The Financial System and The Economy

THE FINANCIAL
SYSTEM AND
THE ECONOMY
PRINCIPLES OF MONEY AND BANKING
ric Tymoigne
THE FINANCIAL
SYSTEM AND THE
ECONOMY
PRINCIPLES OF MONEY AND BANKING
FIRST DRAFT
RIC TYMOIGNE
August2016byEricTymoigne.Allrightsreserved.
TABLEOFCONTENTS
PREFACE.......................................................................................................................................................................V
CHAPTER 1: BALANCE-SHEET MECHANICS ......................................................................................................................................... 1
WHATISABALANCESHEET?.............................................................................................................................................2
BALANCESHEETRULES.....................................................................................................................................................4
CHANGESINTHEBALANCESHEET.......................................................................................................................................6
Netcashflow........................................................................................................................................................6
Netadditiontoassetsandliabilities.....................................................................................................................7
Netincome............................................................................................................................................................8
Netcapitalgain.....................................................................................................................................................8
CHAPTER 2: CENTRAL-BANK BALANCE SHEET: MECHANICS AND IMPLICATIONS................................................... 10
BALANCESHEETOFTHEFEDERALRESERVESYSTEM.............................................................................................................11
FOURIMPORTANTPOINTS..............................................................................................................................................12
Point1:TheFederalReservenotesarealiabilityoftheFed..............................................................................12
Point2:TheFeddoesnotearnanycashflowinUSD.........................................................................................13
Point3:TheFeddoesnotlendreservesanddoesnotrelyonthetaxpayers.....................................................14
Point4:BankscannotdoanythingwithreservebalancesunlesstheyaredealingwithotherFedaccount
holders................................................................................................................................................................16
CANTHEFEDBEINSOLVENTORILLIQUID?.........................................................................................................................17
CHAPTER 3: MONETARY BASE, RESERVES AND CENTRAL-BANK BALANCE SHEET .................................................20
THEMONETARYBASEANDTHEMONEYSUPPLY...................................................................................................................21
RESERVES:REQUIRED,EXCESS,FREE,BORROWED,NONBORROWED......................................................................................23
HOWDOESTHEMONETARYBASECHANGE?.......................................................................................................................27
CANTHEFEDISSUEANINFINITEQUANTITYOFMONETARYBASE?..........................................................................................29
CHAPTER 4: MONETARY-POLICY IMPLEMENTATION .............................................................................................................. 33
WHATDOESTHEFEDDOINTERMSOFMONETARYPOLICYANDWHY?.....................................................................................34
TARGETINGTHEFFRPRIORTOTHE2008FINANCIALCRISIS..................................................................................................37
AGRAPHICALREPRESENTATIONOFTHEFEDERALFUNDSMARKET...........................................................................................40
TARGETINGFFRAFTERTHEGREATRECESSION...................................................................................................................41
CHAPTER 5: FAQS ABOUT CENTRAL BANKING.............................................................................................................................47
Q1:DOESTHEFEDTARGET/CONTROL/SETTHEQUANTITYOFRESERVESANDTHEQUANTITYOFMONEY?......................................48
Q2:DIDTHEVOLCKEREXPERIMENTNOTSHOWTHATTARGETINGRESERVESISPOSSIBLE?...........................................................49
Q3:ISTARGETINGTHEFFRINFLATIONARY?......................................................................................................................51
Q4:WHATAREOTHERTOOLSATTHEDISPOSALOFTHEFED?...............................................................................................52
Q5:WHATISTHELINKBETWEENQEANDASSETPRICES?.....................................................................................................53
Q6:HOWANDWHENWILLTHELEVELOFRESERVESGOBACKTOPRECRISISLEVEL?THENORMALIZATIONPOLICY.......................54
Q7:ISTHEREAZEROLOWERBOUND?..............................................................................................................................55
Q8:WHATARETHEEFFECTSOFANEGATIVEINTERESTRATEPOLICY?.....................................................................................59
Q9:HOWDIDCENTRALBANKERSJUSTIFYUSINGNEGATIVEINTERESTRATESANDQE?...............................................................60
Q10:SHOULDTHEFEDFINETUNETHEECONOMY?............................................................................................................60
Q11:ISTHEFEDAPRIVATEORAPUBLICINSTITUTION?.......................................................................................................62
Q12:WHATARENONOSENTENCESFORWHATTHEFEDDOES?(WILLGIVEYOUAZEROONMYASSIGNMENTS)............................63
CHAPTER 6: TREASURY AND CENTRAL BANK INTERACTIONS........................................................................................ 66
MONETARYPOLICYANDTHEU.S.TREASURY.....................................................................................................................67
Treasurysinvolvementinmonetarypolicyduringthe2008crisis.....................................................................69
OtherexamplesofTreasurysinvolvementinmonetarypolicy..........................................................................72
FISCALPOLICYANDTHEFED...........................................................................................................................................74
ANECESSARYCOORDINATIONOFTREASURYANDCENTRALBANKACTIVITIES............................................................................76
TOGOFURTHER:CONSOLIDATIONORNOCONSOLIDATION?THATISTHEQUESTION.............................................................77
TOGOEVENFURTHER:WHATARETHERELEVANTQUESTIONSTOASKFORAMONETARILYSOVEREIGNGOVERNMENT?...............79
CHAPTER 7: LEVERAGE ..............................................................................................................................................................................84
WHATISLEVERAGE?....................................................................................................................................................85
WHATARETHEADVANTAGESOFLEVERAGE?.....................................................................................................................86
WHATARETHEDISADVANTAGESOFLEVERAGE?.................................................................................................................86
Interestraterisk.................................................................................................................................................86
Highersensitivityofcapitaltocreditandmarketrisks.......................................................................................87
RefinancingRiskandMarginCalls......................................................................................................................87
ImpactOnmortgagedebt................................................................................................................................................87
Impactonsecuritybaseddebt:Margincallrisk..............................................................................................................89
EMBEDDEDLEVERAGE...................................................................................................................................................89
BALANCESHEETLEVERAGE,SOMEDATA...........................................................................................................................91
THEFINANCIALIZATIONOFTHEECONOMY.........................................................................................................................92
CHAPTER 8: THE PRIVATE BANKING BUSINESS .......................................................................................................................... 96
THEBALANCESHEETOFABANK.......................................................................................................................................97
WHATDOBANKSDO?.................................................................................................................................................100
WHATMAKESABANKPROFITABLE?...............................................................................................................................100
RISKSONTHEBANKBALANCESHEET...............................................................................................................................103
BANKINGONTHEFUTURE............................................................................................................................................105
EVOLUTIONOFBANKINGSINCETHE1980S.....................................................................................................................107
CHAPTER 9: BANKING REGULATION ................................................................................................................................................. 111
EXAMPLESOFBANKREGULATIONS.................................................................................................................................112
Reserverequirementratios...............................................................................................................................112
Capitaladequacyratios....................................................................................................................................113
CAMELSrating..................................................................................................................................................114
Underwritingrequirements...............................................................................................................................115
WHYARETHERESTILLFREQUENTANDSIGNIFICANTFINANCIALCRISESIFREGULATIONISSOTIGHT?.............................................115
Deregulation,competitionandconcentration...............................................................................................................115
Deenforcementanddesupervision................................................................................................................................118
Regulatoryarbitrage.......................................................................................................................................................119
THEORIESOFBANKCRISESANDBANKINGREGULATION:TWOVIEWS.....................................................................................120
Laissezfaire,laissezpasser:CrisesasRandomevents......................................................................................120
Savecapitalismfromitself:Crisesasinternalcontradictions...........................................................................122
CHAPTER 10: MONETARY CREATION BY BANKS ........................................................................................................................ 127
MONETARYCREATIONBYBANKS:CREDITANDPAYMENTSERVICES.......................................................................................128
WHATCANWELEARNFROMTHEEXAMPLEABOVE?..........................................................................................................132
Point1:Thebankisnotlendinganythingithas:whenprovidingcreditservices,thebankswapspromissory
noteswithitsclients.........................................................................................................................................132
Point2:Thebankdoesnotneedanyreservestoprovidecreditservices.........................................................132
Point3:Thebankisnotusingotherpeoplesmoney:itisnotafinancialintermediarybetweensaversand
investors............................................................................................................................................................133
point4:Thebankspromissorynoteisinhighdemand....................................................................................134
HOWDOESABANKMAKEAPROFIT?MONETARYDESTRUCTION..........................................................................................135
ii
INTERBANKPAYMENTS,WITHDRAWALS,RESERVEREQUIREMENTS,ANDFEDERALGOVERNMENTOPERATIONS:THEROLEOFRESERVES
...............................................................................................................................................................................138
WHATLIMITSTHEABILITYOFABANKTOPROVIDECREDITSERVICES?....................................................................................140
MOVINGINSTEP........................................................................................................................................................141
LIMITSTOMONETARYCREATIONBYTHECENTRALBANKANDPRIVATEBANKS..........................................................................142
TOGOFURTHER:ASIDENOTEONALTERNATIVEVIEWSOFBANKING:THEMONEYMULTIPLIERTHEORYANDFINANCIAL
INTERMEDIATION........................................................................................................................................................142
CHAPTER 11: ECONOMIC GROWTH AND THE FINANCIAL SYSTEM ................................................................................... 147
THEREALEXCHANGEECONOMY....................................................................................................................................148
Moneysupplyisaveil.......................................................................................................................................148
Financeandtheeconomy.................................................................................................................................149
Conclusions.......................................................................................................................................................151
THEMONETARYPRODUCTIONECONOMY........................................................................................................................152
Moneyiseverything..........................................................................................................................................152
Whymonetaryincentivesmatter?Andwhatareotherimplications?.............................................................153
Financeandtheeconomy.................................................................................................................................154
Beyondincentives:theroleofmacroeconomicforces......................................................................................155
Conclusions.......................................................................................................................................................157
CONCLUSION.............................................................................................................................................................157
CHAPTER 12: INFLATION ......................................................................................................................................................................... 160
THEQUANTITYTHEORYOFMONEY:MONETARYVIEWOFINFLATION.....................................................................................161
INCOMEDISTRIBUTIONANDINFLATION:ANONMONETARYVIEWOFINFLATION.....................................................................164
TOGOFURTHER:KALECKIEQUATIONOFPROFIT,INTERESTRATEANDINFLATION................................................................168
CHAPTER 13: BALANCE-SHEET INTERRELATIONS AND THE MACROECONOMY ....................................................... 171
APRIMERONCONSOLIDATION......................................................................................................................................172
THETHREESECTORSOFTHEECONOMY...........................................................................................................................173
SOMEIMPORTANTIMPLICATIONS..................................................................................................................................175
point1:Thebeginningoftheeconomicprocessrequiresthatsomeonegoesintodebt..................................175
point2:Notallsectorscanrecordasurplusatthesametime.........................................................................176
point3:Publicdebtanddomesticprivatenetwealth......................................................................................180
point4:Businesscycleandsectoralbalances...................................................................................................182
CONCLUSION.............................................................................................................................................................184
TOGOFURTHER:SECTORBALANCESFROMTHEPERSPECTIVEOFTHENATIONALINCOMEANDPRODUCTACCOUNTS.................184
TOGOEVENFURTHER:NIPAANDFADEFINITIONSOFSAVING......................................................................................185
CHAPTER 14: FINANCIAL CRISES......................................................................................................................................................... 190
DEBTDEFLATION........................................................................................................................................................191
Step1:Overindebtednessanddistresssales.....................................................................................................192
Step2:Distresssalesanddeflation,theDollarDisease................................................................................192
Step3:Deflationanddebtliquidation;theDebtDisease..............................................................................192
Step4:Pricesandprofitandnetworth,theProfitDisease...........................................................................193
Step5:theAmplifiereffect............................................................................................................................194
Step6:Pessimism..............................................................................................................................................194
Step7:Interestratespread..............................................................................................................................195
Conclusion.........................................................................................................................................................196
ORIGINSOFDEBTDEFLATION........................................................................................................................................197
Realexchangeeconomy:Efficientmarketsandimperfections.........................................................................197
Monetaryproductioneconomy:Thefinancialinstabilityhypothesis...............................................................198
Financialfragility............................................................................................................................................................199
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TheFinancialinstabilityhypothesis................................................................................................................................200
HOWTODEALWITHFINANCIALCRISES............................................................................................................................202
TOGOFURTHER:PONZIFINANCEANDTHEBALANCESHEET............................................................................................203
TOGOEVENFURTHER:MINSKYANDINCOMEVS.CASHINFLOW....................................................................................204
CHAPTER 15: MONETARY SYSTEMS ................................................................................................................................................... 207
FINANCIALINSTRUMENTS.............................................................................................................................................208
ASPECIFICFINANCIALINSTRUMENT:MONETARYINSTRUMENTS...........................................................................................209
ATWHATPRICESHOULDAFINANCIALINSTRUMENTCIRCULATEAMONGBEARERS?..................................................................210
FAIRVALUEANDPURCHASINGPOWER............................................................................................................................212
ACCEPTANCEOFMONETARYINSTRUMENTS.....................................................................................................................214
TRUSTANDMONETARYSYSTEM:TRUSTINTHEISSUERVS.SOCIETALTRUST............................................................................216
WHYAREMONETARYINSTRUMENTSUSED?THEMONETARYFUNCTIONS...............................................................................218
CHAPTER 16: FAQS ABOUT MONETARY SYSTEMS ...................................................................................................................... 222
Q1:CANACOMMODITYBEAMONETARYINSTRUMENT?OR,DOESMONEYGROWONTREES?..................................................223
Q2:CANAMONETARYINSTRUMENTBECOMEACOMMODITY?...........................................................................................224
Q3:ISMONEYWHATMONEYDOES?..............................................................................................................................225
Q4:ARECONTEMPORARYGOVERNMENTMONETARYINSTRUMENTSIRREDEEMABLE?OR,ISTHEFAIRVALUEOFCONTEMPORARY
GOVERNMENTMONETARYINSTRUMENTSZERO?...............................................................................................................227
Q5:ISMONETARYLOGICCIRCULAR?..............................................................................................................................228
Q6:DOISSUERSOFMONETARYINSTRUMENTSPROMISEASTABLEPURCHASINGPOWER?.........................................................228
Q7:AREMONETARYINSTRUMENTSNECESSARILYFINANCIALINNATURE?..............................................................................229
Q8:ARECREDITCARDSMONETARYINSTRUMENTS?WHATABOUTPIZZACOUPONS?WHATABOUTPRETENDPLAYBANKNOTESAND
COINS?WHATABOUTBITCOINS?..................................................................................................................................229
Q9:WHATWERESOMEERRORSMADEINPASTMONETARYSYSTEMS?..................................................................................230
Q10:DOLEGALTENDERLAWSDEFINEMONETARYINSTRUMENTS?WHATABOUTFIXEDPRICE?.................................................232
Q11:ISITUPTOPEOPLETODECIDEWHATAMONETARYINSTRUMENTIS?WHODECIDESWHENSOMETHINGISDEMONETIZED?......232
Q12:CANANYBODYCREATEAMONETARYINSTRUMENT?..................................................................................................232
CHAPTER 17: HISTORY OF MONETARY SYSTEMS ....................................................................................................................... 235
MASSACHUSETTSBAYCOLONIES:ANCHORINGOFEXPECTATIONSANDINAPPROPRIATEREFLUXMECHANISM.................................236
MEDIEVALGOLDCOINS:FRAUD,DEBASEMENT,CRYINGOUT,ANDMARKETVALUEOFPRECIOUSMETAL......................................237
TOBACCOLEAFSINTHEAMERICANCOLONIES:LEGALTENDERLAWSANDSCARCITYOFMONETARYINSTRUMENTS..........................239
SOMALIANSHILLING:THEDOWNFALLOFTHEISSUERANDCONTINUEDCIRCULATIONOFITSMONETARYINSTRUMENT.....................240
GLOSSARY.................................................................................................................................................................242
ABOUTTHEAUTHOR...................................................................................................................................................248
iv
PREFACE
Thistextisthepreliminarydraftforatextbookthatistheresultofanextensiverevisionofpostspublished
on the blog neweconomicperspectives.org. Why write a new money and banking text when there are
alreadysomanyavailable?Therearethreemainreasons.First,textsusuallydonothaveacoherenttheme
that runs through them and that ties together all the chapters. Second, the monetary and banking
chaptersusuallyleavealottobedesiredbecausetheypresentoutdatedviewsoraretoolimitedintheir
presentationofthetopic.Three,themacroeconomicsectionsusuallydonotusewhatwaspresentedin
thepreviouschapters,leaveasideimportantdebatesinacademia,andonlybrieflydealwithbalancesheet
interrelationshipstoanalyzemacroeconomicissues.Thispreliminarytextdealswiththesethreeissues.
Throughoutthetext,theconceptofbalancesheetiscentralandusedtoanalyzeallthetopicspresented.
Notonlyarebalancesheetsrelevanttounderstandfinancialmechanics,butalsotheyforceaninquirerto
fitalogicalargumentintodoubleentryaccountingrules.Thisiscrucialbecauseifthatcannotbedone
thereisanerrorinthelogicalargument.
Themonetaryandbankingaspectsandtheirrelationtothemacroeconomyareanalyzedextensivelyin
thistextbyrelyingontheliteraturethathasbeenavailablefordecadesinnonmainstreamjournals,but
thathasbeenmostlyignoreduntilrecently.Goneisthemoneymultipliertheory,goneinthefinancial
intermediarytheoryofbanks,goneistheideathatcentralbankcontrolmonetaryaggregates,goneisthe
ideathatfinanceisneutralinanyrangeoftime,andgoneistheideathatnominalvaluesareirrelevant.
Preoccupationsaboutmonetarygains,solvencyandliquidityarecentraltothedynamicsofcapitalism,
andfinanceisnotconstrainedbytheamountofsaving.
Thechaptersdealingwithmonetarysystemsarealsomuchmoredevelopedthanatypicaltextbook.As
such,themoneychapter,usuallyfirstinM&Btexts,onlycomesmuchlaterintheformofthreechapters,
oncebalancesheetmechanicsandfinancialconcepts,suchaspresentvalue,havebeenwellunderstood.
Inaddition,thelinkbetweenmacroeconomictopicsandbankingtheoryisfullyestablishedtoanalyze
issueofinflation,economicgrowth,financialcrisis,andfinancialinterlinkages.
Ofcourse,allthisisstillworkinprogress.Therearemanychaptersmissingforafulltextandsomeofthe
chapterswillneedtoberewrittentoaccountforcommentsbymystudentsandothers.Belowisalistof
missingChaptersthatwillbeaddedbetweenJanuaryandJune2017(someofthisisalreadyincludedin
thebookbutisunderdeveloped):
1. Overview of the financial system (how financial companies differ because of different balance
sheets)
2. Financialstateofdifferentmacroeconomicsectors,flowoffundsanalysis(whoisanetcreditor?
Etc.)
3. FederalReserveSysteminstitutionalanalysis
4. Interestrateandinterestratestructure
5. Pricingofsecurities
6. Securitization
7. Derivatives
8. Monetarypolicyinaction(issuessurroundinginterestraterules,transmissionchannels,etc.)
v
9. Internationalmonetaryarrangementsandexchangerates
10. Modeling (theory of the circuit, including the money supply in models, stockflow coherency,
portfolioconstraints,capitalgains,usingmodels,etc.)
Intheseconddraft,thefirstfiveChaptersabovewillbeChapters2,3,4,5and6respectively;Chapter1
willstillbeaboutbalancesheetmechanicsandwillbeexpanded.TheChapter2inthetextbelowwillbe
includedinChapter3above.Securitizationandderivativewillbeincludedafterstudyingbanksindetails
(i.e.afterChapter10below).Internationalarrangementwillcometowardtheendofthebook.
Inordertousethispreliminaryedition,itisrecommendedthatinstitutionalanalysisbedonefirstbythe
instructor.Anytextwilldoforthatpurposebutthelecturercanemphasizehowthestructureofbalance
sheetsdiffersbetweenfinancialcompaniesinordertoexplainwhateachfinancialcompanydoes.
Iwishtothankallthereadersofthepoststhatformthebasisofthispreliminarytext.Theircomments
wereveryhelpfultoimproveclarityofthetextandcorrectsomemistakes.ManythankstoStavrosN.
Karageorgisforcarefullyreadingandeditingthedraft.
vi
CHAPTER 1:
Afterreadingthischapteryoushouldunderstand:
Whatabalancesheetis
Whyabalancesheetchanges
Howabalancesheetchanges
CHAPTER1:BALANCESHEETMECHANICS
TheU.S.financialsystemisextremelycomplicated.Figure1.1providesanoverviewofthatsystem
thatconsistsofthreemaincategories;financialmarkets,financialcompaniesandregulatoryand
supervisoryinstitutions.Whilemostpartsofthatsystemwillbeatleastmentionedinthisdraft,
thedraftfocusesmostlyontheFederalReserveSystemanddepositoryinstitutions.
International Financial Markets (Foreign Exchange Markets, Eurocurrencies, Eurobonds, Foreign Bonds)
Capital Markets: Securities with a maturity superior to one year
(Stocks, Bonds, Asset-Backed Securities)
Financial Markets
Money Markets: Securities with a maturity of one year or less

(BAs, CDs, CPs, Federal funds loans, RPs, bills)
Primary Market
Organized Exchanges
Secondary Market
OTC Markets
Insurance Markets (Forwards, Futures, Options, Swaps)

Organized Exchanges (CBOT, CBOE, NASDAQ, NYSE)
Financial-Market Companies
Security Firms (Investment Banks, Brokerage Firms)
Commercial Banks
Depository Institutions
Thrift Institutions (Credit Unions, Savings Banks, Savings and Loan Associations)
Financial Sector
Financial Companies
Financial Investment Companies (Hedge Funds, Pension Funds, Mutual Funds, Real Estate Investment Trusts)
Insurance Companies (Life Insurance Companies, Property and Casualty Insurance Companies, Monolines)
Finance Companies (Business Finance Companies, Consumer Finance Companies, Sales Finance Companies, SPEs)
Government Financial Agencies
Government-Sponsored Enterprises (FAMC, FCS, FHLBS, FHMLC, FNMA,

SLMA)
Government Loan Guarantee Programs and Government Loan Programs (ExIm Bank, FHA, FCA, GNMA, SBA, VA, DLP)
Federal Reserve System (Fedwire, Discount Window, Open Market Trading
Desk)
Private: National Associations (SIFMA, FINRA, NBA, NFA), Organized Exchanges, Clearing Systems (OC
Corp., CHIPS), Credit-Rating Agencies
Regulatory and Supervisory Institutions
Government: Department of Housing and Urban Development (FHFA), Department of Labor, Department of
Treasury (OCC, OTS), Independent Federal Agencies (CFTC, FCA, FDIC, Federal Reserve Board, Reserve
Banks, Fedwire, FTC, NCUA, SEC, CFPB), Interfederal agencies (FFIEC, FSOC), State Banking and
Insurance Commissioners
CBOE: Chicago Board Options Exchange, CBOT: Chicago Board of Trade, CFPB: Consumer Financial Protection Bureau, CFTC: Commodity Futures Trading Commission, DLP: Direct Loan Program,
Ex-Im Bank: Export-Import Bank, FAMC: Federal Agricultural Mortgage Corporation (Farmer Mac), FCA: Farm Credit Administration, FCS: Farm Credit System, FDIC: Federal Deposit Insurance
Corporation, FFIEC: Federal Financial Institution Examination Council, CHIPS: Clearing House Interbank Payment System, FHA: Federal Housing Administration, FHFA: Federal Housing Finance
Agency, FHLBS: Federal Home Loan Banks System, FHMLC: Federal Home Loan Mortgage Corporation (Freddie Mac), FNMA: Federal National Mortgage Association (Fannie Mae), FSA: Farm
Service Agency, FSOC: Financial Stability Oversight Council, FTC: Federal Trade Commission, GNMA: Government National Mortgage Association (Ginnie Mae), FINRA: Financial Industry
Regulatory Authority, NASDAQ: National Association of Securities Dealers Automated Quotation System, NBA: National Bankers Association, NCUA: National Credit Union Administration, NFA:
National Futures Association, NYSE: New York Stock Exchange, OC Corp.: Option Clearing Corporation, OCC: Office of the Comptroller of the Currency, OTC: Over-the-Counter, OTS: Office of
Thrift Supervision, SBA: Small Business Administration, SEC: Securities and Exchange Commission, SIFMA: Securities Industry and Financial Markets Association, SLMA: Student Loan Marketing
Association (Sallie Mae), SPE: Special Purpose Entity, VA: Department of Veteran Affairs.
Figure1.1.TheU.S.financialsector
The core of the financial system consists of financial documents and among them are balance
sheets.BalancesheetsprovidethefoundationuponwhichmostofanM&Bcoursecanbetaught:
monetarycreationbybanksandthecentralbank,natureofmoney,financialcrises,securitization,
financial interdependencies, you name it, it has to do with one or several balance sheet(s). As
HymanP.Minskyusedtonote,ifyoucannotputyourreasoningintermsofabalancesheetthere
isaprobleminyourlogic.
WHATISABALANCESHEET?
Itisanaccountingdocumentthatrecordswhataneconomicunitowns(itsassets)andowes(its
liabilities).Thedifferencebetweenitsassetsandliabilitiesiscallednetworth,orequity,orcapital
(Figure1.2).
Figure1.2Abalancesheet
Therearemanydifferentwaystoclassifyassetsandliabilities.Forourpurposes,abalancesheet
canbedetailedabitaccordingtoFigure1.3.Financialassetsareclaimsonothereconomicunits;
nonfinancialassets(akarealassets)maybereducedtophysicalthings(cars,buildings,machines,
pens, desks, inventories, etc.) but may also include intangible things (goodwill among others).
Demandliabilitiesareliabilitiesthataredueattherequestofcreditors(cashcanbewithdrawn
frombankaccountsatwillbyaccountholders);contingentliabilitiesareduewhenaspecificevent
occurs(lifeinsurancepaymentstoawidow);datedliabilitiesaredueatspecificperiodsoftime
(interestandprincipalmortgagepaymentsaredueeverymonth).
Figure1.3Asimplebalancesheet
Balancesheetscanbeconstructedforanyeconomicunit.Thatunitcanbeaperson,afirm,asector
oftheeconomy,acountry,anybodyoranythingwithassetsandliabilities.Table1.1showsthe
balancesheetofallU.S.households(andnonprofitorganizations)intheUnitedStates.In2014,
U.S.householdsowned$98.3trillionworthofassetsandowed$14.2trillionworthofliabilities,
makingnetworthequalto$84.1trillion(98.314.2).Householdsheld$29.2trillionofnonfinancial
assetsand$69.1trillionoffinancialassets.Theirtwomainliabilitiesweremortgages($9.4trillion)
andconsumercredit(creditcarddebts,studentdebts,healthcaredebts,etc.)($3.3trillion).
Table1.1BalancesheetofhouseholdsandNPOs.
Source:FinancialAccountsoftheUnitedStates
BALANCESHEETRULES
Abalancesheetfollowsdoubleentryaccountingrulessoabalancesheetmustalwaysbalance,that
is,thefollowingmustalwaysbetrue:
Assets=Liabilities+NetWorth
Thepractical,andcentral,implicationisthatachangeinoneitemonthebalancesheetmustbe
offsetbyatleastonechangesomewhereelsesothatabalancesheetstaysbalanced.
4
Startwithaverysimplebalancesheet.Theonlyassetisahouseworth$100kthatwaspurchased
byputtingdown20kandaskingfor$80kfromabank(Figure1.4).
Figure1.4Asimplebalancesheet
Whatistheimpactofabankforgiving$40kofprincipalonthemortgage?Thevalueofmortgage
wentdownby40kandthevalueofnetworthwentupby40ksothattheaccountingequalityis
preserved(Figure1.5)
Figure1.5Effectofforgivingsomeofthemortgageprincipal
Goingbacktothefirstbalancesheet,whatistheimpactofthevalueofthehousegoingupby$20k?
Theassetvaluewentupby$20kandthenetworthwentupby$20andhereagaintheaccounting
equalityispreserved.(Figure1.6).
Figure1.6Effectofhigherhouseprice
Sometimes,togettothepointmorequicklyandtohighlightthechanges,economistsprefertouse
socalledTaccounts(becausetheshapeofthetablelookslikeaT)thatrecordonlythechanges
inthebalancesheet(meanschangein).Theoffsettingaccountingentryisshownmoreclearly.
Itcomesfromoppositechangesintwoitemsontherightsideofthebalancesheet(Figure1.7),and
achangeinassetandnetworthbythesameamount(Figure1.8).Ofcourse,thesearenottheonly
5
twowaystheoffsettingisdonetopreservetheaccountingequality.Wewillencounterothercases
aswemoveforward.Thepointisthatonemustchangeatleasttwothingsinabalancesheetto
make sure that the equality A = L + NW is preserved. One must always ask: what is (are) the
offsettingentrychange(s)?Thishaspracticalimplicationswhenstudyinghowbanksandcentral
bankoperate.
Household
LiabilitiesandNetWorth
Mortgage:$40
Networth:+$40
Figure1.7Taccountthatrecordsthedeclineofthemortgageprincipal
Assets
Household
Assets
House:+$20
Networth:+$20
Figure1.8Taccountthatrecordsthehigherhousevalue
CHANGESINTHEBALANCESHEET
Onecanclassifyfactorsthatchangeabalancesheetinfourcategories:
Cashinflowsandoutflows:netcashflow.
Purchasesandsalesofassets,issuanceandrepaymentofdebts:Netacquisitionofassets
andliabilities.
Incomesandexpenses:netincome.
Capitalgainsandcapitallosses:netchangeinthemarketvalueofassetsandliabilities.
The last three categories are recorded more carefully in other accounting documents than the
balancesheet,butthissectionfocusesontheirrelationtothebalancesheet.
NETCASHFLOW
Cashinflowsandcashoutflowsleadtoachangeintheoutstandingvalueofmonetarybalances
heldbyaneconomicunit,thatis,achangeinthequantityofphysicalcurrencyorfundsinabank
accountheldontheassetside.Someassetsleadtocashinflowswhilesomeliabilitiesandcapital
(dividendpayments)leadtocashoutflows.
Ifthecashinflowsaregreaterthanthecashoutflows,monetaryassetsheldbyaneconomicunit
goup.Theeconomicunitcanusethemtobuyassetsorpledgethemtoleverageitsbalancesheet
(seeChapter7).Ifnetcashflowisnegative,thenmonetaryassetholdingsfallandtheeconomic
unitmayhavetogofurtherintodebttopaysomeofitsexpenses(Figure1.9).
Figure1.9Balancesheetandcashflow
GoingbacktothebalancesheetofFigure1.4,assumethatasalaryof$40kisearnedandthatpart
ofthesalaryisusedtoservicea30yearfixedrate10%mortgage.Assuminglinearrepaymentof
principaltosimplify(actualmortgageservicingiscalculateddifferently),Figure1.10showswhat
thecashflowstructurelookslike.
Figure1.10Balancesheetandcashflows,anexample
ThebalancesheetatthebeginningofthefollowingyearisshowninFigure1.11(assumingallcash
flowsinvolveactualcashtransferinsteadofelectronicpayments).Quiteafewthingshavechanged
inthebalancesheet.Thereisanetinflowofcashof$29.3k,theprincipalofthemortgagefellby
theamountofprincipalrepaid,andthechangeinnetworthaccountsforthesetwochanges.
Figure1.11Balancesheetafterthecashflowimpacts
NETADDITIONTOASSETSANDLIABILITIES
Netcashflowrecordsthenetadditionofmonetarybalancesbuttherearemanyotherassetson
thebalancesheets.Overtime,assetslossvalueviadepreciation,ordestruction,orrepaymentof
principal;someassetsaresoldwhileothersassetsarepurchased.Thenetchangeinthemonetary
valueofassets(acquisitionsminuslossofvalueandsales)impactsthebalancesheet.Depreciation
iscountedasanexpenseandsoimpactsnetincome.Similarly,liabilitiesonthebalancesheetare
progressivelyrepaid(principalrepayment)orreducedinotherways,whilenewliabilitiesareissued
by an economic unit. The net issuance of liabilities (new liabilities principal reductions) also
impactsthebalancesheetoftheirissuers.Theyalsoimpactthebalancesheetofthecreditorsgiven
thattheliabilitiesofsomeonearethefinancialassetsofsomeoneelse.
Currentnetworth=Previousnetworth+Netadditiontoassetsandliabilitiesoftheperiod
Figures 1.4 shows the impact of acquiring nonfinancial assets (the house) and incurring new
liabilities(themortgage).Figure1.5showstheimpactofadeclineintheprincipalamountofthe
mortgage.
NETINCOME
Netincomeleadstoachangeinnetworth:
Currentnetworth=Previousnetworth+Netadditiontoassetsandliabilitiesoftheperiod+
Netincomeoftheperiod
Netincomecanbepositiveornegativesonetworthmayriseorfalldependingonwhatthevalue
ofnetincomeis.Inthepreviousexample(Figures1.10and1.11),netcashflowandnetincomeare
the same thing; however, not all incomes necessarily lead to cash inflows (see Chapter 4 and
Chapter10). Thereisadebateabout whetheroneshouldrecordcapital gainsandlossesinthe
incomestatement.Forthepurposeofthissection,thetwoareclearlyseparated.
NETCAPITALGAIN
Thevalueofassetsandliabilitieschangemerelybecauseofchangesintheirmarketpriceseven
though their quantities has not changed (no net addition). If accounting is done on a markto
8
marketbasis,i.e.byvaluingbalancesheetitemsonthebasisoftheircurrentmarketvalue,these
changesareaccountedinthebalancesheet.Someassetsseetheirpricesgoup(capitalgains)while
otherseetheirpricesgodown(capitallosses)andthedifferencebetweencapitalgainsandcapital
losses(netcapitalgains)affectsthenetworthaccordingly:
Currentnetworth=Previousnetworth+Netadditiontoassetsandliabilitiesoftheperiod+
Netincomeoftheperiod+Netacquisitionofassetsandliabilitiesoftheperiod+Netcapital
gainsoftheperiod
TheexampleofFigure1.3isasimpleillustrationoftheimpactofcapitalgains.
The effect of a change in the market prices of assets and liabilities may not be recorded in the
balancesheetif theyare valuedona costbasis.Forfinancialassets,therearethreeoptionsto
recordtheirvalue.Level1valuationusestheavailablemarketprice.Level2valuation,forassets
thatdonothaveanactivemarket,usesaproxymarketasapointofreference.Level3valuation,
alsocalledmarktomodel(ormorecynicallymarktomyth),usesaninhousemodeltogivea
dollarvaluetotheasset.Duringthe2008crisis,majorfinancialinstitutionsarguedthatthemarket
pricesofsomeassetsdidnotreflecttheirtruevaluebecauseofapanicinmarkets.TheSecurities
andExchangeCommissionallowedthemtomovetolevel2orlevel3valuationtoavoidrecording
capitallossesontheirassets.Manyanalystshavebeencriticalofthatdecisionandconsidereditto
beaconvenientwaytohidemajorlossesofnetworthbyfinancialinstitutions.
SummaryofMajorPoints
1Abalancesheetisoneoftheimportantfinancialdocumentsusedtorecordthefinancialstateof
aneconomicunit
2Assetsrepresentwhatisownedandliabilitiesrepresentwhatisowedbyaneconomicunit
3 Net worth or capital or equity is the difference between the monetary value of assets and
liabilities
4Abalancesheetmustbalance,i.e.atalltimethefollowingmustbetrue:Assets=Liabilities+Net
Worth
5Abalancesheetfollowsdoubleentryaccountingrules:achangesomewhereleadstoatleast
oneoffsettingchangesomewhereelsetoensurethatthebalancesheetstaysbalanced.
Keywords
Balance sheet, nonfinancial assets, financial assets, demand liability, time liability, contingent
liability,networth,capital,netincome,netcashflow,netcapitalgain,netacquisitionofassetsand
liabilities,level1valuation,level2valuation,level3valuation
ReviewQuestions
Q1:Whatdoesabalancesheetdo?
Q2:Ifthevalueofassetsgoesupandthevalueofliabilitiesgoesdown,whathappenstonetworth?
Q3:Ifthevalueofassetsandliabilitieschangesbythesameamount,whathappenstonetworth?
Q4:Ifoutstandingassetsdepreciatefasterthantheacquisitionofnewassets,whathappenstothe
valueofassets?Tothevalueofnetworth?
Q5:Ifaneconomicunittakesonnewdebtfasterthanitrepaysoutstandingprincipal,whathappens
tothelevelofliabilities?Ofnetworth?
CHAPTER 2:
AfterreadingthisChapteryoushouldunderstand:
Whatthemaincomponentsofacentralbankbalancesheetare
Howacentralbankprovidesreserves
Thatacentralbankdoesnotrelyontaxpayers
Thatacentralbankdoesnotlendreserves
Thatacentralbankdoesnotuseanydomesticmonetaryinstruments
Thatacentralbankdoesnotearnanycashflowinthedomesticcurrency
Thatbankscannotbuyanythingwithreservebalancesfromthepublic
CHAPTER2:CENTRALBANKBALANCESHEET:MECHANICSANDIMPLICATIONS
The Federal Reserve System (the Fed) is a typical central bank. It provides the currency of the
nation,itisthedepositoryandfiscalagentoftheTreasury,itprovidesadvancesoffundstobanks,
anditintervenesinfinancialmarkets.Inordertounderstandhowallthisisdone,itisimportantto
understandthebalancesheetoftheFed.ThisChapterappliestheinsightsofChapter1tostudythe
balancesheetmechanicsoftheFed.
BALANCESHEETOFTHEFEDERALRESERVESYSTEM
Table 2.1 shows the actual balance sheet of the Federal Reserve System. It sums the assets,
liabilities,andcapitalofalltwelveFederalReservebanksandconsolidatesthem(i.e.removeswhat
Fedbanksowetoeachother).ThemainassetisTreasurysecuritiesthatamountedtoabout$718
billioninJanuary2005.
Table2.1ActualbalancesheetoftheFederalReserveSystem
Source:BoardofGovernorsoftheFederalReserveSystem(SeriesH.4.1)
The main liability is outstanding Federal Reserve notes (FRNs) issuedthat is, held outside the
twelveFederalReservebanksvaultsthatamountedto$718billioninJanuary2005.Thislinein
thebalancesheetincludesallFRNsissuedregardlesswhoownsthem.Adistantsecondliabilitywas
reservebalances(depositsofdepositoryinstitutions)thatamountedto$31billion.
11
CapitalconsistsmostlyoftheannualnetincomeoftheFed(surplusline)andthesharesthat
banksmustbuywhenbecomingmembersoftheFederalReserveSystem(thecapitalpaidinline).
Thesesharesarenottradable,cannotbepledged(bankscannotusethemascollateralandthey
cannot be discounted), do not provide a voting right to banks, and pay an annual dividend
representing6%ofnetincomeoftheFed.
AnyleftovernetincomeistransferredtotheU.S.TreasuryandtheSecretaryoftheTreasurycan
usethefundsonlyfortwopurposes:toincreaseTreasurysgoldstockortoreduceoutstanding
amountofTreasuries.1
Foranalyticalpurposes,itisbesttorearrangethebalancesheetoftheFedaccordingtoFigure2.1.
Throughthisbook,alotwillbedonewithL1,L2andL3aswellasA1andA2becausetheyareall
centraltotheunderstandingofdomesticmonetarypolicyoperations.Inaddition,L1onlycontains
the FRNs held by banks, the domestic public and foreigners. Indeed, for analytical purposes,
economistsliketomeasuretheoutstandingvalueofFRNsincirculation,thatis,FRNsheldoutside
thevaultsofprivatebanks(vaultcash),oftheFederalReservebanks,andoftheU.S.Treasury.
FRNsheldbytheTreasuryareincludedinL3,FRNsheldbytheFederalReservebanksareincluded
nowhere(theyhavenotbeenissuedsotheyarenotaliabilityyet).
Assets
A1:Securities
A2:Domesticprivatebanks
promissorynotes
A3:Foreigndenominatedassets
A4:CoinsandTreasurycurrency
L1:FederalReservenotesin
circulationandvaultcash
L2:Reservebalances(Checking
accountduetobanks)
L3:TreasurysaccountandFederal
ReservenotesheldbyTreasury
A5:Otherassets(buildings,furniture,
L4:Accountsduetoforeignersand
etc.)
others
L5:Otherliabilities(includingequity
capital)
Figure2.1AsimplifiedbalancesheetoftheFederalReserveSystem
FOURIMPORTANTPOINTS
POINT1:THEFEDERALRESERVENOTESAREALIABILITYOFTHEFED.
OneimmediatelynotesthatthecentralbankdoesnotownanycashorabankaccountinUSdollar,
i.e.therearenodomesticmonetaryinstrumentsonitsassetsidebesidesafewTreasurycurrency
items(UnitedStatesnotes,etc.)andsomecoins.TheFeddoesnotusecoinstospend,itactsas
coindealeronbehalfoftheTreasury,2thatis,FedbuysallnewcoinsfromtheU.S.Mintatface
valueandsellsthemtobanksattheirrequestbydebitingtheirreservebalances.TheFedalsobuys
backcoinsthatbankshaveinexcessbycreditingtheirreservebalances.Goldcertificateaccount
(firstlineunderassets)arejustelectronicentriestorecordthesafekeepingofsomeofthegold
stockownedbytheU.S.Treasury;TheFeddoesnotownanygold.3TheFeddoesownsomeforeign
monetaryinstruments(SDRaccounts,accountsatforeigncentralbanks,foreigncurrency).
12
WhattheU.S.populationconsiderstobemoney,theFederalReservenotes(FRNs),isrecorded
asaliabilityonthebalancesheetoftheFed.FRNsareaspecificsecurityissuedbytheFedandthe
FedowestheholdersoftheFRNs.Chapter15studieswhatisowed.FRNsaresecuredbysomeof
theassetsoftheFederalReservebanks,mostofthemareTreasuries(Figure2.2)
Figure2.2.LevelandcompositionoftheassetspledgedagainsttheFRNsoutoftheFederal
Reservevaults,trillionsofdollars
Source:BoardofGovernorsoftheFederalReserveSystem(SeriesH4.1)
Note:USTSmeansU.S.Treasurysecurity,MBSmeansmortgagebackedsecurity.
POINT2:THEFEDDOESNOTEARNANYCASHFLOWINUSD
WhentheFedreceivesanetincomeinUSdollarsitdoesnotreceiveanycashflow,i.e.nomonetary
assetgoesup.Whatgoesupisnetworth.Howdoesthatoccur?Supposethatbanksrequestan
advance of funds of $100 repayable the next day with a 10% interest. Today the following is
recorded:
Fed
Assets
Promissorynotesofbanks:+$100
Reservebalances:+$100
TheFedjusttypedanentryoneachsideofitsbalancesheet,onetorecordthecreditingofreserve
balancesandonetorecordtheFedisnowacreditorofprivatebanksbyholdingaclaimonbanks.
Thenextdaybanksmustpayback$100andanadditional$10.Thefullrepaymentoftheprincipal
leadsto:
Fed
Assets
Promissorynotesofbanks:$100
13
Reservebalances:$100
What about the $10 payment? It leads to an additional decrease in reserve balances and the
offsettingoperationisanincreaseinnetworthattheFed(andadecreaseinnetworthatprivate
banks)
Fed
Assets
Reservebalances:$10
Networth:+$10
ThesetwoTaccountsarenormallyconsolidatedintoone:
Fed
Assets
Promissorynotesofbanks:$100
Networth:+$10
Herewego!TheFedrecordsanincomegain!
HowdoesittransferthattotheTreasury?Easy!AFedemployeetypesthefollowingonakeyboard:
Fed
Assets
Treasurysaccount:+$10
Networth:$10
Thetransferoffundsbetweenaccountsislikekeepingscoresbychangingamountsrecordedonthe
liabilityside.Bankslost10points,Treasurygained10points.
POINT3:THEFEDDOESNOTLENDRESERVESANDDOESNOTRELYON
THETAXPAYERS
InTable2.1,thereisalinelabeledloanontheassetside,andonewilloftenhearandreadeven
inFeddocumentsthattheFedlendsreservestobanks.InthebalancesheetofFigure2.1,thereis
noloanbutinsteadthereisA2:Domesticprivatebankspromissorynotes.
This textbook will not the use the words loan, lender, borrower, lending, borrowing,
whenanalyzingbanks(privateorFed)andtheircreditoperations.Banksdonotlendmoneythey
arenotmoneylendersandcustomersdonotborrowmoneyfrombanks.Wordslikeadvance,
creditor,debtor,aremoreappropriatewordstodescribewhatgoesoninbankingoperations.
Thewordlend(andsoborrow)isreallyamisnomerthathasthepotentialofconfusingand
actually does confusepeople about what banks do. Lending means giving up an asset
temporarily:Ilendyoumycarforafewdaysisrepresentedasfollowsintermsofabalancesheet:
Dr.T
Assets
Car:$100
Claimonborrowerofcar:+$100
Alternatively,ifsomeonegoestoseealoansharkforhisgamblinghabitsandborrows$1000cash,
thenthebalancesheetoftheloansharkchangesasfollows
14
Loanshark
Assets
Cash:$1000
Claimongambler:+$1000
The loan shark loses cash temporarilyhe does lend cashand if the gambler does not repay
quicklywithheftyinterest,theloansharkcomeswithabaseballbatandbreakshislegs(orworse!).
TolendisreallynotaproperverbtoexplainwhattheFeddoesbecausereservebalancesand
FRNsarenotassetsoftheFed,theyareitsliabilities.Asshowninpoint2,whentheFedprovides
reservebalancestobanks,theFedgivestobanksitsownpromissorynote(reservebalances)and
banks give to the Fed their own promissory notes. What the Fed does is to swap/exchange
promissorynoteswithbanks.Thisisonewayforbankstoobtainreservesbalances.Chapter4and
Chapter10explainwhybanksaresointerestedintheFedspromissorynoteandhowtheyobtain
reserves.Figure2.3showswhatthebankspromissorynotelookslike.
Figure2.3TemplateofthepromissorynoteissuedbybankstotheDiscountWindow
Source:FederalReserveBankServices(OperatingcircularNo.10)
15
Inthislegaldocument(andothersattachedtoit),abankrecognizesthatitisindebtedtotheFed
becausetheFedprovidedanadvanceoffunds,thatis,creditedthebanksreservebalance.Now
thebankpromisestocomplywiththetermsofthecontractthatdetailstimetableforrepayment,
interest,collateralrequirements,covenants,whathappensincaseofdefault,etc.TheFedkeepsa
copyofthisdocumentinitsvault;itisanassetfortheFed(A2inFigure2.1)becausethebankmade
alegalpromisetotheFed.TheFedcanforcethebanktocomplywiththedemandsofthepromise.
Themainpointisthat,whentheFedprovidesfundstobanks,theFeddoesnotgiveupsomething
itfirsthadtoacquire.TheFeddoesnotusetaxpayersmoney(oranybodyelsesmoney)aswe
oftenheardduringthe2008financialcrisiswhenlargeemergencyadvanceshadtobeprovidedto
many financial institutions. When the Fed provides/advances funds to banks, it just credits the
accountsofbanksbykeystrokingamounts.Chapter10showsthatthesamelogicappliestoprivate
banks.
POINT 4: BANKS CANNOT DO ANYTHING WITH RESERVE BALANCES

