Saturday, December 31, 2011

Speech by Vítor Constâncio, Vice-President of the ECB


Central bank reserves are held by banks and are not part of money held by the non-financial sector, hence not, per se, an inflationary type of liquidity. There is no acceptable theory linking in a necessary way the monetary base created by central banks to inflation. Nevertheless, it is argued by some that financial institutions would be free to instantly transform their loans from the central bank into credit to the non-financial sector. This fits into the old theoretical view about the credit multiplier according to which the sequence of money creation goes from the primary liquidity created by central banks to total money supply created by banks via their credit decisions. In reality the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money. As Claudio Borio and Disyatat from the BIS put it: “In fact, the 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” [8] In modern banking sectors, credit decisions precede the availability of reserves in the central bank. As Charles Goodhart pointedly argued, it would be more appropriate talking about a “Credit divisor” than about a “Credit multiplier” [9]
Read the rest at the European Central Bank (ECB)
Challenges to monetary policy in 2012
Speech by Vítor Constâncio, Vice-President of the ECB,
26th International Conference on Interest Rates, 

Frankfurt am Main, 8 December 2011
(h/t Ryan V Markov in a comment addressed to me at The Economist)

A promising note on which to end the old year and welcome in the new.

13 comments:

JKH said...

There's hope there.

Ralph Musgrave said...

Strikes me Constâncio is wrong when he says “Central bank reserves are held by banks and are not part of money held by the non-financial sector, hence not, per se, an inflationary type of liquidity.”

Reason is that for every $ of reserves, there is some private sector entity with a $ deposited in a commercial bank, and increasing the latter certainly is potentially inflationary.

Bank reserves rise when government implements QE. Or put another way, reserves rise when the government / central bank machine prints money and spends it into the private sector in a recession. That adds $X to the money that private sector entities have in commercial banks, while the amount deposited by commercial banks at the central bank also rises by $X . . . . . or have I missed something?

Dan Kervick said...

I lost you here Ralp:

"Reason is that for every $ of reserves, there is some private sector entity with a $ deposited in a commercial bank, and increasing the latter certainly is potentially inflationary."

Mike Norman said...

The central bank doesn't "spend money into the private sector." Monetary policy simply changes the composition of financial assets held by the public. It strips the public of one asset (usually a government security) and credits them with another (a reserve balance), hence, monetary policy, QE, whatever, does not create any net new financial assets. The government can create net new financial assets by deficit spending, but not the central bank. Moreover, lending by banks creates both an asset and a liability for the borrower and lender. Here again there are no net new financial assets created. Spending power can certainly increase with an increase in bank loans, but as Costancio says, lending is never constrained or driven by reserves. The relationship runs the other way: loans create reserves.

Dan Kervick said...

A very positive development. If this realization finally catches on with not just CB officials, analysts and researchers, but also policy makers in the political branches, we might finally get some progress.

The money multiplier view is pernicious, not just because it leads people to have inflation fears where none are warranted, but because it gives people exaggerated, unwarranted hopes about the Fed's ability to boost investment and employment via quantitative operations.

And once knowledge of the falseness of the money multiplier view becomes widespread, there too goes the "rational expectations" model of the efficacy of quantitative operations. Fed quantitative operations only influence the rational expectations and confidence levels of private sector investors and consumers to the extent that those investors and consumers have beliefs about the prior efficacy of quantitative operations. Once those background beliefs are eliminated, fewer people will base their expectations on what quantitative operations the Fed is and is not performing.

With the house of monetarist intellectual cards collapsing, maybe the policy-makers will finally rediscover fiscal policy.

Dan Kervick said...

Ralph, there is an excellent paper by Scott Fullwiler in which the point Constâncio is making is developed clearly:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1658232

Tom Hickey said...

Ralph, also remember that a lot of the govts that the cb acquires either through OMO or QE are obtained from banks from their own accounts, so that change in composition of bank assets remains entirely in the interbank system and never influences customer deposit accounts since no direct customer activity is involved in the transactions.

