment.   I think that the reason the Fed has been able to make so much new money without causing inflation is that it has kept $2 trillion from entering the real economy by paying banks interest on excess reserves.  I think that if the current $2 trillion in excess reserves comes into the real economy then inflation will kick up.   People who are not worried about inflation have arguments about how this won't happen.   But none of these arguments seem at all tight.   Banks can loan out money.  Banks can take out cash.  Banks could invest in other things.  

From the comments, the best example so far is a new bank is formed, it borrows $1 million at short term rates from the Fed and loans out $1 million long term.   This would work but since there  there is no "demand deposit account" the bank does not add anything to the money supply.  The Fed probably just made the $1 million, so it probably added to the money supply, but the bank did not.  Perhaps the Fed already had that money sitting around, either way, the private bank did not make money.  Note this bank still has the interest rate risk problem.  The Fed has the risk that this bank was formed by banksters who are just out to rip off the Fed.  This example can work, but it is not a "private bank making money out of thin air" at all.   Nothing close to a magic trick in what the bank is doing.  It is getting money from the Fed and loaning it out.  Nothing to see here, move along.

More from comments.  Imagine it is after closing time and the bank makes two accounts for the same customer, who has put up his house as collateral.  In one account there is a $100,000 loan and in another there is $100,000 deposit.   No physical money has changed hands yet.  The bank needs to use up $10,000 of its excess reserves but it has created a $100,000 demand deposit account.  You could even imagine that the bank charged a $10,000 origination fee and used that for the reserve requirements.     But at the start it sort of adds $100,000 to the money supply out of thin air.   However, as the customer spends the money then the bank would have to get real money from the Fed or someplace else.  Still, you can think of it as making the money and then getting the reserves later.  This is the new best example of "making money out of thin air".  :-)

More comments from Tom.  Thanks so much Tom!   He points out that there are a few really big banks with branches all over the place.  So there is a chance that when the customer who got the loan spends money out of his checking account that the person he gives the check to actually uses the same bank.  In this case the bank can do the transaction still without getting "real money".  

Good Articles On "Banks Making Money"

James Tobin, Commercial Banks as Creators of “Money”

Looking to Debate Hyperinflation

There are many many many many people who say that hyperinflation is not a real risk for countries like Japan, USA, or the UK.   Some people even say deflation is the real risk.   I challenge anyone like this to debate hyperinflation with me.  Mostly I am thinking of a blog to blog debate but I don't rule out a face to face video debate.   My Hyperinflation FAQ is my opening salvo, so anyone can respond to that.  I think I really understand how hyperinflation works but want people to try to poke holes in my logic.   I want a clean debate with no name calling, just good logical arguments. 

My Hyperinflation FAQ is long and many of the points are related, so I  recommend you start with the points you think are easiest to refute.  

If you post a reply to my Hyperinflation FAQ please comment below and I will link to your post at the end of this post and the end of the Hyperinflation FAQ post (assuming it is polite).

I have over 17,000 views on my Hyperinflation FAQ so far and not a single post  replying to mine and linking to mine. 

I have been a bit obsessive compulsive about hyperinflation for years now, using Google to find discussions all over the net.   I have answered just about every reasonable question on hyperinflation that I have seen.   It is like I have run out of good new questions.   I miss the challenge.  I am looking for a worthy adversary.   If you can step up to the plate, please do.  If you know someone who might be able, maybe send them a note.

I challenge anyone who thinks that hyperinflation is not a real risk for Japan to try to poke holes in my Hyperinflation FAQ.   Where exactly did I say something that is not correct?   Please quote the sentence and explain the error.

If someone would like to moderate a blogging debate I would be happy to participate.   If someone wants to moderate a video debate I am even up for that.

If you agree with my Hyperinflation FAQ and would be willing to mention it that would be welcome too.   Or if you mostly agree but differ on a few points, that is fine too. 

List of Replies
8/11/13  Armstrong Economics - I sent an email and then this post showed up which seems to be a response to my FAQ but he does not mention or link to my FAQ.    He wants hyperinflation to mean "inflation ending in the death of a currency" but that is not the standard definition.  It also does not allow you to tell at the time if you are in hyperinflation or not.

Everything Is OK So Far

There are many many posts out there by people who advocated printing lots of new money where they congratulate themselves that, as far as inflation, everything is OK so far.   They seem to believe that the last few years are proof that you can make huge amounts of new money without getting inflation.  This ignores all the rest of history and normal economic theory like the equation of exchange.  It also ignores the fact that while Bernanke has made lots of new money, he has also managed to keep it from leaving his building so far.  It also ignores that really low interest rates make for really low velocity of money but then later as the interest rates go up and the velocity of money goes up you get the inflationary pressure.  So this huge money creation without inflation will not last forever.  

Japan is increasing the money supply at hyperinflation rates but since it has not caused prices to go up yet, everyone seems to think everything is OK so far.   Things are not OK.  It is out of control already.

In any case, this reminds me of an old joke.  A guy jumps off a 100 story building and as he passes the 50th floor he yells out, "everything is OK so far".