UNLESSTHEYAREDEALINGWITHOTHERFEDACCOUNTHOLDERS
OnemayalsonotethatnobodyintheU.S.populationhasabankaccountattheFederalReserve.
Onlydomesticbanks,foreigncentralbanks,andotherspecificinstitutions(suchastheInternational
MonetaryFundandsomegovernmentsponsoredenterprises)haveanaccountattheFed.4When
banksusetheiraccountsattheFedtomakeortoreceiveapayment,theonlyotherinstitutions
thatcanreceivethefunds(ormakeapaymenttobanks)arethosethatalsoholdanaccountatthe
Fed.Bankscannotusetheirreservebalancestobuysomethingfromaneconomicunitthatdoes
nothaveanaccountattheFedbecausefundscannotbetransferred.Similarly,youandIcannot
makeelectronicpaymentstoapersonwhodoesnotholdabankaccount.
Thisiswhathappenswhenbanksspend$100fromtheirreservebalances:
Fed
Assets
This Taccount is incomplete because it lacks the offsetting accounting entry. What are the
possibilities?Belowarethreeofthem:
1 BanksaskforFRNs:
Fed
Assets
FRNs:+$100
2 Bankssettletaxes(theirsorthatoftheUSpopulation):
Fed
Assets
3 Banksparticipateinanofferingofsecuritiesbyagovernmentsponsoredenterprise:
16
Fed
Assets
GSEsaccount:+$100
Youmaythinkofotherwaystotransfer$100worthoffundsontheliabilitysideoftheFed.Once
again,theFedisbasicallykeepingscoresbytransferringfundsamongaccountholdersandkeeping
atab.
The main point is that banks cannot buy anything with reserve balances from anyone in the
domesticeconomyexceptfromeachotherandotherFedaccountholders.Banksasawholecannot
usereservebalancestoacquireanysecurityissuedbytheprivatesectororanygoodsandservices
(onebankcoulduseitsreservebalancetobuysuchthingsfromanotherbank).Morereservesdo
notprovidebanksmorepurchasingpowerinthedomesticeconomytobuyexistingbonds,stocks,
houses,etc.
IfbankswantedbuysomethingfromsomeoneinthedomesticeconomywithFedcurrency,they
wouldhavetogetmorevaultcashfirst(case1above).Chapter10showsthatbanksdonotoperate
thatwaytomakepayments.Nordobankslendcash(theyarenottheloansharkofpoint2).
CANTHEFEDBEINSOLVENTORILLIQUID?
No.TheFedcannotrunoutofdollarsbecauseitistheissuerofthedollar.TheFedcouldhavea
negativenetworthandstillbeabletooperatenormallyandmeetallitscreditorsdemands.
Themainroleofnetworthinaprivatebalancesheetistoprotectthecreditors(theholdersofthe
liabilities). Think of the house example in Chapter 1. The house was funded by $80k of funds
obtainedfromabankand$20kdown.Ifthemortgagordefaults,thebankcanforecloseandsell
thehouse.Withanetworthof20k,thehomepricecanfallby20%beforethebankisunableto
recoverthefundsadvancedtothemortgagor.Ifthedownpaymenthadbeen0%(mortgagewas
$100k),whenthebankforeclosesitdoesnothaveanyfinancialbufferagainstafallinhouseprice.
For the Fed, this is financially irrelevant, although politically it may raise some eyebrows in
Congress.ItcanmeetallpaymentsduedenominatedinUSDatanytime,nomatterhowbigthey
are.
17
1ThemainliabilityoftheFederalReserveSystemisthecashwehaveinourwallet,FederalReserve
notes.
2ThemainassetoftheFederalReserveSystemisTreasurysecurities.
3Lendingmeanstemporarilygivingupanasset;assuchtheFederalReserveSystemdoesnotlend
reservesbecausereservesareitsliability.
4Tocredittheaccountofitsaccountholders,theFederalReserveSystemswapspromissorynotes
withthem.
5 To obtain an advance from the Fed, private banks must provide collateral to back their
promissorynote.
6PayinginteresttotheFedincreasesitsnetworthanddebitstheFedaccountsofwhomeveris
payingtheinterest.Thereisnocashflowgain,i.e.noincreaseinmonetarybalancesontheasset
sideoftheFedsbalancesheet.
7Bankscanonlytransferfundsin/outoftheirFedaccountsfrom/tootherFedaccountholders,in
thesamewayyouandIcanonlytransferfundsfromourcheckingaccounttoanotherchecking
account.Assuchprivatebankscannotbuyanythingwiththeirreservebalancesfromthepublic.
8TheFederalReserveSystemissuestheU.S.currencysoitcannotrunoutofU.S.currencyand
canpayanydebtitowesdenominatedintheU.S.dollar.
Keywords
Currencyincirculation,FederalReservenote,reservebalance,loan,lending,advance,swapping.
ReviewQuestions
Q1:DotheFederalReservebanksownanydomesticmonetaryinstruments?
Q2:DotheFederalReservebanksusecoinstobuyassets?
Q3:WhydotheFederalReservebanksnotlendreserves?
Q4:Whyisitnotpossibleforprivatebankstobuythingsfromthepublicbyusingtheirreserve
balances?
Q5:Whatcanprivatebanksbuywiththeirreservebalances?
Q6: When private banks pay an interest to the Federal Reserve banks, how do Federal Reserve
banksrecordthisincomegain?Isthereanygainofcashflow?
Q7:WhyisitnotpossiblefortheFederalReserveSystemtobeinsolvent?
SuggestedReadings
Check the General Information
https://www.frbdiscountwindow.org/
tag
of
the
Discount
Window
website:
CheckAbouttheFedhere:http://www.federalreserve.gov/aboutthefed/default.htm
Check the website of the Board of Governors of the Federal Reserve System, especially the
following: http://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm. Table 5
containsaninteractivesectionaboutthebalancesheetoftheFed.
18
DatabaseExploration
HowtoretrievetimeseriesdataaboutthebalancesheetoftheFed?
Step1:GotoSeriesH.4.1:http://www.federalreserve.gov/releases/h41/
Step2:ClickonPDFandlookforTable5.Useitasareferencepointtoselectdata.
Step3:ClickonDatadownloadprogram.
Step4:SelectoptionABuildyourpackage.
Step5:In2.CategoryselectAssetsandLiabilitiesandCapital.
Step 6: Continue with the subcategories and components. You can select more or less details
relativetoTable5.
Step7:Continuewithothermiscellaneousselections(frequency,timeframe,etc.)anddownload.
Tip:Alwaysdownloadtotalassetsandtotalliabilitiessoyoucansumallthecomponentsof
eachcategoryandmakesuretheyequalthetotal.Ifnot,youforgotacomponent.
1FordetailseeSection7ofFederalReserveAct.
2
See Current FAQs: What is the role of the Federal Reserve with respect to banknotes and coins? at
http://www.federalreserve.gov/faqs/currency_12626.htm
3 See Current FAQs: Does the Federal Reserve own or hold gold? at http://www.federalreserve.gov/faqs/doesthe
federalreserveownorholdgold.htm
4A recent working paper released by the Bankof England proposes to expandthe access to accounts at the Bank of
Englandtothegeneralpopulation.StaffWorkingPaperNo.605,Themacroeconomicsofcentralbankissueddigital
currenciesbyJohnBarrdearandMichaelKumhof.
19
CHAPTER 3:
AfterreadingthisChapteryoushouldbeabletounderstand:
Whatreservesandmonetarybaseare
Whatthemostcommonmeanstoobtainreservesforbanksare
Howthecompositionofreserveshaschangedovertime
How reserves and monetary base are injected into, and removed from, the
economy
CHAPTER3:MONETARYBASE,RESERVESANDCENTRALBANKBALANCESHEET
The previous Chapter explained how the balance sheet of the Fed works. The current Chapter
beginstostudythedetailsofhowtheFedoperatesintheeconomyintermsofmonetarypolicy.To
understandwhattheFeddoes,itisfirstnecessarytodefinethemonetarybaseandseehowit
relatestotheFedsbalancesheet.TheChapterquicklylooksatthedifferencebetweenmonetary
baseandmoneysupply,andalsolooksmorecarefullyatwhatreservesare.
THEMONETARYBASEANDTHEMONEYSUPPLY
Themonetarybase(akahighpoweredmoney)isdefinedas:
MonetaryBase=Reservebalances+vaultcash+currencyincirculation
In its widest meaning, in circulation refers to any monetary instrument not held by its issuer;
Federal Reserve Notes (FRNs) outside the Federal Reserve banks and any Treasuryissued cash
outsidetheTreasury.Economistsprefertouseanarrowerdefinition.Currencyincirculationisany
currencyoutsidevaultsofprivatebanks(vaultcash),oftheTreasury,andoftheFedwhatis
heldbythepublic.
Figure3.1Monetarybase,billionsofdollars
Sources:BoardofGovernorsoftheFederalReserveSystem(H3andH6series)
Technically,cashmeanscurrencyandcoins.TheFedandTreasuryusethewordcurrencytomean
papermoneyonly.CurrencyincirculationincludesmostlyFRNs,butalsosomeTreasurycurrency
(UnitedStatesnotes,silvercertificates)andnationalbanknotes(issuedpriortothecreationofthe
Fedin1913)thattheTreasurystillagreestotakeatfacevalueatanytime.1Thedistinctionbetween
coinsandcurrencyismostlystatisticalanddoesnothaveanyanalyticalpower.Chapter15shows
that the material of which something is made is irrelevant to determine if it is a monetary
instrument.Thisbookusesthewordcashandcurrencyinterchangeably.
Tosimplify,theU.S.monetarybasecanbereducedto(seeFigure2.1formeaningsofL1andL2):
21
Monetarybase=L1+L2
Thatis,themonetarybaseisthesumofreservebalancesandFRNsheldbyentitiesotherthanthe
FedandtheTreasury.
Untilrecently,currencyincirculationwasthelargestcomponentofthemonetarybaseanditgrew
steadilytoalmost$1.4trilliontoday,mostofwhichareFRNs,2andbetweenonehalfandtwothirds
ofthevalueofcurrencyincirculationisheldabroad.3Theglobalfinancialcrisisledalargeincrease
inreservebalancesfromabout$24billiononaveragefromJanuary1959toAugust2008toabout
$2.5trilliontoday(Figure3.1).
Figure3.2Moneysupply(M1aggregate),billionsofdollars
Source:BoardofGovernorsoftheFederalReserveSystem(SeriesH.6)
The monetarybaseisnotthesamethingasthemoneysupply. Moneysupplymeansmonetary

instrumentsheldbynonbankeconomicunitsandoutsidetheTreasuryandotherofficialforeign
institutions.Thereareseveralwaystomeasurethat,andmonetaryaggregateM1isthenarrowest
(Figure3.2):
M1=Currencyincirculation+Privatebankcheckingaccountsofnonbanks,nonfederal,non
officialforeigneconomicunits+others
M1 relates to the Feds balance sheet only via part of L1. Since 1959, FRNs in circulation has
representedagrowingproportionofthemonetarybase(Figure3.2).From20%inthe1960sto30%
intheearly1990s.The1990srecordedarapidgrowthintheshareofFRNsincirculationthatpeaked
at56%ofthemonetarybasein2007andhasbeenaround40%to50%sincethelate1990s.The
proportionofdemandaccountsrepresentedabout80%ofthemonetarybaseinthe1960s,butthis
share fell quickly and almost continuously following the emergence of alternatives to demand
accounts.Theshareofdemandaccountsinthemonetarybasereached20%ofthemonetarybase
rightbeforethe2008financialcrisis.Sincethecrisis,theshareofdemandaccountshasincreased
sharplytoreach40%ofthemonetarybase.Travelerscheckshavealwaysbeenaninsignificant
22
component of the money supply. For reasons related to monetary policy detailed in Chapter 5
(Question1),thegrowthrateofM1increasedin2009.
Itisimportanttomakeadistinctionbetweenthemoneysupplyandthemonetarybasebecause
thecentralbankhasnodirectinfluenceonthemoneysupply.TheFeddoesnotdealwiththepublic
directly, private banks do. Even for FRNs, private banks are in charge of injecting FRNs into the
economy,andtheydosoonlyifcustomerswanttowithdrawcash.Ina2010interview4Chairman
Bernankenotedregardingtheannouncedpurchaseof$600billionofTreasuries(akaquantitative
easing):
Onemyththat'soutthereisthatwhatwe'redoingisprintingmoney.We'renot
printingmoney.Theamountofcurrencyincirculationisnotchanging.Themoney
supplyisnotchanginginanysignificantway.
Translated in the terms of what was presented above, Bernanke states that L2 has gone up
dramaticallybutthatM1hasnotchanged.TheFeddidnotissueFRNstothepublic(L1didnot
increase),itjustcreditedtheaccountsofbanksbybuyingTreasuriesfromthemand,asChapter2
shows,bankscannotdomuchwithreservebalances.
OneshouldnotethattheTreasurysaccountattheFed(L3)anditsaccountsatprivatebanks(called
TreasuryTaxandLoansaccounts(TT&Ls))arenotpartofthemonetarybaseorthemoneysupply.
Theyarefunds.TheoutstandingvalueoftheTreasurysaccountsisnotcountedinanydefinition
ofthemonetarybaseorthemoneysupply.
RESERVES: REQUIRED, EXCESS, FREE, BORROWED, NON

BORROWED
Within the monetary base, reserves are central to monetarypolicy operations so this section
studiesabitmorecarefullythereservesideofthemonetarybase.Totalquantityofreservesis:
Totalreserves=Reservesbalances+appliedvaultcash=L2+partofL1
AppliedvaultcasharetheFRNsthatbanksdecidetousetocalculatethequantityofreservesthey
reporttotheFed(therestofvaultcashiscalledsurplusvaultcash).Fromthe1990sanduntilthe
GreatRecession,appliedvaultcashhadrepresentedthemajorityoftotalreservesandpeakedto
about 80% of total reserves. Since August 2008, reserves balances have been, by far, the main
componentoftotalreserves(Figure3.3).
It is possible for reserve balances (L2) to be negative, that is, the Fed allows banks to have an
overdraft;however,theFedexpectsthatbankscloseanyoverdraftattheendofeachday.Ifabank
cannot do so, the Fed charges a very high interest rate because the overdraft is a form of
uncollateralizedadvance,contrarytoDiscountWindowadvances.Iftheoverdraftpersists,theFed
maytakeacloserlookathowthebankrunsitsbusiness.
23
Figure3.3Decompositionoftotalreservesintermsofforms,billionsofdollars
Totalreservescanbedecomposedintoothercategoriesthanthosebasedontheformreserves
take.Onemayalsobeinterestedinknowinghowbanksobtainedtheirreserves.TheFedisthe
monopolysupplierofreservesandtherearetwowaysfortheFedtoprovidereserves:
-
DiscountWindowoperations:advancesfundsbyswappingpromissorynoteswithbanks
(seeChapter2):borrowedreserves
Openmarketoperations:Fedbuyssomefinancialassetsfrombankseitherpermanently
(outright purchases) or temporarily (repurchase agreements): nonborrowed
reserves
Totalreserves=borrowedreserves+nonborrowedreserves
Nonborrowedreserveshavebeenthemainsourceofreservesforbanks(Figure3.4)becausethe
Fed discourages the use of the Discount Window (interest rate is higher and Fed may increase
supervisionifabankcomestotheWindowtoooften).ThestigmaofgoingtotheWindowisso
strongthat,duringthe2008crisis,theFedhadtochangeitsDiscountWindowprocedurestoentice
banksthatdesperatelyneededreservestocome.
Nonborrowedreserveswasnegative duringmostof2008andpeakedatabout$330 billionin
October2008justaboutatthesametimeasborrowedreservesreachedtheirpeakvalue(Figure
3.5).Nonborrowedreservesismeasuredbytotalreservesminusborrowedreserves.Borrowed
reservesismeasuredbyA2inFigure2.1.Forreasonsrelatedtomonetarydevelopmentsdiscussed
inChapter4,totalreservesbecamesmallerthanA2duringthe2008financialcrisis.Thecentral
bankprovidedalotofadvancesbutremovesmostofthereserveinjectionthatresultedfromthe
advance.
24
Figure3.4Decompositionoftotalreservesintermsofsources,billionsofdollars
Figure3.5.Borrowedandnonborrowedreservesduringthe2008financialcrisis
Sources:BoardofGovernorsoftheFederalReserveSystem(SeriesH.3)
Finally,thetotalquantityofreservescanbedecomposedintermsofthereasonswhybankshold
reserves. Banks in the United States must have a certain proportion of reserves relative to the
outstandingvalueofthebankaccountstheyissued:
25
-
Required reserves: The quantity of reserves banks must hold in proportion of the bank
accountstheyissued.
Excess reserves: whatever quantity of reserves that banks have in excess of required
reserves.
Totalreserves=Requiredreserves+excessreserves
Upuntilthe2008crisis,banksheldreservesmostlybecausetheyhadtodoso(Figure3.6).Excess
reserveswasvirtuallyzero(Chapter4explainswhy).Upuntilthecrisis,thequantityofreserveswas
alsorelativelystableoverdecadesandaveraged$40billion(Figure3.7).
Onemaysometimesencounterthewordfreereserves,whichjustmeansthedifferencebetween
excessreservesandborrowedreserves.Throughoutthisseries,themostimportantcategorization
willbethelastone:excessversusrequiredreserves.
Figure3.6Decompositionoftotalreservesintermsofuses,billionsofdollars
26
Figure3.7Decompositionoftotalreservesintermsofusesuntilaugust2008,billionsofdollars
HOWDOESTHEMONETARYBASECHANGE?
Themonetarybasegoesupordowndependingonwhathappenstotheotheritemsinthebalance
sheetoftheFed.Followingthepointthatbalancesheetsmustbalancewehave(usingFigure2.1):
L1+L2=A1+A2+A3+A4+A5L3L4L5
Somonetarybasewillbeinjectedwhen:
27
TheFedbuyssomething(i.e.acquiresanasset)frombanksorthepublic
-
HigherA1:Buyingsecurities(Tbills,Tbonds,etc.)
HigherA2:AdvancesofFederalFunds
HigherA3:Buyingforeigncurrencyfromprivatebanks
HigherA5:Buyingapizza,abuilding,oraservicefromsomeone
TheotherFedaccountholdersspendintheUSeconomyandwhentheFedpaysdividends
tobanks
-
LowerL3:Treasuryspends
Lower L4: US exports, governmentsponsored enterprises buy mortgages from

banks
LowerL5:Fedpaysdividendstomemberbanks
Monetarybaseisreducedwhentheoppositetransactionsoccur.BuyingcoinsfromtheTreasury
doesnotchangethemonetarybasebecauseL3goesupbythesameamountasA4;itisanintra
federalgovernmenttransaction.Letusgothroughtwoexamples:
Case1:TheFederalReservebuysTBillsworth$100frombanks
Fed
Assets
A1:+$100
L2:+$100
Banks
Assets
Tbills:$100
Youhavejustwitnessedthecreationofmonetarybase:Thecentralbankcreditstheaccountof
banksbytyping100onthekeyboardofacomputer.TheFedcouldalsohaveprintedbanknotes
(L1=+$100)butpurchasesfrombanksaredoneelectronicallybecauseofconvenience.
Case2:Dr.Tpayshisincometaxesworth$1000.
AssumethatDr.TstillmailshisincometaxpaperworkwithacheckpayabletotheUnitedStates
Treasury.TheTreasuryreceivesthecheckandbringsittotheFed.Tosimplify,thefollowingignores
Treasurystaxandloanaccounts(TT&Ls)becausethatjustcomplicatestheanalysiswithoutadding
anyinsightsatthispoint(seeChapter6).TheFedsendsthechecktothebankofDr.T.andsothe
bankdebitsthebankaccountofDr.Tby$1000.
BankofDr.T.
Assets
AccountofDr.T.:$1000
Whatistheoffsettingoperationonthebanksbalancesheet?The$1000havetogototheTreasury.
GiventhatweassumedthattheTreasuryonlyhasanaccountattheFedweknowthattheoffsetting
operationcannotbe(itwouldbeifTT&Lshadbeenincluded):
BankofDr.T.
Assets
TT&Ls:+$1000
The Treasury only has an account at the Fed so the following will occur when the $1000 are
transferred(whichwouldbethesecondstepifTT&Lswereincludedintheanalysis):
Fed
Assets
Butthatagainbegsthequestion:Whatistheoffsettingaccountingentryonthebalancesheetof
theFed?ItcannotbeAccountofDr.T:$1000becauseDr.TdoesnothaveanaccountattheFed.
TheansweristhatwhentheFedreceivesthecheck,ithasaclaimonDr.T.sbank.Thebanksettles
thatclaimbygivingupreservesandthefundsaretransferredintotheaccountoftheTreasury.
28
Interbankclaims(claimsamongprivatebanks,andbetweentheFedandprivatebanks)arealways
settledwithtransfersofreserves.
BankofDr.T.
Assets
Fed
Assets
You have just witnessed the destruction of monetarybase: taxes destroy monetary base. The
central bank deleted $1000 in the reserve balance and keystroked $1000 in the account of the
Treasury.
Ofcourse,iftheTreasuryspendsthenreservebalancesarecredited,andifTreasuryspendsmore
thanitstaxesthenthereisanetinjectionofreserves:fiscaldeficits(governmentspendinglarger
thantaxes)leadtoanetinjectionofreserves.KeepthatinmindforChapter4.
Asasidenote,onemaynotethatDr.Tsbalancesheetchangesasfollowswhentaxesarepaid:
Dr.T.
Assets
Networth:$1000
AnalternativeaccountingwouldbeifDr.Thadowedaknowndollaramountoftaxesforawhile,
i.e.iftheTreasuryheldsometaxreceivablesagainstDr.T.Inthatcase,insteadofnetworth,it
wouldbetaxreceivablesthatwouldgodownby$1000.
CAN THE FED ISSUE AN INFINITE QUANTITY OF MONETARY

BASE?
Yes,ittechnicallycanbecausethemonetarybaseiscomposedofliabilitiesoftheFed.Inpractice
though, the Feds ability to inject reserves is constrained by the operational requirements of
monetarypolicy.Chapter4showsthatifthecentralbankissuesreservesregardlessoftheneeds
ofbanks,itisnotbeabletoachieveaspecificpolicyinterestrateitsetsforitselfunlessitchanges
itsoperationalprocedures.
AttheoriginsoftheFed,someconstraintswerealsoputonthetypesofsecuritiesthattheFed
couldbuyorthatbankscouldpledgeascollateralwiththeirpromissorynotestogetanadvance
fromtheDiscountWindow.TherewasafearthattheFedwouldoverissuemonetarybasegiven
itsbroadmonetarypower.Hereisthelanguageofthepreambleofthe1913FedActstates:
To provide for the establishment of Federal reserve banks, to furnish an elastic
currency,toaffordmeansofrediscountingcommercialpaper,toestablishamore
effectivesupervisionofbankingintheUnitedStates,andforotherpurposes.
ElasticcurrencyjustmeansthattheFedisabletoaddandremovemonetarybaseatthewillof
banksandthepublic,thatis,inresponsetotheneedsoftheeconomy.However,until1932,the
29
FedoperatedundertheRealBillsDoctrine(RBD).WhatthatmeantwasthattheFedoughttoonly
acceptsecuritiesthatselfliquidateinA1andascollateralforA2(seeFigure2.1).Selfliquidating
securities are those that are issued and destroyed in relation to economic activity. Firms issue
securitiestoproducegoodsandservices(seeChapter10)andrepaythemwhenfirmsselltheir
production. The idea was that by tying monetarybase creation to the financing of economic
activities,theFedwouldavoidinflationarytendenciesthatcouldcomefromanelasticcurrency.
Monetarybase(andsomoneysupplyasthethoughtofthetimeerroneouslywent)wouldgrow
insyncwithproduction.
Inpractice,RBDneverworkedoutwellforboththeoreticalandpracticalreasons.WWIledtoa
largeholdingsofTreasuriesbytheFed.TheGreatDepressionledtotheeliminationofthedoctrine,
and the 1932 Banking Act widened dramatically the types of securities the Fed could accept if
needed(Table3.1).
Table3.1HoldingsofsecuritiesbytheFed,19151950
Source:MarshallsOriginsoftheUseofTreasuryDebtinOpenMarketOperations:Lessonsfor
thePresent
One of the problems of RBD is that it relied on private indebtedness (issuances of securities by
companies to finance production, real bills) for monetary policy to work. During a recession,
banks did not have enough real bills to sell or pledge to the Fed because economic activity is
moribundsoprivateissuanceplunges.Thisisproblematicbecausethescarcityofrealbillslimited
theabilityofbankstoobtainreserves,justatthetimewhenbanksdesperatelyneededadditional
reserves to counter bank runs (people running to banks to ask for cash) and make interbank
payments.
Morerecently,DoddFrankActof2010amendedtheFederalReserveActtoconstrainthecapacity
of the Fed to use emergency powers, that is, its ability to accept any type of securities from
anybody. This was a reaction to the advances provided to AIG; AIG was not part of the Federal
30
ReserveSystem.ItwasalsoareactiontotheopaquenessoftheDiscountWindowoperationsduring
thecrisisandhowquestionablesomeofthetransactionswere.
TheFedneedstobeabletofightpanicsandtheensuingliquiditycrisiswheneverybody(including
everybanks)istryingtogettheirhandsonthecurrency.Thisis,indeed,whytheFedwascreated.
Itcanonlydosobybeingabletobuy,oracceptascollateral,awideverityofsecurities.
Thisleadsustoafinalimportantpoint.GiventhattheFedprovidesasafetyvalveinthefinancial
system,thissafetymayleadtomoralhazard.Financialmarketparticipantsmaytakemorerisks
knowingthat,ifthingsgosouth,theFedwillintervenetoavoidacollapseofthefinancialsystem.
AsaconsequencetheFedmustdotwothings:
-
TheFedshouldalsohaveampleregulatoryandsupervisorypowers,anditshouldusethem.
Thatiswhatthelastbitofthepreambleisallabout.
TheFedshoulddiscouragemoralhazardandpromotesafebankingpracticesbyaccepting
onlysecuritiesthatareofquality(thatisbasedonsoundunderwritingandnotindefault)
andfromsolventinstitutions:TheFedexiststosquashbankingliquiditycrises(temporary
inability to access funds), not to keep insolvent banks alive (permanent inability to pay
creditors).
Unfortunately,thesetwoconditionshavenotbeenmetrecentlyandmoralhazardhasincreased
dramatically.
ThealternativeisAndrewMellonsadvicetoHoover:liquidatelabor,liquidatestocks,liquidate
farmers,andliquidaterealestateitwillpurgetherottennessoutofthesystem.However,the
cleansingpropertiesofmarketmechanismsdonotworkproperly,especiallysointimesoffinancial
crisisandpanic(seeChapter14).
1Banksholdreservesmostlybecausetheyarerequiredtodoso.
2TheFedprovidesreservestobanksmostlybybuyingshorttermTreasuriesfromthem,either
temporarilyorpermanently.
3Currently,theFedisabletoprovideasmanyreservesasneededbybanks.
4Until1932,theFedwaslimitedinitsabilitytoprovidereservestobanksbecauseofconstraints
onthetypeofassetsitcouldbuyortakeascollateralfromthem.
Keywords
Totalreserves,requiredreserves,excessreserves,freereserves,borrowedreserves,nonborrowed
reserves,reservebalances,vaultcash,overdraft,appliedvaultcash,surplusvaultcash,RealBills
Doctrine,elasticcurrency
ReviewQuestions
Q1:Whenabankborrowsreservesfromanotherbankisthatclassifiedasborrowedreserves?
Q2:Isallvaultcashpartoftotalreserves?
Q3:Areexcessreservesthosethatarenotwantedbybanks?
Q4:Whatistheimpactofafiscaldeficitonthemonetarybase?
Q5:WhentheFedsellsTreasuriestobanks,whathappenstothemonetarybase?
Q6:WhatarethetwotypesofoperationsthattheFedusestoprovidereservestobanks?
31
1 See the following link for an explanation of the role of the Fed in terms of coins and notes:
http://www.federalreserve.gov/paymentsystems/coin_about.htm
2Seehttp://www.federalreserve.gov/faqs/currency_12773.htm
3
Board of Governors of the Federal Reserve System, Currency and coins services:
http://www.federalreserve.gov/paymentsystems/coin_about.htm
4Seethefollowing2010interviewwith60minutes:https://www.youtube.com/watch?v=LxSv2rnBGA8
32
CHAPTER 4:
Whatmonetarypolicyisallabout
Whymonetarypolicyisdone
HowtheFederalReserveimplementsmonetarypolicy
HowmonetarypolicyoperationschangedfollowingtheGreatRecession
Howmonetarypolicycanbeconceptuallyanalyzed
CHAPTER4:MONETARYPOLICYIMPLEMENTATION
Chapter2examinedthebalancesheetoftheFedandChapter3providedimportantinformation
aboutthemeaningofreservesandotherbasicconceptsandtheirrelationtothebalancesheetof
theFed.ThisChapterexamineshowacentralbankimplementsmonetarypolicy.
WHAT DOES THE FED DO IN TERMS OF MONETARY POLICY

ANDWHY?
Whilethedetailsofoperatingprocedureshavechangedthroughtime,thefederalfundsrate(FFR)
has progressively gained in importance as a relevant operating tool (that is, as a means to
implement monetary policy) since the 1920s. The FFR is the yearly rate of interest at which
participantsinthefederalfundsmarketlendandborrowfederalfunds(fedfundsforshort)to
each other overnight. For example, if the FFR is at 3% it means that if a bank borrowed $100
continuouslyforayearatthatrateitwouldhavetopaya$3ofinterest.Theequivalentdailyrate
is0.0081%soifabankborrows$100intheevening,ithastorepaythe$100plus$0.0081ofinterest
paymentthenextmorning.Whilethatdoesnotseemmuch,whentensofbillionsofdollarsare
involveddailyevensuchsmallinterestratecanbringsubstantialincometothelenderoffedfunds.1
FedfundsarethedollarvalueoftheaccountsattheFederalReserve(L2,L3,andL4inthebalance
sheetpresentedinFigure2.1).Holdersoftheseaccountsincludeprivatebanks,theU.S.Treasury,
governmentsponsored enterprises, the International Monetary Fund, securities firms, among
others.Someoftheseaccountholdersneedmorefunds(usuallybanks)2whileothersusuallyhave
morethanneeded.Thefedfundsmarket3allowstheseparticipantstomeetandmakedeals.
Figure4.1DailyaverageofFFR(greyline)andFFRtarget(blackline),percent
Source:FederalReserveBankofNewYork.
TheFedishighlyinterestedintheFFRandaimsattargetingthatrate,thatis,theFedwantstomake
surethattheFFRprevailinginthemarketdoesnotdeviatetoomuchfromtheFFRdesiredbythe
34
Fed(theFFRtarget)(Figure4.1).MostofthetimetheFedtargetsaspecificnumberbutsometimes
ittargetsarange.Thisisthecasetodaywitharangeof0.250.5%.Fromthelate1970suntil1991,
theFedalsohadarangethatwasashighas16%22%inmid1981andaswideas13%20%inearly
1980(Figure4.2).Since1994,theFFRtargethasbeenpublicinformationastheFedhascommitted
tobemoretransparent.
TheFedishighlyinterestedinthisinterestratefortwomainreasons.First,theFFRisacostfor
bankssoifthecostchanges,theinterestratestheychargetocustomerschange.Second,market
participantsmakeportfoliochoices(thatis,buyorsellassets)withtheaimofmaximizingtherate
ofreturnonassets.Theycompareportfoliostrategiesandchoosethosethatprovidethehighest
yield.Whilemakingtheseportfoliochoices,financialmarketparticipantstakeintoaccountfuture
monetarypolicy(thatis,futureFFRtargets),whichendsupimpactingthecurrentinterestrateofa
widerangeofsecurities.
RegardingthecostsideofFFR,banksneedreservesforfourpurposes(seeChapter10forfurther
explanation):
Cashwithdrawalsbycustomers:peoplegetcashfrombanks.
Reserverequirements:banksmustkeepacertainquantityofreservesthatisaproportion
ofthedollaramountinthebankaccountstheyissued.
Interbankdebtsettlements:payingdebtsduetootherbanks.
PaymentstootherFedaccountholders:forexampletaxpaymentsleadstoadrainageof
reserves.
Figure4.2MonthlyFFRaverageandtargetFFRrange,19791990,percent
Source:TranscriptsoftheFOMCmeetings
Note:After1990,theFOMCtargetedaFFRdigit
35
Byfar,thelargestdaytodayneedforreservesisinterbanksettlementsbecausebanksthatdonot
haveenoughreservestomakethenecessarypaymentsmustgetreservestoavoiddefault.They
maygetthemeitherfromotherbanksorotherfedfundsholders,ormaygototheFed.Inanycase,
bankshavetopayinterestandtheFFRiswhatbankspaytogetreservesthroughthefedfunds
market(nonborrowedreserves).Thiscostisthenroutinelypassedontotheircustomerssothat
whentheFFRrises,ratesonmortgages,advancestostudents,creditcards,etc.alsogoup(see
primebankrateinFigure4.3).
Intermsofportfoliochoices,saythatin2016youhave$1000andyouwanttofigureoutawayto
makethehighestgainsoverthenexttwoyears.Sayonlytwoportfoliostrategiesareavailable.A
longtermstrategyistobuyandholdfortwoyearsa2yearsecuritythatpays5%.Ashortterm
strategyistobuya1yearsecuritythatpays3%andtoreinvesttheproceedsin2017intoanother
1yearsecurity.Yourchoicebetweenthetwostrategiesshoulddependonwhatyouexpectthe1
yearratetobein2017.Youareindifferentbetweenthetwostrategiesiftheyprovidethesame
rateofreturn,whichmeansthatyouexpecta1yearyieldofabout7%in2017(solve$1000*(1.05)2
=$1000*1.03*(1+x)wherexistheexpectedoneyearratein2017).Ifyouexpectthe1yearrateto
be higher than 7%, the shortterm strategy is more profitable. In that case, financialmarket
participantswillselloutstanding2yearsecuritiesandbuy1yearsecurities,whichraisesthe2year
rate and lowers the 1year rate until the two strategies provide the same rate of return. For
example,iftheexpected1yearrateis8%,thenifthe2yearrategoesupto5.2%the1yearrate
is 2.5%. Generalizing the logic, a rising FFR (similar to 1year rate going up) raises the rates on
longertermsecurities.Longtermratesdependonexpectationsaboutfuturemonetarypolicyand
ifFFRisexpectedtorise(fall),longtermrateswillrise(fall).
There is a very high correlation between the FFR and all other interest rates. The correlation is
about0.99forshorttermsecuritiesandabout0.8forlongtermsecuritieslikeTbonds(Figure4.3).
BeyondexpectationsaboutfutureFFR,theinterestrateonsecurities,especiallyoflongertermsto
maturity,isalsoinfluencedbyinflationrisk,taxrisk,creditrisk,liquidityrisk,amongothers,which
makesthelinkbetweenFFRandlongertermsecuritieslessstrong.
Byinfluencingallinterestrates,theFedhopestoinfluencethewillingnessoftheprivatesectorto
spendongoodsandservices;theultimategoalbeingtoinfluenceinflationandemployment.For
example,iftheFedthinksthatinflationarypressuresarebuildingup,thereasoninggoesatfollows:
HigherexpectedinflationbytheFedleadstoahigherFFRtarget,whichraisestheFFR,whichraises
other rates, which discourages private economic units from seeking external funds and raises
thriftiness,whichslowsdownspendingongoodsandservices,whichlowersinflation(seeChapter
12).TherearealotofstepsbetweenFFRandinflation/employment,andonemaydoubtitworks
well,butthatisthelogicbehindtheinterventionoftheFedinthefedfundsmarket.
TheFedhasadualmandate,thatis,itsgoalistoachievebothpricestability(currentlydefined
unofficially as achieving a 2% inflation rate) and full employment (defined as being at an
unemployment rate at which inflation is stable, the NAIRU). Other central banks, like the
EuropeanCentralBank,onlyfocusonpricestability.
36
Figure4.3FFRandotherrates
Source:BoardofGovernorsoftheFederalReserveSystem(seriesH.15)
TARGETINGTHEFFRPRIORTOTHE2008FINANCIALCRISIS
Whilebanksdoneedreserves,theyalsodonotliketoholdmorereservesthantheyneedbecause
reservesdidnotusetopayanyinterest.Chapter3showsthat,priortothecrisis,banksheldvery
fewreserves,andmostofthemwereheldbecausetheFedrequiredit.Banksliketokeepabitof
37
excess reserves to avoid the overnightoverdraft penalty rate (Chapter 2 explains that reserve
balancescanbenegative).
Whathappensifbankscannotgetenoughfedfundsfortheirneeds?Bankscannotcreatemore
thanwhatisavailable,onlytheFedcan.IftheFeddoesnotaddmorefedfundsthentheFFRrises
steeply and quickly given that bank must have the reserves they need. A higher FFR does not
incentivizebankstodemandlessfedfunds;theirdemandforreservesisinelasticandmostlynon
discretionary.
Whathappensifbankshavetoomuchfedfunds?Bankscannotdestroy/removefedfunds,onlythe
Fedcan.IftheFeddoesnotremoveenoughfedfunds,theFFRwillfallveryquicklyto0%giventhat
banksdonothaveanyotherusefortheexcessreservebalancestheyhave.AlowerFFRdoesnot
givebanksanincentivetosupplylessfedfunds.
TominimizefluctuationsintheFFRandkeepitaroundthetarget,theFedintervenesdailytoadd
ortoremovefedfundsbyaddingorremovingreservebalancesaccordingtotheneedsofbanks.If
the FFR is above target then the Fed adds reserves, if the FFR is below target the Fed removes
reservebalances.
ThewaytheFeddoesthisisviaopenmarketoperationsthatusuallyinvolveexchangingreserves
withTbillswithbanks(Figure4.4):
IfFFR<FFRT,bankslendandborrowataninterestratethatistoolowrelativetowhatthe
Fedwants.TocorrectthattheFedsellsTBillstobanks,whichdrainsreserves.
Fed
Assets
Tbills:$100
Banks
Assets
Tbills:+$100
IfFFR>FFRT,bankslendandborrowattoohighaninterestraterelativetowhattheFed
wants. Banks have too few reserves. To correct that the Fed buys Tbills from banks by
creditingtheirreservebalances.
Fed
Assets
Tbills:+$100
Banks
Assets
Tbills:$100
Theopenmarketoperationscanbepermanent(outrightpurchase/salebytheFed)ortemporary
(repurchase agreement and reverse repurchase agreement: the Fed and banks agree to
performtheoppositetransactionthefollowingmorning).ForbankstoagreetotradewiththeFed
insteadofputtingreservesinthe marketorforbankstogetreservesfromtheFedinsteadof
38
borrowingfromotherbankstheFedhastoprovideincentives.TheFedalsohastomaketrades
thatensurethattheFFRstaysarounditstarget.
Supposethatabankhas$1000worthofreservesthatitisreadytosupplyinthefedfundsmarket.
SupposethattheFFRiscurrentlyat3%(soadailyrateof0.0081%),wheretheFedwantsittobe,
butifthebanksuppliedthefundstheFFRwouldfallto2%.HowcantheFedenticethebanknotto
dumpthefundsinthemarket?Onewayistodosomethingsimilartothefollowing:theFedsellto
thebankoneTbillfor$999.92andpromisestobuyitbackthenextdayfor$1000.Thisprovidesa
dailyrateofreturnof0.0081%tothebank.
TheFeddoessomethingsimilarwhenbanksborrowfedfundsataratehigherthanwhattheFed
wants(FFR>FFRT).ItbuysTbillsatapriceconsistentwithFFRT.Thatforcesthosewillingtolend
fedfundstocomplywiththeFFRT;otherwise,nobankwillborrowfromthemgiventhattheFed
offerstoprovidereservesatalowerrate.
Figure4.4TargetingtheFFR:Openmarketoperations
TheFedcoulddothisalldaylongandFFRwouldbeontargetallthetime,butpracticallytheFed
onlyintervenesonceadayandacceptsthattheFFRfluctuatesaroundthetarget.Eachday,theFed
anticipates the approximate need for reserves by estimating how the items that change the
monetarybasewillchangeduringtheday(A1throughA5,L3,L4,andL5ofFigure2.1).
TheFedis basicallyapplyingasortof bufferstock policyonreservesinthe samewaydiamond
cartelslimitthesupplyofdiamondtocontroldiamondprice(Iamsorrytotellyouthatdiamonds
are not rare). The main difference between the Fed and diamond cartels is that the Fed has
completepricingpowerbecauseitisthemonopolysupplierofreserves.
BeyonddaytodayinterventioninthefedfundsmarkettomaintainaFFRT,theFedalsosometimes
changesitsFFRT.Giventhatthedemandforreservesisalmostperfectlyinelasticandgivenhow
smalltheincrementsanddecrementsintheFFRTare(usually25basispointsatatime,thatis,0.25
percentagepoint),whentheFedchangesitsFFRT,itusuallydoesnotdoanythingforthetargetto
bereached.IftheFeddecidestolowertheFFRT,itdoesnothavetoinjectreservesfirstforthe
targettobereached.IftheFeddecidestoraisetheFFRT,itdoesnothavereducethequantityof
39
reserves to reach the target. The FFR will move quickly around the target following the
announcementofachange.4
Anotherwaytounderstandthatpointistoagaingobacktothepointthatbankscannotdomuch
withreservebalances,soanyreservestheyhaveinexcesstheywillsupplyinthefedfundsmarket.
IftheFedannouncesitwillofferreservesatalowerFFRT,banksmustcomplywiththenewFFRT
whentheyoffertolendreserves,otherwisenobodywillborrowfromthem.IftheFedannounces
itoffersreservesatahigherFFRT,bankswithreservestolendalsoraiseatwhichtheyoffertolend
reserves.Otherwise,theyforegoanincomeopportunitybecausebanksthatneedreserveshave
nowhereelsetogo(onlytheFedcancreatemorereservesanditwilldoitonlyatahigherFFR).It
istheFedswayorthehighway.
A GRAPHICAL REPRESENTATION OF THE FEDERAL FUNDS