And as MIke notes, eve when it would involve customer deposit accounts, it is still just a shift in composition and term. Moreover, sales of govts to govts by non-govt reduce non-govt interest income, which is substantial in aggregate.

Ralph Musgrave said...

The most important point here is that Constâncio is saying that banks are not reserve constrained. So well done Tom for drawing attention to this speech.

My above point is a minor quibble by comparison. It would take too long to fully explain it here, so I’ve explained it in a blog post here:

http://ralphanomics.blogspot.com/2012/01/my-quibble-with-vice-president-of-ecbs.html

Tom Hickey said...

Dan K: And once knowledge of the falseness of the money multiplier view becomes widespread, there too goes the "rational expectations" model of the efficacy of quantitative operations. Fed quantitative operations only influence the rational expectations and confidence levels of private sector investors and consumers to the extent that those investors and consumers have beliefs about the prior efficacy of quantitative operations. Once those background beliefs are eliminated, fewer people will base their expectations on what quantitative operations the Fed is and is not performing.

Exactly, Summer and Beckworth are wrong now (in part) because the Fed's gun as no bullets left in it. From here out, it's all bluff.

But in the larger context, once the money multiplier notion is exposed, then what the MMT economists have been saying becomes clear. The Fed's only monetary tools are setting the policy rate and managing the yield curve if it chooses to do so (ordinarily it does not).

Some MMT economists prefer setting the policy rate to zero, other not, holding that adjusting the policy rate plays a useful role in altering the balance of saving and investment.

MMT economists generally agree that the policy rate is too blunt a tool for managing the economy or controlling inflation and that fiscal policy, being more tightly targeted and acting directly on the amount of non-government NFA, is more suitable for that.

TomatoBasil said...

The general public doesn't own a huge amount of marketable securities but if the central bank does buy my bond and gives me reserves in exchange, I will search for another asset to replace the lost interest income, presumably. So indirectly, it could push up the prices of other assets in a diverse groups of alternative investments like commercial real estate, oil wells, farm land or equities or foreign financial assets. Those increased valuations spur real investment. If it were done in the middle of a frothy period, couldn't it cause inflation? But then you have the increased value of the assets pushing down yields on every thing so you get less income all around. It has to be close to a wash. Confusing and circular.

Tom Hickey said...

TB, the idea is that the cb can influence inflationary expectations. So the cb wouldn't buy tsys in a forthy period. The idea is that the cb should do this counter-cyclically to stimulate inflationary expectations. We see how well that has worked.

From what I can see, monetarists don't think though actual effects. See my recent interaction with David Beckworth on this. My question to him is about establishing a causal transmission mechanism from the psychological to real, since correlation is not causation.

On the other hand, MMT shows actually transmission mechanisms that can actually be observed in terms of monetary ops. A theory involving non-observable is inherently weaker than one based entirely on observables.

Matt Franko said...

TB,

Another thing is that the Fed under the QE2 was often just buying newly issued USTs that never left the PDs, and refused to pay a high price for them, rather the Fed set prices for Treasuries LOWER.

It is a Dealer Market.

QE2 actually caused a bond sell off as the Fed was acting as a very large scale down buyer in a market that initially experienced speculative selling... this always exacerbates a speculative sell off. The market can never recover until the large scale down buyer exits the marketplace. See the work of Steve Briese on this type of market dynamics...

QE2 in effect was an operation by a monopolist to lower the prices of Treasury bonds and RAISE interest rates.... these morons do not know what they are doing.

so if anybody sold to the Fed they actually sold into an exaggerated spec sell off of Treasuries anyway, and lost USD balances to the govt sector. Which would have imo a bearish effect on asset prices in general....

Resp,

googleheim said...

it's the virtual creation of "money"

it can be manipulated as a plastic symbol can be done as so

if you are creating something from nothing, then you owe nothing no where