MARKET
TheFedsupplies,atacostequaltotheFFRtarget,whateverquantityofreservesisneeded(Figure
4.5).ThedemandforreservesisalmostperfectlyinsensitivetochangesinFFR.5Banksmustmeet
interbankpayments,taxpayments,reserverequirementsandwithdrawalsregardlessofwhatthe
FFRis,andbankshaveverylittleincentivetoaskformorereserveswhenratesfallbecause,as
explainedinChapter3,bankscannotdomuchwiththem.
Figure4.6Thefederalfundsmarket
ThefactthatthesupplyofreservesishorizontalseemstosuggestthattheFedsuppliesaninfinite
quantityofreserves.Thatisnotthecase,allthatissayingisthattheFedsupplieswhateverbanks
demand.Ifbankswantmorereserves(demandcurveshiftstotheright),theFedsuppliesmore.If
bankswantfewerreserves,theFedremovesreserves;thecurrencyiselastic.TheFeddoesnot
proactivelyaddorremovereserves:
IftheFedaddsreserveswithoutconsultingbanks,theFFRfallstozero.
IftheFedremovesreserveswithoutconsultingbanks,theFFRrisestoinfinity.
Thus,whiletheFeddoestheinjectionanddeletionofreserves,theFedaddsorremovesonlyona
defensivebasistomaintaintheFFRontarget.
40
Whatmonetarypolicyisallaboutissettingthepriceofreservesandlettingthequantityofreserve
adjust.TheFFRisapolicyvariablethatdoesnotreflectanyscarcityorabundanceofreserves,or
thepreferenceofbanksforreserves.AlowFFRcanprevailwithveryfewreservesbecauseifbanks
donotneedmanyreserves,theFeddoesnotsupplymanyatagivenFFRT.AhighFFRcanprevail
withaverylargequantityofreservesbecauseifbanksneedlots,theFedsupplieslotsatagiven
FFRT.
TARGETINGFFRAFTERTHEGREATRECESSION
Asthefinancialcrisisgrewfrom2007onward,theFedbegantoloweritsinterestratetargetfrom
late2007(Figure4.1)and,fromearly2008,toprovidesignificantquantitiesofemergencyfundsto
thefinancialsystem(Figure4.6).Atfirst,theFedneutralizedtheimpactofallemergencyadvances
bysellingTreasuriessoitssupplyofTreasuriesfellby40%inaboutsixmonths(Figure4.6).TheFed
providedreservestobankXthatwasindifficulty,bankXpaiditscreditorbankY,bankYhadexcess
reserves available to lend in the fed funds market, Fed drained all excess reserves by selling
TreasuriestobankY.ThisallowedtheFedtomaintainapositiveFFRwhilealsohelpingstruggling
financialinstitutions.
In September 2008, the collapse of Lehman Brothers led to a panic and the Fed responded by
providing large amounts of emergency advances (A2 of Figure 2.1 went up a lot). No fed funds
marketparticipantwaswillingtolendreservestoanybody;thefedfundsmarketfrozeandtheFFR
becamehighlyvolatile(Figure4.1).EmergencyadvancesbytheDiscountWindowledtoaverylarge
increaseinreservebalancesbyalmost$1trillionbyearly2009.FromSeptember2008untiltheend
oftheyear,inordertokeepFFRpositive,theFeddidtrytoneutralizesomeoftheimpactofits
massiveemergencyoperationsbyworkingwiththeTreasury(Chapter6delvesintotheTreasury
centralbankcoordination).However,inordertofighttherecession(andsopotentialdeflationand
unemployment), the Fed also rapidly lowered its FFR target, eventually to reach zero (00.25%
rangetobeprecise)byDecember2008(Figure4.1).
TheFedthenwonderedwhatitcoulddonexttohelplowerinterestratesfurthergiventhatthe
FFRtargetwasat0%andgiventhattheFeddidnotintendtohaveanegativeFFRtarget.Twothings
weredone:
1 Promise not to raise the FFR target for a long time (forward guidance): this pushed
expectationsofariseinFFRfurtherinthefutureandsoloweredotherinterestrates.
2 Outright purchases of longterm securities with the goal of lowering longterm interest
rates(crediteasingfollowedbyquantitativeeasing).Bybuyinglongtermsecurities,
theFedraisedthepriceofthesesecuritieswhichloweredtheiryield.
The Fed bought outright longterm Treasuries but also longterm private securities (Mortgage
backedsecuritiesguaranteedbyFannieMae,FreddieMacandGinnieMae)6(Figure4.6,Table4.1).
Itdidsowithoutneutralizingtheimpactonreservessoreservesbalancesincreasedrapidlybeyond
theneedsofbanks(seeChapter3).Asaconsequence,iftheFedhadcontinuedtooperateasitdid
beforethecrisis,theFFRwouldhavestayedstuckat0%foraslongastherewouldhavebeena
largequantityofexcessreserves.
41
Figure4.6AssetsofFedandexcessreserves(whiteline),trillionsofdollars
Source:BoardofGovernorsoftheFederalReserveSystem(seriesH.4.1)
Table4.1Maturitydistributionofsecurities,loans,andselectedotherassetsandliabilities,
January20,2016,millionsofdollars
Currently,theFedwantstobeabletoraisetheFFReventhoughbankshaveamplequantitiesof
excessreserves.Todoso,ithaschangeditsoperatingproceduresbypayinginterestonreserve
balances(L2).ThistheoreticallyputsafloorontheFFRbecauseifbankscanearninterestontheir
Fedaccounts,theydonothaveanincentivetolendthesereservesinthefedfundsmarketifthe
FFRgoesbelowtheinterestrateonreservebalances(IOR).
TheFedandothercentralbanksnowoperateunderacorridorframework(Figure4.7).Intheory,
theFFRcanonlyfluctuatebetweentheIORandthediscountwindowrate(DWR).TheFFRtargetis
42
setinthemiddleofthecorridorandthethreerates(IOR,FFRTandDWR)movetogether.Thereis
ahorizontalbandinsteadofahorizontalline.BankshavenoincentivetolendreservesifFFRis
belowIORsoFFRcannotfallbelowthat.Bankshavenoincentivetoborrowinthefedfundsmarket
iftheDWRislowerthanFFRsoFFRwillnotriseabovetheDWR.
Figure4.7Interestratecorridor
Inpractice,thecorridorintheUnitedStatesisporous.Intermsofthefloor,otherFedaccountsdo
notqualifytoreceiveinterestsotheirholdershaveanincentivetokeeplendingfedfundsinthe
marketevenifFFRisbelowIOR.Governmentsponsoredenterprises(inL4),especiallytheFederal
HomeLoanBanks,7wereamajorsourceofexcesssupplyoffedfunds.Sincetheendof2015,the
Fed has solved this problem 8 by indirectly paying interest to other account holders through an
auction mechanism. Now the IOR is a true floor. In terms of the ceiling, access to the Discount
Window is highly stigmatized and contains some nonmonetary costs in terms of increased
supervisionandlossofreputation.Asaconsequence,banksrefrainfromgoingtotheWindoweven
ifDWRisinferiortoFFR.Thetrueceilinginthatcaseistheovernightoverdraftpenaltyrate.During
the2008financialcrisis,theFeddealtwiththisproblembyprovidingfedfundsthroughtheWindow
viaoccasionalauctionsinwhichparticipantscouldbidanonymously.
Acorridorpolicydoesnothavetobeimplementedonlyinperiodofexcessreserves.Ifacentral
bankwantstointervenelessfrequentlyintheovernightmarket,acorridorpolicycanbeusefulto
limitthevolatilityoftheovernightinterbankrate.Forexample,theECBhasbeenoperatingthat
way since the beginning (Figure 4.8). It intervenes in the market only once a week and lets the
ceilingandfloordothejobofcontainingtheovernightratearoundthetargetovernightrateduring
the rest of the week. Narrowing the gap between the floor and the ceiling would reduce the
volatility of the overnight rate. The Fed had been on a semicorridor since 2003 when the Fed
decidedtoraiseDWRabovetheFFRTandtomovebothinsyncwhileIORstayedatzeroallthe
time.
43
Figure4.8CorridorofECB
Source:KahnsMonetaryPolicyunderaCorridorOperatingFramework
1TheFederalReservetargetsthecostofreservesnotthequantityofreserves.Itdoessobysetting
thecostofprovidingadvances(DiscountWindowoperations)andbysettingthecostatwhichbanks
lendto,andborrowfrom,eachother(openmarketoperations).
2 By setting directly the cost of reserves, the Federal Reserve can indirectly influence all other
interestrates.Theinfluenceisthestrongestonshorttermmarketratesandoninterestratesthat
bankschargetotheircustomers.
3Throughchangesininterestrates,theFederalReservehopestochangespendinghabitsandso
toinfluenceemploymentandinflation.
4WhentheFedchangesitsFFRtarget,itdoesnothavetochangethequantityofreservestomake
theFFRmovetowardthetarget.InordertomaintaintheFFRaroundagivenFFRtarget,theFed
intervenesdailytoperformopenmarketoperations.
5TheFedcannotsupplyfewerormorereservesthanbanksdemand,otherwiseitmissesitsFFR
target.TheFedaddsorremovesreservesaccordingtothedemandsofbanks.
6AhighFFRcanprevailwithalargequantityofreservesandalowFFRcanprevailwithasmall
quantityofreserves.FFRisapolicyvariablenotamarketdeterminedvariable.
7Quantitativeeasingledtoalargeincreaseinexcessreserves.InordertobeabletoraisetheFFR
whenitwants,theFedchangeditsoperatingproceduresbypayinginterestonreserves.Quitea
fewcentralbanksnowoperateunderacorridorframework.
Keywords
Federalfundsrate,federalfundsmarket,DiscountWindowrate,interestrateonreserves,corridor
framework, quantitative easing, openmarket operation, outright purchase/sale, repurchase
agreement,discountwindowoperations,elasticcurrency.
44
ReviewQuestions
Q1:IftheFedsuppliesmorereservesthanbankswant,whathappenstotheFFR?Whatifsupplies
less?WhatwilltheFeddotomaintaintheFFRontarget?
Q2:Whatdoesahorizontalsupplyofreservesmeansintermsofthesupplyofreservesandthe
federalfundsrate?
Q3:HowcanacorridorframeworkhelpreducethevolatilityoftheFFR?Whatwouldhappentothe
FFRifthediscountrate,interestrateonreservesandFFRtargetwereallequal?
Q4:WhyaretheinterestratessetbybankshighlycorrelatedwiththeFFR?
Q5:WhyaremarketratescorrelatedwiththeFFR?WhathappensifitisexpectedthattheFFRwill
fall?
Q6:IftheFedhadnotadoptedacorridorframework,whatwouldhavebeentheproblemforfuture
monetarypolicy?
Q7:HowcouldacorridorfailtocontaintheFFR?
Q8:WhatdoesitmeanfortheFedtoprovideanelasticcurrency?
Suggestedreadings
ComewithmetotheFOMCbyGovernorDukebrieflypresentswhatgoesonduringameeting:
https://www.federalreserve.gov/newsevents/speech/duke20101019a.htm
Chapter 7 of Meulendykes U.S. Monetary Policy and Financial Markets is a detailed version of
Dukesspeech,albeitabitdated:https://research.stlouisfed.org/aggreg/meulendyke.pdf
KahnsMonetaryPolicyunderaCorridorOperatingFrameworkprovidesareadablepresentationof
thecorridorframework.
Moreadvancedreadingsare:
Dow, S.C. (2006) Endogenous money: structuralist, in P. Arestis and M.C. Sawyer (eds) A
HandbookofAlternativeMonetaryEconomics,3551,Northampton:EdwardElgar.
Fullwiler, S.T. (2008) Modern central bank operationsGeneral principles,
http://www.cfeps.org/ss2008/ss08r/fulwiller/fullwiler%20modern%20cb%20operations.pdf
Fullwiler, S.T. (2013) An endogenous money perspective on the postcrisis monetary policy
debate,ReviewofKeynesianEconomics,1(2):171194.
Lavoie,M.(2006)Endogenousmoney:Accomodationist,inP.ArestisandM.C.Sawyer(eds)A
Lavoie, M. (2010) Changes in central bank procedures during the subprime crisis and their
repercussionsformonetarytheory,InternationalJournalofPoliticalEconomy39(3),323.
Moore, B.J. (1988) Horizontalists and Verticalists: The Macroeconomics of Credit Money.
Cambridge:CambridgeUniversityPress.
Moore,B.J.(1991)Moneysupplyendogeneity:reservepricesettingorreservequantitysetting,
JournalofPostKeynesianEconomics,13(3):404413.
45
Historical data about the federal funds market can be found at the Federal Reserve Bank of New York:
https://apps.newyorkfed.org/markets/autorates/fedfundssearchresultpage
2 See Whos Borrowing in the Fed Funds Market? by Gara Afonso, Alex Entz, and Eric LeSueu at
http://libertystreeteconomics.newyorkfed.org/2013/12/whosborrowinginthefedfundsmarket.html
3 See The Federal Funds Market: A Study by a Federal Reserve System Committee by the Federal Reserve System at
https://fraser.stlouisfed.org/docs/meltzer/bog1959.pdf
4Thisabsenceofaliquidityeffecthasbeenwelldocumented.SeeFullwiler,S.T.(2003)TimelinessandtheFedsDaily
Tactics.JournalofEconomicIssues37(4):851880
5Thisgraphignorescomplicationsthatcomesfromreservesrequirements,whichwouldflattenthedemandforreserves
attheFFRT.SeeFullwiler,S.T.(2013)Anendogenousmoneyperspectiveonthepostcrisismonetarypolicydebate
ReviewofKeynesianEconomics,1(2):171194.
6The Federal National Mortgage Association (Fannie Mae) was a government agency created in 1938 to improve the
liquidity of mortgages by acting as dealer of FHA/VAinsured mortgages. Until the 1966 credit crunch, Fannie Mae
remainedaminorplayerinthesecondarymarketformortgagesbecauseitexclusivelydealtinconformingmortgages.
ThecrunchledFannieMaetoenlargeitsdealershiptoconventionalmortgagesanditbecamethelargestplayerinthe
secondary mortgage market. In order to cope with this new state of affairs, Fannie Mae was split in 1968 into the
GovernmentNationalMortgageAssociation(GinnieMae)andFannnieMae.GinnieMaetookthepreviousroleofFannie
Mae and is focused on maintaining a secondary market by providing guarantee on MBSs backed by FHA/VAinsured
mortgages.FannieMaewasconvertedintoagovernmentsponsoredenterprisebyactingasadealerofconventional
mortgages. Federal Home Loan Mortgage Corporation (Freddie Mac) was created by an act of Congress in 1970 to
competewithFNMAintheconventionalmortgagemarket.
7SeeWhosLendingintheFedFundsMarket?byGaraAfonso,AlexEntz,andEricLeSueurfromtheFederalReserve
Bank of New York at: http://libertystreeteconomics.newyorkfed.org/2013/12/whoslendinginthefedfunds
market.html
8
More details about the reverse repurchase agreement operations is available here:
https://www.newyorkfed.org/markets/rrp_faq.html
46
CHAPTER 5:
Why targeting the quantity of reserves is not practically possible and goes
againstthepurposeforwhichtheFedwascreated
Whyprovidinganelasticsupplyofcurrencyisnotbyitselfinflationary
Howquantitativeeasingimpactsfinancialmarkets
Whatanormalizationpolicyis
Howcentralbankscansetnegativenominalinterestrate
Whycentralbankswantinterestratestobenegative
Whattheimpactofnegativeinterestratesisontheprofitabilityofbanks
Whataresomepotentialissueswithfinetuningtheeconomywithmonetary
policy
CHAPTER5:FAQsABOUTCENTRALBANKING
PreviousChaptersstudiedthebalancesheetoftheFed,definitionsandtheirrelationtothebalance
sheetoftheFed,andmonetarypolicyimplementation.ThisChapteranswerssomeFAQsabout
monetarypolicyandcentralbanking.Eachofthemcanbereadindependently.
Q1:DOESTHEFEDTARGET/CONTROL/SETTHEQUANTITYOF
RESERVESANDTHEQUANTITYOFMONEY?
TheFeddoesnotsetthequantityofreservesanddoesnotcontrolthemoneysupply(M1).Itsets
thecostofreserves;thatisit.
Intermsofreserves,theFedwascreatedtoprovideanelasticcurrency,i.e.toprovidemonetary
baseaccordingtotheneedsoftheeconomicsysteminnormalandpanictimes.Itwouldbeagainst
thispurposetoimplementmonetarypolicybyunilaterallysettingthemonetarybasewithoutany
regardforthedailyneedsoftheeconomicsystem.
Intermsofthemoneysupply,theFedhasnodirectinfluence.EvenFederalReservenotes(FRNs)
aresuppliedthroughprivatebanks,andbankssupplyonlyifcustomersaskforcash.TheFeddoes
notforcefeedFRNstothepublic,i.e.FRNscannotbehelicopterdroppedviamonetarypolicy.If
theFeddidthis,notonlywoulditoperateagainsttheFederalReserveAct,butalsoitwouldlead
peopletotaketheFRNs,bringthemtobanks,bankswouldhavemorereserves,FFRwouldfall,Fed
wouldremoveexcessreservestobringFFRbackupbacktosquareone.
The Fed may have an indirect influence on the money supply through changes in its FFR target
becausechangesinthecostofcreditmaychangethewillingnessofeconomicunitstogointodebt,
butthelinkistenuous(seeQ10).
ThroughitspolicyofQuantitativeEasing,theFedmayhaveanindirectinfluenceintwootherways.
First,iftheFedbuyslongtermTreasuriesfrombanks,banksusuallyhaveanincentivetoreplenish
their holdings of Treasuries because they allow to meet capital requirements (see Chapter 9)
withoutcompromisingtoomuchprofitabilityandliquidity.Treasurieshavealowcapitalweight,
havealiquidmarket,andpayinterestincome.Bankswillbuysecuritiesfromnonbankeconomic
unitsbycreditingthebankaccountsofthelatter(seeChapter10).Second,iftheFedwantstobuy
securitiesfromnoncentralbankaccountholders,theFedworksthroughbanksandthefollowing
occurs:
Fed
Assets
Securities:+$100
Banksofsellersofsecurities
Assets
Accountofsellers:+$100
Sellersofsecurities
Assets
Accountofsellers:+$100
Securities:$100
48
Themoneysupplygoesupby$100whenaccountofsellersincreasesby$100(butitdoesnotif
onlyreservebalancesgoupby$100).
Q2: DID THE VOLCKER EXPERIMENT NOT SHOW THAT

TARGETINGRESERVESISPOSSIBLE?
Inthe1970s,theMonetaristschoolofthoughtgainedsomeinfluenceinpolicycircles.Monetarists
arguedthatthereisacloserelationbetweenthequantityofreservesandthemoneysupply,and
thattheroleofacentralbankistocontrolthequantityofreservesinordertoinfluencethemoney
supplyandultimatelyinflation(seethequantitytheoryofmoneyinChapter12).TheFed,under
theleadershipofPaulVolcker,triedtoimplementamonetarypolicyprocedurethataimedatmore
closely targeting reserves and monetary aggregates, with the hope of taming a doubledigit
inflationrate.
Practically, the Fed changed interestrate targeting from a narrow range to a wide range (see
Chapter4),whichincreasedthelevelandvolatilityoftheFFRdramatically(Figure5.1).TheFeddid
notallowtheFFRtomovefreelyasatargetingoftotalreservesimplies.
ThereisanacademicdebateabouthowtrulyMonetaristtheVolckerexperimentwas,andthis
debateisreflectedintheFOMCdiscussionsofthetime
MR. ROOS. Well, if the level of borrowing comes in higher than we would
anticipate, [cant] you reduce the level of the nonborrowed reserves path
accordingly? Cant you adjust your open market operations for the unexpected
bulgeinborrowingortheunexpectedlylowborrowingifyouignoretheeffecton
thefedfundsmarket?Cantyoujustsupplyorwithdrawreservestocompensate
forwhathashappened?
[]
CHAIRMANVOLCKER.TheDeskcant[adjust]intheshortrun.Itsfixed.Inasense
theycoulddoitovertimeifpeopleareborrowingmore,astheymaybenow.They
seemtobeborrowingmorethanwewouldexpect,giventhedifferentialfromthe
discountrate.Butinanyparticularweekitisfixed.
MR.ROOS.Dowehavetosupplythereserves?
CHAIRMANVOLCKER.Wehavetosupplythereserves.
MR.ROOS.[Why]dowehavetosupplythereserves?Ifwedidnotsupplythose
reserves,wedforcethecommercialbankstoborrowortobuyfedfunds,which
wouldmovethefedfundsrateup.(FOMCmeeting,September1980,page6)
Mr.RooswasdeeplydissatisfiedwiththeFedstillusingaFFRtarget,albeitintheformofawide
range.WhiletheFedhadatotalreservegrowthtargetrelatedtothe3monthgrowthrateofM1,
ifbanksneededmorethanwhatwastargeted,theFedwouldsupplyextrareservesinorderto
relievepressuresontheFFR.Roosarguedagainstthislenientreservetargetingandwasforatotal
abandonmentofanyFFRtargetingandastricttargetingoftotalreserves.Hereheisin1981:
Ithinktheresaverybasiccontradictionintryingtocontrolinterestratesexplicitly
or implicitly and achieving our monetary target objectives. And I would express
49
myself as favoring the total elimination of any specification regarding interest
rates.(Roos,FOMCmeeting,February1981,page54)
MostFederalOpenMarketCommitteememberswereagainstthatpositiononthegroundthatthe
roleoftheFedispreciselytopromoteanelasticmonetarybase.TheFedwasnotcreatedtodictate
what the quantity of reserves ought to be but to eliminate liquidity problems through smooth
interbankdebtclearingandsettlementatpar,lenderoflastresort,andinterestratetargeting.In
addition,banksmostlyholdreservesbecausetheyarerequiredto,soiftheFeddoesnotsupply
enoughreservestomeettherequirementsthenbankswillbreakthelaw.
The experiment was a monetarypolicy failure. The Fed was never able to reach its reserve or
money targets and the experiment contributed to massive financial instability and a doubledip
recession.Onemayevendoubtthatitcontributedsignificantlytothefallinlongterminflation,
which had more to do with the downward trend in oil prices, oilsaving policies and greater
internationallaborcompetition:
MayIremindyouthatweshouldnttaketoomuchcreditforthepriceeasing?I
neverthoughtweweretotallyatfaultforthepriceincreasesthatwesufferedfrom
OPECandfood;andIdontthinkthefactthatOPECandfoodhavecalmeddown
hasagreatdealtodowithmonetarypolicyperse,exceptintheverylongrun.
(Teeters,FOMCmeeting,July1981,page46)
TheVolckerexperimentwas,however,apublicrelationsuccess.MostFOMCmembersknewthat
reservetargetingwasnotpossible;still,itallowedthemtoclaimthattheywerenotresponsiblefor
thehighinterestratesoftheperiod:
Idothinkthatthemonetaryaggregatesprovidedaverygoodpoliticalshelterfor
us to do the things we probably couldnt have done otherwise. (Teeters, FOMC
meeting,February1983,page26)
I think the important argument, and really the reason why we went to this
procedure,wasbasicallyapoliticalone.Wewereafraidthatwecouldnotmove
thefederalfundsrateasmuchaswereallyfeltweoughtto,unlessweobfuscated
in some way: Were not really moving the federal funds rate, were targeting
reservesandthemarketshavedriventhefundsrateup.Thatmayhavehadsome
validity at the time, and I had some sympathy for it. But as time goes on, Ive
becomemoreandmoreconcernedaboutaprocedurethatreallyinvolvestryingto
foolthepublicandtheCongressandthemarkets,andattimesfoolingourselvesin
theprocess.(Black,FOMCmeeting,March1988,page12)
Of course the high and volatile FFR was precisely the result of the change in monetarypolicy
procedures.Ifneeded,someFOMCmemberswerewillingtodothesamethinginthefuture:
Well,Ihaveonlyalittletoaddtoallofthis.IthinkTomMelzerisprobablyright:
Weregoingtoneedtoshiftthefocustosomemeasureormeasuresofthemoney
supplyasweproceedhereifwecan,bothforsubstantivereasonsandalsobecause
that has some political advantages as well, as we go forward. (Stern, FOMC
meeting,December1989,page50)
50
Figure5.1AverageandstandarddeviationoftheFFR
Source:FederalReserveBoard,NYFederalReserveBank
Q3:ISTARGETINGTHEFFRINFLATIONARY?
WiththefailureoftheVolckerexperiment,theFOMCenteredaperiodofoperationaluncertainty
untilthemid1990s.TheFedwasbackonatightFFRtargetprocedure(therewasstillawiderange
until1991buttheFedmostlytargetedthemiddleoftherange)andthiswasdeeplyunsatisfactory
toFOMCmembers.
Weveadvancedfrompragmaticmonetarismtofullblowneclecticism.(Corrigan,
FOMCmeeting,October1985,page33)
No,Iwouldsaythatwehaveaspecificoperationalproblemthatwehavetofinda
wayofresolving.Justtobelockedinonthefederalfundsrateistomesimplistic
monetary policy: it doesnt work. (Greenspan, FOMC meeting, October 1990,
pages5556)
Inaworldwherewedonothavemonetaryaggregatestoguideusastothethrust
ofmonetarypolicyactions,wearekindofgropingaroundjusttryingtocharacterize
wherethestanceis.(Jordan,FOMCmeeting,March1994,page49)
TheFedwasunwillingtodisclosethatitwastargetingtheFFR,andcontinuedtoannouncetargeted
growthrangesformonetaryaggregateseventhoughitdidnotusethemforpolicypurposes.
[In response] to talk that says we can significantly influence this or as the
phraseologygoesthatifwelowerrates,wewillmoveM2upintotherangeIsay
garbage.Havingsaidallofthat,Ithenaskmyself:Whatshouldwebedoing?
Well,wehaveastatuteoutthere.Ifwedidnthavethestatute,Iwouldarguethat
weoughttoforgetthewholething.Ifitdoesnthaveanypolicypurpose,whyare
51
wedoingit?Bylaw[wehave]tomakesuchforecasts.Andifwearetodoso,I
suggestthatwedotheminacontextwhichdoesustheleastharm,ifImayputit
thatway.(Greenspan,FOMCmeeting,February1993,page39)
Wedonot,infact,discussmonetarypolicyintermsoftheMsbetweenHumphrey
Hawkinsmeetings.DonKohndutifullymentionsthembecausehethinksheought
to,butthatisnotthewaywethinkaboutmonetarypolicy.(Rivlin,FOMCmeeting,
February1998,page91)
ToannouncetothegeneralpublicthattheFOMCwastargetingtheFFRwouldbegoingagainstall
theMonetaristprinciples(reservetargeting,moneymultipliertheory,quantitytheoryofmoney).
Targetinganinterestrate,andsohavinganelasticsupplyofreserves(horizontalsupplyatagiven
FFRT),seemedtoindicatethattheFedwasnolongerwillingtocontrolinflation.FOMCmembers
themselvesbelievedthatwasthecase:
Manyanalysts,bothinsideandoutsidetheFed,arguedthatusingtheFederalfunds
rate as the operational target had encouraged repeated overshooting of the
monetaryobjectives.(Meulendyke199849)
Talking about the FFR target became a taboo and the Committee deliberately avoided explicit
announced federal funds targets and explicit narrow ranges for movements in the funds rate
(Kohn,FOMCTranscripts,March1991,page1):
ImustsayImstillquitereluctanttocavein,ifyouwill,onthisquestionthatwe
candonothingbuttargetthefederalfundsrate.(Greenspan,FOMCtranscripts,
March1991,page2)
Asapracticalmatterweareonafedfundstargetingregimenow.Wehavechosen
nottosaythattotheworld.Ithinkitsbadpublicrelations,basically,tosaythat
thatiswhatwearedoing,andIthinkitsrightnotto;butinternallyweallrecognize
thatthatswhatwearedoing.(Melzer,FOMCtranscripts,March1991,page4)
We will see later why the entire Monetarist logic is flawed. Monetary policy is always about
providinganelasticsupplyatagiveninterestrate.Thereisnothingintrinsicallyinflationaryabout
this.Havinganelasticcurrencyusuallyjustmeanssupplyingwhateverquantityofreservesbanks
want,andusuallybanksdonotwantmuch.
WhileallthiswasverywellunderstoodbymanyeconomistslongbeforeVolckersexperiment(see
forexampleNicholasKaldor),1ittookFOMCmembersuntilthemid1990stogetcomfortablewith
FFRtargeting.
Q4:WHATAREOTHERTOOLSATTHEDISPOSALOFTHEFED?
Monetarypolicyisalwaysaboutsettingatleastoneinterestrate.WhiletodaytheFedoperates
mostlythroughthefedfundsmarket,ithasothertoolsatitsdispositiontohelpinfluenceinterest
rates.
Oneisthe(re)discountrate,therateatwhichbankscanobtainborrowedreserves(seeChapter3).
ThisinterestrateisnowhigherthantheFFRtargetbutfromthemid1960suntil2003thediscount
ratewasusuallybelowtheFFRtarget.TheFed decidedtoputthe discountrateabovetheFFR
targettoputaceilingontheFFRandsolimitupwardvolatilityinFFR(seeChapter4).
52
ReserverequirementratioscanalsohelptargettheFFR.Theseratiosstatehowmanytotalreserves
banksmustkeepontheirbalancesheetasaproportionofthebankaccountstheyissued.While
theseratiosareoftendiscussedinrelationtotheabilityofbankstocreatecheckingaccounts,their
actual purpose is once again to help target the FFR. By raising reserve requirement ratios, the
demandforreservesbecomesmorepredictablegiventhata greaterproportionofthereserves
availablemustbeheldbybanks.Withamorestabledemandforreservescomeslessvolatilityin
theFFR.
Q5:WHATISTHELINKBETWEENQEANDASSETPRICES?
The link cannot be one where banks have excess reserves that they use to buy assets in the
secondarymarket.Chapter2explainsthatbankscannotdothisasawhole.Theycouldbuyfrom
oneanother,butiftheyallhavereservestheywanttogetridof,thisisnotpossiblebecauseno
bankwantstosellassetsforreserves.
Thelinkgoesthroughthefollowingchannels:
1 The Fed buys large quantities of securities from banks which raises their prices and so
lowerstheiryields.
2 Asyieldsonthesesecuritiesfall,economicunitsseekassetsthatprovidehigheryields.They
willlookforassetswithlargeexpectedcapitalgains,especiallysoknowingthatothersare
experiencingthesameproblemsandaresearchingforyield.Theywillcontinuetobuy
thesesecurities,whichwillraisetheirprices,untilallratesofreturnareequalizedonce
adjustedforrisks.
Financialcompanieshavetodothesecondstepbecausetheytrytoreachthetargetratesofreturn
thattheypromisedtotheirstakeholders.Pensionersexpectasubstantialrateofreturnfromtheir
pensionfunds,wealthyindividualsexpectasubstantialrateofreturnfromhedgefunds,mutual
fundsshareholderswantsasubstantialrateofreturnandtheyallcheckeveryquarteriffinancial
companiesstayoncoursetomeetthepromisedtarget.LongtermTreasuriesusedtoprovidea
safeandsimplewaytomeetthispromise;nolongerso.
Bill Gross (a wellknown portfolio manager who specializes in bond trading) brought the point
forwardveryclearly.HehopesthattheFedwillraisetheFFRtomakeiteasiertoreachtargeted
ratesofreturn.Henotes2thatlowFFRpreventssaversfromearningenoughtopayforhealthcare,
retirementandothercostsbecauseyieldsonfinancialassetsaresolowcomparedtotheexpected
7%or8%.IftheFeddoesnothelpbyraisingtheFFR,financialmarketparticipantswilltakelarge
risksontheirassetside(speculative,highcreditrisk,andstructuredsecurities)andliabilityside
(highleverage)totrytoreachtheirtargetedrateofreturn.
Thereisabroadproblemthough.Inaneconomyinwhichthegrowthofthestandardoflivingis
low,whyshouldanyoneexpectthatdemanding78%besustainable?Thosecanonlybeachieved
throughcapitalgainsandleverage,andthecombinationofthesetwoishighlytoxic(seeChapter9
andChapter14).InsteadoftheFedraisingitsFFR,itshouldbetherentierswhoshouldreducetheir
expectationsofratesofreturn.Aneconomythatgrowsat2%peryearcannotsustainablyprovide
arealrateofreturnhigherthan2%;eventhatisastretch.Othermeans3mustbeusedtomeetthe
challengeofanagingeconomythanincreasingthefinancializationoftheeconomy.
53
Q6:HOWANDWHENWILLTHELEVELOFRESERVESGOBACK
TOPRECRISISLEVEL?THENORMALIZATIONPOLICY
Normalizationpolicy4meansthewillingnessoftheFedtodotwothings:1toraisetheFFRtoa
morenormallevel2toreducethesizeofitsbalancesheetinordertoreturntheproportionof
excessreservestoprecrisisvalue.Chapter4showshowthiswouldbedonefortheFFR.Regarding
reservebalances,Chapter3showsthattheirdollaramountisdeterminedasfollows:
L2=AssetsoftheFed(L1+L3+L4+L5)
MostofL2isnowcomposedofexcessreserves,whichisunusual.Agraphicalrepresentationofthis
balancesheetidentityisFigure5.2.
Figure5.2BalancesheetoftheFedandreservebalances
Source:BoardofGovernorsoftheFederalReserveSystem(SeriesH.4.1)
Theimplicationofthisbalancesheetidentityisthatreservesbalanceswillfalleitherwhenassets
oftheFeddeclinegivenotherliabilities,orwhentheotherliabilitiesoftheFedrisegivenassets.
Letuslookateachcaseinturn.
Givenliabilitiesotherthanreservesbalances,reserveswillnotgobackdownuntilthefollowing
happenstothesecuritiesheldbytheFed:
1 Securitiesissuedbynonfedaccountholdersmature(letuscallthemprivatesecuritiesto
simplify)
2 TheFeddecidestosellsomesecuritiestobanks.
IftheFedletTreasuriesmaturetheaccountoftheTreasury(L3),notreservebalances,isdebited:
54
Fed
Assets
Treasuries:$100
L3:$100
Treasury
Assets
L3:$100
Treasuries:$100
WhenprivatesecuritiesheldbytheFed,currentlyagencyguaranteedMBS,5maturethefollowing
occurs:
Fed
Assets
Privatesecurities:$100
Banksofissuer
Assets
Accountofissuer:$100
Issuerofprivatesecurities
Assets
Accountofissuer:$100
Privatesecurities:$100
IfallMBSheldbytheFedmaturedatonce,thatwouldreducereservebalancesbyalmost$2trillion
(theFeddoesnotplantosellmostoftheMBSitholds).6
Givenassets,reservebalanceswillgodownifbanksneedtomakepaymentstootherFedaccount
holders or if banks convert reserve balances into cash. For example, if the Treasury ran fiscal
surpluses,reservebalanceswouldfallasfundswouldmovefromL2toL3.WhiletheFedmayask,
andhasasked,fortheTreasuryshelpinmanagingmonetarypolicy(seeChapter6),theFedhas
mostlynocontroloverwhathappenstoliabilitiesthatimpactreservebalances.
Onemaynotetoconcludethat,besideschangesinassetsandliabilities,anotherwaytoreduce
excessreserveswithoutreducingthequantityofreservesistoraisereserverequirementratios.As
towhenthereserveswillbebacktotheirusuallevel,nobodyknows.Thepaceofdeclinewillchange
astheeconomicenvironmentchange,whichbringsustoafinalpoint.ThereisnoneedfortheFed
tobeproactiveaboutnormalizingitsbalancesheetbecause,withthechangeinmonetarypolicy
proceduresthatoccurredin2008,theFedcantargettheovernightinterbankrate.
Q7:ISTHEREAZEROLOWERBOUND?
Thisquestionisso2013!Thereisnolowerbound.Thediscountrateisthemoststraightforwardto
grasp because the Board of Governor has perfect control over the discount rate and can set it
whereveritwantswheneveritwants.ThereisnooperationalconstraintthatpreventstheBoard
fromsettingadiscountrateat1%,10%oreven100%,itjustneedstoannouncetomorrowthat
thisiswhatitisandthatisit.
55
Thefederalfundsrateisslightlymorecomplicatedbutnotthatmuch.Tosetanegativefedfund
rate,theFedjusthastodoovernightreposonsecuritiesatapremium.Ifoneappliesthistozero
couponsecuritieslikeTbills,thepresentvalueofaTbillis:
P=FV/(1+d)t
Pisthemarketprice,FVisthefacevalue,disthediscountfactor,andtistimetomaturity(letus
sett=1tosimplify).Usually,dispositivemeaningthattheFedbuysTbillsat$90andbankers
agreetobuybackthenextdayat$95(d=5%).Afterthe2008,onecanassumethatd=0%,thatis,
ifbankerswantreservesfromtheFed,theysellTbillsat$90andpromisetobuythembackat$90
thenextday.Tosetdnegative,theonlythingtheFedhastodoistobuyat$95andresellat$90.
Inthiscasethefederalfundsratetargetwillbenegative5%:90/951.IftheFedperformsenough
ofthesekindsofoperations,thefederalfundsratewillreachthe5%target.Rememberthatthe
Fedsetsthepriceofreserves.Itcansetitwhereveritwants:ItistheFedswayorthehighway.
Whichinterestratecanbebelowzero?AnyofthemaslongastheFediscommittedtodoingsoby
buyingenoughofsecuritiesatapriceconsistentwiththeinterestrateitwantstotarget.
Theinterestratesusedinthecorridorframework(seeChapter4)areunderthetotalcontrolofthe
Fedsotheyareeasytomakenegative.TheSwedishcentralbankshowsushowthisisdoneunder
acorridorframework(Figure5.4).TheSwisscentralbankshowsushowitisdonewithanegative
overnightinterbankraterange(Figure5.3).
Figure5.3Targetovernightraterangeanddailyovernightrate,SwissNationalBank,percent
Source:SwissNationalBank
56
Figure5.4CorridoroftheSverigesRiksbank,percent
Note:Thedepositrateistheinterestrateonreservebalances,thelendingrateistherate
chargedbythecentralbankforadvances(thediscountrateoftheFed),thereporateisthe
rateatwhichthecentralbankperformsopenmarketoperations(thetargetedovernightrate).
Ofcourse,ifacentralbankhasnegativepolicyratesandisexpectedtocontinuetohavenegative
rates for a while, this enters into portfolio strategies and pushes longerterm rates into/toward
negativeterritories(Figures5.5and5.6).But,theEuropeanCentralBankisgoingfurtherandis
buying large quantities of longterm government bonds. And financialmarket participants took
notice 7and bought government bonds in anticipation of the intervention of the ECB. Financial
marketparticipantsaresosuretheECBwillbuyalotofsecuritiesthattheyarewillingtobuyata
premium(soyieldstomaturityarenegative)(Figure5.4).TheywillselltotheECBwhowillbethe
onetakingthelossbyholdingtomaturity.
Forexample,takea1yearzerocoupongovernmentsecuritywithafacevalueof$1000.Normally,
thissecurity willtradeat adiscount,thatis,economic unitswillonlybuyitforlessthan $1000
becauseitdoesnotpayanycoupon.Theywillearnanincomebykeepingthesecurityuntilthe
Treasuryrepaysthe$1000atmaturity.Ifthesecurityisboughtat$800thentherateofreturnis
$200/$800=25%(rateofreturniswhattheearningyougetforwhatyoupaidforit).Ratesof
return on Eurozone government 1year securities are now negative because securities sell at a
premium.Forexample,ifonehastopay$1200ona1yearzerocouponsecurityandgets$1000at
maturity,therateofreturnis$200/$1200=17%.Nobodywillwanttobuythatunlessoneexpects
someoneelsetobuyat,say,$1300inupcomingdaysormonths.TheECBiswillingtodosoandwill
take a loss of $300 (23% rate of return) when the securities mature, while financial market
participantsmakeareturnof$100/$1200=8%.
57
Figure5.5Yieldsongovernmentbonds
Source:TheEconomist
Figure5.6YieldsonSwedishgovernmentsecurities,percent
Source:SwedishCentralBank
58
Q8:WHATARETHEEFFECTSOFANEGATIVEINTERESTRATE
POLICY?
Itdependsonwhichrateisconcerned.Asimplifiedbankprofitis:
Profitofbanks=(ROA*otherassets+IOR*R)FFR*fedfundsdebt
ROAisthereturnonassetsheldbybanks(sayyouhavea$1000mortgagewithaninterestrateof
5%,this5%isanincomeforthebankequaltoROA*mortgage=5%*$1000=$50).IORisinterest
onreservebalancesandRisreservebalances.Therearenootherdebtsthanthoseincurredfrom
gettingreservesinthefedfundsmarketeitherfromFedorfromothermarketparticipantsthan
banks.Interestpaymentsoninterbankloanscanceloutintheaggregateprofitofbanks,itisan
incomeforonebankandanexpenseforanother).
Giveneverythingelse,negativeFFRraisestheprofitabilityofbanksbecausebanksarepaid
togetanadvanceofreserves.
Given everything else, negative IOR lowers the profitability of banks. This is especially
significanttodaygivenhowlargereservebalancesare.
Bankswillreacttotheseeffectsinseveralwaysinordertopreservetheirprofitability.Tocounter
anegativeIOR,banksmaydothreethings:
Asktheircustomerstopayafeeontheircheckingaccounts(eitheralargeroneorraisethe
minimumquantityoffundsinanaccountbelowwhichafeeispaid)
Raisethebankprimerate(i.e.interestratepaidbythemostcreditworthyeconomicunits)
oracquireriskierassetssoastoraiseROA.
RaiseleverageonthefundingofassetswithpositiveROA.
Ifthefeeonbankaccountsistoolarge,customersmayaskforcashandclosetheiraccounts,but
thatisnotreallyaproblemforbanksgiventhat:
1 IftheFFRisnegative,bankscanborrowallthereservestheyneedandberewardedforit.
Todaytheyhaveplentyofreservessothiseffectislimited,butitalsomeansthatmeeting
cashwithdrawalsiseasy.
2 Banks work by granting advances and making electronic payments so some individuals
musthavedeposits.Inaddition,nobodycanaccesscash(FederalReservenotes)ifonedoes
not have an account in the first place, and banks create these accounts by providing
advances.Advancespayinterest.
TherealproblemisanegativeIORinthecontextofalargequantityofexcessreserves.Itactslike
ataxandmayincentivizebankstotakemorerisks.Thiseffectisallthemorestronggiventhatbanks
donotneedtoborrowinthefedfundsmarketsoanegativeFFRhasalimitedabilitytooffsetthe
negativeimpactofanegativeIOR.
Intermsofnegativebondrates,theimpactisthatbondholdersmakecapitalgainsbysellingtothe
centralbank(seeQ7).Thecentralbankhopesthatbondholderswillusesomeoftheircapitalgains
toconsumeandsostimulatetheeconomy.Givenhowunequalwealthdistributionis,theabilityof
thischanneltoworkseemsdoubtful.Itisaformoftrickledowneconomics.
59
Q9: HOW DID CENTRAL BANKERS JUSTIFY USING NEGATIVE

INTERESTRATESANDQE?
Hereisthelogicfollowed:
1 Anegativepolicyrateinatimeofdeflation(orlow/zeroinflation)allowsustokeepthereal
interestratelow(allowsustolowertherealrate).Economicunitspayattentiontothereal
rate (interest rate less inflation) when they decide to go into debt. If policy rate goes
negativethatshouldincentivizeeconomicunitstogointodebt.
2 Bybuyingalotofsecuritiesfrombanks,bankswillhavealotofexcessreservesandwillbe
encouragedtoprovidecredit.Andtherewillbeademandforcreditgivenstep1.
3 NowthatQEprovidedbankswithlotsofexcessreserves,banksaresupposedtolend
(seemoneymultipliertheoryinChapter10).BysettingIORnegative,bankswillhaveless
incentive to cling on their reserves and instead will provide credit. Indeed, if they keep
reservesanegativeIORwouldleadtolosses(seeQ8).
4 Beyondthepositiveimpactofbankcredit,negativepolicyratesandquantitativeeasing
alsohelppushdownotherrates,whichpromotescapitalgainsbysecuritiesholdersandso
consumption.
Thereareseveralissuesbutthethreemainonesare:
1 Theabilityofbankstograntcreditisunrelatedtothequantityofexcessreservestheyhave.
Chapter 4 shows that banks cannot do much with reserve balances (see Chapter 10).
Centralbankscanfeedbankstotonsofreservesandmayeventhreatenbanksprofitability
withnegativeIOR,butitisjustlikebeatingadeadhorse;banksarestuckwithreserves.
2 Inadepressedandoverindebtedeconomy,incentivizingeconomicunitstogointodebtis
thewrongwaytoproceed.
3 The form of trickledown economics that quantitative easing and negative yield rates
representhasneverworked.
Weneedabottomupapproach8thatfocusesonprovidingjobs,fightingpoverty,andmeetingthe
needsofthenation.Fiscalpolicyisthemeanstodoso.
Q10:SHOULDTHEFEDFINETUNETHEECONOMY?
WhiletheFedisheavilyinvolvedinfinetuningtheeconomyi.e.makingsuretheeconomyis
nottoohot(inflation)nortoocold(unemployment)bymovingtheFFRtargetupanddownone
maynotethattheFed(andothercentralbanks)wasnotcreatedforthatpurpose.Centralbanks
werecreatedeithertofinancethecrown/state,ortopromotefinancialstability(bothgoalsare
actuallyintertwinedasshowninChapter6).
Someeconomists,likeHymanMinsky,thinkthatfinetuningandpromotingfinancialstabilityare
incompatiblegoals.Acentralbankshouldfocusonpromotingfinancialstabilitythroughlowand
stablenominalinterestrates,aswellasproperregulation,supervisionandenforcement.TheFed
couldalsoinfluencefinancialinnovationsbyrefusingtoacceptascollateralanyfinancialinstrument
60
that promotes Ponzi finance (see Chapter 14). Finetuning the economy with interest rates
impliesraisinginterestrateduringanexpansion,whichultimatelycontributestoproblemswith
servicingdebts.Giventhatdecisionstogointodebtarenotinterestratesensitive,raisingratesjust
pusheseconomicunitstogomoreintodebttopayexistingdebts.Thehopeisthatincomeand
capitalgainswillultimatelyenablethefullrepaymentofdebts.
Morebroadly,thelinkbetweenFFRandtheendgoalsofemploymentgrowthandinflationcontrol
istenuousandsubjecttoperverselinkages.Forexample:
Thelinkbetweeninterestratesandbusinessinvestmentisveryweak,withinvestmentby
companiesoverwhelminglydependentonexpectednetcashflows.
Higherinterestrateraisesthecostofdoingbusinessandfirmsmaypassthatcosttotheir
clients,resultingininflation.
Higher interest rate also raises the income of rentiers and so their consumption. If the
economy has a large proportion of rentiers (pensioners, wealthy individuals, etc.) then
raisingratesmaybeinflationary.
Higherinterestrateraisestheprivatedebtburdenandpromotesfinancialinstability.
Interestratevolatilitypromotesfinancialinnovationstoremovethesensitivityofprofitto
interestrateswings.
Increments in FFR are small and announced well in advance, giving plenty of time to
economic units to adapt in order not to let their decisions be influenced by the cost of
credit.
Instead of nudging incentives so that, maybe, the private sector will spend, some economists
promoteamoredirectapproach.Intimesofcrisis,implementlargescalefiscalspendingtomeet
theneedsofthenations(intheUS,oneoftheseneedswouldbeinfrastructurethatisinreallybad
shape).9Atanytime,involvethegovernmentindirectjobcreationbyemployingpeopleinsimilar
wayitwasdoneintheNewDeal;aJobGuaranteeprogram.Intimesofexpansion,constantlycheck
financialinnovationsandforbidfinancialpracticesrelatedtoPonzifinanceoratleastremoveany
safetynetforthem.
Finally, there have been some debates 10 also about how to set the FFR target. In the more
mainstream literature, this issue boils down to what to include in the Taylor rule (a rule that
determineswhattheoptimalFFRtargetshouldbegivenastateoftheeconomy)andhowmuch
weight to put on each element that influences the rule. In the nonmainstream approach, the
discussionisbroaderandincludesdiscussionsaboutthedistributiveanddestabilizingimpactsof
monetary policy. Some authors want the central bank to target a specific interest rate to make
rentiersincomestableandrelatedtotheproductivitygainsoftheeconomy.Otherswanttoleave
FFRpermanentlyaroundzeroandletotherratesdothejobofsortingcreditrisk,inflationrisk,etc.
ApositiveFFRjust adds extraincome torentiersanddoes notrewardanyrisk(seeQ5withBill
Gross).
ForyourreadingpleasurebelowarethreeextractsfromsomeFederalOpenMarketCommittee
meetingsthatillustratesomeofthepreviouspoints.Firstonthelackofinterestratesensitivity:
Inadditiontotheinputthatwebringtothesemeetingsandtheusualsourcesof
ourownresearchstaffanddirectors,lastFridaywhenViceChairmanSchultzvisited
usinSanFranciscowecalledinaspecialsmallgroupofbankers,businessmen,and
61
academiciansforaveryfrankexchangeofviews.Wesoundedthemoutabouttheir
feelingsontheeconomyandonFedpolicy,andImustsay,Fred,thatIthoughtthe
reactions were quite candid and somewhat humiliating in a way. The bankers
generallyexpressedtheviewthatasyettheresverylittleevidencethatthehigh
level of interest rates is having any significant total effect on cutting off credit
demand.Now,onehastoaddtothattheexpressionswegotfromtheminour
usualgoaroundwithbankersandbankdirectorsthatthesehighratesarehaving
acuttingeffectonthesocalledmiddlemarketforbusinessborrowersthesmaller
firmsandformortgageloansandsomesmallfarmers.Thatswheretheincidence
ofthehighinterestrateeffecthasbeenfeltthusfarinourpartofthecountry.But
as a general matter, even if the businessmen present were mostly from big
concerns, they simply indicated that the higher rates per se are not having any
effectatallontheircapitalprojects.Ifaprojectisworthwhile,itsnotgoingtoget
cutoffbyaoneortwopercentagepointincreaseinthecostoffunds.Aminority
expressedtheviewthatthisisleadingtosomegreatercautiononinventorypolicy,
whichisalreadybeingviewedasquitecautious.Onemajorrealestatedeveloper
presentindicatedthatthehigherratesarejustbuiltintotheirprojectsandarent
havinganydampeningeffectatall.(Balles,FOMCmeeting,September1979,page
27)
Secondonthecostimpactofraisinginterestrates:
Interestratesmaybe[low]aftertax,orinrealterms,buttheyarestillcontributing
tocostandarecreating,Ithink,someoftheupwardpressureonprices.(Teeters,
FOMCmeeting,May1981,page10)
Thereisdeteriorationintheinflationratestemmingfrominterestcostsandenergy
costs,andthosearenottrivialsourcesofdeterioration.Attheendofthedayit
doesnthavetobelaborcoststhatarecausingtheoverallinflationdeterioration.
(Greenspan,FOMCmeeting,November2000,page85)
Q11:ISTHEFEDAPRIVATEORAPUBLICINSTITUTION?
PartlyduetothecultureoftheUnitedStates,andpartlyduetostrongeconomicinterestsagainst
centralized institutions, the Federal Reserve System is an oddly organized publicprivate
partnership.MemberbanksdoholdstocksissuedbytheSystemthatprovideadividendpayment
butthisdividendpaymentisnotguaranteed,thestocksdonotprovideanyvotingrights,andthey
cannot be traded. For example, recently 11 Congress decided to divert some of the dividend
paymentstofundhighwayexpenses.
Inaddition,allleftoverincomeoftheSystemmustbetransferredtotheTreasury.Notethatthis
makesforanoddsituation.TheFedholdsTreasuriesthatpayinterest,partofthisinterestincome
endsupgoingbacktotheTreasury:theTreasurypaysitselfinterest!Inaddition,theTreasurytries
tomaximizeitsearningsfromtheFedthroughcashmanagement.12
Insteadoflookingatstockholdingsandincomepayment,amorerelevantanalysisofthepolitical
economyoftheFedlooksatitsstructureandwhocanmakedecisionsregardingmonetarypolicy
andemergencyoperations.Intermsofmonetarypolicy,theinfluenceofWallStreetislarge,with
strongrepresentationontheFederalOpenMarketCommitteeviamemberswithformertiesto
62
majorbanks(in2016halftheFedpresidentshaveformertiestotwomajorbanks:GoldmanSachs
and Citibank). Financial sector members tend to be more hawkish and more concerned, if not
obsessed,withpricestability.ThisleadsthemtowanttoraisetheFFRtargetearly,leadingtoa
level of employment lower than it would otherwise have been. They are also friendlier to the
financialindustryandmorelenientintermsofregulationsandintermsofresponsetoafinancial
crisis.Finally,thereisariskofregulatorycapture.
IfonecombinesthiswiththefactthateconomistsattheBoardaremostlypromarketsupplysided
economists (economic growth is ultimately a supplyside thing), financial regulation and
enforcementdonotmakemuchsenseandraisingratesveryearlyinanticipationofinflationmakes
sense.Manyeconomists,however,doubtthatmarketsareefficientandthatdemandhasnorole
toplayinthelongrun.
Q12: WHAT ARE NONO SENTENCES FOR WHAT THE FED

DOES?(WILLGIVEYOUAZEROONMYASSIGNMENTS)
1 TheFedcontrolsthemoneysupply:No,itdoesnot,itsetsaninterestrate,whathappens
afterthatisuptofirmsandhouseholdsandtheirdesireforexternalfunds(seeChapter4).
2 TheFedinjectsreserveswhichlowerstheinterestrateor,worseoffender,TheFedinjects
money which lowers interest rate. Under normal circumstances (that is, preGreat
Recession,whichiswhatmostpeoplehaveinmindwhensayingthis),theFeddoesnot
proactivelyinjectreserves,itwaitsforbankstoask.And,theFedsmonetarypolicynever
injectsmoney,i.e.neverdealsdirectlywiththepublic(M1)(seeChapter4).
3 The Fed printed money during the financial crisis: No, it just credited account by
keystroking dollar amounts, no Federal Reserve notes were printed. More to the point,
noneofthesefundsenteredthemoneysupply,thatis,fundsheldbythepublic.
4 TheFedusedtaxpayersmoneyduringthefinancialcrisis:No,itjustcreditedaccountsof
banksbykeystrokingdollaramounts(seeChapter2).
5 Banks use reserves to buy stocks and corporate bonds: No banks cannot do that with
reserves(seeChapter2).
6 Thelargeinflowofreservesinbanksdidnotleadtoinflationbecausebanksdidnotlend
thereservesorbasedonreserves:No,banksdonotoperatethatway,bankcreditand
quantityofreservesareunrelated(seeChapter10)
7 Centralbankslendreserves:No,theFeddoesnotlendreservesbecausereservesareits
liability(seeChapter2).
8 Fiscaldeficitsraiseinterestrates:No,therewasahintaboutthisinChapter3.Moreis
cominginChapter6.
63
1Settinganinterestratedoesnotmeansupplyinganinfinitequantityofreserves.Itjustmeans
supplyingwhatbankswant.
2TheVolckerexperimentaimedatfollowingmorecloselytheMonetaristprinciplesofmonetary
policymaking.Inpractice,theFedwideneddramaticallythetargetrangefortheFFRbutitnever
completelylettheFFRrespondtomarketforces.
3FOMCmembersdidnotunderstandthattargetingtheFFRwasnotinflationaryuntilthemiddle
ofthe1990s.
4Normalizingthebalancesheetsmeansreturningthequantityofexcessreservesbacktoitspre
GreatRecessionproportionintotalreserves.Thiscanbedonebysellingassetstobanksorbyletting
someofthesecuritiesheldbytheFedmature.
5NormalizingthebalancesheetoftheFedisnotnecessarygiventhattheFedhaschangedits
proceduresforsettingtheFFR.
6TheFFRanddiscountratearepolicyvariablescompletelyunderthecontroloftheFed.Theycan
besetwherevertheFedwants,eveninnegativeterritory.
7Inordertosetmarketrateintonegativevalues,theFedjusthastocompleteenoughpurchases
ofsecuritiesatapremium.
8Byprovidingcapitalgainsandbymakingitcostlytoholdreserves,anegativeinterestratepolicy
issupposedtopromoteeconomicactivity.
9Finetuningtheeconomymaybedifficultandcounterproductivebecauserisinginterestrates
maypromotefinancialfragilityandmaybeinflationary.Inaddition,businessinvestmentisnotvery
sensitivetochangesininterestrates;thetransparentandgradualmonetarypolicystrategiesused
sincethemid1990shavemadespendingdecisionsevenlesssensitivetointerestratehikes.
Keywords
Volckerexperiment,premium,finetuning,normalization,excessreserves,totalreserves
ReviewQuestions
Q1:HowdidtheVolckerexperimentleadtoanincreaseinthevolatilityoftheFFR?DidtheFed
abandoncompletelyinterestratetargeting?
Q2:FOMCmembersdidnotbelievethatsettinganinterestratewasasustainablemonetarypolicy
practice;whynot?Whyweretheywrong?
Q3:HowdoesQEimpacttheyieldsofsecurities?Whythelinkcannotbeoneinwhichbanksbuy
securitieswithreserves?
Q4:Howcanbanksoffsettheadverseimpactofnegativeinterestratesontheprofitabilityofbanks?
Q5:WhatarethetwowaysthroughwhichQEissupposedtoboosteconomicactivity?Whatare
potentialissueswiththispolicy?
Suggestedreadings
ForananalysisofFOMCmeetingsduringtheperiod19791999seechapter6ofCentralBanking,
AssetPrices,andFinancialFragilitybyEricTymoigne.
Kaldor,N.(1982)TheScourgeofMonetarism,Oxford:OxfordUniversityPress.
64
1AsuccinctprofileofNicholasKaldorwaswritteninthecentralbankoftheSlovakRepublicBIATEC,VolumeXIV,12/2006
http://www.nbs.sk/_img/Documents/BIATEC/BIA12_06/26_30.pdf
See Bill Gross: Americans are being "cooked alive" by the Fed's zero interest rates by Chis Matthew at
http://fortune.com/2015/09/23/billgrossfederalreserveinterestrates/
3SeeWray,L.R.(2006)GlobalDemographicTrendsandProvisioningfortheFutureLevyEconomicsInstitute,Working
PaperNo.468athttp://www.levyinstitute.org/pubs/wp_468.pdf
4SeePolicyNormalizationPrinciplesandPlansAsadoptedeffectiveSeptember16,2014bytheFederalOpenMarket
Committeeathttp://www.federalreserve.gov/monetarypolicy/files/FOMC_PolicyNormalization.pdf
5
See About MBS/ABS by the Securities Industry and Financial Markets Association at
http://www.investinginbonds.com/learnmore.asp?catid=11&subcatid=56&id=134
6SeePolicyNormalizationPrinciplesandPlansAsadoptedeffectiveSeptember16,2014bytheFederalOpenMarket
Committeeathttp://www.federalreserve.gov/monetarypolicy/files/FOMC_PolicyNormalization.pdf
7 See Euro Area's NegativeYielding Debt Tops $2 Trillion on Draghi by Lucie Meakin at
http://www.bloomberg.com/news/articles/20151123/euroareasnegativeyieldingdebttops2trillionondraghi
8 See Tcherneva, P.R. (2013) Reorienting Fiscal Policy: A Critical Assessment of Fiscal Fine Tuning Levy Economics
Institute,WorkingPaperNo.772athttp://www.levyinstitute.org/pubs/wp_772.pdf
9
See the Infrastructure Report Card by the American Society of Civil Engineers at
http://www.infrastructurereportcard.org/
10SeeTymoigne,E.(2006)AssetPrices,FinancialFragility,andCentralBankingLevyEconomicsInstitute,WorkingPaper
No.468http://www.levyinstitute.org/pubs/wp_456.pdf.Seealso
11 See Fed Money Tapped in Highway Bill as Banks Get Dividend Break by Cheyenne Hopkins at
http://www.bloomberg.com/news/articles/20151201/fedsurplustappedinhighwaybillasbanksgetdividend
break
12Santoro,P.J.(2012)TheEvolutionofTreasuryCashManagementduringtheFinancialCrisis,FederalReserveofNew
YorkCurrentIssuesinEconomicsandFinance,18(3):18.
2
65
CHAPTER 6:
HowandwhythecentralbankandTreasurymustcoordinatetheirfiscaland
monetaryoperations
HowtheTreasuryhelpsthecentralbankimplementmonetarypolicyonadaily
basis
WhytheTreasuryisinvolvedintheimplementationofmonetarypolicy
WhythefinancingoftheTreasurybythecentralbankisnotoptionalandmust
alwaysoccurdirectlyorindirectly
HowthecentralbankgetsinvolvedinfinancingtheTreasury
Why a monetarily sovereign government does not face any financial
constraint
Whatrelevantquestionsamonetarilysovereigngovernmentmustanswer
CHAPTER6:TREASURYANDCENTRALBANKINTERACTIONS
This Chapter concludes the study of central banking matters included in this draft. The Chapter
studies how the Fed is involved in fiscal operations and how the U.S. Treasury is involved in
monetarypolicy operations. The extensive interaction between these two branches of the U.S.
governmentisnecessaryforfiscalandmonetarypoliciestoworkproperly.
Onceagain,thebalancesheetoftheFederalReserveprovidesasimplestartingpoint.TheTreasury
holdsanaccount(calledTreasuryGeneralAccount,TGA)attheFed,whichispartofL3.Tosimplify,
thisChapterassumesthattheFedstillfollowsthemonetarypolicyproceduresthatitfollowedprior
tothe2008crisis.
MONETARYPOLICYANDTHEU.S.TREASURY
When Treasury spends, the Fed debits the TGA and credits reserve balances. Simultaneously,
privatebankcreditstheaccountofprivateeconomicunits.SaytheTreasurybuys$100worthof
paperfromapapercompany.
Fed
Assets
TGA:$100
Bank
Assets
Accountofpapercompany:+$100
Papercompany
Assets
Paper:$100
Accountofpapercompany:+$100
Treasury
Assets
TGA:$100
Paper:+$100
IfTreasuryreceives$25ofincometaxpayments,thefollowinghappens:
Fed
Assets
Reservebalances:$25
TGA:+$25
Bank
Assets
Reservebalances:$25
67
Accountoftaxpayer:$25
Taxpayer
Assets
Accountoftaxpayer:$25
Networth:$25
Treasury
Assets
TGA:+$25
Networth:+$25
Therefore,incaseofadeficit(taxeslessthanexpenses),thereisanetinjectionofreserves.The
consolidationofthetwopreviousfiscaloperationsis:
Fed
Assets
TGA:$75
IftheFeddoesnotneutralizetheimpactofthefiscaldeficitbyremovingtheextrareserves,banks
willdumpeverythingintheFedFundsmarketandtheFFRrapidlyfallstoward0%(seeChapter4).
AslongastheFedtargetsapositiveFFR,ithastoneutralizetheimpactofdailyfiscaldeficits(L3
falls)thatlowertheFFRandtheimpactofdailyfiscalsurpluses(L3rises)thatraisetheFFR.
TheTreasuryunderstoodtheimpactofitsfiscaloperationsonmoneymarketslongbeforetheFed
wascreated.Inthecurrentsetup,theTreasuryhashelpedtheFedtoachieveitsFFRtargetthrough
twomeans:
1 Cash management: The Treasury collects proceeds from taxes and bonds issuances in
thousandsofprivatebankaccountscalledtheTreasurysTaxandLoanaccounts(TT&Ls).
TreasurymovesfundsbetweenitsTT&LsandTGAtohelpmonetarypolicy.
2 Publicdebtmanagement:TheTreasurychangesthelevelofitsoutstandingTreasuries,or
changesthestructureofitsTreasuries(proportionofshorttermvs.longtermsecurities).
GiventhatfluctuationsintheTGA(L3inFigure2.1)influencereservebalances(L2inFigure2.1),
untiltheGreatRecessiontheTreasurylimitedthesefluctuationsbykeepingtheTGAaround$5
billion (Figure 6.1). Treasury employees met every morning with Fed employees to discuss the
expectednetcashflowonTGAforthedayandtodecideonthequantityoffundstomoveinorout
ofTT&Lstomeetthe$5billiontarget.
Forexample,saytheTGAiscurrentlyat$5andthatthisisthetargetoftheTreasury.IftheTreasury
expectstospend$2,itwouldcall$2fromitsTT&Lsduringtheday.CashflowsoftheTGAarevery
erraticthroughoutthedaysotheycannotbeoffsetperfectly.Assumethatspendingoccursfirst
(paymenttoapapercompany):
Bank
Assets
Reservebalances:+$2
Accountofcompany:+$2
Fed
Assets
68
Reservebalances:+$2
TGA:$2
TheinjectionofreservesisremovedbycallingfundsfromTT&Ls:
Bank
Assets
Reservebalances:$2
TT&Ls:$2
Fed
Assets
Reservebalances:$2
TGA:+$2
SooverallthenetimpactonreservebalancesiszeroandthebalancesheetoftheFedisunchanged.
Theonlychangeisontheliabilitysideofprivatebanks.
Bank
Assets
Accountofcompany:+$2
TT&Ls:$2
Figure6.1TGA,weeklyaveragesuntil9/17/2008,billionsofdollars
Source:BoardofGovernorsoftheFederalReserveSystem(H.4.1.series)
TREASURYSINVOLVEMENTINMONETARYPOLICYDURINGTHE2008
CRISIS
Lehmans collapse in September 2008 led to a large injection of reserves but this injection was
partlycontainedbyarapidincreaseinotherliabilitiesthatpeakedinvalueat$1.7trilliononthe
week of November 5th 2008 (Figure 6.2). The cause of the increase is a massive cash and debt
69
management operation by the Treasury that started late September 2008. First, Treasury
transferredtensofbillionsofdollarsfromitsTT&LsintotheTGA,therebybreakingwithitsattempt
tomaintainTGAat$5billion.Second,TreasuryissuedSupplementaryFinancingProgramTbills
(SFP bills), and immediately put the proceeds into a new Treasury account at the Fed called
TreasurysSupplementaryFinancingAccount(TSFA)(Figure6.3).
Figure6.2BalancesheetoftheFederalReserve,trillionsofdollars
WhydidtheTreasurydothis?TohelpdrainreservesinordertomaintaintheFFRontarget.The
FFRtargetwaspositiveuntilDecember2008,soreserveshadtobedrainedinordertomaintain
the FFR around the nonzero target. Chapter 4 explains that the Fed had been neutralizing the
impactofemergencyprogramsonreservessinceDecember2007.Ithadbeendoingsobyselling
itsholdingsofTreasuriestobanksandinsixmonthstheoutstandingvalueofitsholdingsfellfrom
$780billioninJanuary2008to$480billioninJune2008.IftheFedhadcontinuedtoneutralize
emergencyprogramsinthatfashion,itwouldhaverunoutofTreasuriesveryquicklywiththepanic
ofSeptember2008.ItisallthemoresothattheFedhadstartedtolendsomeofitsTreasuries,so
thedollaramountofunencumberedTreasuriesactuallydroppedto$250billion.
InordertoavoidrunningoutofTreasuries,theFedaskedtheTreasurytohelpdrainreservesvia
cashmanagement(TT&LstoTGAtransfers)anddebtmanagement(issuanceofSFPbills).TheT
bills were issued at the request of the Fed for monetarypolicy purposes, that is, to help drain
reserves. 1 The outstanding dollar amount of SFP bills peaked at almost $560 billion in late
October/earlyNovember2008.Afterthat,theoutstandingdollaramountwentdownquicklyfor
reasonsexplainedbelow.Combinedwithitscashmanagementoperations,Treasuryremovedup
to slightly more than $600 billion worth of reserves. As the Discount Window was advancing
reservestobanksindifficulty,theTreasurywassimultaneouslydrainingthem(Figure6.4).
70
Figure6.3TreasurysaccountsattheFed,billionsofdollars
Figure6.4Injection(+)andejection()ofreservebalances,trillionsofdollars
Source:FederalReserve(SeriesH.4.1)
In its announcement of the Program, the Treasury misrepresented the purpose of SFP bills by
statingthattheirpurposewastoprovidecashforuseintheFederalReserveinitiatives.2Ofcourse
thisisincorrectbecausetheFeddoesnotneedcashfromanybody,itcreatescash.
71
TheTreasuryrapidlyreduceditshelpthroughtheSFPprogrambyagreeingtorolloveronly$200
billionofTbills.Treasurydidsobecauseitshelpwasnolongerasneeded(FFRtargetwasatzero),
andbecauseofthedebtceilingdebateofthetimethatalmostkilledtheprograminearly2010.
OTHER EXAMPLES OF TREASURYS INVOLVEMENT IN MONETARY

POLICY
TheTreasuryhasusedotherdebtandcashmanagementtechniquesinthepastinordertohelp
monetarypolicy.Forexample,TreasuryusedtobeabletohaveanintradayoverdraftonitsTGA;
unlimitedfrom1914to1935andup to$5billionfrom1942until1979 (Table6.1).3Assuch,at
times,theTGAwouldcarryanegativebalanceduringthedayand,bytheendoftheday,theTGA
would be replenished by direct financing of the Fed. The Treasury issued special certificate of
indebtednesstotheFedandinexchangetheFedcreditedtheTGA.
The Treasury used this overdraft authorization exclusively for monetarypolicy purposes. For
example,beforeamajortaxseason:
Onoccasion,theTreasury,inanticipationofheavytaxreceiptsduringheavytax
months, will, under statutory authority, replenish balances at Federal Reserve
Banks by borrowing directly from such banks through the issuance of special
certificatesofindebtedness,ratherthanwithdrawingfundsfromTreasurytaxand
loan accounts. These funds are borrowed for only a few days and enable the
Treasurytemporarilytomakedisbursementsinexcessofitscurrentreceiptsthus
providing the banks with additional reserves in advance of a later unavoidable
drain.(U.S.Treasury1955,282,italicsadded)
ThisallowedtheTreasurytoreplenishitsTGAwithouthavingtodrainitsTT&Ls.TheTreasurydid
thisnotbecauseitwasrunningoutofmoney:
Atthetime[Treasurysadministrators]haveusedtheoverdraftinthepast,ithas
notbeenwhentheyhavehadnobalanceswiththebanks.Theyhaveusuallyhad
very substantial balances with the banks. And they could have drawn on those
balances to meet the overdraft. That, however, [] would be undesirable and
unstabilizingtothemoneymarkettowithdrawthe[TT&Ls]forsuchaveryshort
periodoftime.ItwouldthenbuildupunnecessarybalancesintheReservebanks,
andwouldcreateadeficiencyofreservesinthebanksthroughoutthecountry,and
wouldcompelthemtosellsecuritiesortoborrowfromtheFederalReservebanks
(EcclesinU.S.House1947,7))
ThroughoutmostofWWII,theFedwastargetingtheentireyieldcurve(thatis,alltheinterestrates
onTreasuries)andTreasuryhelpedthroughdebtmanagement(Figure6.5).Thestricttargetingof
Tbondrateat2.5%wasrelaxedabittowardtheendofthewar,butTreasuryandFedstilldidnot
wanttheratetodeviatetoomuchfrom2.5%.Afterthewar,fiscalsurplusesremovedTbondsfrom
themarketeventhoughtherewashighdemandforthem.Thissituationraisedtheirpriceandthe
yieldon10yearTbondsdeclinedsteadilytoward2%.TobringbacktheTbondrateuptoward
2.5%,moreTbondsneededtobesupplied.Unfortunately,theFeddidnotholdenoughTbondsso
theTreasurysuppliedmore:
72
Atanyrate,theeffectofabudgetsurplusatthattimewasterriblyimportantinall
ofthemonetaryanddebtmanagementoperationsthatwenton.[]Atthattime,
the Federal Reserve System owned practically no longterm Government bonds
and,therefore,initsopenmarketoperationswasunabletosupplythemarketwith
thattypeofinvestment.TheTreasuryDepartment,however,heldlargeamounts
of longterm bonds in various investment accounts. After consultations and
discussions,bothatastafflevelandatapolicylevel,betweentheTreasuryandthe
Federal Reserve and in full agreement, the Treasury Department, through the
openmarketcommitteeoftheFederalReserve,soldlargeamountsoflongterm
Governmentbondssoastofillthedemandandtopreventafurtherdeclineinthe
longterminterestrate.Duringthisperiod,theTreasurysold$1.5billionoflong
termbonds.However,theamountwasnotadequatetosatisfythedemandnorto
increasethemarketyieldonsuchsecurities.Thereupon,theTreasuryDepartment,
afterconsultationwiththeFederalReserveandwithfullagreementonthepartof
both,soldanonmarketable18yearissueintheamountof$1billion.Thepurpose
of this sale was to mop up any remaining investment funds that were exerting
upwardpressureonthemarket.(WigginsinU.S.Senate,1952,p.227,p.237))
FromafiscalperspectivethisseemsstrangeaTreasurytryingtoraisethecostofitsindebtedness
and a Treasury issuing securities when running a fiscal surplusbut again all this was done for
monetarypolicypurposes,andmorebroadlyforwhatwasconsideredthesocialpurpose.
1923
1924
1925
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
1940
1941
1942
(1)
30
14
15
14
46
20
17
18
18
8
4
19
(2)
1
1
1
1
1
1
1
1
1
1
1
6
(3)
156.5
184
182
246
251.5
316
314
218
219.5
32
9
422
1943
1944
1945
1946
1947
1948
1949
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
(1)
48
9
2
2
4
30
29
15
2
-
(2)
28
7
2
1
2
9
20
13
2
-
(3)
1,302
484
220
180
320
811
1,172
424
207
-
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
(1)
3
7
8
21
9
1
10
1
16
4
N/A
-
(2)
3
3
6
12
7
1
6
1
7
4
N/A
-
(3)
169
153
596
1,102
610
38
485
131
1,042
2,500
2,600
-
Table6.1DirectfinancingoftheTreasurybytheFedtoclosetheTGAoverdraft:Numberof
DaysUsed(1),MaximumNumberofDaysUsedatanyOneTime(2),andMaximumOutstanding
atanyTime(MillionsofDollars)(3)
Sources:U.S.House(1962),U.S.Treasury(1978),BoardofGovernorsoftheFederalReserve
System(1979)
73
Figure6.5U.S.Interestratesinthe1930s,1940sand1950s,percent.
Sources:NBER,BoardofGovernorsoftheFederalReserveSystem
Note:GreyareaisrepresentsU.S.officialinvolvementinWorldWarTwo.
There have been other cash and debt management techniques used by the Treasury but those
aboveshouldgiveyouasensethattheFedcannotdoitalonegiventhewayitoperatesintermsof
monetary policy (it uses Treasuries so Treasury must supply enough securities), and given that
Treasury has an account at the Fed (a fiscal surplus/deficit drains/injects reserves). In other
countries the institutional details change, but some coordination between Treasury and central
bankisneededformonetarypolicyoperationstoworkproperly.
FISCALPOLICYANDTHEFED
Foragovernmentthathasmonetarysovereignty,onethatissuesitsowncurrencyandsecurities
only denominated in its unit of account, the central bank always helps one way or another to
financethebudgetoftheTreasury.Afterall,centralbankswerecreatedinparttohelpfinancethe
state,thatis,tomakesurethatthestatehasthefinancialmeanstofulfillitsgoalsexpressedinthe
annualbudget.Onceagain,thefollowingfocusesontheUnitedStates.
ThemoststraightforwardinvolvementoftheFedintofiscaloperationswastheavailabilityofan
overdraftonTGAuntilthelate1970s.Asstatedintheprevioussection,inpracticethisoverdraft
facility had been strictly used for monetarypolicy operations, but it could be used for fiscal
purposesincaseofnationalemergency.The$5billionlimitwas,however,verylimitingforthat
purpose and there were Congressional hearings in the 1960s that looked into the possibility of
expandingthatlimitandmakingtheoverdraftlinepermanent(authorizationoftheoverdrafthad
toberenewedbyCongresseverytwoyears).Thiswentnowherebecausetheuseoftheoverdraft
forfiscalpurposeswasseenasinflationaryandunsound.TheTreasuryalwaysjustifiedtheuseof
74
the overdraft as a brief and occasional means to finance its expenditures in order to avoid
disruptionsinthemoneymarket.
Even though direct financing was discouraged and later forbidden, the Treasury uses Feds
monetaryinstrumentstospend.Thus,onewayoranother,theTreasurywillgetfinancedbythe
FedbecauseonlytheFedsuppliesthefundsthattheTreasuryuses.Indeed,whileTT&Lsareused
toreceivebondandtaxproceeds,theyarejustatoolthatallowsforsmoothingouttheimpactof
tax and bond proceeds on reserves. Ultimately, all the proceeds go to the TGA, which drains
reserves.AsaconsequencetheFedhastoensurethatbankshaveenoughreservestoallowthe
TreasurytobeabletomakethetransferfromTT&LstoTGA.
Inaddition,theFedalsohasbeenheavilyinvolvedintreasuryauctions4toensurethattheygoon
smoothly. Chairman Eccles again provides an insightful insiders view on the financing of the
Treasury:
[In past Congressional hearings] there was a feeling that [] Government
[borrowing] directly from the Federal Reserve bank [] took off any restraint
toward getting a balanced budget. Of course, in my opinion, that really had no
relationship to budgetary deficits, for the reason that it is the Congress which
decides on the deficits or the surpluses, and not the Treasury. If Congress
appropriatesmoremoneythanCongressleviestaxestopay,then,thereisnaturally
a deficit, and the Treasury is obligated to borrow. The fact that they cannot go
directlytotheFederalReservebanktoborrowdoesnotmeanthattheycannotgo
indirectlytotheFederalReservebank,fortheveryreasonthatthereisnolimitto
theamountthattheFederalReserveSystemcanbuyinthemarket.[]Therefore,
if the Treasury has to finance a heavy deficit, the Reserve System creates the
condition in the money market to enable the borrowing to be done, so that, in
effect, the Reserve System indirectly finances the Treasury through the money
market,andthatishowtheinterestrateswerestabilizedastheywereduringthe
war,andastheywillhavetocontinuetobeinthefuture.Soitisanillusiontothink
thattoeliminateortorestrictthedirectborrowingprivilegereducestheamount
ofdeficitfinancing.Orthatthemarketcontrolstheinterestrate.Neitheristrue.
(EcclesinU.S.House,1947,8)
If the Treasury does not get the funds it needs to implement Congressional mandates, and if
Congresspassesabudgetindeficit,thenthedemocraticprocesswillnotbefulfilled(thebudget
cannotbeimplemented),andinterestrateswillrise.
IntermsofauctionsofTreasuries,theFedmakessuretheyarealwayssuccessful;bondvigilantes
havenoinfluence.TheFedhasdonesoinmanydifferentways;onewaywastobuywhateverwas
leftoverduringanauction.TheFedhadtodoso,eitherbecauseuntilthe1970sTbondauctions
werenotwellestablishedandsoparticipationwasnotalwaysashighasneeded,orbecausethe
Fedwastargetingtheentireyieldcurve.
NowtodayinpricinganewTreasuryissue,theFederal[Reserve]isintheposition
ofunderwriter.DuringtheperiodoftheofferingtheFederal[Reserve]triestosee
toitthattheTreasury'sissueissuccessful[]Itstabilizesthemarketjusttheway
anyunderwriterdoes.(MartininU.S.Senate,1952,p.96)
AnotherwayhasbeentoprovideadependablerefinancingchanneltotheTreasurybecausethe
FedisstillallowedtoparticipateinauctionstoreplaceitsmaturingTreasuries.
75
Finally,todaytheFedparticipatesindirectlyinthefinancingofTreasurythroughthePrimaryDealer
System.Duringanauction,primarydealersmustsubmitareasonablebidandtheFedensuresthat
theyhaveenoughreservesattimeofsettlementbypurchasing,orrepoing,outstandingTreasuries.
PriortothePrimaryDealerSystem,theFedalsoensuredthatbankshadenoughreservestosettle
anauction.ForexampleduringWorldWarTwo(seeFigure6.6forreservedataduringthatperiod):
Itwasevidentthatallfundsneededforfinancingthewarwhichwerenotraisedby
taxationorbythesaleofGovernmentsecuritiestononbankinvestorswouldneed
toberaised bythesaleofsecuritiestothebankingsystem.At firstcommercial
bankswereabletodrawdownexcessreservesbyseveralbilliondollars,butlater
theyhadtobesuppliedwithaconsiderableamountofadditionalreservefundsin
order to purchase the necessary securities [] In general, further reserve funds
weresuppliedbyFederalReservepurchasesofshorttermGovernmentsecurities.
(MartininU.S.Senate,1952B,p.288)
Thus,onewayoranothertheFedwillensurethatauctionsneverfail;andintheprocessitwillbe
financingeitherdirectlyorindirectlytheTreasury.
Figure6.6Totalreserves,Aug.1917toDec.1958,billionsofdollars
Sources:BankingandMonetaryStatistics19141941,BankingandMonetaryStatistics1941
1970.
A NECESSARY COORDINATION OF TREASURY AND CENTRAL

BANKACTIVITIES
TheTreasuryandthecentralbankmustworkextensivelytogetherforfiscalandmonetarypolicies
toworkproperly.ThecentralbankcannotbefullyindependentfromtheTreasury:
76
Thehistoryofcentralbanking,aswasbroughtoutearlierbythechairman,isthat
centralbankingcannotgettoofarawayfromthepoliciesofGovernmenttoolong;
andthatwhilecentralbankshistoricallyhavewonbattlesagainsttheGovernment,
theyhavealwayslostthewar.(WigginsinU.S.Senate,1952,p.235)
The central bank has independence of tools (interestrate setting) and goals (inflation, etc.) but
must work Treasury operations into its daily activities. Similarly, the Treasury needs to work
monetarypolicyconsiderationsinitsdailyactivitiesotherwiseinterestratestabilitywouldnotbe
maintainedandinflationarypressurescouldmoreeasilymaterialize.
TOGOFURTHER:CONSOLIDATIONORNOCONSOLIDATION?
THATISTHEQUESTION.
ItshouldbeclearfromtheprevioussectionsthatultimatelyallthefundsthattheTreasuryuses
comefromtheFed.Indeed,whiletaxesandbondissuancesdebittheaccountofprivateeconomic
unitsandcreditTT&Ls,ultimatelytheTreasuryneedsfundsinitsaccountattheFed(theTGA).And
these funds cannot exist before reserves exist unless the Fed directly provides funds to the
Treasury.PutintermsofTaccounts,assumesthattheTGAgetscredited$100:
Fed
Assets
TGA:+$100
There are only a few possible offsetting operation. One is that the Fed directly finances the
Treasury:
Fed
Assets
Treasuries:+$100
TGA:+$100
AnotheristhatotherFedaccountsaredrainedasaresultsoftaxsettlementorthesettlementof
auctionsofTreasuries:
Fed
Assets
TGA:+$100
OtherFedaccounts:$100
Inthelattercase,theFedpreviouslyhadtoprovidethosefundstotheholdersoftheseaccounts,
eitherbyadvancingfundstothemorbybuyingsomethingfromthem(seeChapter4).TheFedis
thenindirectlyfinancingtheTreasurybyworkingthroughintermediaries(primarydealers,banks,
etc.).
Pushing a bit further, it is quite clear that tax payments cannot be settled unless reserves are
injectedfirstinthebankingsystemeitherbytheFed(throughadvancesorpurchases:assetsgoup,
L2goesup)orbytheTreasury(viaspending:L3falls,L2goesup).Thesameappliestoproceeds
fromissuingTreasuries.MonetaryfinancingoftheTreasuryisnotoptional,itoccursonewayor
another.EithertheFedbuysTreasuriesdirectlyfromtheTreasury,oritbuysthemindirectlybyfirst
providingfundstoprimarydealersthroughsomeoutrightortemporarypurchasesofTreasuries.
77
SomeeconomistsfollowingModernMoneyTheory(MMT)haveusedtheseconclusionsandnoted
thatnoanalyticalinsightisgainedfrommakingadistinctionbetweenTreasuryandcentralbank
whendealingwithamonetarilysovereigngovernment.Wemightaswellconsolidatetheminto
oneeconomicunit,thegovernment.Consolidationisactuallynotinfrequentineconomicanalysis,
butMMTpushesforconsolidationbasedonadetailedanalysisoftheinnerworkingsofTreasury
and central bank relationships. It is a theoretical simplification that is grounded in a detailed
institutionalanalysis.Moreimportantly,MMTclaimsthatconsolidationhassomeimplicationsfor
understanding the role of taxes and governmentbond issuances for a monetarily sovereign
government.
The balance sheets of Treasury and central bank look as follows (the word currency is used
broadlytomeanallformsofcentralbankmonetaryinstruments:cashandreservebalances).
TreasuryDepartment
Assets
A1T:Physicalassetsandfinancialclaimson L1T:Treasuriesheldbycentralbank
thenonfederalsectors
L2T:Otherliabilitiesplusnetworth
A2T:TGA+FRNsheldbyTreasury
Centralbank
Assets
A1CB:Physicalassetsandfinancialclaims
onthenonfederalsectors
A2CB:Treasuries
L1CB:Monetarybase
L2CB:TGA+FRNsheldbyTreasury
L3CB:Otherliabilitiesandnetworth
Thegovernmentbalancesheetis:
Federalgovernment
Assets
A1:Physicalassetsandfinancialclaimson L1:Monetarybase
thenonfederalsectors
L3:Otherliabilitiesheldbythedomestic
nonfederalsectorsandtherestofthe
worldplusnetworth
Taxpaymentsleadto:
-
L1<0:governmentcurrencyisreturnedtothegovernment
L2>0:highernetworthofgovernment(orA1<0ifataxliabilityisonthebalance
sheet,forexample,taxreceivablesarepartofA1)
Governmentspending(fiscalpolicy)andadvances(monetarypolicy)injectgovernmentcurrency:
L1>0.
Taxesdonotfundthe(consolidated)government,thatis,thereisnocreditingofagovernment
checkingaccount,noaccumulationoffundsbygovernment:taxesdestroygovernmentcurrency
(L1<0).Inaddition,injectionofgovernmentcurrency(L1>0)mustoccurbeforetaxingbecause
taxpaymentisdonebyhandingovertothegovernmentitscurrency(L1<0).Thisisexactlywhat
wassaidintheprevioussections.
78
Governmentbondissuanceleadsto
-
L1<0:governmentcurrencyisreturnedtothegovernment
L2>0:interestearningsecuritiesareissued
Bondissuancesareequivalenttoatransferoffundsfromacheckingaccounttoasavingsaccount.
Theyarepartofmonetarypolicyoperations.Theprevioussectionsshowedthatthiswasillustrated
intimesofstressinthemonetarysystem.
MMT authors tend to like to work with a consolidated government because they see it as an
effectivestrategyforpolicypurposes(seenextsection),butalsobecausetheunconsolidatedcase
just hides under layers of institutional complexity the main point: one way or another the Fed
finances the Treasury, always. This monetary financing is not optional and is not, by itself,
inflationary.
TO GO EVEN FURTHER: WHAT ARE THE RELEVANT

QUESTIONS TO ASK FOR A MONETARILY SOVEREIGN
GOVERNMENT?
AnadvantageoftheTaxesdontpayforanythingpositionisthatitallowsonetoframeexisting
debatesdifferently.Insteadofjudgingaprogramintermsofhowarewegoingtopayforit?,one
maynowlookatwhatthesocialneedsareandfigureouthowtoimplementtheirproduction.That
isthehardpart.Thefinancingofproductioniseasy:itisalwaysmonetaryfinancing,onewayor
another.
Focusing the political discussion on taxes and how or who will pay, who gets the benefits, etc.
moves away from the public purpose of government and into an individualized benefit/cost
analysis:Ipaidtaxes,whatdoIgetforit?Thesimplestanswerismaybenothingbecausethe
purposeofgovernmentisnottobenefitanyspecificindividualbutsocietyasawhole.Ormaybean
individualaskingthisquestionistoonarrowlydefininghis/herbenefitstotheirimmediate,material
andpersonalaspects.Somefamiliesmaynothavekidsandsomaynotpersonallybenefitfrom
payingtaxesforpublicschooling,butabettereducatedpopulationhasimmensebenefitsnowand
forthefuture,whichdoesimpactthequalityoflifeofall.
Inaddition,movingawayfromthetaxespayforframeworkhelpstobettertacklesomeproblems,
simplybecausetaxesforamonetarilysovereigngovernmentarenotmeanttopayfinanciallyfor
anything,butrathertofreeupsomeresources(goods,workers,services,rawmaterials,etc.)for
the public purposes. For example, the Social Security problem is not a financial problem; Social
Securitycannotgobankrupt.ThereisnoneedforaTrustFund,noneedtoputdollarsinalocked
box,noneedforpayrolltaxes.SocialSecuritybenefitscanbepaidthedaytheyareduejustby
typinganumberonthecomputer.ThefundswillcomefromdebitingtheTGA.TGAwillobtainfunds
directlyorindirectlyfromtheFed.
Thehardpartisfiguringouthowandwhattoproducetomeettheneedsofanagingsociety.We
will need more infrastructure, workers, goods and services that cater to the needs of an older
population;wewillneedtoraisetheproductivityofavailableworkers.Thatcannotbedonebythe
Treasurysavingdollars.Instead,theTreasuryshouldprobablyspendmoreonmakingschoolingand
training easier to access, and should provide some financial help to individuals and businesses
79
willingtobeinvolvedinsolvingtheproblemsofthefuture.Thegovernmentshouldalsobeinvolved
directly through infrastructure spending and others. All this means more federal government
spendingtoday,notless.
Taxesandtaxstructuresareimportantbutnotforfinancingpurposebuttopromotepricestability,
tochangebehaviorsandtocorrectarbitraryinequalities.Payrolltaxdoesnoneofthat.Itraisesthe
costoflabor,itdiscouragesemploymentanditisregressive.
Intheend,theproblemofpayingforsomethingisnotafinancialissueforamonetarilysovereign
government,itisapoliticalandproductiveone.IfCongressiswillingtodoit,itwillgetfunded;ifit
getsfundedthencomestheproblemoffindingtheresourcestoimplementtheproject.Thereally
relevant questions are: What do we want the government to do for us?, Do we want a
governmentthatrepresents50%ofGDPor20%ofGDP?,Dowewanttheburdenofswitching
realresourcestoschooling,childcare,eldercare,etc.tobesharedbysocietythroughhighertaxes,
ordowewanttoindividualizethatburdenthroughhigherpersonalexpenses?,Doweprefera
societyinwhicheverybodyfightsforhimselfordowepreferacooperativesociety?Oncethese
questions are answered (hopefully through democratic process), the public purpose is clearly
definedandthepointbecomestoimplementit.Payingforitsimplementationinfinancialtermsis
easy;payinginrealresourcesmaybehard(especiallyatfullemployment).
KeynessHowtoPayfortheWarisaclassicexampleofthecorrectwaytoframethequestion.He
notesthat:Agovernmentwhichhascontroloverthebankingandcurrencysystemcanalwaysfind
thecashtopayforitspurchasesofhomeproducedgoods.Theproblemofhowtopayisnota
financialproblemaslongasgoodsandservicesareavailableforpurchaseinthedenominationof
thecurrencyissuedbythegovernment.Theproblemisthisatthetime:Everyuseofourresources
isattheexpenseofanalternativeuse,thesizeofthecakeisfixed.Thereareopportunitycosts
andifnothingisdoneinflationwillgrowoutofcontrolasgovernmentcompeteswiththeprivate
sectortoaccessresourcestofightthewar.Theproblemisoneofproductionandconsumption.In
peacetime,theeconomyisusuallybelowfullemploymentsotoproducemoreonejustneedsto
employmore.Butatfullemployment,somechoicesmustbemadethatinvolvegivingupsome
alternativesandmakingsacrifices;thatiswhatpayingformeans.Theprivatesectormustsacrifice
someconsumptiontofreeresourcesforgovernmentuses.Thequestionsare:whoshouldsacrifice
themost?Howmuchsacrificeshouldtherebe?Howshouldthesacrificebeimplemented?
Inthecontextofthewar,prioritiesareeasytosetgiventhebroadpoliticalconsensusaboutwhat
thepublicpurposeis(winningthewar):whenthreequartersofthecakeusedtogoforprivate
consumption,nowonlyonequartercangoforthatpurpose.Peoplehavetoliveatsubsistencelevel
tobeabletowinthewar.Governmentcouldtrytoachievethisthroughvoluntarysaving(warbond
issuances),orbyrationing,butthemosteffectivewaytoachievethatistocutpurchasingpowerat
thesource:ifpeopledonothaveasbigamonetaryincometheywillnotgoshoppingasmuch.This
can be done through taxing (permanent sacrifice of private consumption) or deferred pay
(temporarysacrificeofprivateconsumption),withtheaimofreducingprivatemonetaryincometo
whatisneededtomeetsubsistence.
WhileKeynesputsthechoiceinfrontofusinabluntfashiongiventhedramaticsituationofthe
time, the same applies in peace time. The two main differences are that, first, there is more
flexibilityintermsofresourcesgiventhatusuallythesizeofthecakecangrowand,second,thata
politicalconsensusaboutthepublicpurposeislesseasilyachieved.Ofcourse,somecountriesthat
aremonetarilysovereignmaynothavemuchresourcesandmaynotexportenoughtoobtainthe
80
foreigngoodsandservicesneededtofulfillthepublicpurpose.Inthatcaseitisdifficult,butnot
impossible,toimplementthesocialpurpose.If,inaddition,acountryisnotmonetarilysovereign,
thenimplementingthepublicpurposeisevenharder.
1AfiscaldeficitleadstoannetinjectionofreservesandsopushesdownFFRandothershortterm
interestrates
2 To neutralize the impact of fiscal operations on the FFR, the Treasury uses cash and debt
management techniques. These techniques have varied in amount and obviousness overtime
dependingonthecircumstanceandthepoliticalappetiteforanovertinteractionbetweencentral
bankandTreasury.
3TheTreasuryhashelpedtoimplementmonetarypolicybyissuingTreasuriesattherequestof
theFed,bytakinganoverdraftattheFedinsteadofusingfundsinitsTT&Ls,bytargetingastable
amountoffundsinitsTGA,amongothers.
4ThecentralbankhasbeeninvolvedinfinancingtheTreasury,eitherdirectlyorindirectlythrough
thebankingsystem.MonetaryfinancingoftheTreasuryisnotoptional,itisrequiredformonetary
policytoworkproperly,forthesettlementoftaxestobepossibleandforthesettlementofauctions
ofTreasuriestobepossible
5ThecoordinationbetweentheFedandtheTreasuryisalwaysextensiveandensuresthatthe
Treasuryalwayscanfinanceitsbudget.Treasuriesauctionscannotfail.
6Thereisnofinancialconstraintonthefederalgovernment,itcannotrunoutofdollars.There
are,however,politicalconstraintsthatdefinethepublicpurposes,andproductiveconstraintsthat
definehowmuchthegovernmentcanspendwithoutgeneratinginflationarypressures.
7DuringtheGreatRecession,theTreasuryhelpedtheFedtodrainsomeofthereservesinjected
viatheDiscountWindowbyissuingTreasuriesattherequestoftheFedandbymovingallthefunds
inaspecialaccountattheFed.
8TheFedcantargetperfectlytheentireTreasuriesyieldcurveifitwishestodoso.Itdidsoduring
WorldWarTwo.
9OnceoneunderstandshowdeepthecoordinationbetweentheFedandtheTreasuryis,onemay
arguethattaxesdonotfinancethegovernmentandneitherdoTreasuries.Allfinancingismonetary
becausereservesmustbeinjectedfirstbeforetaxescanbepaidandTreasuriescanbebought.
Keywords
TGA, TT&Ls, TSFA, excess reserves, FFR, cash management, debt management, tax
receivable/payable
81
ReviewQuestions
Q1:IftheFedorTreasurydidnotneutralizetheimpactofafiscaldeficit,whatwouldhappentothe
FFR?Whatwouldhappentootherrates?
Q2:IftheFeddidnotensurethatbankshaveenoughreserves,howwouldthatcreateproblems
fortaxsettlements, Treasuriesauctionsettlements,and targetingtheFFR? Explain eachcasein
detail.
Q3:HowdidtheTreasuryhelptheFedduringtheGreatRecession?WhydidtheFedrequestthe
helpoftheTreasury?
Q4:ExplainhowtheFedwasandisstillinvolvedinthedirectfinancingoftheTreasury
Q5: Explain how the Fed has been involved in the indirect financing of the Treasury and why
auctionsofTreasuriescannotfail.
Suggestedreadings
ForamoredetailedanalysisofthecashmanagementtechnicsusedduringtheGreatRecessionby
the Treasury read Santoro, P.J. (2012) The Evolution of Treasury Cash Management during the
FinancialCrisis,FederalReserveofNewYorkCurrentIssuesinEconomicsandFinance,18(3):18.
ForadiscussionofthehistoricalroleoftheU.S.Treasuryinmonetarypolicyandthereasonsforits
involvement,seeU.S.Treasury(1955)AnnualReportoftheSecretaryoftheTreasuryontheState
of the Finances for the Fiscal Year Ended June 30 1955. Washington, D.C.: Government Printing
Office,
pages
275290:
http://fraser.stlouisfed.org/docs/publications/treasar/AR_TREASURY_1955.pdf
BruceK. Maclauryprovidesaninterestingandaccessiblediscussionoftheindependenceofthe
central bank and its necessary coordination with the U.S. Treasury.
https://www.minneapolisfed.org/publications/annualreports/perspectivesonfederalreserve
independenceachangingstructureforchangingtimes.
ForanhistoricalanalysisoftheauctionsoflongtermTreasuriesandtheroletheFederalReserve
hasplayed,seeGarbade,K.D.(2004)TheInstitutionalizationofTreasuryNoteandBondAuctions,
197075, Federal Reserve Bank of New York Economic Policy Review, May: 2945.
https://www.newyorkfed.org/medialibrary/media/research/epr/04v10n1/0405garbpdf.pdf
Moreadvancedreadingsare:
Bell,S.A.(2000)DoTaxesandBondsFinanceGovernmentSpending?JournalofEconomicIssues
34(3):603620.
Mitchell, W. F., and Muysken, J. (2008) Full employment abandoned: Shifting sands and policy
failures.Cheltenham:EdwardElgar.(CHAPTER8)
Tymoigne,E.(2016)Governmentmonetaryandfiscaloperations:Generalisingtheendogenous
moneyapproach,CambridgeJournalofEconomics,forthcoming
Wray,L.R(2007)Theemployeroflastresortprogramme:Coulditworkfordevelopingcountries?
International Labor Organization, Economic and Labour Market Papers 2007/5.
http://natlex.ilo.ch/public/english/employment/download/elm/elm075.pdf
______. (2015) Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary
Systems,SecondEdition.NewYork:Palgrave.
82
1SeeFederalReserveBankofNewYork,StatementRegardingSupplementaryFinancingProgram,September17,2008
athttps://www.newyorkfed.org/markets/statement_091708.html
2 See U.S. Treasury, Treasury Announces Supplementary Financing Program, September 17, 2008, HP1144 at
https://www.treasury.gov/presscenter/pressreleases/Pages/hp1144.aspx
3Overtheyears,avarietyofprovisionshadpermittedtheTreasurytoborrowlimitedamountsdirectlyfromtheFederal
Reserve.Optionsforsuchloansexisteduntil1935.Temporaryprovisionsfordirectloanswerereintroducedin1942and
renewedwithvaryingrestrictionsanumberoftimesthereafter.AuthorityforanykindofdirectloanstotheTreasury
lapsedin1981andhasnotbeenrenewed.(Meulendyke1998,238,n.3)
4 The following link brings you to a video made by two of my students that provides a visual explanation:
https://www.youtube.com/watch?v=Wgcv_wJOLcA
83
CHAPTER 7:
Whatleverageis
Whattheadvantagesanddisadvantagesofleverageare
Howbeneficialleverageisforprofitability
Whyleverageincreasesthesensitivityofaneconomicunittodevelopmentsin
thefinancialsector
CHAPTER7:LEVERAGE
GiventhattheconceptofleveragewillbeusedoftenintheupcomingChapters,thisChapterspends
sometimeexplainingwhatleverageisandsomeofitsimpactsonthebalancesheetofeconomic
units.
WHATISLEVERAGE?
Leverageistheabilitytoacquireassetsinanamountthatislargerthanwhatonesowncapital
allowsonetobuy.Saythataneconomicunithasanetworthof$100,thatithasnodebtandthat
thecounterpartis$100incash(Figure7.1).Thebalancesheetlookslikethis:
Figure7.1Abalancesheetwithoutleverage
Whatistheleverage?Leverage=asset/networth=asset/equity=A/E=$100/$100=1.Nodebt
used,allthecashtheeconomicunithaswasacquiredwithoutthehelpofanydebt(e.g.,grandpa
gaveyou$100forChristmas,oryouworkedtoget$100).Nowtheeconomicunitdecidestouseits
cashtobuyabondthatpays10%yearly(Figure7.2).
Figure7.2Anotherbalancesheetwithoutleverage
Whatistheleverage?Leverage=A/E=$100/$100=1.Stillnoleveragebutassetportfolioallows
theeconomicunitearnsinterestincome:Cashinflowis$10yearlyasinterestpayment.Ofcourse,
buyingabondinvolvesadditionalriskscomparedtocash:
Defaultrisk(thebondissuerdoesnotpaythe$10interestandcannotrepaypartorallthe
principaldue)
Marketrisk(themarketvalueofthebonddeclinesandonemighthavetosellitforless
thanwhatonepaidforit)
Goingbacktocase1,nowtheeconomicunitdecidestogeta$900advancefromabankat1%and
tobuy10bondsthatpay10%(Figure7.3).Whatistheleverage?Leverage=A/E=$1000/$100=
10.Theeconomicunithasacquired10timesmoreassetsthanwhatitscapitalallowstobuy.Itdid
so by going into debt. This example is the simplest form of leverage. There are many ways to
introduceleverageinafinancialdeal.Someofthatleveragedoesnothavetobereflectedonthe
balancesheetintheformofadebttosomeone.Aslongasonecanacquireanassetbypaying
upfrontonlyafractionofthevalueofthatasset,thereissomeleverage.
85
CHAPTER7:LEVERAGE
Figure7.3Abalancesheetwith10xleverage
WHATARETHEADVANTAGESOFLEVERAGE?
A key metric of profitability is the return on equity (ROE). This return is the ratio of profit over
equity.TheROEcanbedecomposedasfollows:
Profit/Networth=(Profit/Assets)*(Assets/Networth)
ROE=ROA*Leverage
Return on Assets (ROA) measures the earning power of the assets on a balance sheet; ROE
measureshowsuccessfullyaneconomicunituseditsowncapital.Leveragemultipliestheimpact
ofROAonROEbecauseitallowsaneconomicunittoacquiremoreassetswithouthavingtopay
thefullamountduewithonesownfunds.Thusleveragegivesthefollowingadvantages:
1 Betternominalreturn:
-
Noleverage:income=netincome=$10
10xleverage:income=10x$10=$100,Netincome=$100$9=$91>$10
2 Betterreturn
ReturnonAsset(ROA)
-
Noleverage:interest/bond=$10/$100=10%
10xleverage:netinterest/bond=($100$9)/$1000=9.1%
Returnonequity(ROE)
-
Noleverage:interest/equity=$10/$100=10%=ROA
10xleverage:netinterest/equity=($100$9)/$100=$91/$100=91%
Byleveraging10x,ROEis10timeshigherthanROA(9.1%vs91%)simplybecauseonecouldacquire
tentimesmoreassets.
WHATARETHEDISADVANTAGESOFLEVERAGE?
INTERESTRATERISK
86
CHAPTER7:LEVERAGE
Whatiftheinterestrateonbankdebtgoesupto12%inthepreviousexample?
-
Noleverage:cashoutflow=$0=>netcashflow=$10
10xleverage:cashoutflow=$900x.12=$108=>netcashflow=$8.
Thisriskisespeciallyhighifaneconomicunitwentintodebtonashorttermbasisforalongterm
portfoliostrategy.Assumeoneplanstohold10bondsfor2yearsbutissueddebtwitha6month
termtomaturity;thenoneneedstorefinance(i.e.repaythedebtandaskforcreditagain)three
times.
Buttherearemoreworriesbecauseeconomicunitscaremuchmoreaboutpercentagegains(ROE)
thannominalgains.Inthiscase,ROElossesarealsomultipliedbythesizeoftheleverage.
-
Noleverage:ROA=ROE=10%
10xleverage:ROA=$8/$1000=0.8%
10xleverage:ROE=$8/$100=8%
HIGHERSENSITIVITYOFCAPITALTOCREDITANDMARKETRISKS
Thesamepercentagedeclineinthevalueofbonds(duetodefaultorlossofmarketvalue)leadsto
muchbiggerdeclineinequity(Figure7.4).
-
No leverage: A 10% decline in the value of the bond wipes out only 10% of net
worth
10xleverage:A10%declineinthevalueofbondswipes100%ofnetworth
Chapter9showsthatbankscanonlytoleratealimiteddeclineinthevalueoftheirassets.Indeed,
notonlyaretheyhighlyleveraged,butthereareregulationsgoverningtheamountofcapitalthey
arerequiredtohave,aswell.
Figure7.4Impactoncapitalofa10%declineinthevalueofbondsundernoleverageand10x
leverage
REFINANCINGRISKANDMARGINCALLS
IMPACTONMORTGAGEDEBT
87
CHAPTER7:LEVERAGE
Saythatin2006ahouseholdwantstobuyahousethatcosts$100kandthatthebankstatesthat
onemustprovidea20%downpayment.Howmuchofthecostofthehouseisthebankwillingto
fundatthemaximum?
0.8*100000=$80000
Now,saythatthevalueofthehomegoesdownto$50000.Assumingthebankisstillwillingto
provideupto80%ofthehousevalue,themaximumthebankwillprovideis:
.8*50000=$40000
Forthesamehouse,thebankiswillingtoprovidelessofanadvance.
Table7.1showsthreedifferentcontractstructureswithactualnumberswhenahouseholdagrees
toissuean$80kmortgagenote:
Year
Case
Structure
DebtService
2006
A
A30yearfully
amortizedwithafixed
rateof10%
$8,424.69for30years
2006
2016
B
C
An30yearIOwitha
30year5%fixedrate
10%fixedrate,startsto fullyamortized
amortizeafter10years
First10Years:$8000
$5153.49for30years
Last20years:$9264.21
Table7.1Mortgagenoteswithdifferentterms
IntheU.S.thetraditionalmortgageisafixedratefullyamortized(i.e.forwhichprincipalisrepaid
bit by bit every month) mortgage (case A). During the 2000s housing boom, a lot of prime and
subprime households choose to issue interestonly mortgages (IOs) (case B). With an IO, a
mortgagorcanchoosetopayonlytheinterestdueforacertaintimeperiod(say10years),andafter
thattheprincipalmustberepaidbitbybit.Thismeansthatforaperiodoftime,caseBischeaper
thancaseA.
TheproportionofIOissuedbynonprimehouseholdsinagivenyearwentfromvirtually0%to30%
ofmortgagesissuedbynonprimehouseholds.AstheFedstartedtoraiseinterestratein2004,the
proportionofpayoptionmortgagesissuedbynonprimehouseholdsgrew(Figure7.5).Payoption
mortgagesallowdebtorstopayonlypartoftheinterestdue.
ThesellingpointofferedbymortgagebrokerswasthatIOarecheapertoservicefor10yearsand
that,whileitistruethatonemightnotbeabletomakethatadditional$1264paymentthatwill
comein10years,thereisnoneedtoworrybecauserefinancingatbettertermsisalwayspossible
giventhathomepricesalwaysgoup.
Come2016andthehouseholdcancannotmaketheadditional$1264payment.Whatcanbedone?
Letusrefinancebyissuingan$80000fixedratemortgagewithbetterterms(optionC)andbyusing
thefundstorepaythe$80000dueontheIOmortgage.Sothehouseholdgoestoabankwiththe
intentiontogetacreditof$80000.Unfortunately,thebankstatesitcanonlyprovide$40000,i.e.
itrefusestorefinanceunlessthehouseholdcancomeupwith$40000.Why?Becausethehome
valueisnow$50000.
Intimesofcrisis,therefinancingprobleminducedbythedeclineinthevalueofhousesisactually
reinforcedbythefactthattheloantovalueratiodeclines.Soinsteadofgrantinganadvanceofup
88
CHAPTER7:LEVERAGE
to80%ofthehomevalue,nowabankwilldoonly60%,whichmeansthatthehouseholdcanonly
get$30000fromthebank.
Figure7.5Shareofexoticmortgagesinnonprimemortgageoriginations,percent.
Source:FederalDepositInsuranceCorporation(FDICOutlook,Summer2006).
IMPACTONSECURITYBASEDDEBT:MARGINCALLRISK
Abrokerallowsaneconomicunittohaveoutstandingbondswithanominalvalue10timesaslarge
asthevalueofequity.Whatifsuddenly:
-
Thevalueofbondsdeclines.Networthdeclinessoleverageismuchhigherthan10andthe
brokerdemandsadditionalcollateral(andsonetworthinthebalancesheet)torestorea
10xleverage.
Thebrokerincreasesthemarginrequirement(loantovalueratiodeclines),thatis,decides
tolowertheallowedleveragefrom10to5.Thisisequivalenttosayingthatnowinorder
tobeabletogetexternalfundstobuy$1000worthofbondsonemustputdown$200
insteadof$100.
EMBEDDEDLEVERAGE
Leveragecomesinmanyformsandmaynotbedirectlyobservableinthebalancesheet.Infact,
financialinstitutionstrytohideleverageasmuchaspossibletocircumventregulation,and,inthe
worstcases,toconfusepotentialclientswhoareattractedbythehighpromisedROE.
Aformofleveragethatgainedattentionduringtherecentcrisisisembeddedleverageorleverage
onleverage.Figure7.6presentsasimplecaseofembeddedleverage.
89
CHAPTER7:LEVERAGE
Households
Houses
Subprime
Mortgages
SPE1
Subprime
Mortgages
Highrate
MBSs
SPE2
Lowrate
MBS
High
CDOs
rate
Mezzanine
CDOs(14%)
Equity (very
thinornone)
Lowrate
MBSs(5%)
Lowrate
CDOs(10%)
SPE3
Mezzanine
CDOs
SeniorAAA
CDO2s
(60%)
Other CDO2
(40%)
Figure7.6Financiallayeringorembeddedleverage.
Thefollowingisgoingoninthispicture:
1 Abunchofhouseholdswithpoorcreditworthinessissuedmortgagestoabanktofinance
100%oftheirhouses($100khouseisfinancedby$100kmortgage)(balancesheetA)
2 Thebankdidnotwanttokeepthemortgagesonitsbalancesheetsothebankcreatedan
SPE1 (specialpurposeentity1) thatpurchasedthe mortgages.Tofinance thepurchase,
SPE1issuedbondscollateralizedbythemortgages(mortgagebackedsecurities,MBS)of
twodifferentratings,lowandhigh,withlowrepresenting5%oftheissuance.Thedebt
servicereceivedfromsubprimemortgagesisusedtoservicetheMBSs(balancesheetB)
3 NobodywantedtobuythelowrateMBSsothebankcreatedSPE2topurchasethem.SPE2
issuedbondsbackedbyMBSs(collateralizeddebtobligations,CDOs).Thedebtservicefrom
lowrateMBSsisusedtoserviceCDOs(balancesheetC)
4 NobodywantedtobuythemezzanineCDOsthatrepresent14%ofalltheCDOsissuedby
SPE2.ThebankcreatedyetanotherSPEthatboughtthemezzanineCDOsbyissuingbonds
backedbythem(CDOsquared).AAACDO2sareboughtbypensionfunds,othersarebought
byhedgefundsandothers.ThedebtservicefromthemezzanineCDOsprovidesthecash
flownecessarytoservicetheCDO2s(BalancesheetD)
Taken in isolation, i.e. looking at SPE3 alone, AAA CDO2s seem very safe because the value of
mezzanineCDOsmustfallby40%beforetheprincipalontheAAACDO2sstartstobeimpacted
(otherCDO2sactasequityforAAACDO2s).Apensionfundthatlooksonlyatthatdealdoesnot
evenblink;AAACDO2sprovidehigheryieldthanAAAcorporatebonds:Buy!Buy!Buy!
Ofcourse,thehigheryieldwasachievedbytheembeddedleverage.Saythathouseholdsstartto
default,whatisthedefaultratethatmakesAAACDO2worthless?
90
A5%lossonthemortgagesmakeslowrateMBSworthless(theyarethefirsttotakethe
lossinthisSPEstructure),whichmakesSPE2insolventandsoallCDOsworthless.
CDO2becomeworthlessmuchfaster.IfthemezzanineCDOsareworthlessthenCDO2are
worthless. MezzanineCDOsareworthlessaftera1.2%declineinthevalueofsubprime
mortgages(5%*24%)!SuddenlythoseAAACDO2donotseemthatsafeanymore,especially
so knowing that delinquency rates on subprime mortgages are way north of 1.2%.
However,oneneedstolookattheentirechainofsecuritizationtounderstandthat.Most
buyersofAAACDO2didnotdothat(theyusuallycouldnotdothatgiventheinformation
available)andonlylookedatthehighreturnofAAACDO2relativetoAAAcorporatebonds,
togetherwiththe40%bufferagainstlossprovidedbyotherCDO2.
CHAPTER7:LEVERAGE
Thereisawaytoestimatewhattheleverageisinthistypeoftransaction.1Financialinstitutions
createdmanySPEsthatboughtfromeachother.2
BALANCESHEETLEVERAGE,SOMEDATA
TheFinancialAccountsoftheUnitedStatesprovidesimplemeasuresofbalancesheetleveragethat
areeasytogetfortheprivatenonfinancialsectorbecauseactualbalancesheetsareprovided.We
arenotsoluckyforthefinancialsectorforwhichdataabouttotalassetsisnotavailable.Onecan
get an idea of the leverage used by financial institutions by using the ratio (liabilities +
equity)/equity,knowingthatintheorythesumofliabilitiesandequityoughttobeequaltototal
assets.Inpracticethesumofliabilitiesandequityisnotveryreliableandgivesleveragelevelsthat
sometimesaremuchtoohigh.Figure7.8onlypresentspreliminarydatathatseemstopassthe
smelltest.Chapter8presentsofficialleveragedatainthebankingsector.
Figures7.7and7.8giveabroadideaoftherelativeleverageacrosssectorsandofthetrendin
leverage.Clearly,thenonfinancialsectorislessleveragedthanthefinancialsectorwithhouseholds
beingtheleastleveragedofallsectors.Overall,leverageinthenonfinancialsectorgrewrelatively
smoothlyuntiltheGreatRecession,especiallysoforhouseholds.Leverageinthefinancialsectoris
muchmorevolatile.
Figure7.7Balancesheetleverageinthenonfinancialprivatesectors,assets/networth
Source:BoardofGovernorsoftheFederalReserveSystem(SeriesZ.1)
91
CHAPTER7:LEVERAGE
Figure7.8Balancesheetleverageinthefinancialsector,(liabilities+equity)/equity
THEFINANCIALIZATIONOFTHEECONOMY
Thefinancialindustryisinthebusinessofdealingwithleverage.Itsbusinessisaboutincentivizing
othereconomicunittogointodebt(thatiswhatmostofitsassetsare:claimsonothers)andthe
financialsectoritselfusesalotofleveragetoboosttheprofitabilityofitsbusiness.Banksgrant
credit, pension funds rely on financial claims to pay pensions, etc. For every creditor there is a
correspondingdebtorandsoforeveryfinancialassetthereisacorrespondingfinancialliability:
financializationalsomeansdebtizationoftheeconomy.
The financialization of the economy means that the financial sector has become much more
important to the daily operations of the economic system than it used to be. The private
nonfinancial sectors have become more dependent on the smooth functioning of the financial
sectorinordertomaintaintheliquidityandsolvencyoftheirbalancesheets,andtoimproveor
maintaintheireconomicwelfare.
Householdshavebecomemorereliantonfinancialassetstoobtainanincome(interest,dividends
and capital gains) and have increased their use of debt to fund education, healthcare, housing,
transportation,leisure,and,morebroadly,tomaintainandgrowtheirstandardofliving.
Nonfinancialbusinessesalsohaverecordedaveryrapidincreaseinfinancialassetsintheirportfolio
andagrowinguseofleverage.Someofthem,likeFordorGE(untilrecently),haveafinancialbranch
thatprovidesmorecashbalancesthantheircorenonfinancialactivity(Figures7.11)andabouthalf
of their cash flows. The counterpart of these trends has been a growing share of outstanding
financial assets held by private finance (Figure 7.9). From the late 1960s, the share of financial
assetshelddirectlybyhouseholdsdroppedsignificantlyfromabout55percenttoabout35percent.
Instead,agrowingshareofassetshasbeenheldbyprivatefinancialinstitutions,whichwentfrom
92
CHAPTER7:LEVERAGE
25percentinthelate1940sto40percentrightbeforethecrisis.Therestoftheworldrecorded
mostoftherestofthegainsfrom2percentto10percentofU.S.financialassets.Theshareof
nationalincomegoingtothefinancialindustryhasalsogrownquitesignificantlyafterWWII(Figure
7.10).Afirstwaveoccurredinthe1950sandasecondoneinthe1980sand1990s.Today,about
18%ofnationalincomegoestothefinancialsector,somethingnotseensincethe1920s.
Figure7.9DistributionofU.S.financialassetsamongthedifferentmacroeconomicsectors.
93
CHAPTER7:LEVERAGE
Figure7.10Proportionofnationalincomeearnedbythefinancialsector.
Sources:BEA,HistoricalstatisticsoftheUnitedStates
Figure7.11Percentofcashbalancecomingfromfinancialactivities
Source:SEC(10Kstatements)
94
CHAPTER7:LEVERAGE
1Toleverageistheactofgoingintodebt
2Thisdebtcanbeonthebalancesheetorcanbehiddenoffbalancesheet
3Leveragehelpstoboostthereturnonequitybymultiplyinggainsbutitcanalsomultiplylosses.
4Theuseofleveragehasincreasedthroughoutnonfinancialeconomicsectors,whileleverageis
usually higher in the financial industry. The financial industry uses a lot of offbalancesheet
leverage.
5Thefinancialsectorhasplayedaneverincreasingroleintheeconomiclifeofthenonfinancial
sectorbyprovidinganincreasingshareofnationalincomeandbyprovidingadvancestomaintain
existingstandardsofliving.
Keywords
Financialization, debtization, leverage, embedded leverage, return on asset, return on equity,
interestraterisk,refinancingrisk,margincallrisk,interestonlymortgage,payoptionmortgage
ReviewQuestions
Q1:Whymayadeclineinhomepricescreateaproblemforrefinancingamortgage?
Q2:Iftheleverageis3X,whatdoesitmean?
Q3:Iftheleverageis3X,whatwouldhappentonetworthfollowinga5%decreaseinthevalueof
assets?WhatwouldhappentoROEgivenROA?
Q4:Whydoesthefinancializationoftheeconomyimpliesthedebtizationoftheeconomy?
Suggestedreadings
Chapter1ofGuns,TradersandMoneybySatyajitDasrelatespersonalrecollectionssurrounding
leverageisaveryclearandfunnywayandpresenthowleveragecanbebuiltoutsidethebalance
sheet.
For a more technical view of leverage and its relation to regulation, the Basel III leverage ratio
framework provides an example of a regulatory framework for different forms of leverage:
http://www.bis.org/publ/bcbs270.pdf
1Checkpage26ofRiddiough,T.J.(2010)CanSecuritizationWork?Economic,StructuralandPolicyConsiderations.At
https://www.fdic.gov/bank/analytical/cfr/mortgage_future_house_finance/papers/Riddiough.PDF
2In2010,PropublicamadeanicevisualmadewithactualdatainInteractive:CDOsInterlockingOwnership,byJeff
LarsonandKarenWeiseathttps://www.propublica.org/special/interactivecdosinterlockingownership#cdo/
95
CHAPTER 8:
Whatbanksdo
Howbanksmakeaprofit
Whattherisksofthebankingbusinessare
Howthebankingindustryhaschangedoverthepastfourdecades
CHAPTER8:THEPRIVATEBANKINGBUSINESS
The US financial system is extremely complicated and this preliminary text shades light only on
somecornersofthatsystembyfocusingonthebankingsector.Sincethebeginningofthistext,
Chaptershaveemphasizedtheimportanceofbalancesheetstogetasolidunderstandingofthe
mechanicsatplayinthefinancialsector.ThisChaptercontinuesthattrend.
THEBALANCESHEETOFABANK
Figure 8.1 depicts the balance sheet of a commercial bank. Promissory notes issued by others
include any kind of agreement between the bank and an entity that promised to pay some
monetaryamount(s).Thatentitycanbeadomesticorforeign,household(mortgagenoteorany
other customer notes), company (business credit, corporate securities), and government
(Treasuries, municipals). Promissory notes may or may not have a market in which they can be
traded.Iftheyhaveamarkettheyarecalledsecurities,iftheydonottheyarecalledloansand
leases(Chapter2andChapter10explainthatthewordloanisreallyinappropriate).Chapter3
studiedindetailsreserves,whicharethemselvesapromissorynoteasexplainedinChapter15,but
are singled out for analytical purposes. Nonfinancial assets include real estate, computers,
goodwilletc.
Assets
Reservebalancesandvaultcash
Promissorynotesissuedbyothers
(akaloansandleases,securities)
Nonfinancialassets
Promissorynotesissuedbythebank
(akaaccounts,CDs,etc.)
Networth/Equity/Capital
Figure8.1.Balancesheetofatypicalcommercialbank
Promissory notes issued by the bank include checking accounts, savings accounts and other
transactionaccounts.Theyalsoincludeotherliabilitiessuchascertificatesofdeposits(CDs),bonds
andothersecuritiesissuedbythebank.Onemaychoosetoincludeshareshereorinnetworth;for
ourpurposes,itisnotthatimportant.
Asusual,networthistheresidualitemanditsmainrole,asexplainedinChapter2,istoprotect
thecreditorsofthebank,i.e.thosewhoholdthepromissorynotesissuedbythebank(youandI
fortheaccounts,CDholders,etc.).
Figures8.2and8.3showhowthecompositionoffinancialassetsandliabilitiesofUSbankshas
changed since 1945 (quantity of nonfinancial assets is not available). After WWII, banks were
stuffedwithTreasuriesandreservesthatrepresentedabout75%oftheirassets.Aswitchoccurred
progressivelytowardprivatelyissuednotesandmunicipalsasbanksturnedtheirbusinessactivity
towardsupportingthegrowthoftheeconomyinsteadofthewareffort.Today,percentagewise,
Treasuriesandreservesaremarginalitemsintheassetsofbanks.
Bank accounts (deposits) are still the main liability of commercial banks but the structure of
accountschangedwithcheckingaccountsrepresentingabout10%ofliabilitiesin2010versus75%
afterWWII.Timeandsavingsaccountshavegrowninproportion,andtheyrepresentedabout55%
oftheliabilitiesofbanksin2010.Figure8.2alsoclearlyshowstheriseofthefederalfundsmarket
fromthe1960s(seeChapter4).Figure8.2doesnotshowinterbanklendingdebtgiventhatitisthe
balancesheetofthebankingsector.Indeed,ifbankXowestobankY,whentheyareputtogether
in one balance sheet the consolidation removes debt owed to each other. Federal funds and
repurchaseagreements(RPs)areliabilitieswithotherparticipantsofthefederalfundsmarket.
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Figure8.3showshowthepredominanceofprivatedepositoryinstitutions(commercialbanksand
thrifts)inthefinancialsectorhaschangedthroughtime.From1980until2000,theshareoffinancial
assetsheldbybanksfelldramaticallyfrom50%ofallfinancialheldbythefinancialindustrytoabout
20%; this has been a stable proportion since 2000. Instead, money managers (mutual funds,
pensionfunds,etc.)havegainedinimportanceasdidfinancialinstitutionsrelatedtosecuritization
thattogetherheldabout55%ofthefinancialassetsheldbythefinancialindustryin2015.Money
lenders(paydayloans,etc.)havealsorecordedanincreaseintheproportionoffinancialassets
theyholdsincethe1970s.
Figure8.1FinancialassetsofUScharteredcommercialbanks
Source:BoardofGovernorsoftheFederalReserveSystem(seriesZ.1)
Note:Othersecuritiesincludescorporateandforeignbonds,mutualfundsshares,corporate
shares,andopenmarketpapers.
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Figure8.2FinancialliabilitiesandcorporatesharesofUScharteredcommercialbank
Note:Othersincludenettaxespayables,corporatebonds,openmarketpapers,netinterbank
transactions,andmiscellaneousliabilities.
Figure8.3Allocationoffinancialassetswithinthefinancialsector
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WHATDOBANKSDO?
Thepreviousbalancesheethintsthatbanksareinvolvedinmanycrucialactivitiesincluding:
Credit services: Swapping promissory notes to allow liquidity, creditworthiness, and

maturitytransformation
Paymentservices:Transferringfundsbetweenbankaccounts
Retail portfolio services: Providing incomeearning opportunities for small entities with
excessmonetarybalancesandprovidingcashatwill.
Acentralaspectofthebalancesheetofbanksisthatthepromissorynotesissuedbybankshavea
shorter term to maturity than the promissory notes on their asset side. Banks are involved in
maturity transformation. They accept promissory notes from their customers for which the
principalwillnotberepaidforalongtime.Inexchange,theygivetheircustomerssomepromissory
notesthatareduerelativelyquickly.Checkingaccountsaredueatthedemandoftheirbearersand
CDscomedueatmostinafewyears,whereastheprincipalonmortgagenoteswillbefullyrepaid
indecades.
Acentralimplicationofmaturitytransformationisthatbankshaveaninherentneedforastable
refinancingsourcebecausetheymustfundlongtermpositionsinassetswithshorttermliabilities.
Tolimittherefinancingrisk(thatwasexemplifiedwithhouseholdsinChapter7)thatcomeswith
thisbalancesheetstructure,acentralbankthatprovidesstablelowcostrefinancingchannelsis
crucial.
Some of the promissory notes that banks issue have another other interesting property for
potentialclients.Chapter15explainsthattheirfinancialcharacteristicsaresuchthattheyoughtto
tradeatpariftheydonotcarryanycreditriskandifthefinancialstructureisproperlysetup.Today,
transfersbetweenbankaccountsaredoneatpar,conversionsintoFederalReservenotearedone
at par, and in case of default FDIC guarantees the funds in bank accounts, and the interbank
paymentsystemworkssmoothly.Themaintakeawayisthatbanksprovidetotheircustomersa
reliablemeansofpaymentsthatiswidelyaccepted.Bycontrast,thepromissorynotesissuedby
clientsarenotwidelyacceptedsomakingpaymentswiththemisdifficult,ifnotimpossible.
WHATMAKESABANKPROFITABLE?
Like any other forprofit business, a bank operates to meet its profitability target while being
constantlyonthelookouttomaintainitsliquidityandsolvency.Atleast,thatisthehope.When
banks are run by fraudsters or are focused on shortterm results, concerns about liquidity and
solvencygooutofthewindow.1Theprofitofabankdependsonthefollowingcomponents:
Profitofabank=Netcapitalgains+Netinterestincome+OtherincomeOtherexpensesthan
interestpayments
Netcapitalgainsisthedifferencebetweencapitalgainsandcapitallosses.Thisnetchangecanbe
positive (net capital gain) or negative (net capital loss). Net interest income (aka net interest
margin) is the difference between interest earned on bank assets and interest paid on bank
liabilities.Otherincomeincludefeesandotherchargesimposedoncustomers.Netinterestincome
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isthebiggestsourceofincomeforbanksbutitsproportioninbankincomehasdeclinedsincethe
early 1980s for reasons explained in the last section. In 2014, net interest income represented
about60%oftheincomeearnedbybankscomparedto80%fromaboutthemid1940stotheearly
1980s(Figure8.4).Netinterestincomeisthelowestproportionofprofitforthelargestbanks.
Figure8.4SourcesofincomeofFDICinsuredbanks.
Source:FDICAnnualFinancialData
Banks,however,arenotinterestedinmonetaryprofitperse.Instead,akeymeasureofprofitability
isthereturnonequity(ROE),theratioofmonetaryprofitovernetworth.Chapter7explainsthat
thisratiocanbedecomposedintothereturnonassets(ROA)andleverage(Figure8.5).ROEand
ROAaveraged9.7%and0.84%respectivelyfrom1984to2014.TheROAofthelargestbanksis
morevolatileandhasbeenrelativelyhighersincethelate1990s(Figure8.6).Thelargerthebank,
thehighertheleverage(Figure8.7),butbalancesheetleveragehasmostlyfallenovertimeand
Tier1leveragehasconvergedto9forallbanks,11forthebiggestbanks,8forthesmallest.
BankshaveaROEtarget(amongothertargets)inmindtowhichbonusesofemployeesarerelated
(ifabankreachesorpassesthetarget,employeescanexpectagoodbonus).Bankemployeeshave
twomeanswherebytoreachthetargetifROEisfallingawayfromit:raiseROAand/orincrease
leverage.
Raising ROA means charging a higher interest rate on customers notes (higher mortgage rate,
higher consumer credit rate, etc.), charging more fees, buying higheryield securities, trading
securities more aggressively to make bigger capital gains, and/or reducing expenses. Given
expenses, all this means taking more credit risk and market risk, because raising ROA implies
cateringtolesscreditworthyeconomicunitsorbeinginvolvedinmorevolatiletradingstrategies.
Raisingleveragemeansincreasingthesizeofliabilitiesrelativetonetworth.Chapter7exploresthe
conceptofleveragemorecarefullyin termsofitsadvantagesandrisks.Chapter9explainsthat
banksarelimitedatanypointin timein theirabilitytoleveragebyregulation,buttheyalways
innovateovertimetobypassregulations.
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Figure8.5ROA,ROE,leverageofallFDICinsuredinstitutions
Source:FDICGraphBook
Figure8.6Annualreturnonassets
Source:FDICAggregateTimeSeriesData
Note:Bankswithover$10billioninassetsrepresentabout10%oftheFDICinsuredbanks(595
institutions).MostFDICinsuredbanks(62%or3800institutions)arebetween$100and$1
billion.
102
Figure8.7Tier1leverage(inverseoftier1leveragecapitalratio)
Note:Tier1capitalisacomponentofcapital.
RISKSONTHEBANKBALANCESHEET
Theprofitabilityofabankcriticallydependsonthefollowing:
TheROAwhichdependson:
Creditworthiness of the issuers of promissory notes (credit risk): households,

businesses, and government may not be able to service their promissory note,
whichmeansthatabankdoesnotreceiveitsexpectedincomeandinsteadrecords
aloss.
Actualandexpectedmarketvalueofsecurities(marketrisk):capitalgainandlosses
arerecordedonadailybasisforsomeassets.
Thecostoffundingthebankingbusiness(refinancingrisksinducedbyinterestraterisk,
maturitymismatchrisk):costofacquiringreservesandcostofholdingaccounts(i.e.giving
incentivetoaccountholdersnottowithdrawtheirfundsinordertoavoidhavingtoborrow
reserves or to sell interestearning assets to get reserves). If the Fed raises FFR quickly,
banksthathavefixedratelongtermassetsseetheirnetinterestincomedwindlequickly.
Creditworthiness,capitalgainsandlosses,andbankfundingcostsareinfluencedbythestateof
theeconomy,expectedinterestrates,futuremonetaryandfiscalpoliciesandmanyotherfactors.
Forexample,ifitisexpectedthateconomicactivitywillslowdown,thenonemayexpectthatlayoffs
willriseandsothatsomedebtorswillhaveproblemsservicingtheirdebts.Chapter4explainshow
expectedmonetarypolicyimpactscurrentassetpricesandrefinancingcost.
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Thismeansthat,torunabankingbusinessproperly,abankermustformexpectationsaboutawide
rangeoffactors.Ofcourse,theseexpectationsusuallyturnouttobeincorrect.Whenexpectations
areunderoptimistic,bankersarepleasantlysurprisedandmaydoubledownontheriskstheytake.
Whenexpectationsareoveroptimistic,thingscanturnsourveryquicklyifcreditanalysiswasnot
done properly, if capital, liquidity, and lossreservebuffers are inadequate, or if fraud has been
prevalent.
Figure 8.8 shows the impact of credit and market risks. The value of promissory notes falls as
economicunitsdefaultorthevalueofsecuritiesfalls.Thisimpactsnetworthandsotheabilityto
meetthecapitalrequirementspresentedinChapter9(intheexamplea15%lossonpromissory
notesleadstoadeclineinthecapitalratiofrom20%to5%).Ifabankisunabletomeetitscapital
requirements,regulatorsmaydemandthatthebankbeclosed.
Figure8.9showsthevalueofnontradablepromissorynotesthatwerepastduebyatleast30days
relativetothevalueoftier1capitalandloanlossreserves.Loanlossreservesarenotthesame
thingasbankreserves,theyareextracapitalthatbankskeeptobufferagainstexpectedlosseson
thenontradablepromissorynotesoftheirclients.Ingeneral,thelargerthebankstheworstthe
performance,thatis,thelargerthebank,thehighertheproportionofpastdueloans.Thiscanbe
explainedbylookingatFigure8.6.Majorbanks(thosewithassetsworthatleast$1billion)have
increasedtheirROAtomaintaintheirROE.RaisingtheROAmeansacquiringmoreriskyassets,that
is,assetsthathaveahigherlikelihoodofdefaulting.
Figure8.8Impactofdefaultand/orcapitallosses
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Figure8.9Noncurrentloans&leasesasapercentoftier1capitalplusloanlossreserves
BANKINGONTHEFUTURE
Astudyoftheprofitabilityofbanksclearlyshowsthatthisbusinessisallaboutbankingonthe
future.Thereisamyriadoffutureeconomiceventsthatinfluencestheassetsandliabilitiesof
banksandsohowprofitable,solventandliquidbanksare.Intermsofassets,theroleofbanksisto
judgeandvalidate(ornot)theexpectationsthatarebroughttothetablebytheirclients.Asthe
sayinggoesinthebankingindustry,IveneverseenaproformaIdidntlike.Economicunitsthat
wanttogointodebtwithabankalwayspresentaveryfavorableviewoftheirprojectandfuture
economicprospects.Theroleofbankersoughttobetotamethatvisionofthefutureintoamore
realisticview,inthesensethattheviewconformsmorecloselytopasteconomictrendsandpast
historyofprobablesuccess.
Bankersaresupposedtodothisbyrequestingdocumentsthatprovideevidencethataneconomic
unitwillbeabletofulfilltherequirementofthepromissorynote(usuallypayinterestandprincipal
dueontime),andbyrequestingsomeguaranteesintermsofcovenants(e.g.,abilitytocheckhow
abusinessisrunorabilitytoinfluencebusinessmanagementifneeded)andcollateral(abilityto
seizeassetsheldbytheeconomicunitincaseofdefault).Bankersarethensupposedtocheckthis
informationagainstagivensetofstandardsthatdefineswhatacreditworthyeconomicunitis.Such
standardsincludeamongothers:
Thedebtservicetoincomeratio:whatisasustainableamountofinterestandprincipal
paymentrelativetotheincomeearned?20%,30%,40%?
Thevalueofmonetarybalancesrelativetothevalueofdebt:whatisasustainableamount
ofliquidsavingsthataneconomicunitshouldhaverelativetoanamountofdebt?10%,
50%,60%?
105
Theloantovalueratio:Whatisthemaximumamountofcreditacustomercanaskrelative
tothevalueofacollateral?Isitoktohaveamortgagethatrepresents50%ofthehouse
value,80%,100%?
Inpractice,giventhatthefutureisuncertainandgiventheelasticnatureofthestandardsused,
assessing creditworthiness is not always easy. In addition, banking is a competitive sector so
assessingcreditworthinessisinfluenced,notonlybytheneedtocheckcarefullyaneconomicunits
abilitytopay,butalsobytheneedtomaintainandgrowmarketshares.IfaTVmakerhassoldall
theblackandwhiteTVsthatcouldbesold,thenextstepisnottocloseshoportorelyonlyon
repairsandreplacements.ThenextstepistoinventcolorTVs,flatscreenTVs,3DTVs,etc.sothat
consumershaveanincentivetoditchtheiroldTVsandbuynewones.Thesamedynamicsareat
playinbanking.Maintainingmarketsharemayrequirebankstoinnovate:
Bypushingexistingandnewclientsintonewlowcostproducts.Atypicalexampleofthat
wasthemid2000s,whenclientswereincentivizedtogointointerestonlymortgages,pay
optionmortgages,cashoutrefinancemortgages,homeequityadvances.
Byincentivizingexistingclientstogofurtherintodebtortorefinance.Atypicalexampleof
thatisthe2001refinancingwaveofprimemortgagorswhentheyrefinanceintofixedrate
mortgageswithlowerrates.
Bylooseningcreditstandardswhenthepoolofwhatisdeemedacreditworthyclientis
shrinkingandnewbusinessopportunitiesmustbesoughttomaintainROE.Afterthe2001
refinancingwaveamongprimehouseholds,banksturnedtowardnonprimehouseholds
fornewbusinessopportunities.
Thus,overtime,creditstandardsmayloosen.Whenpreviouslyonehadtohaveadebtserviceto
income ratio of at most 30% to be considered creditworthy, now banks are ok with 40%. The
mortgageboomofthemid2000sbrokeallstandardsofcreditworthiness,withbankerswillingto
provide highinterestrate mortgages to customers with no proof of income, job or assets (the
infamousNINJAloans)inanamountthatrepresentedover100%ofthevalueofahouse.Even
prisonerscouldgetamortgage.2Theonlywaytomakethattypeofmortgageprofitablewasto
resellthehouseatapricehighenoughtocovertherepaymentofalltheprincipalandinterestdue.
Thisimpliesfindinganotherpersonwillingtogointodebttobuythehouseatthishigherprice.A
typicalPonzigamewasatplay.
Somebankmanagersthoughtthatthewholesystemwasbasedonrapingthepublicandrefused
tolowertheircreditstandards;but,thiscameatthecostofacceptingamassivelossofmarket
share.3Mostbankers,especiallyonWallStreet,cannotacceptsuchadecline;infacttheycannot
evenacceptstablemarketshares,asMr.Blankfeinnoted:
Itshouldbeclearthatselfregulationhasitslimits.Werationalisedandjustified
the downward pricing of risk on the grounds that it was different. We did so
because our selfinterest in preserving and expending our market share, as
competitors, sometimes blinds usespecially when exuberance is at its peak.
(Blankfein2009)
Wallstreet financial institutions are growthoriented businesses and so must find ways to
constantlyexpandtheirbusiness.Thelooseningofcreditstandardswilloccurallthefastergiven
thatthebankingstructureissuchthatitrewardsbankersbasedonthevolumeofpromissorynotes
106
acceptedinsteadofthequalityofpromissorynotes.Asexplainedbelow,thebankingindustryhas
movedinthatdirectionsincethe1980satleast.
Thispressuretoloosencreditstandardshasbeenillustratedneatlyquiteafewtimes.Forexample
Wojnilowernotedin1977:
In the 1960s, commercial bank clients frequently inquired how far they could
prudentlygoinbreachingtraditionalstandardsofliquidityandcapitalizationthat
were clearly obsolescent. My advice was always the sameto stick with the
majority.AnyoneoutfrontriskeddrawingthelightningoftheFederalReserveor
otherregulatoryretribution.Anyonewholaggedbehindwouldlosetheirmarket
share. But those in the middle had safety in numbers; they could not all be
punished,forfearoftherepercussionoftheeconomyasawhole.[]Andifthe
problem grew too big for the Federal Reserve and the banking system were
swamped, well then the world would be at an end anyhow and even the most
cautiousofbankswouldlikelybedraggeddownwiththerest.(Wojnilower1977,
235236)
John Maynard Keynes noted more than eighty years ago while talking about financialmarket
participants:Worldlywisdomteachesthatitisbetterforreputationtofailconventionallythanto
succeedunconventionally.4
EVOLUTIONOFBANKINGSINCETHE1980s
The promotion of competition and shortrun rewards, together with the lack of regulatory
enforcement (see Chapter 9) and a monetary policy focused on finetuning the economy (see
Chapter 4), have pushed banks to move away from a business model that promotes careful
underwritingandtowardmarketsharegrowth.Figure8.4givesahintofthattrend.Thisbanking
systemismoreunstablebecauseitpromotesanincreaseinthesizeofleverage(indebtednessis
bigger) and a decline in the quality of leverage (more dangerous financial products, fewer
guarantees,lessverification).
Within banks, there are two important desks, the loanofficer desk (whose task is to judge the
qualityoftheprojectsproposedbypotentialclientsandtotameoptimism)andthepositionmaking
desk (whose task is to finance and to refinance the asset positions taken by the bank). In the
originateandholdbankingmodel,thepointofabankistoestablishlongtermrelationshipswith
clients based on trust and recurring credit agreements, and to make a profit based on the net
interest margin. A bank carefully checks the 3Cs of credit analysis: cash flow, collateral, and
character.ThinkofGeorgeBaileyinItsaWonderfulLifeasthestereotypicalbankerofthistypeof
bankingmodel:heknowshisneighborhoodwellanddoesbusinessthere,heknowsmostofhis
clientspersonally,hekeepshisclientspromissorynotesinthebankvault,hemakesaprofitby
waitingpatientlyfordebtstobeserviced;ifaclienthasaproblemtheysitdownandtrytoworkit
outgiventhatGeorgessuccessdependsonhisclientssuccess.
This form of banking always exists at any point in time (that is what banking is after all), but it
thrivedaftertheGreatDepressionwhencompetitioninthefinancialindustrywasreducedandthe
central bank kept its refinancing cost stable and low. With increased competition from other
financialinstitutionsandchangesinthemonetarypolicypracticesoftheFed,thisbankingmodel
becamelessviableastheinterestrateriskbecametoogreat.Chapter5showsthattheVolcker
107
experimentled toavery largeincreaseinthelevelandvolatilityofthefederalfundsrate. This
occurredatatimewhenbankshadalotoffixedratelongtermassetsontheirbalancesheet(think
mortgages)sotheirnetinterestmarginshrank.Thisisallthemoresogiventhatrisingshortterm
rate pushed banks to raise the rate on their savings accounts. Regulation Q (a Fed regulation
regardingthemaximuminterestratethatsavingsaccountandcertificatesofdepositcouldcarry)
limited banks ability to do so, and so lots of economic units removed funds from their savings
accountsandputthemintomorelucrative,butstillliquid,financialinstruments.RegulationQwas
relaxedasFFRroseandwasultimatelyabandoned.
Bankspushedforandobtainedaderegulationoftheirbusinesstoallowthemtodiversifythe
assetstheycouldbuyandtoallowthemtoprovidemoreattractiveratesontheirliabilities.This
ultimatelyledtothesavingsandloan(S&L)crisiswhensavingsandloaninstitutions(banksthat
specializedinholdingmortgagenotes)werehitbymassivecreditrisk.Fromtheearly1980s,they
hadtakenpositionsinmoreriskyassetstooffsetthehighercostoftheirliabilitiesinducedbythe
Volker experiment, and widespread fraud by top bank managers followed deregulation. 5 Other
bankswerenotimmunefromthecrisisandalsorecordedlargedefaults(Figure8.9).TheS&Lcrisis
markstheendoftheoriginateandholdbankingmodel.
Figure8.10Tradingrevenuesfromcashandderivativepositions
Source:OCCQuarterlyReportonBankDerivativesActivities
Note:DatadiscontinuedforallbanksasofQ22014
Note:ThenumberandcompositionofTopBanksvarythroughtime.Currentlytherearefour
topbanks:JPMorganChase,BankofAmerica,Citibank,andGoldmanSachs.
This model has now been replaced by an originateanddistribute banking model. Profitmaking
activitieshavebeenshiftedtowardthepositionmakingdesk.Whilenetinterestmarginisstilla
significantsourceofprofitforbanks,itsimportancehasdiminishedsubstantially(Figure8.4).Banks
nolongerlookforalongtermindividualizedrelationshipwithrecurringborrowers;therelationis
impersonalandjudgedinminutesthroughacreditscoringmethod.Promissorynotesofcustomers
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are packaged and sold to special purpose entities that fund the purchase by issuing bonds
(mortgagebacked securities, collateralized debt obligations, etc.). Banks make money from the
feesthatcomefrompassingthedebtservicetotheSPEs,andhavebeenmoreinvolvedintrading
activities,especiallytopbanksthatcurrentlygetbetween6%and9%oftheirgrossrevenuefrom
trading(Figure8.10).
1 The main assets of commercial banks are mortgages, consumer credit and other promissory
notesofeconomicunitsresultinginadvancesprovidedtotheprivatesector.
2 The main liabilities of commercial banks are deposits of all sorts, with small timedeposits
(certificatesofdeposits)andsavingsaccountsrepresentingthemajorityoftheliabilities.
3Overthepast30years,theimportanceofcommercialbanksandotherdepositoryinstitutions
has declined, with a greater share of financial assets held within the financial industry going to
moneymanagersandissuersofsecuritizedproducts.
4Thebusinessofbankinginvolvessettlingpaymentsbetweenprivatenonbankeconomicunits,
providing opportunities for small savers to access higher earning financial assets, supplying the
currencytothenonbanksectors,andhelpingeconomicunitstofinanceeconomicandspeculative
activities.
5Whilethemajorityoftheincomeofbankscomesfrominterestreceipts,theshareofthatincome
hasdeclinedby20percentagepointssince1980.
6Thesizeofleverageinthebankingindustryhasdeclined.Majorbanks(thosewithover$1billion
inassets)takemorerisksontheirliabilityside(moreleverage)andassetside(relianceonriskier
financialassetsthatprovidehigherROA).
7Thebusinessofbankingisinfluencedbyallsortsofinternalandexternalfactorsthatinfluence
thevalueoftheirassets,defaultrisk,andtheinterestratetheypayontheirliabilities.Ononeside,
bankstrytoanticipateadversechangesinthesefactorstoprotecttheirbalancesheet,butonthe
othersideeachbankalsowilltendtoignorethosefactors,ortodiscountthem,ifanticipatingthem
decreasesitscurrentmarketshare.
8 Banking is about anticipating the future while also keeping up with the competition to avoid
losing market shares. As such, credit standards are elastic and tend to loosen over a period of
economicprosperityandtosharplytightenduringarecession.
9 Banks have moved away from a business structure that involves acquiring nontradable
promissory notes and keeping them until they mature. Much more emphasis is put on trading
securities.
Keywords
Bank profit, promissory note, loan and lease, security, certificate of deposit, mortgage, credit
service,paymentservices,retailportfolioservices,creditstandards,maturitytransformation,net
interestincome,netcapitalgain,returnonequity,returnonassets,leverage,loantovalueratio,
debtservice,originateandholdmodel,originateanddistributemodel
109
ReviewQuestions
Q1:Whatistheimpactofadeclineinthevalueofbankassetsonthenetworthofbanks?Whyis
thataproblemforbanks?
Q2:Whydobanksexist?
Q3:Ifinterestratesontheliabilitiesofbanksgoup,whathappenstotheirprofit?
Q4:Inordertoprovideanadvanceoffunds,whatdoesabankdo?Whydoesitneedtodothat?
Q5: Why does the profitability of a bank depend on the ability of its customers to fulfill their
promissorynotes?
Q6:Havebanksbecomemoreorlessdependentontheabilityoftheircustomertoservicetheir
debts?
Q7:Dobigbankstakemoreorlessriskthansmallbanks?Howso?
Q8: Why is it important for a bank to loosen its credit standards at about the same pace as its
competitors?Whathappensifitismoreconservativethanothers?Lessconservativethenothers?
Suggestedreadings
For a succinct view of the evolution of banking since the 1960s and a bullish view of its recent
development, read Banking a 2004 speech by Chairman Greenspan:
http://www.federalreserve.gov/BOARDDOCS/Speeches/2004/20041005/default.htm
Hyman,H.P(1984)Bankingandindustrybetweenthetwowars:TheUnitedStates,Journalof
EuropeanEconomicHistory,13(SpecialIssue):235272.
1SeeBlack,W.K.(2005)TheBestWaytoRobaBankistoOwnOne.Austin:TexasUniversityPress.
2 See Part 4 of Klein, A. and Goldfarb, Z.A. (2008) The bubble, The Washington Post, June 15, 16, 17 at
http://www.washingtonpost.com/wpdyn/content/article/2008/06/14/AR2008061401479_4.html
3 See Schwartz, N.D. (2007) Can the Mortgage Crisis Swallow a Town? The New York Times, September 2 at
http://www.nytimes.com/2007/09/02/business/yourmoney/02village.html
4
In
Chapter
12
of
the
General
Theory.
Available
at
https://www.marxists.org/reference/subject/economics/keynes/generaltheory/ch12.htm
110
CHAPTER 9:
Whybanksneedtoberegulatedandsupervised
Howbanksareregulatedandsupervised
Whathasledtoadeclineintheabilityandwillingnesstoregulatebanksand
toenforceexistingregulations
Why economists may have different views about the more relevant way to
performbankregulation
CHAPTER9:BANKINGREGULATION
Itmaysurpriseyoutoknowthatthebankingsectorisoneofthemostregulatedindustriesinthe
United States, with each bank having to file regulatory documents with several agencies. These
regulationsdeterminehowbanksshouldandshouldnotoperatetheirbusinessintermsofmany
aspects; from disclosure of information to potential customers, to means of determining
creditworthinessofapotentialclient,tothequantityofreservestohold,tomanagementissues,
amongothers.ForexampletheNationalAssociationofMortgageBrokersnotedin2006
Mortgage brokers are governed by a host of federal laws and regulations. For
example, mortgage brokers must comply with: the Real Estate Settlement
ProceduresAct(RESPA),theTruthinLendingAct(TILA),theHomeOwnershipand
Equity Protection Act (HOEPA), the Fair Credit Reporting Act (FCRA), the Equal
Credit Opportunity Act (ECOA), the GrammLeachBliley Act (GLBA), and the
FederalTradeCommissionAct (FTCAct),aswellasfairlendingandfairhousing
laws.Manyofthesestatutes,coupledwiththeirimplementingregulations,provide
substantive protection to borrowers who seek mortgage financing. These laws
impose disclosure requirements on brokers, define highcost loans, and contain
antidiscrimination provisions. Additionally, mortgage brokers are under the
oversightoftheDepartmentofHousingandUrbanDevelopment(HUD)andthe
FederalTradeCommission(FTC);andtotheextenttheirpromulgatedlawsapply
tomortgagebrokers,theFederalReserveBoard,theInternalRevenueService,and
theDepartmentofLabor.
Letusfocusonfourexamplesofregulation.
EXAMPLESOFBANKREGULATIONS
RESERVEREQUIREMENTRATIOS
The reserve requirement ratio (RRR) dictates the quantity of total reserves banks must have in
proportiontotheaccountstheyissued(seeChapter3).Table9.1showswhattheratioslooklike
todayintheUS.Ifabankissuedlessthan$15.2millionoftransactionaccounts(checkingaccounts
andothers)itdoesnothavetohaveanyreserves,3%between15.2to$110.2millionworthof
outstandingtransactionaccounts,and10%beyondthat.Somecountriesdonothaveanyreserve
requirements.
112
LiabilityType
Requirement
%ofliabilities
Effectivedate
$0to$15.2million2
12116
Morethan$15.2millionto$110.2million3
12116
Morethan$110.2million
10
12116
Nonpersonaltimedeposits
122790
Eurocurrencyliabilities
122790
Nettransactionaccounts1
Table9.1ReserverequirementratiosfortheUnitedStates.
Source:BoardofGovernorsoftheFederalReserveSystem
CAPITALADEQUACYRATIOS
Saythatabankhasthefollowingbalancesheet:thevalueofassetsis$100,bankaccountsare$90
andnetworthis$10.Thenetworthactshasabufferforaccountholdersagainstlossesonassets,
i.e.aslongas,thevalueofassetsfallsby10%orless,thebankcanfullyrepayallaccountholders
byliquidatingitsassets(assuming,ofcourse,thatattimeofliquidationmarketsarewellbehaved
andallowquickliquidationatlow cost). Regulatorswantto makesurethatbankshaveenough
capitaltoprotecttheircreditorsagainstasubstantialdeclineinthevalueofbankassets.Thisisall
themoresogiventhatthegovernmentmayguaranteethatcustomerswillgetthefundsintheir
bankaccountsevenifabankgoesbankrupt.
Since 1988, with the Basel Accords, central banks have tried to make capital regulation more
uniform across the world. Table 9.2 shows the current capital adequacy ratios (CAR) for FDIC
insuredbanks.WewillfocusonthetotalriskbasedCAR(TotalRBCratiocolumn).IntheUS,abank
shouldhaveatleast8%ofcapital,preferablyatleast10%,relativetoitsriskweightedassets.This
meansthatthemaximumweightedbalancesheetleverageoughttobe12.5(A/E=1/0.08)and
preferably10.
Table9.2Capitaladequacyratios.
Source:FDICCapitalRegulationManual.
Assetsareweighedaccordingtotheriskthattheirnominalvaluefalls.Assumethatabankhasthe
followingbalancesheet(Figure9.1):
113
Assets
Mortgagenotes=$40(100%)
Municipalbonds=$30(80%)
U.S.Treasuries=$30(0%)
Reserves=$10(0%)
Bankaccounts=$104
Capital=$6
Figure9.1Bankbalancesheetwithweights
Theratiocapital/assetsis$6/$110=5.45%,whichisbelowthe8%minimumCAR.However,assets
weighmoreheavilyiftheyhaveahigherchanceofgeneratinglosses.Mortgagenotesareilliquid
andcontaincreditrisksotheyareattacheda100%weight,municipalscontaincreditriskbutare
somewhatliquidsotheyhaveaweightof80%,U.S.Treasuriescontainnocreditriskandtradein
themostliquidfinancialmarketintheworldsotheyareattachednoweight.Samewithreserves.
Sotheactualcapitalratiois$6/($40+$24)=9.38%,notidealbutadequate.
BaselAccordshaveevolvedovertimeascentralbankshavetriedtoaccountforchangesinthe
financialindustryandfordrawbacksofthepreviousversionsoftheAccords(theAccordsarein
theirthirdversion).Asonemayexpect,thewaytosettheweightsandpropervalueofassetscan
getverycomplicated.Thelastsectionwillexplainwhyonemaydoubtthatthistypeofregulation
willbesuccessful.
CAMELSRATING
BesidethewellknownRRRandCAR,regulatorssuchastheFDICalsocalculateaCAMELSratingfor
eachbank:
C:Capitaladequacy
A:Assetquality
M:Managementquality
E:Earningslevelandquality
L:Liquidity
S:Sensitivitytomarketrisk(changeinthenominalvalueofsecurities)
CAMELSratinggoesfrom1(strongbusiness)to5(highlytroubled).Aratingof4orhigherleads
regulatorstocheckcarefullyabankandifnecessarytoissueaceaseanddesistorder
In a cease and desist order, a bank must stop immediately its dangerous activities (risky credit,
impropermanagement,toolowcapitalratio,etc.)andmustfindmeanstorestoreitssoundness
permanently(asmeasuredbytheCAMELSrating).Restoringpermanentsoundness(i.e.,desisting
fromdangerousactivities)mayimplysignificantchangesinmanagementandbusinessstrategies,
andmayinvolvefindingreliablesourcesoffunding,andotherrelevantrestructuringoperations.
Theboardofatroubledbankisgivenalimitedamountoftime(e.g.,60days)tocomplywiththe
demandsofitsregulator.Iftheboardcannotcomply,thebankisclosedandtheregulatorusesthe
leastcostlyproceduretotakecareoftheproblembank:liquidationorfacilitationofacquisitionby
anotherbank.
114
UNDERWRITINGREQUIREMENTS
Onewouldthinkthatbankscarefullycheckthecreditworthinessofacustomerbeforetheyaccept
her promissory note. They would ask for proof of income and verify with the Internal Revenue
Services(nobodyinflateshisincomeonanincometaxstatement),carefullydeterminethevalueof
availablecollateral,andjudgeabilitytopaybasedontheoveralldebtservicethatwouldcomedue.
Afterall,thisiswhatbanksaresupposedtodo;theirjobispreciselytojudgeabilitytopayandto
tameexpectations.
As noted in Chapter 8, during the housing boom all this went out of the window, banks
manufacturedcreditworthinessbyinflatingitoncreditapplication(sometimesraisingtheincome
statedonamortgageapplicationwithouttheknowledgeoftheapplicant),theydidnotbotherto
checkwiththeIRSeventhoughitcanbedoneeasily(theydidnotdosofortheobviousreasonthat
theyliedontheapplication),theymaintainedablacklistofhouseappraiserswhowerehonestand
would not provide an inflated valuation of a house, they qualified households on the basis of
interestpaymentscalculatedfromaverylowinterestrate(akateaserrate)thatwouldprevailonly
forafewmonths.Itisasifyourmechanicdideverythingtowrecktheengineofyourcar.Soit
turnedoutregulationshadtobeputinplacetotellbankerswhattheyaresupposedtodo!
ThisisincludedinTitle14oftheDoddFrankact.Itforcesmortgageestodeterminethecapacityto
payofmortgagorsonthebasisofothermeansthantheexpectedrefinancingsourcesandexpected
equityinthehouse,aswellastoverifyincomeandtoqualifyindividualsbasedonthefulldebt
service:
Adeterminationunderthissubsectionofaconsumersabilitytorepayaresidential
mortgageloanshallincludeconsiderationoftheconsumerscredithistory,current
income,expectedincometheconsumerisreasonablyassuredofreceiving,current
obligations,debttoincomeratioortheresidualincometheconsumerwillhave
after paying nonmortgage debt and mortgagerelated obligations, employment
status, and other financial resources other than the consumers equity in the
dwelling or real property that secures repayment of the loan. A creditor shall
determinetheabilityoftheconsumertorepayusingapaymentschedulethatfully
amortizestheloanoverthetermoftheloan.(DoddFrankAct,768)
WhileTitle14islimitedtoresidentialmortgages(commercialmortgageswereabigproblemduring
theS&Lcrisisandotherpromissorynotesshouldalsofollowthesameunderwritingmethods),this
Title is a great contribution to financial stabilityif enforced. The need for such a regulation
suggestshowmuchthebankingindustryhaschangedfortheworse.
WHY ARE THERE STILL FREQUENT AND SIGNIFICANT

FINANCIALCRISESIFREGULATIONISSOTIGHT?
This is, at least, a threepart answer: 1 there was some deregulation that has promoted
competitionandconcentration,2thewillingnessandabilitytoenforcethelawhasdiminished,3
regulatoryarbitrageandregulatoryapathy.
DEREGULATION,COMPETITIONANDCONCENTRATION
115
The Great Depression put in place financial regulations that compartmentalized the financial
industry.Bankswereforbiddentoperformsomeactivitiesrelatedtofinancialmarkets,theywere
limited in the types of assets they could hold, and they had access to a low cost and stable
refinancingsourceviathecentralbank.Thisledtoaverystablebankingsystemwithveryfewand
limitedproblems.Table9.3showsthegrosssavingofdepositoryinstitutionsgrewataslowerbut
steadierpacecomparedtothepost1970speriod.Thenumberoffailuresandassistanceswasalso
dramaticallysmalleraround4failuresandassistancesperyearversus113fromthe1980sand
representedonly2.8percentofallfailuresandassistancesthatoccurredbetween1945and2010.
Takingabroaderhistoricalperspective,Figure9.2showsthatthestabilityofthebankingfrom1940
to1980alsostandsout.
GrossSaving,Average
GrowthRate
19451971
19822010
GrossSaving,Std.
Deviation
19451971
19822010
InsuredBankFailures
andAssistances
19451971
19822010
U.S.
Depository
Institutions
8.2%
24.0%
Credit
Unions
Commercial
Banks
15.1%
14.1%
9.1%
11.7%
15.1%
225.8%
20.1%
31.2%
16.4%
26.1%
Number(%oftotal)
YearlyAverage
100(2.8%)
3266(93.5%)
3.7
112.6
Table9.3GrosssavingandfailuresofFDICinsureddepositoryinstitutions.
Sources:BoardofGovernorsoftheFederalReserveSystem,FederalDepositInsurance
Corporation.
Note:Grosssavingisdefinedasundistributedprofitplusconsumptionoffixedcapital
Chapter8notesthattheenthusiasmofbanksfortheoriginateandholdmodeldeclinedsharplyin
the1980s.Theypushedforaderegulationoftheirindustrytobeabletoofferhigherinterestrate
on their liabilities and to widen the type of assets they could hold (1980 Depository Institution
Deregulation and Monetary Control Act, 1982 Garn St. Germain Act). Then, banks lobbied to
deregulate branching restrictions (1994 RiegleNeal Interstate Banking and Branching Efficiency
Act),tobeabletoparticipateinbroaderfinancialactivities(1999FinancialModernizationAct),and
tolimitregulationinthederivativemarkets(2000CommodityFuturesModernizationAct).
Today,theU.S.bankingindustryishighlyconcentrated(Figure9.3)andafewlargefinancialholding
companiesdominatetheindustry.80%oftheassetsofthebankingindustryareconcentratedin
the595largestbanksthataccountforabout10%ofFDICinsuredbanks.Amongthese,thetop5/7
banksholdalmostallthederivativecontractsheldbybanks.Table9.4showstherecentdataabout
derivative holding concentration among FDICinsured institutions; the seven biggest institutions
hold 97% of derivate contracts held by FDICinsured institutions, worth almost $170 trillion
notionally.Thehighconcentrationoftheindustrymeansthatifoneofthebanksfails,itmayhave
amajorimpactonthefinancialsystem.Banksmaybecometoobigtofail,andsomustbesaved
even though they are not economically viable. This may promote moral hazard and increase
financialinstabilityovertime.
116
Figure9.2Annualnumberofbanksuspensions(18921941)andbankfailures(19342015)
Sources:FDIC(Bankfailures)andMonetaryandBankingStatistics19141941(Bank
suspensions)
Note:Banksuspensionsincludebanksthatclosedtemporarilyorpermanentlyonaccountof
financialdifficulty;excludestimesofspecialbankholiday.Bankfailuresrefertobanksthat
closedpermanently.
117
Figure9.3Concentrationofthebankingindustry
Note:LargestFDICInsuredBankhaveover$10BillionofAssets(595institutionsin2016or10%
oftheindustry)
Report Date
Derivative
Contracts
(Trillions)
Percent of
Total
Derivative
Contracts
Number of
Banks
Spot Foreign
Exchange
Contracts
(Billions)
Size
Grouping
December
31, 2015
$169.3
97%
$928.0
7 Largest
Participants
December
31, 2015
$4.7
3%
1,400
$105.5
All Other
Participants
Table9.4.Concentrationofderivativesnotionalamounts
DEENFORCEMENTANDDESUPERVISION
Overall, there was a deregulatory trend but the fact remains that this industry is still heavily
regulated.However,forasetofregulationstoworkproperlyithastobeenforced.Withthereturn
offreemarketthinkingasadominantframeworkofthoughtinthe1970s,enforcementtookatoll.
Freemarketthinkerswhodonotbelieveingovernmentinterventionwereputinchargeofmajor
regulatorybodies;individualssuchasAlanGreenspanattheFed,RobertRubinattheTreasury,and
Christopher Cox at the SEC. These are individuals who believe in the selfcleansing and self
stabilizingpropertiesofmarket.1Assuch,accordingtothem,thereisnoneedtodoanythingto
preventfraudanddangerousfinancialpractices,ortomakesurethatbanksdonotgetinvolvedin
118
predatorybusinesspractices.Marketstakecareofit,afterall,asthethoughtgoes,abusinessis
judgedbyitsclientssoiftheclientsdonotlikewhatabusinessdoes,thebusinesswillclose.
Thus,inrecentyears,regulatorsliketheFederalReservedeliberatelylooselyimplementedexisting
regulations or chose to not conduct consumer compliance examinations of, nor to investigate
consumercomplaintsregarding,nonbanksubsidiariesofbankholdingcompanies.2Inaddition,the
FederalReserveandtheOfficeoftheComptrolleroftheCurrency(OCC)blockedeffortsoffederal
regulators,andstateslikeGeorgiaandNorthCarolinawereprohibitedbyOCCandtheOTSfrom
investigatinglocalsubsidiariesofnationallycharteredbanks.ChairmanBairattheFDICworkedwith
FederalReserveGovernorGramlichtoraiseconcernsaboutpredatorymortgagepracticesstarting
in2001buttheireffortdidnotleadanywhere.ChairmanBornattheCommodityFuturesandTrade
Commission (CFTC) raised concerned about derivatives and wanted to make them more
transparentbutwasshutdownbyCongress.3
In1994,aGovernmentAccountabilityOffice(GAO)reportstronglycriticizedtheexistingderivatives
legislation.Itnotedthatnocomprehensiveindustryorfederalregulatoryrequirementsexistedto
ensure that U.S. OTC derivatives dealers followed good riskmanagement practices and that
regulatorygapsandweaknessesthatpresentlyexistmustbeaddressed,especiallyconsideringthe
rapidgrowthinderivativesactivity.4Noneoftherecommendationswasimplementedandinstead
largecutsweremadebyCongresstothebudgetoftheGAO.Thesecutswereestimatedtoreduce
thestaffoftheGAOby850persons(20percentofitsemployees).
Other regulators also suffered large cuts to their staff. The FDIC staff was cut drastically and
constantlyfrom20,000employeesintheearly1990sto5,000employeesrightbeforetheGreat
Recession (Figure 9.4). This occurred at the same time as the financial industry became more
concentratedandmorecomplex.Inaddition,thecutinstaffwasmuchmorerapidthanthedecline
in the number of FDIC insured institutions to be supervised, thereby increasing the burden of
supervisiononeachemployee.Thisdoubletrendofincreasingcomplexityandincreasingburden
onsupervisorsdrasticallydecreasedtheircapacitytoperformeffectivesupervisionandregulations.
TheSEC,underChristopherCox(who,likeAlanGreenspan,isafollowerofAynRandseconomic
thinking),alsodecreaseditsstaffand,by2009,theSecuritiesandExchangeCommissionhad400
peopletoexamine11000investmentadvisers,whichledittocontractwithprivateauditorsand
other external reviewers. In addition, the SEC did not develop the necessary tools it needed to
performeffectiveregulation.
REGULATORYARBITRAGE
Beyond deregulation, desupervision and deenforcement, banks themselves have always found
meanstobypasspartlysomeoftheregulationsthattheyhavefoundtooconstraining.Anexample
ofthatarecapitalregulationsthatbankshavebypassedpartlythroughsecuritization.Securitization
allowsbankstoremovehighlyweightedassets(thatiscarryinghighrisks)fromtheirbalancesheet
withoutcompromisingtheirprofitability.Regulatoryarbitrageisacommonresponseofbanksto
newregulations.Tocounterit,regulationneedstobeflexibleandbroadenough,andregulators
need to act quickly; both requirements are lacking with regulators today focused on limiting
interventiontoavoidhurtingbankprofitsandcompetitivenesswithforeigninstitutions.Inaddition,
abankcanchooseitsmainregulator,andabankcanchangeitsregulatorifitthinksanotherone
will be more lenient. This regulator shopping is all the more prevalent given that regulators
119
competetogetthemostbanksundertheirwingsbecauseregulatorsarefundedpartlythroughthe
feestheychargeforsupervision.
Figure9.4NumberofemployeesattheFederalDepositInsuranceCorporation.
Source:FDIC.
THEORIES OF BANK CRISES AND BANKING REGULATION:

TWOVIEWS
Theway the bankingsystemisregulatedheavilydependsonregulatorsunderstandingofwhat
causes banking crises. There are two broad views regarding the origins of banking crises and
financial crises more generally; one states that crises are random events in an otherwise self
stabilizingeconomicsystembasedon marketprinciples,anotherstates that bank crisesarethe
resultoftheinnerworkingofmarkets.
LAISSEZFAIRE,LAISSEZPASSER:CRISESASRANDOMEVENTS
Greenspansummedupneatlythefirstviewwhenhecharacterizedthe2008financialcrisisasa
onceinacentury credit tsunami. Crises are equivalent to weather calamities that affect the
return on assets (see Chapter 7). These adverse random shocks are amplified by individual
imperfections (think of any deviation from the cold rational homo economicus) and market
imperfections(lackofinformation,etc.).Marketimperfectionscanthemselvescontributetothe
growingriskoffinancialcrisesiftheycontributetothemispricingofsecurities,whichleadsrational
agentstotaketoomuchriskontheirassetsandliabilitiesgiventhepricesignal.Thus,accordingto
thisview,therecentcrisisistheproductofmispricedassets(likeCDOs)thatledtotheissuanceof
toomanyofthem(seediscussionaboutembeddedleverageinChapter7),andofablackswan
120
event,thatis,anunusuallylargenegativeshock.Onemightcallthisviewtheshithappensview
offinancialcrises.
Inthistypeofview,thereisnopointintryingtopromotearegulatoryframeworkthatproactively
helpspreventcrisesandlimittheirstrengthinthesamewaynoonecanproactivelypreventthe
occurrence and reduce the strength of tsunamis. Market mechanisms weed out problems by
themselves because, with enough disclosure, financialmarket participants will not engage in
fraudulent practices, and unsustainable business will be closed down. Anything that promotes
market mechanisms is praised and that includes the recent innovations in derivatives and
securitization. Policy makers such as Alan Greenspan and academics such as Philip Das made
statementsinthemid2000thatillustratewellthisposition:
Developmentoffinancialproducts,suchasassetbackedsecurities,collateralloan
obligations,andcreditdefaultswaps,thatfacilitatethedispersionofriskThese
increasinglycomplexfinancialinstrumentshavecontributedtothedevelopment
ofafarmoreflexible,efficient,andhenceresilientfinancialsystemthantheone
thatexistedjustaquartercenturyago.(Greenspan2004,2005)
Financial risks, particularly credit risks, are no longer borne by banks. They are
increasingly moved off balance sheets. Assets are converted into tradable
securities,whichinturneliminatescreditrisks.(Das2006)
Given that markets usually get it right, instead of having regulations that constrain market
mechanisms, regulation should focus on limiting the destructive impact of financial crises on
economicactivityandimprovingdisclosureofinformationandmarketmechanisms.Followingthe
tsunamianalogy,thegoalistobuildhighenoughseawallssothatprotectionisavailableagainst
mosttsunamis.Ifthereisaonceinacenturytsunamiwelltoobadatleastwetried!
Intermsofbankingregulation,thegoalistoputinplacelargeenoughliquidityandcapitalbuffers
inthebalancesheetsofbanks.TheBaselaccordsareanexampleofsuchregulatoryview:
Giventhescopeandspeedwithwhichtherecentandpreviouscriseshavebeen
transmittedaroundtheglobeaswellastheunpredictablenatureoffuturecrises,
itiscriticalthatallcountriesraisetheresilienceoftheirbankingsectorstoboth
internalandexternalshocks.(Basel2010a:2)
Withenoughcapital,bankswillbeabletoprotecttheircreditorsagainstmostdeclinesinthevalue
oftheirassets.Withenoughliquidassets,thevalueofassetswilldeclinelessthanitwouldhave
otherwise.Atthesametime,havingtoomuchcapitalandliquidityputsdownwardpressureson
theROEthatbankscanearnbecauseleveragedeclinesandROAislowered(themoreliquidan
asset,thelowertheROA).Thepoint,therefore,becomestofindtheoptimallevelofcapitaland
liquidity. The move toward risk management is the ultimate expression of this belief. It uses
complex mathematical algorithms to determine what the appropriate level of buffers is given
existingrisksonandoffbalancesheets.Thegoalhasbeentorefinethemeasurementofdifferent
risksaswellasthemethodsusedtocalculatetheappropriatelevelofeachbuffer.Thegovernment
hasalimitedroletoplayindeterminingappropriatebuffers,especiallyforsophisticatedfinancial
institutions.Thegovernmentalsohasnotmuchtosayaboutthewaybanksshouldbemanaged,
theproperunderwritingprocedures,andthetypesofassetsthatbanksshouldbeallowtohold.
Bankersknowbest.
121
SAVE CAPITALISM
CONTRADICTIONS
FROM
ITSELF:
CRISES
AS
INTERNAL
Anotherviewoffinancialcrisesarguesthattheyarethenormalresultofprofitseekingoperations
of banks, and that the way the banking system is structured greatly dampens or amplifies the
destabilizing effect of profitseeking operations. While an unstable banking system can be
attributedinparttogreedandirrationalorbadpeople,themostimportantcontributoristhe
waythebankingsystemissetup.Themoreofaroleisgiventomarketmechanisms,themore
unstablethefinancialsystemwillbe.Theissueisnotoneofmispricing,lackofdisclosure,black
swan,massivetsunami,orimperfections.Tsunamisarecreatedbytheverypracticesofbankswhen
tryingtomakeabuckand,ifbanksareleftalone,theirpracticeswillleadtoaonceinacentury
tsunami.Putdifferently,financialcrisesarenottheresultsofbadluckbecausenaturethrewa
tantrum;banksmaketheirownluck.Assuch,onemayalsodoubtthatcapitalregulationandother
bufferrequirement approach will do much to prevent financial crises. 5 They are too passive
regulations.
As explained in Chapter 8, over a period of stability, banks are incentivized to change their
underwriting practices by lowering credit standards and/or deemphasizing income as the main
meansofservicingdebts.Someofthislooseningiswelcomedwhenbankshavetightenedcredit
standardssomuchthateconomicgrowthcannotproceedwell.Thistendstohappenafterfinancial
crises, when bankers become too careful. 6 However, credit standards are elastic and, when
profitabilityisthreatened,looseningcreditstandardsistheeasyroad,especiallyduringaperiodof
economic stability when economic news is good. Periods of economic stability feed the models
usedbybankerswithinformationthatsuggeststhatleverageissafeandrisktakingiswarranted.
Beyondbanks,otherfinancialinstitutionssuchaspensionfundshaveanincentivetobuyCDOsand
other risky financial assets (even a noninvestment grade securities) in order to maintain the
targetedROEtheypromisedtheirpensioners;thisissoespeciallywheninterestratesareverylow.
Morebroadly,corporatebusinesseshavesomeprofitabilitytargettomeetthatislargelyinvariant
tothegrowthoftheirassets,therebypushingthemtoinnovateandtouseleveragetoreachthat
target.Again,averyrationalresponsetoprofitabilitypressuresdefinedbyatargetROE.
Assuch,riskmanagementtoolsmayprovideinformationthatsuggeststhatitissafernottoengage
in certain activities, but this information will be ignored if it threatens market shares and
profitability:
To some extent [] all risk management tools are unable to model/present the
most severe forms of financial shocks in a fashion that is credible to senior
management [].To the extent that users of stress tests consider these
assumptionstobeunrealistic,tooonerous,[]incorporatingunlikelycorrelations
orhavingsimilarissueswhichdetractfromtheircredibility,thestresstestscanbe
dismissed by the target audience and its informational content thereby lost.
(CounterpartyRiskManagementPolicyGroupIII2008:70,84)
ThisissoespeciallyinanenvironmentwhereitisdifficulttoreachthetargetROEandthesearch
foryieldisintensive.Chapter8illustrateshowthebankingsystem(andfinancialsystemasawhole)
isdrivenbycompetitivepressuresandtheneedtostickwiththemajoritytoavoidlosingmarket
shares.Assuch,financialinstitutionswillengageinunsustainablefinancialpracticesifthatmeans
keepingprofitabilityup.Giventhatprofitistheonlyrelevantmetrictojudgeabusiness,market
122
mechanismswillnotweedoutunsustainablepracticesiftheysustainprofit.Astheseaccumulate,
theeconomicsystembecomesmorefragileandultimatelycollapsesunderadebtdeflation(see
Chapter14).
Thepointisthattheweedingoutofbadapplesthatmarketproponentsargueoccurstoprevent
crisesdoesnothappen.Theproblemcomesfromtoomuchfocusonprofitasthekeymetricsof
healthforabusiness.Fromthebankmanagersstandpoint,ifthebusinessisprofitable,itmeans
theydowhatcustomerswantandsoarefulfillinganeed(nevermindthatthismayinvolveraping
thepublicasshowninChapter8).Regulatorsseeprofitasakeymeasureofhealthbecauseprofit
grows capital (see Chapter 1) and so improves buffers against crises. However, from a financial
stabilityperspective,akeyissueisnotmerelyifprofitisgeneratedbuthowthatprofitisgenerated.
Ifthissecondquestionisignored,theweedingoutmechanismusedbymarketsisthecrisisitself,
andthatendsupdestroyingtheentireeconomyandwipingoutanybufferavailable.Somuchfor
asmoothselfstabilizingmechanism.
Giventhatcreditstandardsareelasticconcepts,onemaywonderifthereisameanstoknowwhat
asustainablecreditpracticeisandhowtousethatforregulatorypurpose.Fortunatelyyes.Hyman
P. Minsky provides us with a useful categorization of underwriting practices in terms of Hedge,
SpeculativeandPonzifinance.Chapter14studiesthiscategorizationmorecarefully.Themainpoint
isthatifdebtisunderwrittenonthebasisofincome(incomebasedcredit),itismuchlesslikelyto
leadtofinancialinstability.If,instead,banksgrantadvancesbyqualifyingclientsonthebasisofthe
expectedriseinthevalueofacollateralorotherassets(assetbasedcredit),thentheeconomic
system is prone to financial instability. The recent housing boom with its dangerous mortgage
practices,presentedinChapter8,isanexampleofsuchunsustainableunderwritingpractices.
Theproblemisnotmerelyoneofknowingifacustomerwillbeabletoservicehisdebt(themain
concern of banks), but also how a customer will service his debt: servicing debt with income is
sustainable, debt servicing by liquidating assets is not. It is not sustainable because while an
individualmaybeabletodoitbyrelyingonabonanza(assetpriceswentupasexpectedandcan
beliquidatedeasily),forthesystemasawholeitisimpossibletoliquidateassets.Marketsrelyon
abalanceofbuyersandsellersandif asignificant proportionofdebtorsrelyonastrategythat
involvessellingassetstoservicedebts,assetpriceswillplungewhenliquidationoccurs.APonzi
strategyissustainableonlyforsolong,giventhatthenumberofparticipants(andindebtedness)
mustexponentiallygrowtokeepthestrategygoing.
With the H/S/P categorization in mind, the point is to discourage, and if necessary, forbid any
economicgrowthprocessthatisnotbasedonsoundfinancialpractices(incomebasedcredit),even
ifeverybodyisprofitingfromthecontinuationofthisprocessintheshortterm,andevenifthe
financial community ends up considering those practices acceptable and a normal way to do
business.Inordertodoso,thefinancialpracticesofeconomicagentsshouldbecheckedcarefully
andgrowingsignsofassetbasedcreditshouldbetackledimmediately,evenifthereisnobubble,
norisingdefaultrate,risingwealthandprofit.
Thispolicyagendais,ofcourse,muchbroaderandmoreambitiousthanthepreviousone,butits
relevancehasbeendemonstratedmanytimes.Forexample,priortothesavingsandloancrisis,
several infield supervisors wanted to shut down some thrifts that were recording large profits,
because they were suspected of being involved in Ponzi finance sustained by massive frauds.
However,therewerestrongpressuresfromtheirbossesandpoliticiansnottoclosethesethrifts
123
because their profitability made them models for the industry. 7 Those thrifts were allowed to
continuetooperatebutendedupcostinghundredsofbillionsofdollarswhentheyfailed.
Similarly, during the housing boom of the mid2000s, households wealth grew very rapidly,
financialcompaniesregisteredrecordhighprofits,andhomeownershipalsoreachedarecordhigh,
butallthesegainswerewipedoutoncetheeconomycollapsed.Homeownershipisbacktoitslevel
priortothehousingboom,andisstillfalling(Figure9.5).
Figure9.5HomeownershiprateintheU.S.(Percent).
Source:U.S.CensusBureau
Steps should have been taken since at least 2003 to prevent the unsustainable growth of
homeownershipanddangerousbusinesspractices.Thisshouldhavebeendonebyforbiddingno
docmortgages,bylimitingaccesstopayoptionmortgagestohouseholdswithenoughcashbuffer
andincome,bynotallowingfinancialinstitutionstocreatePonzigeneratingfinancialinnovations,
and by regulating closely all new financial activities. Instead, in 2004, Greenspan praised the
dynamicmortgagemarketandarguedthatrisingmortgagedebtamongU.S.householdswasnota
problembecausehouseholdswealthwasrisingthankstorapidlyrisinghomeprices;preciselywhat
assetbasedcreditisallabout.8
Finally,assetbasedcreditisimpossibletobufferproperlyinaneconomicallyprofitablewayandso
shouldnotbeallowedatleastbybanks.Analternativeistoremoveanygovernmentbackingfrom
economic activities that rely on, or promote, assetbased credit, which implies isolating the
paymentsystemfromthoseactivities.
In the end, CDOs and other financial innovations were problematic not because they were
mispriced(althoughtheysurelywere),butbecausetheywereencouragingfinancialpracticesthat
are unsustainable even if priced correctly. Assetbased credit always fails because there is
ultimatelynoincometomeetthedebtserviceandassetsmustbeliquidatedindistress.Financial
marketparticipantsarealwayswillingtopayforsomethingifthatmeansmoreprofit(evenmore
sowhenbonusesarebasedonshorttermprofitability),andtheywillgetabetterideaofwhatto
124
paywithmoreinformation.Butprofitseekingactivityisdifferentfromfinancialcrisisavoidance
activity.Infact,thesetwoactivitiesusuallyarecompleteoppositeactivitiesandthelatterisnever
ontheradarofanyparticularfirm(ifwefail,wefailtogether,nobodygetsblamed;letmefocus
onmyprofitisthethoughtasWojnilowerillustratesinChapter8).
1Banksareheavilyregulatedbecausetheyareatthecoreofthepaymentsystem.Iftheyfailen
masse, the economy freezes because other economic units cannot get paid, cannot make
payments,andcannotobtaincurrency.
2Banksmusthaveacertainproportionofcapitalrelativetotheweightedvalueoftheirassets.
This is supposed to allow banks to be able to sustain large unexpected adverse shocks on their
assets,whilestillbeingabletopaytheircreditors
3Banksmusthaveacertainproportionofreservesrelativetotheoutstandingvalueofthebank
accountsthattheyhaveissued.Thisissupposedtoallowthemtomeetunexpectedlargedemand
forcashbycustomers.
4Ifbanksdonotcomplywithregulations,regulatorsmayissueaceaseanddesistorderandgive
alimitedamountoftimeforabanktocomply.Afterthattime,thebankiseithersoldtoanother
bankoritsassetsareliquidatedtopaythecreditors.
5Thebankingindustryhasbecomehighlyconcentratedandhighlydependentonderivativesand
capital gains to maintain its profitability. This is the results of a period of deregulation,
desupervisionanddeenforcemntthathaveallowedmajorbankstobroadentheiractivities.
6Someeconomistsbelievethatmarketsselfregulateandthat,atmost,banksonlyneedtobe
protectedagainstthemostprobablyshocksthatmayadverselyimpacttheirbalancesheet.This
canbedonebypassiveregulationsuchascapitalregulation.Othereconomistsbelievethatbanks
make their own luck, that is, that financial crises are the product on the loosening of credit
standardsduringperiodofeconomicprosperity.Assuch,regulationofthebankingbusinessmust
bemorethorough,flexibleandproactive,andmustfocusonthetypeofassetsacquiredby,and
underwritingmethodsusedbybanks.
Keywords
Reserve requirement, capital requirement, CAMELS rating, efficient markets, financial instability
hypothesis,riskmanagementtechniques,underwritingrequirements
ReviewQuestions
Q1:Whatistheroleofcapitalregulation?Underwritingregulation?
Q2:WhatdoesaCAMELSratingmeasureandhowdoesitdoit?
Q3:Whathashappenedtothebankingindustryoverthepast30to40yearsandwhy?
Q4:Whatcanbedoneintermsofregulationifonebelievesthatfinancialcrisesarerandomevents,
akablackswanevents?
Q5:Whattypeofregulationshouldbeputinplaceifonebelievesthatfinancialcrisesaretheresult
ofthewaybanksconducttheirbusiness?
Q6:Howcananincreaseintheconcentrationofthebankingindustry,togetherwithderegulation
andlackofenforcement,promotetheoccurrenceoffinancialcrises?
125
Suggestedreadings
Forarelativeeasyreadwithacompellingnarrativeaboutsaving&loanwhitecollarcrimesandthe
fight of some regulators to stop them read The Best Way to Rob a Bank Is to Own One: How
CorporateExecutivesandPoliticiansLootedtheS&LIndustrybyWilliamK.Black.
Moreadvancedreadings:
Cargill, T.F. and Garcia, G.G. (1982) Financial Deregulation and Monetary Control: Historical
PerspectiveandImpactofthe1980Act.Stanford:HooverInstitutionPress.
Campbell,C.andMinsky,H.P.(1987)HowtoGetOfftheBackofaTigeror,DoInitialConditions
ConstrainDepositInsuranceReform?InFederalReserveBankofChicago(ed.)Proceedingsofa
ConferenceonBankStructureandCompetition,252266.Chicago:FederalReserveBankofChicago.
Minsky,H.P.(1975)Suggestionsforacashfloworientedbankexamination,inFederalReserve
BankofChicago(ed.)ProceedingsofaConferenceonBankStructureandCompetition,150184,
Chicago:FederalReserveBankofChicago.
Knutsen,S.andLie,E.(2002)Financialfragility,growthstrategiesandbankingfailures:Themajor
Norwegianbanksandthebankingcrisis,198792.BusinessHistory,44(2):88111.
1WhenthefullblowncrisisoccurredintheSeptember2008,Greenspanandothersconcededthattheywenttoofarin
believingintheefficiencyofmarketsitwasthetimeforapublicmeaculpa.DonaldKohn,formerViceChairmanofthe
Federal Reserve, stated: I placed too much confidence in the ability of the private market participants to police
themselves(KohninHouseofCommons2011:Ev3).AhumbleGreenspanwasaskedtotestifytoCongressandcreated
somestirbystating:
Imadeamistakeinpresumingthattheselfinterestoforganizations,specificallybanksandothers,
weresuchis[sic]thattheywerebestcapableofprotectingtheirownshareholdersandtheirequity
inthefirms.(GreenspaninU.S.HouseofRepresentatives2008b:34)
SimilarremarksweremadeintheUnitedKingdombyAdairTurner,chairoftheU.K.FinancialServicesAuthority(FSA):
Inthepast,intheyearsrunninguptothecrisis,itwasthestrongmindsetoftheFSAsharedwith
securities and prudential regulators and central banks across the world, it was almost part of our
DNAthatweassumedthatfinancialinnovationwasalwaysbeneficial,thatmoretradingandmore
liquiditycreationwasalwaysvaluable,thatevermorecomplexproductswerebydefinitionbeneficial
becausetheycompletedmoremarkets,allowingamoreprecisematchingofinstrumentstoinvestor
demandforliquidity,riskandreturncombinations.Andthatmindsetdidaffectourapproachand
theapproachofthewholeworldregulatorycommunitytothesettingofcapitalrequirementson
trading activity; it affected our willingness to demand risk reduction in the CDS market; and it
influencedthedegreetowhichwecouldevenconsidershortsellingbansinconditionsofexceptional
marketvolatility.[][Steppingoutofthatmindset]posesforregulatorsthechallengeofcomplexity,
because it involves rejecting an intellectually elegant but also profoundly mistaken faith in ever
perfectandselfequilibratingmarkets,everrationalhumanbehaviors.(Turner2009)
2Appelbaum,B.(2009)Fedheldbackasevidencemountedonsubprimeloanabuses,TheWashingtonPost,September
27athttp://www.washingtonpost.com/wpdyn/content/article/2009/09/26/AR2009092602706.html
3WatchTheWarningbyPBSFrontlineathttp://www.pbs.org/video/1302794657/
4GovernmentAccountabilityOffice(1994)FinancialDerivatives:ActionsNeededtoProtecttheFinancialSystem,Report
No.GAO/GGD94133,May,athttp://www.gao.gov/assets/160/154342.pdf
5
http://www.levyinstitute.org/conferences/minsky2015/minsky2015_tymoigne.pdf
6 In 2014, Chairman Bernanke could not refinance his mortgage http://www.bloomberg.com/news/articles/201410
03/whyevenbenbernankecantrefinancehismortgagechart
8 The mortgage market and consumer debt, remarks by at Americas Community Bankers Annual Convention,
Washington,D.C.,October19,2004.http://www.federalreserve.gov/boardDocs/speeches/2004/20041019/default.htm
126
CHAPTER 10:
Whatbanksdobeforeprovidingcredit
Howbankscreatetheirmonetaryinstruments
Howbanksdestroytheirmonetaryinstruments
Howbanksmakeaprofit
Whatthelimitstothemonetarycreationprocessbybanksare
CHAPTER10:MONETARYCREATIONBYBANKS
ThelastthreeChaptershaveexplainedhowtheoperationsofbanksareconstrainedbyprofitability
andregulatoryconstraints,andhowbanksoperatetotrytobypasstheseconstraints.Itisnowtime
togointothedetailsofhowbanksprovidecreditandpaymentservicestotherestoftheeconomy.
MONETARY CREATION BY BANKS: CREDIT AND PAYMENT

SERVICES
BankAjustopenedforbusinessanditsbalancesheetlookslikethis:
BankA
Assets
Building:$200
Networth:$200
Nowcomeshousehold#1whowantstobuyahouseworth$100fromhousehold#2.#1sitsdown
with a banker (a.k.a. loan officer) who asks a few questions regarding annual income, available
assets,monetarybalances,thedownpayment#1iswillingtomake,amongothers.Thebankerasks
fordocumentationthatcorroboratestheanswersprovidedby#1.
Thebankeralsoshows#1whatfinancingoptionsareavailable;thatis,thebankershows#1what
typeofmortgagenotehousehold#1hastoissuetobeacceptedbybankA.Figure10.1istaken
fromanactualwebsite.
For100%financing(nodownpaymentbyhousehold),thebankispreparedtoprovideup
to$330,000anditwillonlyaccepta30year5.125%fixedratemortgagenote.Thebank
willnotaccepta20yearmortgagenote,ora3.875%notefor100%financing.
Forupto97%financing(householdprovidesatleasta3%downpayment),thetypesof
mortgagenotethatahouseholdcanissuetothebankwiden.Thebankiswillingtoaccept
a30year3.875%fixedratenote,ora15year3.125%fixedratenote,amongothers.The
maximumfacevalueofthenotethatthebankwillacceptis$417,000unlessthehousehold
isabletoprovidea20%downpayment.
#1picksoneoftheoptionsandfillsupacreditapplicationthatisattachedtoallthedocumentation
providedby#1.Thecreditapplicationisthensenttothecreditdepartmentforfurtheranalysis
(checkthe3CsofChapter8)andeitherapprovedornot.
Allthisissimilartobondissuancesbycorporations,exceptthatmortgagenotesdonothavean
activemarketinwhichtheycanbetraded.Inthecaseofabond,acorporationmayissueabond
withtermsthataredifferentthanwhatmarketparticipantswant.Thebondwilltradeatadiscount
or a premium in that case. If Ford issues a 10year 5% corporate bond but the market yield is
currently6%(i.e.marketparticipantswanta6%rateofreturn),marketparticipantswillonlybuy
thebondfromFordatadiscount.Tosimplify,assumeabondwitha$1000facevalueanda5%
couponrate(everyyearthebondpays$50ofinterestincome),thentogeta6%yieldsomeone
shouldpay$833(50/833=6%);a17%discount.
Unfortunatelyfor#1,thereisnoactivemarketforitspromissorynotes,soif#1doesnotissuea
mortgagenotewiththetermsrequiredbyA,itsnotewilltradeat100%discount;Awillnotbuyit
(#1couldalwayscheckwhatanotherbankwouldoffer).Thatisthedisadvantageofnontradable
promissorynotesoversecurities;theissueriscompletelyboundbywhatpotentialbearersrequire
intermsofthecharacteristicsofthepromissorynote(interestrate,termtomaturity,etc.).
128
Figure10.1Exampleoftypesofmortgagenoteabankwillaccept
Figure10.2showswhatamortgagenotelookslike.Itisalegaldocumentthatformalizesapromise
madebyahouseholdtoabank.Thehouseholdissueda30yearfullyamortizedfixedrate7.5%
note to a bank called Shelter Mortgage Co., which means that, over 30 years, the household
promisestopayanannualinterestrepresenting7.5%oftheoutstandingnotevalueandtorepay
some of the principal every month. That comes down to a monthly payment of $1896.27. The
mortgagenoteisaccompaniedbyamortgagedeed(andmanyotherdocuments).Thedeedisa
legaldocumentthatestablishestherightofthebanktoseizethehouseifthehouseholddoesnot
fulfillthetermsofthemortgagenote.
129
Figure10.2Amortgagenote
Goingbacktoourhousehold#1thatwantstobuya$100house,supposethatbankAagreesto
acquirefrom#1a30year5%mortgagenotewitha$100facevalue.HowdoesApayforit?Bank
Aissuesitsownpromissorynote,calledbankaccount,to#1.
BankA
Assets
30year5%mortgagenoteof#1:$100
Building:$200
Or,intermsoftaccount,wehavethefollowingfirststep:
130
Bankaccountof#1:$100
NetWorth:$200
BankA
Assets
30year5%mortgagenoteof#1:+$100
Bankaccountof#1:+$100
#1thenpays#2and,forthemoment,letusassume#2opensanaccountatA(wewillseewhat
happensbelowwhen#2hasanaccountatadifferentbank):
BankA
Assets
Building:$200
Bankaccountof#1:$0
NetWorth:$200
Orintermsoftaccounts,wehavethefollowingwhenthepaymentoccurs:
BankA
Assets
Household#1
Assets
House:+$100
BankaccountatA:$100
Household#2
Assets
House:$100
BankaccountatA:+$100
Whiletheaboveshowsthelogicofwhatgoesonwhenabankprovidescreditservices,thebank
alsoprovidespaymentservices.Thismeansthat,inpractice,theaccountingissimplerbecauseA
makesthepaymentonbehalfof#1,itdoesnotlet#1touchanyfunds.Instead,Adirectlycredits
theaccountof#2sothefirststepisactually:
BankA
Assets
Andthefinalbalancesheetis(#1doesnotneedtohaveabankaccountforthepaymenttogo
through,Ajustcreditstheaccountof#2bytyping100onthecomputer)
BankA
Assets
Building:$200
Networth:$200
The promissory note of the bank called bank account is one type of monetary instrument as
explainedinChapter15.
131
WHATCANWELEARNFROMTHEEXAMPLEABOVE?
POINT 1: THE BANK IS NOT LENDING ANYTHING IT HAS: WHEN
PROVIDINGCREDITSERVICES,THEBANKSWAPSPROMISSORYNOTES
WITHITSCLIENTS
Theaccountingoftheprevioussectioniscommonlyreferredtoasbanklending,i.e.theAissaid
tolend$100to#1.AsstatedinChapter2,whenstudyingcentralbanking,lendingmeansgiving
uptemporarilyanasset,Ilendyoumypenforaminute.Thisisclearlynotwhatisgoingon.Banks
arenotinthebusinessofallowingcustomerstotemporarilyusesomeofthebanksassets:thatis
aloansharkbusiness.Thebankisnotlendinganythingitowns.Lendingwouldmeanthis:
BankA
Assets
Reserves:$100
Household#1isborrowingcashfromthebank.Butwhathappenedisthis:
BankA
Assets
Onemayask:Istherenotanindirectlendingofreservesthough?After#1getsitsaccountcredited,
itcouldwithdrawreservesandmakeacashpaymentto#2.#1wouldthenhavetogetreserves
backtoA.Theanswerisnofortworeasons:
Wehavejustseenthatinpracticethebankmakesthepaymentfor#1.Thatpaymentdoes
notneedtoresultintoanyreservedrainage(itdidnotabove).
As shown below, #1 does not have to give back reserves to A to repay its debt, and #1
rarely,ifever,doessoinpractice.
Sonotonlyis#1notborrowingreservesfromA,butalso#1isnotgivingbackreservestoA.There
isnolendingorborrowingofreservesgoingonbetweenAand#1,eitherdirectlyorindirectly.What
abankdoesdoistoswappromissorynoteswitheconomicunitsandtomakepaymentsforthem.
Reservesmayenterthepictureatthetimeoftheprovisionofpaymentservices,neveratthetime
oftheprovisionofcreditservices.
POINT 2: THE BANK DOES NOT NEED ANY RESERVES TO PROVIDE

CREDITSERVICES
Whileitmayneedreservestoprovidepaymentservices(thatistotransferfundsto#2),Adoesnot
needanyreservestoprovidecreditservicesto#1.Allitdoeswithhousehold#1istoexchange
promissorynotes:
132
Thehouseholdmakesthefollowingpromise:pay5%interestontheoutstandingmortgage
valuefor30yearsandrepaysomeoftheprincipaleverymonth.
Thebankmakesthefollowingtwopromises:
o
To convert bank accounts into Federal Reserve notes at the will of the account
holders
Toacceptitsownpromissorynotewhen#1servicesthemortgage.
Allthesearepromisesandnoneoftheissuershastohavewhatisneededtofulfillthepromiseright
awaywhenheissueshispromissorynotes.Thatisthepointoffinance;itisaboutbankingonthe
future(seeChapter8).
Thinkofapizzashopthatissuescouponsforafreepizza.Theshopdoesnothavetomakepizzas
first before it issues the coupons; it will make pizzas only if people show up with coupons.
Converting the coupons into pizzas is costly for the shop and so affects its profitability, but the
issuanceofcouponsisnotconstrainedbythecurrentavailabilitytopizzas.Theshopisjustmaking
a promise and anybody can make any kind of promise. The hard parts are, first, to convince
someoneofthegenuinenessofthispromiseand,second,tofulfillthepromiseonceithasbeen
acceptedbysomeone.
Inthesameway,abankdoesnothavetohaveanyFederalReservenotesnowtobeabletoissue
abankaccountthatpromisesFederalReservenotesondemand.Abankwillneedreservesonlyif
accountholdersrequestcashormakepaymentstosomeonewhohasanaccountatanotherbank.
TheFedwillprovidereservesondemand,i.e.atthewillofsolventbanks,sobanksneverworry
aboutbeingunabletogetreserves(seeChapter4).Reserveswillneverrunout.Whatbanksdo
needtoworryaboutisthecostofacquiringreserves.Innormaltimes,thiscostispredictableand
relatively stable but the Volcker experiment shows that a central bank may make reserves
prohibitivelyexpensive.
POINT 3: THE BANK IS NOT USING OTHER PEOPLES MONEY: IT IS

NOTAFINANCIALINTERMEDIARYBETWEENSAVERSANDINVESTORS
This is a development of the first and second point. A view of banking, from which the word
lending probably comes from, is that banks are intermediaries between savers and investors.
Somepeoplecometodepositcashandthenbankslendthecash.Itisquiteclearthatabankisnot
lendinganyfundsthatsomedeposited(nobodydepositedanythinginourexample).And,worse
offender,abankiscertainlynotusingothersbankaccountstograntcredit.Assumethathousehold
#3comestobankAtogeta$100credit,Aneverdoesthis:
BankA
Assets
Thatis,itdoesnottakethefundsof#2andgivethemto#3.Thistaccountwouldbeapayment
from#2to#3,notacreditbybankA.Toprovideacreditisexactlywhatcreditmeans,itisabout
creditingaccounts.Thecreditingisdonebytypinganumberonthecomputer.Oncethisnumberis
entered,thebankisliabletotheaccountholderforthetworeasonspresentedabove.
133
Banks do not wait for depositors before they engage in the provision of credit services. Say
household#3comestoopenanaccountbydepositing$50worthofFederalReservenotes.The
followingoccurs:
BankA
Assets
Reserves:+$50
ThisdepositdoesnotenhancetheabilitytoprovidecreditservicesbecauseAisnotinthebusiness
oflendingreservestononbankeconomicunits.Theabilityofthebanktoacquirenonbankprivate
promissorynotesisunrelatedtothequantityofreservesonitsbalancesheetbecauseabankpays
forthembyissuingitsownpromissorynotes.
Thereisonecasewhereabankdoesneedreservestoacquireapromissorynote:ifabankbuysthe
notefromaninstitutionwithaFederalReserveaccount.Forexample:
IfabankparticipatesinanauctionofTreasuries,theTreasuryonlyacceptsfederalfundsin
payment.Inthepast,theTreasurysometimesallowedbankstopayfortheTreasuriesby
creditingtheTT&Ls(anothercashmanagementmethodusedformonetarypolicypurpose
beyondtheonespresentedinChapter6),butitnolongerdoessince1989.
ifitbuyspromissorynotesfromanotherbank
Inthefirstcase,thebalancesheetchangesasfollows(saysthebankbuys$10worthofTreasuries
fromtheTreasury)
BankA
Assets
Reserves:$10
Treasuries:+$10
AndonthebalancesheetoftheFedthefollowingoccurs
Fed
Assets
Reserve:$10
TGA:+$10
AndtheTreasury:
Treasury
Assets
TGA:+$10
Treasuries:+$10
Chapter 6 showed that the Fed always ensures that banks have enough reserves to make the
auctionsuccessful.ThesupplyofFederalReservenotesbysaversisirrelevantforthesuccessof
auctionsofTreasuries.
POINT4:THEBANKSPROMISSORYNOTEISINHIGHDEMAND
Whydid#1enterinanagreementwithA?Becausenobodyelsewouldaccept#1spromissorynote
andalargenumberofeconomicunitsacceptsAspromissorynote(ifsomeonedoesnot,Aoffers
134
conversion into cash that most accept in payments). Chapter 15 explains why bank monetary
instrumentsarewidelyaccepted.
If#2hadbeenwillingtoaccept#1spromissorynotethennoneofthepreviousagreementwould
havebeenneeded.Theproblemswith#1spromissorynotearetwofold:
Thereisacreditrisk:#2isnotsurethatitwillgetpaidtheinterestdueandthatitwillbe
abletomakepaymentsto#1bygivingbackto#1itspromissorynote.If#2knewthatit
would become heavily indebted ($100 is a lot in our example) to #1 in the future, then
assumingthat#1iscreditworthy,#2maybewillingtoaccept#1spromissorynoteforthe
paymentofthehouse.Later#2coulduse#1spromissorynotetopaydebtsowedto#1.
Thereisaliquidityrisk:thepromissorynoteonlycomesduein30yearssohousehold#1
doesnothavetotakeitbackbeforethattime(thoughitcouldbecausemortgagenotes
usuallyallowacceleratedrepaymentofprincipal).Inthemeantime,#2isstuckwiththis
promissorynotethatnobodyelsewillaccept.
BankAspromissorynoteisdueatanytimethebearerwants(itconvertsintocashondemandand
itcanbeusedtopaythebankatanytime)andthecreditworthinessofabankisstrong.Thisisall
the more so given that the government guarantees that As promissory note can always be
convertedintoFederalReservenotesatpar,andthatthe(nominal)valueofAspromissorynote
willnotfallevenifAgoesbankrupt.AllthismakestheAspromissorynotefreeofcreditriskand
perfectlyliquid.
HOW DOES A BANK MAKE A PROFIT? MONETARY

DESTRUCTION
Banksaredealersofpromissorynotes:bankstakenonbanknonfederalpromissorynotesandin
exchangegivetheirownpromissorynote.Banksmakeaprofitbytakingbacktheirownpromissory
notes.Atthebeginningofthesecondmonth,#1startstohonoritspromisemadetoAbyservicing
the mortgage note. The monthly principal due is 27 cents ($100/(30*12), assuming linear
repaymentofprincipal)andthefirstinterestpaymentis41cents(theannualinterestrateis5%so
onamonthlybasistherateis0.407%=(1.05)1/121)makingthetotaldebtserviceforthefirst
month$0.68.Howdoes#1paythis?
Therearetwowaysthisamountcanbepaid;oneisbygiving$0.68incashtothebank.Another
morecommonsolutionistofollowuponthepromiseembeddedinthebankspromissorynote:
BankApromisedtotakebackitspromissorynoteasmeansofpaymentofdebtsowedtoBankA.
Thus,anothermeanstopaythemortgageistodebit$0.68fromtheaccountof#1.Letusassume
that#1hasanaccountatA,thataccountfirstneedstobecredited:
BankA
Assets
Building:$200
Howcanhousehold#1getfundscreditedtoitsaccount?
135
Bankaccountof#1:$0
Networth:$200
Case1:#1receivesa$1paymentfromthefederalgovernmenteitherbyselling
something to the government or by receiving a transfer payment. The balance
sheetofthebankwouldlooklikethis(Chapter6showsthattransactionswiththe
federalgovernmentleadtoreservecreditinganddebiting)
BankA
Assets
Reserves:$1
Building:$200
o
Bankaccountof#1:$1
Networth:$200
Case2:#1worksforbusinessthatproduceswidgets.Businessjuststarted.It
hasnotsoldanythingyetbutmustpurchaserawmaterialsandpay#1(theonly
employee)tobeabletoproducewidgets.Inordertodothat,askedfora$10
operatinglineofcreditfromA(anoperatinglineofcreditisanoffbalancesheet
itemunlessitisused).Whenpays#1thefollowinghappens:
BankA
Assets
Creditlinepayableby:$1
Building:$200
Bankaccountof#1:$1
Networth:$200
Business has gone into debt by $1 to be able to pay the monthly wage of
household#1.Notehowsimilarcase2istothefirstsection:businessgetscredit,
banksmakespayment,businessdoesnottouchanyfunds.
o
Case3:#1receivesa$1from#2.Why?Iwillletyoudecide.
One may note that any payment made to #1 that does not come from the government (or an
institutionthathasafederalreserveaccount)(case1),orfromfundsthatgotcreatedpreviously
by#1goingintodebt(case3),requiresthatsomeoneotherthan#1goesintodebttowardabank
(Case2).Otherwise#1cannotgetaccesstothepaymentservicesofferedbyA.
Letassumethatcase2prevailedsonow#1hasenoughfundstopayAthefirstmonthlyserviceof
$0.68.Howisthatrecorded?Itisexactlythesameprocedureasdebtservicepaymentsbybanks
tothecentralbank.
BankA
Assets
30year5%mortgagenoteof#1:$99.73
Building:$200
Bankaccountof#1:$0.32
Networth:$200.41
Orintermsoftaccounts:
BankA
Assets
136
Networth:+$0.41
Again,asinthecaseofacentralbankpresentedinChapter2,thebankisnotgaininganycashflow
fromthetransaction.Itsprofitdoesnotincreasethequantityofreservesontheassetside.What
profit does is to raise the net worth of the bank. As noted in the first Chapter, profit is just an
additiontonetworth,themonetarygainthatprofitrepresentsmaynottranslateintoanycash
flow gains. What the servicing of debts owed to banks does is to destroy bank monetary
instruments,thatis,bankliabilities.
WhilethereisnocashflowgainforA,profitisextremelyimportantfortheviabilityofitsbusiness.
Indeed,thebankneedstomeetitscapitalratioandmakingaprofitimprovesnetworth.Inaddition,
capitalisextremelyimportanttoallowanybanktofurtherdevelopitscreditservicebecauseitcan
nowcreatemorepromissorynotes,giventhatithasmorecapitaltoprotectitscreditors.
LetuslookathowthecapitalpositionofAevolvedthroughtime(tosimplifytheunweightedcapital
ratioiscalculated):
1 Afteritopened:
BankA
Assets
Building:$200
Networth:$200
Capitalratio=networth/assets=$200/$200=100%
2 Afteritgrantedcreditto#1:
BankA
Assets
Building:$200
Networth:$200
Capitalratio=$200/$300=66.7%
3 Afteritgrantedcredittoandmadethepaymentto#1:
BankA
Assets
Bankaccountof#1:$1
Networth:$200
Building:$200
Capitalratio=$200/$301=66.4%
4 Afteritreceivedthemortgageservicepaymentfrom#1:
BankA
Assets
Networth:$200.41
Building:$200
Capitalratio=$200.41/$300.73=66.64%
UntilAreceivesthemortgageservicepayment,itscapitalpositionworsensasAgrantsmorecredit.
Profit allows a bank to restore its capital position and to further pursue the provision of credit
services.Italsoallowsabanktopayitsownemployeeswithoutfurtherloweringitscapitalposition.
137
So if A has one employee (household #3) who receives a monthly salary of 20 cents, then the
followingisrecorded:
BankA
Assets
Building:$200
Bankaccountof#3:$.2
Networth:$200.21
BankApays#3bytypinganumberonthecomputer.Thecapitalratiois66.57%,stillbetterthan
the66.4%thatprevailedafterAgrantedcreditto.
INTERBANK
PAYMENTS,
WITHDRAWALS,
RESERVE
REQUIREMENTS,ANDFEDERALGOVERNMENTOPERATIONS:
THEROLEOFRESERVES
Reservesareconspicuouslyabsentfromthepreviousdiscussionsbutbanksdoneedreservesas
explainedinChapter3.Reservesenterthepicturewithpaymentservices(interbankpayments),
retail portfolio services (withdrawals and deposits), the law (reserve requirements) and federal
government operations (taxes, government spending, and auctions of Treasuries), as well as
transactionswithotherFedaccountholders(wewillleavethataside).
Letusgobacktothepointwhere#1pays#2andnowletussaythat#2hasanaccountatbankB
instead of bank A. In that case, A instructs B to credit the account of #2 on behalf of A and A
acknowledgesitisindebtedtoB:
BankA
Assets
Building:$200
DebttobankB:$100
Networth:$200
BankB
Assets
Promissorynote:$170
DebtofbankA:$100
Building:$80
Otherbankaccounts:$50
Networth:$200
Interbankdebtsaresettledwithreservesbutthereisasmallproblem:bankAdoesnothaveany
reserves!HowcouldAgetthemrightnow?Thereareseveralpossibilities:
1 Selling nonstrategic tradable assets to another bank or the Fed, say Treasuries: bank A
doesnothaveany(thebuildingisastrategicassetsbecauseAcannotoperatewithoutit,
themortgagenoteof#1isnottradable).
2 Gettingreservesintheinterbankmarket:borrowfromafedfundsmarketparticipantwith
excessfunds(seeChapter4).
3 GettingreservesfromtheFed:swappromissorynotewithFedviatheDiscountWindow
138
4 Recordinganovernightoverdraftonitsreservebalance.
OvertimetherewillbeothermeansforAtogetreservesbecause:
5 OtherbankswillaskAtomakepaymentsontheirbehalftoeconomicunitswithaccounts
atA.
6 SomeeconomicunitswillcometodepositFederalReservenotesatA
7 ThegovernmentwillmakepaymentstoeconomicunitswithaccountsatbankA(seecase
1above).
ButrightnowbankAdoesnothavethereservessoitneedstousesources1through4.Recording
an overnight overdraft is the costliest solution because it requires the payment of very high
penalties.1Goingatthewindowispossiblebut,innormaltimes,thereisalargestigmaintheUS
anditiscostly.Borrowingreservesinthefederalfundsmarketisusuallythepreferredmeansto
getreserves.Assumethat,first,BankAusestheoverdraftfacilitytopayBankB:
BankA
Assets
Reserves:$100
Building:$200
Networth:$200
Aslongasthebalanceisnegativeonlyduringtheday,bankAdoesnothavetopayanyintereston
it.Beforetheendoftheday,bankAborrowsreservesintheinterbankmarketfrombankC:
BankA
Assets
Reserve:$0
Building:$200
DebttobankC:$100
Networth:$200
Thisdebtisduethenextmorningand,attheendofthenextday,bankAwillneedtoborrowagain
from bank C or another bank until it receives enough reserves from sources 5, 6, or 7. While it
borrows from other banks, it must pay the interest rate that prevails on the interbank market,
which, to simplify, is the Federal Funds rate target. Say bank A has to borrow every night for a
month,thenitsprofitforthefirstmonth,assumingaFFRof2%,is:
Profit=Interestreceivedinterestpaid=0.41%*1000.083%*100=$0.327
AslongastheFFRstaysbelowtheinterestrateonthemortgagenote,thebankisprofitable.Itis
notasprofitableasitwouldhavebeenhaditnotborrowedreserves,butitisprofitable.
Beyondtheneedtomakeinterbankpayments,insomecountriesbanksarealsorequiredtomeet
somereserverequirements.BankAhasthefollowingbalancesheetifwecontinuefromthelast
balancesheetoftheprevioussection:
BankA
Assets
Building:$200
139
Bankaccountof#3:$.2
Networth:$200.21
Theoutstandingvalueofbankaccountsis$104.93soAnowneedstoget$10.49ofreservesonits
balancesheetifthereserverequirementratiois10%.Againthesourcesofreservesare1through
7butifAneedsthemrightawayonlysources13areavailableforreserverequirementpurpose(A
cannothaveanoverdraftinthatcase).Theaccountingimplicationsandprofitimplicationsarethe
sameasjustpresented.ForexampleifitborrowsfrombankB:
BankA
Assets
Reserve:$10.49
Building:$200
Bankaccountof#3:$.2
DebttobankB:$10.49
Networth:$200.21
Beyondreservesneededforinterbankdebtsettlementsandreserverequirements,Chapter6also
looksattheneedtogetreservestosettleauctionsofTreasuriesandtopaytaxes.
Inallthesecases(andthecaseofwithdrawalsofcashbyaccountholders),thecentralbankalways
accommodatestheneedsofthebankingsystemtoensurethatthepaymentsystemworksproperly
(economicunitsgetpaidanddebtsaresettled),toensurethatbanksfollowthelaw(onlytheFed
canprovidethereservesthatbanksneedtomeetreserverequirements),andtoensurethatnon
bankeconomicunitscangetthecashtheyneed(seeChapter4).Banksareneverconstrainedby
thequantityofreservesavailable,aslongasacentralbankmerelytargetsaninterestrate.
WhilethequantityofreservesdoesnotconstrainbankAinanyway,theFeddoessetapriceon
thesupplyofreservesandthispriceimpactstheprofitabilityofbankA.Assuch,bankstrytofind
thecheapestsourcesofreserves,whichusuallymeansattractingandkeepingdepositors.Banks
alsotrytoeconomizeonreserveneedsbynetclearinginterbankdebtsbeforesettlingthem,among
othermeans.
Finally,banksdonottrytoholdmorereservesthanwhattheyneed.AsshowninChapter3,in
normal times, most reserves are held because banks are required to do so. Demand for excess
reservesisverysmallandvirtuallyzero.AsshowninChapter4,bankshavealmostnoincentiveto
keepexcessreservesbecausetheycangetanyquantityofreservestheywantatanytime,because
theycannotdomuchwithreserves,andbecausekeepingexcessreserveslowersROA.Banksdo
notproactivelytrytogetreservesaheadofcreditactivitiesand,ifcreditactivityslows,theyslow
theirdemandforreservesandmaywanttoavoidattractingnewdepositorstoavoidingbuilding
excessreserves.Theymaykeepaslightquantityofexcessreservestoavoidhavingtorecordan
overnightoverdraft.
WHAT LIMITS THE ABILITY OF A BANK TO PROVIDE CREDIT

SERVICES?
Saythatabankreallywantstoincreaseaggressivelyitsmarketshare;thiswilltendtodrawthe
attentionofregulatorsforseveralreasons:
1 Inordertogrowfast,thebeststrategyistoprovidecredittoeconomicunitsthatother
banks do not want to qualify; for short nonprime economic units. This can be done by
loosening credit standards faster than other banks and/or, as shown in Chapter 8, by
140
offeringtoacceptpromissorynoteswithinitiallowmonthlypaymentsbutupcominglarge
paymentshocks(hopefullyrefinancingwillbepossibledowntheroad).Bothcasesleadto
ahigherchanceofdefaultandsoahigherprobabilityoflossofnetworthforabank.The
declineinthequalityofassetsmayattracttheattentionofregulators.
2 Theproportionofliquidassetsrelativetoilliquidassetsdeclinesfasterthanitspeers.
3 Its interbank debt will balloon rapidly as payments made on behalf of the bank grow
quickly,whichpushesdownitsprofitabilityandsoitsabilitytobuilditscapitalbase.
4 Thequalityofitsearningsdeclines.Ifabankgrantsalotofpayoptionmortgagestonon
primeeconomicunits,theseunitswillusuallyonlypaypartoftheinterestdue.However,
accrualaccountingallowsabanktorecordthewholedebtservicedueasreceivedandto
record phantom profits. This may again attract the attention of regulators if accrual
interestincomegrowsoutofproportion(accrualaccountingisnotaproblemperseandis
aconvenientmeanstosmoothbusinessoperationsifusedproperly).
Basically,ifabankgrowsfasterthantherestoftheindustry,itsCAMELSratingtendstoincrease
relativetoothersanditsinterbankdebtbecomesunsustainable.Ultimatelyregulatorswillissuea
ceaseanddesistorder.Notethatifabankgrowsfastbyprovidingcredittononprimeclientsata
premiuminterestrate,then,giveninterbankdebt,itsshortrunprofitabilityrisesasleverageand
ROArise.However,such abankwillthenexperience massivelossesinthenearfuturethatwill
lower rapidly profit and capital. As such, there are two limits to the monetary creation process
inducedbytheswappingofpromissorynotes:
Thecreditstandards:ifAconsidersthat#1doesnotmeetthe3Csofcreditanalysis,Awill
notaccept#1promissorynoteandsowillnotcredit#1sbankaccount(or#2s).
Regulation,butnotthroughreserverequirementsgiventhattheFedwillprovideallthe
reservesneededtofulfilltherequirements,but,rather,throughregulatoryelementsthat
impactCAMELSrating,thatconstrainthelooseningofcreditstandards,andthatlimitthe
typesofassetsbankscanhold(seeChapter9).
MOVINGINSTEP
AsnotedinChapter8,thereissafetyinnumbers.Aslongasbanksgrowinstep,thatis,aslongas
they create bank accounts at about the same speed (and so acquire assets at the about same
speed),theymaynotattracttheattentionofregulators:
1 Interbankdebtforabankwillnotballoonoutofcontrol:requeststomakepaymentsona
banksbehalfareoffsetbyrequeststomakepaymentsofbehalfofothersbanks.
2 Leveragemayrise,atleastuntildebtservicingstarts,andliquiditymayfallbutallthisoccurs
attheindustrylevelsonobankissingledout.
Aslongasunderwritingisdoneproperly,ultimately,bankswillmakeaprofitandcapitalwillbe
gainedandsoleveragewilldeclineovertime.However,asexplainedinaChapter8,thingsmayget
outofhandifmostbanksaggressivelypursuegrowthinmarketsharesandsearchforyield.
141
LIMITS TO MONETARY CREATION BY THE CENTRAL BANK

ANDPRIVATEBANKS
Financeisnotascarceresourceaslongasthegovernmentismonetarilysovereign.Banksandthe
centralbankcancreateanunlimitedquantityofmonetaryinstrumentswhenevertheywant.While
theycancreateanunlimitedquantityofmonetaryinstruments,theywillnotdosoforthefollowing
reasons:
Forthecentralbank:undernormalcircumstances(seeChapter4),themainlimittothe
reserve creation process is the need to maintain the overnight interbank rate positive,
which basically implies that the central bank must supply whatever banks demand; no
more,noless.
For banks: core limits to the monetary creation process are profitability and regulatory
concerns.
IwillfinishthisChapterwithFigure10.4,whichillustratesthepointsmadeabove.Thesupplyof
credit is slightly upward sloping and then becomes vertical as banks ration credit given a set of
credit standards. The supply slopes upward to reflect the fact that, at a point in time, as credit
grows,thecreditworthinessoftheremainingpoolofacceptableeconomicunitsfalls.Agivenset
ofcreditstandardsdefineswhataminimumlevelofcreditworthinessisandanybodybelowthat
level will not be granted credit (hence the vertical supply of credit). The demand for credit is
downwardslopingbutnotveryelastic.AsexplainedinChapter5,demandforcreditbybusinesses
isveryinsensitivetointerestrateconditions.
Figure10.4Themarketforbankcredit
TO GO FURTHER: A SIDE NOTE ON ALTERNATIVE VIEWS OF

BANKING:THEMONEYMULTIPLIERTHEORYANDFINANCIAL
INTERMEDIATION.
142
A now discredited view of monetary creation by banks argues that banks actively seek excess
reservestobeabletoprovidecredit.Thelogicgoesasfollowswitha10%reserverequirement
ratio:
1 Thecentralbankinjectsexcessreservesbybuying$100worthTreasuriesfrombankA
2 Reservesdonotearnanyinterest,soBankAprovidesacreditof$100tohousehold#1who
makesa$100paymenttohouseholds#2atbankB.BankBnowhas$100ofextrabank
accountonitsliabilitysideand$100ofextrareservesonitsassetside.BankBhas$90of
excessreserves.Itgrantsacreditof$90tohousehold#3whopays$90tohousehold#4at
bankC.BankChasnow$90ofextrareservesandhasissued$90ofextrabankaccountso
excessreservesis$81,uponwhichBankCprovides$81credittohousehold#5,etc.This
continuesuntiltherearenoexcessreservesleftinthebankingsystem.
3 Thesumofbankaccountscreatedis$100bybankA,$90bybankB,$81bybankC,$72.9
bybankD,etc.,whichamountsto$1000:With$100ofexcessreservesbankscouldcreate
$1000ofbankaccounts.
4 Conclusion:bankcreditisconstrainedbythequantityofexcessreservesandthereserve
requirementratio.Bothcanbeusedbythecentralbanktotargetthemoneysupplyand
ultimatelyinflation.
There are several issues with this view of how banks provide credit and so create monetary
instruments:
-
Step1neverhappensundernormalmonetarypolicysetup(seeChapter4):anyunwanted
excess reserves are drained out of the banking system to prevent a fall of FFR to zero.
Chapter3notesthatbankshaveverylittleneedforreserves.TheVolkerexperiment(see
Chapter5)triedtomovetowardreservetargetingwiththegoaloftargetingmoneysupply,
butthiswasafailure.
Itisjustnothowbanksoperate(step2):Banksareprofitseekinginstitutions;theydonot
waitforreservestograntcredit.Theygrantcreditfirstandlookforreservesafterwards,in
the same way a pizza shop prints coupons first and then make the pizzas as needed.
FloodingbankswithreservesjustreducestheirROA;itactslikeatax.
Bankscannotforceeconomicunitstogointodebt.Bankcreditisdemanddrivensoevenif
bankshavealotofreservesthatdoesnotimprovetheirabilitytoprovidecredit.BankA
hadtowaitfor#1toshowupbeforeanythingcouldhappen.AndwhilebankAcouldhave
triedtoentice#1tocometothebankforfinancing,ultimatelyitis#1whodecidestotake
acredit.
MiltonFriedmanhimselfrecognizedtheproblemwiththisapproach:Giventhemonetary
policyofsupportinganearlyfixedpatternofratesongovernmentsecurities[duringWWII],
the Federal Reserve System had no effective control over the quantity of highpowered
money.Ithadtocreatewhateverquantitywasnecessarytokeepratesatthatlevel.Though
itisconvenienttodescribetheprocessasrunningfromanincreaseinhighpoweredmoney
toanincreaseinthestockofmoneythroughdepositcurrencyanddepositreserveratio,
thechainofinfluenceinfactranintheoppositedirectionfromtheincreaseinthestock
ofmoneyconsistentwiththespecifiedpatternofratesandothereconomicconditionsto
theincrementinhighpoweredmoneyrequiredtoproducethatincrease.(Friedmanand
Schwartz1963,566).Therearetwomainproblemswithhisview:
143
-
HeseemstoviewtheWWIIexperienceasaspecialcaseinsteadofthegeneralcase:
acentralbankalwaystargetsinterestrates,atleasttheovernightinterbankrate
andatleastwithinaband(seeChapter4).
His theoretical position is untenable: if causality is known with certainty to be

reversed(moneysupplytoreservesinsteadofreservestomoneysupply),thenone
cannotproceedasiftheoppositeweretruebecauseitisconvenient.
Anotherviewofbankingisthatbankslendotherpeoplesmoney.Peoplesaveanddepositcash
inthebank,andthebankproceedstolendthecashdeposited.TheChaptertouchedonthisabove
butherearetheproblems:
Banksdonotlendthesavingsofhouseholds:banksdonottemporarilytakePaulsfunds
andgiventhemtoPierre.
Banksdonotlendreservestononbanks:theydonotlookifPauldepositedenoughcash
beforegrantingcredittoPierre.
Banksarenotinthebusinessoflendinganythingtheyhave:Pierredoesnottemporarily
takecashfromthebank,and,usually,doesnotgivebackcashtoabankwhenheservices
hisdebt.
Saverscandepositcash,butsaversarenotthesourceofcash,cashcomesfromtheFed.
AndtheFedcreatescashatthedemandofbankssosavingdoesnotconstraintcredit.
144
1Banksare notmoneylendersbecausetheirmonetaryinstrumentsaretheirliability nottheir
assets.Onecannotlendonesowndebt.
2Banksarepromissorynotedealers.Theytakenonbankpromissorynotesandinexchangegive
theirownpromissorynotes.Contrarytomostnonbankpromissorynotes,bankpromissorynotes
arewidelyacceptedandperfectlyliquid.
3Ifcustomersdefaultontheirpromissorynotes,thevalueoftheassetsofbanksfallsandtheydo
notearnaprofit,sobanksareveryinterestedinmakingsurethatcustomersarecreditworthy.
4Monetarycreationbybanksmerelyinvolvesaccountingentries.Theseaccountingentriesmake
banksliablebecausetheirpromissorynotesareconvertibleincashandcanbeusedtopaiddebts
owedtobanks.
5Themoneysupplydoesnotfallfromthesky;itinvolvesasimultaneousdebtcreation.Banks
promise to pay customers, customers promise to pay banks. Banks accept their customers
promissory note because banks think that their customers are involved in activities that are
profitable.Assuch,monetarycreationmovesinsyncwiththeneedsoftheeconomicsystem;these
needsmayormaynotberelatedtoproductionandthepurchaseofgoodsandservices.
6Banksarenotboundbythequantityofreserveswhentheycreatemonetaryinstruments.Their
monetaryinstrumentsarejustpromisestoobtainreservesatthedemandofthebearers.Banksdo
nothavetowhattheypromisetodeliverwhentheycreatemonetaryinstruments.Inaddition,the
centralbank providesreservesatthedemandofsolventbanks,sosolventbanksneverhaveto
worryaboutnotgettingthereservestheyneedwhenneeded(ataprice).
7 Monetary creation by banks is limited by regulatory and profitability concerns. They have to
complywithcapitalrequirementsandassetqualityrequirements,amongothers,andpromissory
notesthathaveapoorcreditworthinessnegativelyimpacttheirprofitability.
8Themoneymultipliertheoryandthefinancialintermediarytheoryofbanksarenolongerseen
asvalidbymostoftheacademiccommunity.
Keywords
Creditstandards,promissorynotes,overdraft,capitalratio,creditservice,paymentservice,retail
portfolioservices,networth,interbankdebt,withdrawals,reserves,moneymultiplier,creditline,
creditreceivable/payable
ReviewQuestions
Q1:Whenbanksprovidecreditwhatistheaccountingsideofthisoperation?
Q2:Ifacustomercomestoaskforabankcreditwhatwillthebankdo?Why?
Q3:Whencustomersservicetheirpromissorynoteswhathappenstothequantityofreservesheld
bybanks?
Q4:Whatdobanksdowiththecashthatsomecustomersdeposit?
Q5:Whyisbankcreditnotlimitedbythequantityofreserves?Whyaresaversirrelevantforcredit
operations?
Q6:Howdoesprofithelptomeetcapitalrequirement?Andwhyisthatallowingbankstocontinue
tokeeptheirbusinessgoing?
Q7:Whataretheproblemswiththemoneymultipliertheoryateachstageoftheargument?What
aboutthefinancialintermediationtheoryofbanking?
145
Suggestedreadings
For an oldie but goodie video that explains correctly how banks grant advances watch
https://www.youtube.com/watch?v=OJMJ24U0Jp4#t=136
Followingthefailureofreservesinjectiontoboostbankcredit(orinflation),theBankofEngland
published a paper that explains correctly banking operations and rejects other theories:
http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prerel
easemoneycreation.pdf
Moreadvancedreading:
Carpenter,S.andDemiralpS.(2012)Money,reserves,andthetransmissionofmonetarypolicy:
Doesthemoneymultiplierexist?JournalofMacroeconomics34(1):5975.
Dow, S.C. (2006) Endogenous money: Structuralist, in P. Arestis and M.C. Sawyer (eds) A
Moore, B.J. (1988) Horizontalists and Verticalists: The Macroeconomics of Credit Money.
Cambridge:CambridgeUniversityPress.
Keister,J.andMcAndrews,J.(2009)Whyarebanksholdingsomanyexcessreserves?Federal
Reserve Bank of New York Current Issues in Economics and Finance 15 (8): 110:
www.newyorkfed.org/research/current_issues/ci158.pdf
Lavoie,M.(2006)Endogenousmoney:Accomodationist,inP.ArestisandM.C.Sawyer(eds)A
Wray,L.R.(1990)MoneyandCreditinCapitalistEconomies:TheEndogenousMoneyApproach,
Aldershot:EdwardElgar.
Wray, L. R. (2007) Endogenous money:
http://www.levyinstitute.org/pubs/wp_512.pdf
Structuralist
and
Horizontalist
1FederalReservespolicyonOvernightOverdraftsathttp://www.federalreserve.gov/paymentsystems/oo_policy.htm
146
CHAPTER 11:
Why economists disagree about how the financial system contributes to
economicprosperity
How the financial system can benefit, or be detrimental to, economic
prosperity
How different views about how money supply is created lead to different
understandingsofhowmoneysupplycancontributetoeconomicprosperity
Whattheroleofmonetaryincentivesisininfluencingeconomicoutcomes
CHAPTER11:ECONOMICGROWTHANDTHEFINANCIALSYSTEM
ThepreviousChapterconcludesthestudyofbankingoperations.Thenextstepistoincorporate
them into the analysis of macroeconomic issues and this Chapter begins the discussion of such
topicsbyfocusingoneconomicgrowth.
Moneyisthelifebloodofcapitalistenterpriseandfinanceisaboutmoneynowformoneylater.As
such,awelldevelopedfinancialsystemisessentialforeconomicactivityinacapitalisteconomy.
The broader the range of promissory notes that can be issued, the more accommodative the
financialsystemistothedemandsoftheproductivesystem.Householdscannotfundthepurchase
ofahousewithacreditcardandthereisnopointinbuyinggrocerieswitha30yearmortgage.
Whileallthismayseemobvious,economistshavebeendividedabouttherelevanceoffinancefor
economicactivity.Thisdivideultimatelyrestsondifferentpremisesonhowtodoeconomics,which
John Maynard Keynes characterized as Real Exchange Economy versus Monetary Production
Economy.
Before I go further, a word of caution. Economists and national income accounts use the word
investmentinaspecificway.Investmentmeansaddingtothequantityofrealassets,i.e.growing
productivecapacities.Onecannotinvestinshares,bonds,andotherfinancialassetsbutmerelyin
machines and raw materials (knowledge is also an area emphasized by economists). Portfolio
choice,whichisusuallywhatpeoplehaveinmindwhentalkingabout(financial)investment,isnot
thesamethingas(physical)investment.
THEREALEXCHANGEECONOMY
MONEYSUPPLYISAVEIL
Until at least the 1980s, most economists believed that finance is neutral, 1 i.e. irrelevant for
economic activity. The study of exchange within a barter economy with small independent
producersthink of farmers with their own plot of landis regarded as a satisfactory proxy to
understandthebasicsofcapitalism:
Despitetheimportantroleofenterprisesandofmoneyinouractualeconomy,and
despitethenumerousandcomplexproblemstheyraise,thecentralcharacteristic
ofthemarkettechniqueofachievingcoordinationisfullydisplayedinthesimple
exchangeeconomythatcontainsneitherenterprisesnormoney.(Friedman1962,
13)
Thepointistounderstandhowmarketexchangehelpseconomicunitstomanagetheprevailing
naturalscarcityofresourcesbyallocatingresourcesaccordingtogivensetsofinitialallocations,
preferencesandtechniquesofproduction.Oncethisisunderstood,moneysupplycanbeaddedto
the analysis but it does not substantially change anything. It merely smooths exchange, is not
soughtafterforitself,andsodoesnotinfluenceallocation,production,anddistribution.Capitalism
is equivalent to a barter economy with money. In addition, monetary instruments are
conceptualized as commodities used as medium of exchange. As such, a willingness to hoard
monetaryinstrumentsandtoreducespendingonotherthingsismerelychangingthestructureof
demandforgoodsandservices;itdoesnotchangeitslevel.Asaconsequence,thelevelofeconomic
activityisnotimpactedbymonetaryincentivesandthewillingnesstohoardmonetaryinstruments.
148
Putintermsofthefinancialindustry,onemaythinkoffinancialmarketsandbanksasinstitutions
used by economic units to borrow and lend current production; finance is a market for
intertemporaloutput:
Itmaybesupposedintheorythattheentrepreneurborrowstheseconsumption
goodsfromthecapitalistsinkind,andthenpaysthemoutinkindintheshapeof
wagesandrents.Attheendoftheperiodofproductionherepaystheloanoutof
hisownproduct,eitherdirectlyorafterexchangingitforothercommodities.[]If
this procedure were adopted by all entrepreneurs who work with borrowed
capital,competitionwouldbringaboutacertainrateofinterestthatwouldhave
tobepaidtothecapitalistsintheformofsomecommodityorother.[]Nowif
moneyisloanedatthissamerateofinterest,itservesasnothingmorethanacloak
tocoveraprocedurewhich,fromthepurelyformalpointofview,couldhavebeen
carriedonequallywellwithoutit.(Wicksell1898,103104)
Assumeabartereconomyinwhichtheonlyproductispotatoesandinwhichworkersandother
incomeearnersarepaidinpotatoes.Someeconomicunitsmayhavetoomanypotatoesforcurrent
consumption,sotheysavepotatoes.Potatosaverscangointoamarketinwhichtheylendtheir
potatoestoeconomicunitswhoplantpotatoesthepotatoinvestors.Thefollowingyear,there
willbemorepotatoesthanwhatwasplanted,aseachpotatoisaseedthatcanbeusedtoproduce
morepotatoes,themarginalproductofpotatoes.Thismarginalproductisatthefoundationofthe
interestrateearnedbythepotatosavers;theirrewardismorepotatoesinthefuture,whichmeans
thatinterestandprincipalservicingcreatesanautomaticdemandforoutput(asdidpaymentof
wages).Monetaryconsiderationscanbeaddedtothisstory,buttheydonotaddanythingtothe
understandingofwhatgoesoninthefinancialindustry.Moneysupplyandotherfinancialclaims
arejustclaimsonproduction,thatis,themoneysupplyisameremediumofexchange.
Monetaryconsiderationsareirrelevantandtheobjectivesofagentsthatdeterminetheiractions
andplansdonotdependonanynominalmagnitudes.Agentscareonlyaboutrealthings,suchas
goods[]leisureandeffort(Hahn1982,34).Assuch,economicunitsstrivetogetinvolvedinthe
mostproductiveeconomicactivitiesinordertoproduceasmuchaspossibleinrelationtotheir
preferences.Marketsaretheretohelpthemdiscoverthemostproductiveeconomicactivitiesin
themostefficientway.Thiswayofthinkinggoesbackatleastto19thcenturyAustrianeconomists
suchasvonBhmBawerkandMenger.
Inmanycurrentmacroeconomicmodels,thisreasoningissimplifiedevenfurtherbygettingridof
any market and assuming a farmer who is both a saver and an investor (as well as
producer/consumerandemployer/employee).Hesavespotatoestodaytoplantthem.Theamount
he saves (and so invests) depends on the reward received to be next year. The reward is the
marginalproductofpotatoes.
FINANCEANDTHEECONOMY
Thisunderstandingoffinanceisgraftedtoaspecifictheoryofeconomicgrowth.Economicgrowth
isdrivenbysupplyfactors,i.e.thegrowthrateofinputs:physicalcapital(machines)andlabor.
Financehelpseconomicgrowthbecausetheabilitytoinvest(thatis,togrowphysicalcapital:Kt=
Kt1+It1)dependsontheabilitytosaveandthepointoffinanceistoallocatesavingsavingdrives
investment.
149
Goingbacktothepotatoeconomy,inordertohavemorepotatoesnextyear,oneneedstosave
moretoday.Saythatifoneplantsapotatoatyear0onegetstwopotatoesatyear1.Togetthree
potatoesatyear2,onemustnotconsumeoneandhalfpotatoesatyear1.Ofcourse,savingis
painfulbecauseonegetsfewerpotatoestoeat,sosavingmustberewarded(onemorepotatonext
year).Thequestionbecomes:istherewardworththepain?Thegraphicalwaytorepresentallthis
istheloanablefundsmarket(Figure11.1).
Figure11.1Theloanablefundsmarket
Economicunitsmeetinamarkettoborrowandlendcurrentoutput,potatoes.Thehigherthe
interest rate provided to reward saving, the more saving there is, i.e. the more economic units
reducetheircurrentconsumptionandsupplypotatoestoeconomicunitswhoinvest.Theinterest
rateneedstorisebecauseeachadditionalunitofsavingisincreasinglypainful.Theinterestrateis
ofcourseaphysicalreward,arealinterestrate,morepotatoesinthefuture.Savers/lendersare
notinterestedinmonetaryearningssotheircreditstandardsaresetinrealterms.
Theoppositegoesonwiththeplantersofpotatoes/borrowers.Theincentivetoinvestdecreases
astherewardtopayoutincreases.Thereasonforthatisfoundintheproductionprocess.Asmore
potatoesareplanted,thenutritivequalityofagivenquantityofsoildeclinesandsoeachadditional
potatoseedwillproducefewerpotatoes.Assuch,investorscanaffordtopayasmallerrewardfor
eachadditionalpotatothatisinvested.Intechnicalterms,themarginalproductofcapitalfallsas
morecapitalisusedintheproductionprocessgivenotherinputs.
Thegovernmentmaycomeinthemarkettoborrowrealresourcestoo:
The government's fundamental objective is to borrow a given amount of real
resources,notagivenamountofmoney.(Friedman1952,690)
This leads to the wellknown crowding out effect (Figure 11.2). As government enters the
loanable funds market, the real interest rate rises and private investment declines. Assume a
market without a government that is at equilibrium (Figure 11.1). As the government comes to
borrowpotatoes(Figure11.2),itcompeteswiththeprivatesectorforthecurrentquantityofsaved
potatoes.Asinanyotherwellbehavedmarket,ahigherdemandforsomethingincreasesthe
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priceofthatthing.Thisisthemarkettoborrowpotatoes,sotherealinterestrate(i/P)willriseuntil
themarketfindsanewequilibrium.Ahigherinterestratereducestheincentivetoinvest.
I<0
Figure11.2Thecrowdingouteffect
CONCLUSIONS
Intheend,financeisamereintermediarybetweensaversandinvestorsandwhatfinancedoesis
tohelpbarterintertemporaloutput.Thereareseveralconclusionsonecandrawfromthisview:
1 Theamountofcurrentinvestmentisconstrainedbytheamountofcurrentoutputthathas
been saved. To encourage more investment today, one must discourage present
consumption (that is, promote saving today), and saving allows the transfer of current
outputthroughtime:savingisjustdelayedconsumption.
2 Thewholepointoffinanceistoallocatesavingtothemostdeservinginvestmentprojects,
which are the ones who are involved in the most productive activities (the investment
projectswiththehighestmarginalproduct).
3 Banks are just intermediaries between savers and investors: banks lend unconsumed
outputonbehalfofsavers.
4 Whengovernmentdeficitspends,itdiscouragesinvestmentandsodiscouragesthegrowth
oftheeconomy.Governmentshouldavoiddeficitspending.
5 While the financial system works with money, money is just a veil, a mere medium of
exchange to smooth market mechanisms. What is really going on is the borrowing and
lending of current output. Monetary payments generated by financial contracts are
irrelevantforthecourseoftheeconomybecauseallcontractsarerealcontracts,thatis,
accountforinflationordeflationtomaintainpurchasingpowerconstant;Valorismprevails
(seeChapter15)
6 Theeconomyisalwaysatfullemploymentbecausesavingisjustdelayedconsumption,and
firmsknowthisgiventhatthereisamarketforintertemporaloutput(financialmarkets)
151
thatsignalsfutureconsumption.Assuch,adeclineincurrentconsumptiondoesnotlead
firms to reduce their production. Instead, firms increase their productive capacities to
respondtothehigherfuturedemandforgoodsandservicesinducedbythepaymentof
interestincome.
7 Monetary results are driven by real results: nominal interest rates are driven by the
marginal product of capital and expected inflation, economic growth is driven by the
growthofinputs
In the end, finance and its monetary dealings do not matter. The real exchange economy
perspective has changed slightly since the early 1990s. What makes finance matter are market
imperfections. Finance can specialize in circumventing imperfections such as asymmetries of
information.Inthatcase,financecanberationed,whichpreventstheoccurrenceoftheequilibrium
that would prevail under a perfectly competitive set up (fewer potatoes are saved and so
investment is lower than it would have been otherwise). Asymmetry of information can also
reinforcenegativeshocksontheeconomyandcreatefinancialcrises(seeChapter14).
THEMONETARYPRODUCTIONECONOMY
MONEYISEVERYTHING
Someeconomistsarguethatcapitalismisnotmerelyabartereconomywithmoney.Capitalismis
a monetary economy, that is, an economy in which allocation, production, and distribution are
influencedbymonetary/nominalincentives.Whileeconomicunitsmayadjustnominalrewardsto
accountforinflationandtaxes,thenominalgainsarenotdrivenbyunderlyingphysicalvariables.
Instead,itistheotherwayaround,nominaloutcomesdriverealoutcomes.
Assuch,whiletheREEviewseeslimitedornorolefortheinclusionofmonetaryconsiderationsin
itscoretheoreticalframework,Keynesnotedthatthisisatoddswiththewaycapitalismfunctions:
Theclassicaltheorysupposesthat[]onlyanexpectationofmoreproduct[]will
induce [an entrepreneur] to offer more employment. But in an entrepreneur
economy this is a wrong analysis of the nature of business calculation. An
entrepreneur is interested, not in the amount of product, but in the amount of
money which will fall to his share. He will increase his output if by so doing he
expectstoincreasehismoneyprofit,eventhoughthisprofitrepresentsasmaller
quantityofproductthanbefore.[]Thustheclassicaltheoryfailsusatbothends,
sotospeak,ifwetrytoapplyittoanentrepreneureconomy.Foritisnottruethat
theentrepreneursdemandforlabourdependsontheshareoftheproductwhich
willfalltotheentrepreneur;anditisnottruethatthesupplyoflabordependson
theshareoftheproductwhichwillfalltolabour.(Keynes1933c(1979):8283)
Monetary considerations are crucial at the beginning and at the end of the economic process.
Businesses need monetary instruments to start the production process because employees and
sellersofrawmaterialdemandmonetarypayments.Businessesjudgetherelevanceofaneconomic
activityandsoemploypeopleinthisactivityinrelationtoitsabilitytogeneratealargeenough
monetaryprofit.Firmsandtheiremployeesarenotinterestedinconsumingwhattheyproduce;
theyareinterestedinsellingtheirproductionformonetarygains.Goingbacktoourpotatofarmer,
152
his employees do not want to be paid in potatoes and the farmer is not merely interested in
producingpotatoes.Assuch,evenifanindividualishighlymotivatedandhighlyexperiencedin
producing potatoes (his marginal product is very high), the individual will not be hired if it is
expected that the output he will produce cannot be sold at a high enough price. Indeed, while
lowering the price of potatoes may allow to sales more of them, deflation comes with its own
problemsgiventheexistenceofdebtsthatrequirefixedmonetarypayments(seeChapter14).
Thus, monetary incentives have a strong influence on the level and organization of production.
Veblenmadethispointthatbyfocusingonthedifferencebetweentheengineersperspectiveand
the businessmans perspective. From an engineers perspective, the goal is to produce as many
potatoesaspossibletosolveaphysiologicalproblem(hunger).Assuch,thegoalistofindthemost
efficientwaystoproduceanabundanceofpotatoes.Fromabusinessmansperspective,theonly
thingthatmattersisthatamonetaryprofitbegenerated.Thismayentailasabotageofproduction
(leaving fields idle, letting potatoes rot) in order to maintain an artificial scarcity of potatoes.
Indeed,capitalisttechniquesofproductionaresoproductivethatlettingthemloosewoulddrive
thepriceofpotatoestozero.Thesupplyofpotatoesmustbeconstrained.Inaddition,thedemand
side must constantly be aroused to create new needs and wants because people do not have
naturally unlimited preferences. They get contented quickly unless invidious comparisons and
consumptionhabitsareconstantlystimulatedthroughadvertisementandothermeans.Assuch
scarcityisnotanaturalstate;itisratherarequirementofaneconomythatismanagedbycapitalist
businesses.2Whileabundanceispossible,itisnotaviableeconomicstateforcapitalism.
WHY MONETARY INCENTIVES MATTER? AND WHAT ARE OTHER

IMPLICATIONS?
Partoftheansweristhatbanksareinthebusinessofdealingwithpromissorynotesthatinvolve
monetary payments not inkind payments. Another has to do with states involvement in the
monetization of economies via the imposition of monetary dues.3If one focuses on the role of
banks,theemphasisonmonetaryincentivesisinitiatedattwostagesofcreditoperations:
1 Banksjudgeabilitytopaybasedoncreditstandardssetinmonetaryterms(seeChapter8):
a normal nominal debt service to monetary income, or normal nominal value of
collateralrelativetobankadvances,anormalnominalamountofliquidassets.
2 Debtorstoabankmustmakepaymentsinmonetaryterms;theycannotpaybankswith
potatoes.
Beyond the impact on incentives, bank operations have several important macroeconomic
implications:
1 Banksarenotconstrainedbythelevelofcurrentsavingtograntcredit.AsnotedinChapter
10,banksarenotinthebusinessoflendinganythingtheyown.Theydonotlendother
peoplesmoney,they donotlendreserves,andtheydonotlendpotatoesonbehalfof
savers;notevenasif.
2 Servicingthedebtsduetobanksdoesnotcreateanautomaticdemandforcurrentoutput:
paymentstobanksdestroymonetarygainsofnonbanks(seeChapter10);thatisit.Again
therearenosaversbehindbanksaskingfortheirpotatoesbackwithinterest(inpotatoes).
153
3 The expected demand for goods and services becomes key to economic activity. Firms
employworkersanduseexistingproductivecapacitiesonlyiftheybelievetheywillbeable
toselltheirproducttomakeahighenoughmonetarygains.
4 In this type of economy, purchasing power concerns, even though relevant, are usually
outweighedbyliquidityandsolvencyconcerns.Economicagentsarehappieriftheirbuying
powerincreasesbut,usually,economicagentspayalotmoreattentiontobalancesheet
risks: Liquidity is a fundamental recurring problem whenever people organize most of
theirincomereceiptandpaymentactivitiesonaforwardmoneycontractualbasis.Forreal
world enterprises and households, the balancing of their checkbook inflows against
outflowstomaintainliquidityisthemostseriouseconomicproblemtheyfaceeverydayof
theirlife.(Davidson2002:78).Saythatworkerslaborforonehourandearnawagerate
ofw=$5,andthattheyhavetopayadebtcommitmentofCC=$2eachmonthtoservice
their debts, and assume that the general price level is P = $1. The real wage earned by
workersisw/P=5andthenetwageofworkersiswCC=$3.Assumethatworkersgeta
raise that doubles their wage so that w = $10, and that the general price level is also
doubledP=$2.Therealwageisunchangedbutthecapacityofworkerstomeettheirdebt
commitmentsismuchimproved,wCC=$8.
5 Neutrality is [] restricted to the realm of helicopter economics (Gale 1982: 15). In
capitalism,banksdonotsuddenlyallocatedbagsofmoneywithwhichindividualsdonot
knowwhattodo;monetarycreationbybanksisendogenoustotheeconomicprocess.In
addition, bank monetary creation comes with a simultaneous creation of a debt that
requiresmonetarypayments(seeChapter10).Thesemonetarypaymentsforceeconomic
unitstofocustheirattentiononmonetaryconsiderationsintheirdecisionmakingprocess.
OnecanextendthatpointtomonetarycreationbytheTreasuryviafiscalpolicy.Automatic
stabilizers generate an endogenous monetary creation by the state that comes with a
simultaneouscreationofnetfinancialwealth(seeChapter13).Thestatealsoimposesof
taxliabilitiesthatinvolvesfuturemonetarypayments(seeChapter15).
6 Eliminatingamarketsurplusbyloweringoutputpricesmaynotbeaviablesolution.Firms
must make sure that they can sell their output at a high enough price to generate a
monetarygainthatallowthemtopaytheircreditorsandtorealizeamonetaryprofit.If
prices fall too much, a debtdeflation occurs and market mechanisms promote financial
instability(fallingpricesleadtohighersurplusesofoutput)(seeChapter14).
7 Current saving does not incentivize current investment; saving discourages investment:
Firm will not invest if current spending (and so sales) is falling. Saving is not delayed
consumptionbecausesaversarenotpaidinkind.Thisisallthemoresogiventhatafallin
salesleadstolayoffsandsolossesofincomebyemployees.
Thus,economicgrowthisdrivenbydemandconditionsbecauseofmonetaryconsiderations.As
such,expectedsalesareusuallytoolowtojustifyemployingeverybodywillingtowork,sothereis
achronicunderemploymentofresources.Inaddition,thereisnogivenstateoftheeconomyout
there(anaturalgrowthrate)thatisindependentofcurrentdemandconditions.Ifproductive
capacitiesbecometooheavilyused,firmsinvest.
FINANCEANDTHEECONOMY
154
Thefirstphaseoftheeconomicprocessistoaskforcreditatbanks(thefinancingphase).Therole
ofbanksistojudgeiftheexpectationsoffirmsarereasonable(seeChapter8).Banksprovidecredit
to anybody who shows up and is deemed creditworthy. The standards of creditworthiness
accommodatearangeofeconomicunits(thinkeconomicunitswithdifferentcreditscores).Banks
chargemoretolesscreditworthyeconomicunitsandrationcredit(Figure11.3).
Figure11.3Themarketforbankcredit
Once they have been granted credit, businesses can buy the resources needed to start the
productionrequiredtomeettheexpecteddemand.Willthatraiseinflation?Chapter12notesthat
ifthegrowthofcreditraisestheoutputgaporpushesupthegrowthrateofunitcostoflaborthen
yes;however,usuallytheeconomyoperatesbelowfullemploymentandcanadjusttoanincrease
inthewagebillandspending.
Thenextstep(thefundingphase)istosellwhatwasproduced.Ifexpectationsarecorrectorare
toopessimistic,thenalloutputissold;otherwisetherearesomeinventories.Oncetheyhavesold
theirproduct,firmsrepaytheirdebtstobanks.Oncedebtsandexpenseshavebeenpaid,firms
realizeaprofit,thatis,theirnetworthrises.Ifmonetarygainsarenotrealizedoraretoosmall,a
business may ultimately close. Households also save some of the incomes they received, which
increasestheirnetworthbutreducesfirmspotentialprofits.Firmsmaytrytocapturesomeofthe
income saved by households by issuing securities to fund the acquisition of assets and/or to
refinancetheirdebts.
Thus, saving is the end result of the economic process not the beginning. It matters during the
fundingphasebutnotthefinancingphase.Atthattime,likeatanyothertime,interestratesare
driven by monetary conditions. One of these monetary conditions is the policy rate of the Fed,
whichhasastronginfluenceonallothernominalratesthroughcostandportfoliochannels(andof
course,economicunitsdocareaboutnominalinterestratesbecauseoftheirimpactonliquidity
andsolvency).4Assuch,governmentdeficitandinvestmentmaynothavemuchofanimpacton
interestrates.
BEYONDINCENTIVES:THEROLEOFMACROECONOMICFORCES
Whilemonetaryincentivesarecentraltothedynamicsatplayinacapitalisteconomy,theMPE
approachalsoarguesthatonecannotusemicroeconomicanalysistodrawconclusionsaboutthe
155
economyas awhole.Byrelyingonconclusionsdrawnfromstudyinghoweconomicunitsmake
decisionsinisolation(microeconomy),onemissesthefinancialinterdependencesthatexistamong
economic units. When these financial interdependences are taken into account, they lead to
counterintuitiveconclusionsrelativetopersonalexperiences.
Forexample,attheindividuallevel,incomeisindependentofspending(ahouseholddoesnotearn
moreifitshopsmore);howevernationalincomeisnotindependentofspending.Themoreisspent,
themoreisearned:GDP=C+I+G+NX.Tosimplify,themorepeopleshop,themorepeopleare
employedandsothegreaterthenumberofpeoplewhodrawanincome,andsothehighernational
income.Whensomeonespends,thatcreatesincomesforothers.
Assuch,savingcannotbethebeginningoftheeconomicprocessforaneconomy.Incomeallows
saving,but,atthemacroeconomiclevel,spendingcreatesincomeandsospendingcreatessaving.
The Kalecki equation of profit more is a neat way to show that for business saving. National
accountingidentitiestellusthatgrossdomesticproductcanbedeterminedinthreeways,twoof
whicharetheincomeapproachandtheexpenditureapproach:
W+Z+UnD+TUC+I+G+NX
WithUgrossprofitoffirms,UnDthedisposablenetprofitoffirms(i.e.profitafteraccountingfor
businessincometax,distribution,andsubsidies),Wemployeescompensations,Zthegrossnon
wageincomespaidbyfirms(dividends,interests,rentalincome),andTUbusinessincometax(tax
onprofit),Ctheconsumptionlevel,Ithelevelofinvestment,Gthelevelofgovernmentspending,
andNXnetexports.Accountingfornettaxpaymentsinducedbytaxesandtransferpaymentsinall
sectorsonegets:
WD+ZD+UnDC+I+DEF+NX
WiththesubscriptDindicatingdisposableincome(i.e.aftertaxandtransferpayments),andDEF
thegovernmentbudgetdeficit(includingtransferpayments).SubtractingWD+ZDfromeachside
anddefiningCUastheconsumptionoutofdisposablenetprofitonehas:
UnDCUSH+I+DEF+NX
WithSH(=SW+SZ=(WDCW)+(ZDCZ))thesavinglevelofhouseholds(wageearnersandrentiers).
Kalecki argues UnD is not under the control of firms, whereas variables on the right side
(expenditures)dependondiscretionarychoices,sothecausalityrunsfromspendingtoprofitso:
UnD=CUSH+I+DEF+NX
Morespendingleadstomorebusinesssaving(profit).
SavingisclearlydifferentiatedfrominvestmentcontrarytotheREEapproach.Savingisanincrease
innetworth;itisfinancialaccumulation(seeChapter1).Itisdifferentfromphysicalaccumulation,
which is investment. In the REE approach saving and investment are the same thingphysical
accumulation. For the MPE approach, this is not appropriate because capitalist economies are
monetaryeconomiessoincomeisearnedinmonetaryformandsavingisdoneinmonetaryform.
More importantly, at the macroeconomic level, it is not possible to transfer national income
throughtimebysavingit.Indeed,giventhatnationalincomeisdrivenbyspending,asthriftiness
goesupnationalincomefalls.Theonlywaytotransferincomethroughtimeisbyinvestingit,i.e.
bybuyinggoodsandservicesforthepurposeofmaintainingorincreasingproductivecapacities;
156
however,notconsuming(saving)depressesinvestment.Ifpeopleconsumefewerpotatoes,there
isnoincentivetoplanttheresultingexcessinventoryofpotatoestoproducemorepotatoes.
CONCLUSIONS
Moneysupplyisneverneutralinamonetaryproductioneconomy.Themoneysupplyisnotonly
usedasamediumofexchangebutalsoasameansofpayment,soitmustbepresentateverystep
oftheeconomicprocessforthatprocesstoworksmoothly.Severalconclusionscanbedrawnfrom
thisview:
1 Thereisnosavingconstraintontheeconomicsystem.Atthemacroeconomiclevel,saving
iscreatedbyspending.
2 Thefinancialsystemexiststoprovidefinancialresourcestothemostprofitableeconomic
activities.Theseactivitiesmayormaynotbeproductive,mayormaynotbeefficient,may
ormaynotbeuseful;thesecriteriaarenotrelevanttothedecisiontoprovidefunds.The
financializationoftheeconomyhaspushedbusinessesawayfromtheproductionofgoods
andservices(seeChapter8).
3 Banksarenotintermediaries:theydonotlendonbehalfofsavers.Abankdoesnotlend
anything to nonbank, it is not a potato lender nor a money lender; it is a dealer in
promissorynotesthatrequiremonetarypayments(seeChapter10).
4 Whengovernmentincreasesdeficitspending,itboostssalesandcreatesmoremonetary
income,whichpromoteseconomicactivityunlesstheeconomyisatfullemployment(in
whichcasepricesgoup).Thereisnocrowdingouteffectfromgovernmentdeficitsbecause
financeisnotalimitedresource(itisnotbasedonsaving)andproductionisdemanddriven
(ifgovernmentdemandsmoreoutput,moreisproduced).
5 Monetaryincentivesarecrucialbecausedebtsowedtobanksandgovernmentcreatea
need to have reliable streams of future monetary incomes; Nominalism prevails (see
Chapter15).
6 Theeconomyisusuallybelowfullemploymentbecauseitusuallygoesagainstmonetary
incentivestobeatfullemployment(itisnotprofitable,orasprofitable,inmoneyterms).
Promoting thriftiness discourages economic activity because profit declines as sales
decline.Amarketforintertemporaloutputdoesnotexist.
7 Real results are driven by monetary results: Anything that is monetarily profitable and
anyone who meets standards of creditworthiness will be financed. The financing stage
allows the creation of output, and the output is used potentially to increase productive
capacitiesduringthefundingstage.
Beyondalltheseimplications,Chapter13showsthateconomicactivityrequiresthatatleastone
economicsectorgoesintodebtforeconomicactivitytoproceed.
CONCLUSION
The way one should include finance into economic analysis is subject to sharp divisions among
economists.Thesedivisionsultimatelyrestofverydifferentpremisesusedtodoeconomics.This
157
divisionisoldandcanbefoundindebatesbetweenMalthusandRicardointheearlypartofthe
19thcentury:IcannotagreewithAdamSmith,orwithMr.Malthus,thatitisthenominalvalueof
goods, or their prices only, which enter into the consideration of the merchant (Ricardo 1820
(1951):26).Thesedifferentpremisesleadtoverydifferentpolicyprescriptionsthatrestonavery
differentunderstandingofhowthefinancialsystemworkswiththerestoftheeconomy.Chapters
15and16showsthatmanyofthesedifferencescanbeboileddowntoadifferentunderstanding
ofthenatureofmonetaryinstruments:FortheREE,monetaryinstrumentsareamerecommodity
andsodemandingmoneyisalsodemandingoutput;forMPE,monetaryinstrumentsarefinancial
instruments.
1Theeconomicprofessioncanbedividedaccordingtothepremisesitusesregardingtheroleof
monetary incentives and monetary outcomes on the direction of economic activity. The real
exchangeeconomyviewarguesthatmonetaryaspectsareirrelevant,exceptforimperfections,and
thatcapitalismcanbeunderstoodwithoutincludingmonetaryaspects.Themonetaryproduction
economicviewarguesthatmonetaryaspectsarecrucialandmustbeincludedatthebeginning,the
middleandtheendoftheanalysisofcapitalisteconomies.
2Intherealexchangeeconomy,creditstandardsaresetinrealterms,financeisconstrainedby
the amount of output saved, and finance is about moving output through time by incentivizing
peoplenottoconsume.Theeconomyisagiantmarketforcurrentandfutureoutputandtherole
offinanceistoallocateoutputbetweenthepresentandthefuture.
3Intheintertemporalmarket,ifgovernmentborrowsrealresourcesthenitremovesaccessto
realresourcesbytheprivatesector,whichcrowdsoutinvestment.Thereisagivensizeofoutput
andanyusebyoneeconomicunitisattheexpenseofothers.
4Monetaryinstrumentsareameremediumofexchange;theyhelptomaketransactionsmore
efficientbuttheydonotalterthestructureoftransactions,whichisdeterminedbyrelativeprices.
5Inthemonetaryproductioneconomy,creditstandardsaresetinnominalterms,financeisnot
constrainedbysavingofoutputorbysavingbydepositorsofcash.Thereisnowaytotransferreal
outputbysavingit,i.e.bynotconsumingit.Adeclineinconsumptiondepresseseconomicactivity
soreducescurrentoutputandfutureoutput.Theonlywaytotransferoutputthroughtimeisby
investing, but investment is not constrained by saving and is discouraged by thriftiness. Put
differently,thesizeofthepieisnotfixedsomoredemandleadstomoreoutput;andifindividuals
increasetheirthriftinessthensalesfallandthatdiscouragestheexpansionofproductivecapacities.
6 Given that monetary aspects are crucial in the monetary production view, the economy is
demandlednotsupplyled.Salesdriveproductionnottheotherwayaround,soadeclineinsales
(highersaving)leadstoadeclineinproduction.
7 There are two phases of economic activity: the financing phase and the funding phase. The
formerinvolvesthefinancialsectorintheproductionofoutput;thelatterinvolvesthefinancial
sectorintheacquisitionofoutput.Savingiscreatedbyincomeandincomeisfinancedbycredit;
therefore,savingcannotexistbeforecredit.Savingmayhavearoletoplayinthesecondphaseby
reducingthedemandforcurrentoutputandbyprovidingadditionalfinancialfundstoacquirelong
termassets.
7 This difference of opinion about how do to do economics is old and involves very different
paradigms.
158
Keywords
Crowding out effect, intertemporal output, saving, investment, credit standards, demandled,
supplyled,financingphase,fundingphase
ReviewQuestions
Q1:Whatisthecrowdingouteffectandhowdoesitwork?
Q2:Whataretheargumentsagainstthecrowdingouteffect,bothintermsofresourcesaswellas
finance?
Q3:Whydoessavingnotleadtoadeclineineconomicactivityintherealexchangeeconomy?Why
doesitdosointhemonetaryproductioneconomy?
Q4:Whatisthefinancingphase?Howisfinanceinvolvedinthatphase?Whataboutthefunding
phase?
Q5:Doesinvestmentcreatesavingordoessavingcreateinvestment?
Q6:Issavingneededforbankingorisitnot?
Q7:Iseconomicactivitydemanddrivenorsupplydriven?Howisthatrelatedtotheviewsregarding
theroleoffinanceintheeconomy?
Q8: According to John Maynard Keynes: Dishoarding and credit expansion provides not an
alternativetoincreasedsaving,butanecessarypreparationforit.Itistheparent,notthetwin,of
increasedsaving.Explainthatsentencebyusingthemonetaryproductioneconomyview.
Q9: In order to promote economic growth, should policymakers promote saving or should they
promotespending?
Q10:Ifeconomicunitssuddenlyincreasetheirwillingnesstohoardmonetaryinstrument,willthat
lowereconomicactivity?Why?Whynot?
Suggestedreadings
Chapter1ofCapitalismandFreedombyMiltonFriedmanisaveryclearandconcisepresentation
oftherealexchangeeconomyframework.
Dudley,D.(1980)AMonetaryTheoryofProduction:KeynesandtheInstitutionalists,Journalof
EconomicIssues14(2):255273.
Dugger,W.M.andPeach,J.T.(2008)EconomicAbundance:AnIntroduction,Armonk:M.E.Sharpe.
Keynes,J.M.(1933)Thecharacteristicsofanentrepreneureconomy,reprintedinD.E.Moggridge
(ed.)(1979)TheCollectedWritingsofJohnMaynardKeynes,vol.29,87101,London:Macmillan.
1SeeGertler,M.(1988)Financialstructureandaggregateeconomicactivity:Anoverview,JournalofMoney,Creditand
Banking,20(3),Part2:559588.
2SeeGalbraithsAffluentSociety,especiallyChapters10,11and13.
3Forstater,M.(2005)TaxationandPrimitiveAccumulation:TheCaseofColonialAfrica.InTheCapitalistStateandIts
Economy:DemocracyinSocialism,ResearchinPoliticalEconomy,Volume22,5165.
4Tymoigne,E.(2006)Fisher'sTheoryofInterestRatesandtheNotionof'Real':ACritique,LevyEconomicsInstitute,
WorkingPaperNo.456http://www.levyinstitute.org/publications/fishertheoryofinterestratesandthenotionofreal
159
CHAPTER 12:
Howeconomistsaredividedaboutwhatcausesinflation
Whyinflationoccursaccordingtodifferentapproaches
Whatthepolicyimplicationsareofthedifferentviewsofinflation
CHAPTER12:INFLATION
Wheninflationismentioned,itisusuallyinrelationtothecostofbuyingnewlyproducedgoods
and services for consumption purposes. Another type of inflation concerns asset prices, i.e. the
priceofnonproduciblecommoditiesandoldproduciblecommodities.ThisChapterdoesnotstudy
assetprice inflation, which concerns theories of interest rate. There are two broad ways to
categorize existing explanations of inflation (and deflation); monetary explanations and real
explanations(realmeansrelatedtoproduction).Belowaretwopopulartheoriesbasedonsuch
acategorization.
THE QUANTITY THEORY OF MONEY: MONETARY VIEW OF

INFLATION
Thequantitytheoryofmoney(QTM)isalogicalextensionoftherealexchangeeconomyframework
presentedinchapter12.ItstartswiththeidentityMVPQwithMthemoneysupply,Vthevelocity
ofmoney(thespeedatwhichthemoneysupplycirculatestocompleteallnecessarytransactions),
P the price level, and Q the quantity of output. The identity is a tautology; it just says that the
monetaryvalueoftransactionsongoodsandservices(PQ)isequalthemonetaryvalueoffinancial
transactionsneededtocompletethetransactionsongoodsandservices.Togetatheoryofoutput
price (the QTM), one must make some assumptions about each variable and make a causal
argument.TheQTMassumesthat:
H1:Misconstant(orgrowsataconstantrate)andiscontrolledbythecentralbankthrough
amoneymultiplier(seeChapter10).
H2:Visconstant(habitsofpaymentsarestable).
H3:Qisconstantatitsfullemploymentlevel(Qfe)orgrowsatitsconstantnaturalrate
(gQfe). Supply conditions (productive capacities) are supposed to be independent of the
demandconditions(spendingongoodsandservices).
Giventhissetofhypotheseswehave:
P=MV/Qfe
Or,intermsofgrowthrates(Visconstantsoitsgrowthrateiszero):
gP=gMgQfe
Ifthemoneysupplygrowsfasterthanthenaturalrateofeconomicgrowth,thereissomeinflation
(gP>0).IfgM=2%andgQfe=1%thengP=1%.Ifthecentralbankincreasesthegrowthrateofthe
moneysupply,inflationrisesbythesamepercentagepointswhilethegrowthrateofproductionis
unchanged.Inflationhasmonetaryorigins.
Theeconomiclogicisthefollowingintermsofpricelevel.First,supposesomemoneyfallsintothe
handsofeconomicunits.How?MiltonFriedmanisfamousforarguingthateconomistsdonotneed
tocareabouthowthemoneysupplyenterstheeconomy;onecanmerelyassumethatitfallsfrom
ahelicopter.FollowingH1,onemaysaythatthecentralbankinjectsreserves,whichleadstoalarge
increaseintheamountofbankcredit.
Sonoweconomicunitshaveadditionalmonetaryinstruments.TheycouldsavethembutH2implies
that economic units have hoarded everything they wanted to hoard so economic units rush to
storestospend.Giventhattheeconomyisatfullemployment,theonlywaytheeconomicsystem
161
CHAPTER12:INFLATION
canadjusttothelargeincreaseinthe demandforgoodsandservicesisthroughan increasein
prices.Moneyisneutral,itdoesnotimpactproduction.
Themainpolicyimplicationisthatcentralbanksarebestsuitedtotackleinflationaryproblems,
while productive issues are best left to relative price adjustments via market mechanisms. The
centralbankcanmanageoutputpricesbytargetingthequantity(growthrate)ofreservesandby
settingthereserverequirementratio.Thiswillconstrainthequantity(growthrate)ofthemoney
supplyandsetaspecificpricelevel(inflation).Controllinginflationisaneasyjob;acentralbank
justneedstodecidewhatitsinflationtargetis(gPT)andtodeterminewhatthenaturalgrowthrate
oftheeconomyis(gQfe).If,forexample,acentralbankhasaninflationtargetofgPT=2%andthe
naturalgrowthrateoftheeconomyisgQfe=3%,thegrowthrateofthemoneysupplyshouldbegM
=5%.Assumingastablemultiplier,thismeansthatthegrowthrateofreservesshouldbe5%.
This argument has been extended to a central bank that targets an interest rate. Most central
bankersnowrecognizethatmonetarystimulusisnotneutralintheshortterm,hencetheabilityto
finetunetheeconomythatis,tomakesuretheeconomyisneithertoohot(risinginflation)nor
toocold(risingunemployment)throughaninterestratepolicy.However,inthemediumtolong
run, the neutrality of money is argued to prevail, hence the importance of inflation targeting.
Central bankers can use that to guide their shortrun policy. Central banks should determine a
referencevalueforthegrowthofmoneysupply(gM*).Thisvalueshouldbeconsistentwiththe
inflationtarget(gPT),theprevailingnaturalgrowthrate,andtheexistingtrendofvelocity(gV):
gM*=gPT+gQfegV
IfgM>gM*,acentralbankistoolax(i.e.,itsinterestratetargetshouldbehigher)andinflationwill
beabovetargetinthemediumterm.
There are several issues with that approach that relate to the hypotheses made to reach the
conclusion,andtothecausalityatplay:
Themoneysupplyisnotcontrolledinanywaybythecentralbank.Notonlydoesthemoney
multipliertheorynotapply,butalsothegrowthofthemoneysupplyisdrivenprimarilyby
thedemandforbankcreditbyprivateeconomicunits(bankscannotforcefeedcreditto
economicunits)andbygovernmentspendingandtaxing(seeChapter10andChapter6).
Interestratetargetinghasonlyaremoteanduncertaineffectonthegrowthofthemoney
supply,evenmoresooninflation(seeQ.10inChapter5).
Theeconomyisrarelyatfullemploymentsoifthedemandforgoodsandservicesincreases
thesupplyofgoodsandservicesincreases.
Measuringthenaturalgrowthrateoftheeconomyisactuallydifficult.Moreimportantly,
the demand for goods and services and the supply of goods and services are not
independent factors. Demand matters even in the long run. 1 Greenspan put it nicely
duringanFOMCmeeting:
LetmejustsayverysimplythisisreallyarepetitionofwhatIvebeen
sayinginthepastthatwehaveallbeenbroughtuptoagreaterorlesser
extentonthepresumptionthatthesupplysideisaverystableforce.[]
In my judgment our models fail to account appropriately for the
interactionbetweenthesupplysideandthedemandsidelargelybecause
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CHAPTER12:INFLATION
historically it has not been necessary for them to do so. (Greenspan,
FOMCmeeting,October1999,pages4647)
In terms of basic empirical evidence, the strong correlation between money supply and
pricethatoneshouldexpectwerethistheorytobecorrectdoesnotexist,eveninthelong
run (Figures 11.1 and 11.2). While correlation improves as the length of time increases
(oneyearcorrelationis0.55,fiveyearcorrelationis0.67,tenyearcorrelationis0.71),the
correlationisweakerthanwhatthetheorysuggests.
Thefactthatinflationandmoneysupplygrowtharepositivelycorrelateddoesnottellus
thedirectionofcausality.OnemaydoubtthatthecausalitygoesfromMtoPgiventhe
strong assumptions required for that to be the case. The next section will develop this
point.
Figure12.1AnnualgrowthrateofCPIandofthemoneysupply,percent
Sources:BureauofLaborStatistics,BoardofGovernorsoftheFederalReserveSystem.
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CHAPTER12:INFLATION
Figure12.2FiveyeargrowthrateofCPIandofthemoneysupply,percent
Sources:BureauofLaborStatistics,BoardofGovernorsoftheFederalReserveSystem
INCOMEDISTRIBUTIONANDINFLATION:ANONMONETARY
VIEWOFINFLATION
Anothertheoryofthepricelevelstartswithanidentitygroundedinmacroeconomicaccounting:
PQW+U
ThisistheincomeapproachtoGDP.ItsaysthatnominalGDP(PQ)isthesumofallincomes.For
simplicity,thereareonlytwoincomes:wagebill(W)andgrossprofit(U).Allofthemaremeasured
beforetax.DividebyQoneachside:
PW/Q+U/Q
Wisequaltotheproductoftheaveragenominalwagerate(w)andthenumberofhoursoflabor
(L):W=wL(forexample,ifwis$5perhourandLisequalto10hours,thenWisequalto$50).
Thus:
PwL/Q+U/Q
Q/Listhequantityofoutputperlaborhour,theaverageproductivityoflabor(APL):
Pw/APL+U/Q
w/APListheunitcostoflabor.U/Qisamacroeconomicmarkupoverthelaborcost.Togettoa
theory,thefollowingassumptionsaremade:
164
H1:theeconomyisusuallynotatfullemploymentandQ(andeconomicgrowth)changes
withexpectedaggregatedemand(thisisKeynesstheoryofeffectivedemand).
CHAPTER12:INFLATION
H2:wissetinabargainingprocessthatdependsontherelativepowerofwageearners
(theconflictclaimtheoryofdistributionunderliesthishypothesis)
H3: U, the nominal level of aggregate profit, depends on aggregate demand (Kaleckis
theoryofprofitunderliesthishypothesis,seebelow)
H4:APLmoveswiththeneedsoftheeconomyandthestateoftheeconomy;itisprocyclical
tothestateofaggregatedemandforgoodsandservices.2Ingeneral,inperiodsoflabor
time scarcity gAPL goes up while, during an economic slowdown, gAPL goes down before
employeesarelaidoff.
Thus:
P=w/APL+U/Q
Thepricelevelchangeswithchangesintheunitcostoflaborandthesizeofthemacroeconomic
markup.Intermsofratesofgrowth:
gp(gwgAPL)sW+(gUgQ)sU
WithsWandsUthesharesofwagesandprofitinnationalincome(sW+sU=1).Thus,inflationhas
twosources:
Costpushinflation:thegrowthrateoftheunitlaborcostoflabor(gwgAPL)dependson
how fast nominal wage grows on average relative to the growth rate of the average
productivityoflabor.Thecorrelationbetweentheunitcostoflaborandinflationisvery
strongbothintheshortrun(0.82foryearlygrowthrates)andlongrun(0.93forfive
yeargrowthrates)(Figure12.3).
Demandpullinflation:UfollowsKaleckisequationofprofitwhichstatesthatthelevelof
profitintheeconomyisafunctionofaggregatedemand(seeChapter11).Thus,theterm,
gUgQrepresentsthepressuresofaggregatedemandontheeconomy;itisanoutputgap.
IfgU(thegrowthofaggregatedemand)goesupandgQ(thegrowthofaggregatesupply)is
unchanged,thengPrisesgiveneverythingelse.However,toassumethatgQisconstantis
not acceptable unless the economy is at full employment. Usually, a positive shock on
aggregatedemandgrowthleadstoapositiveincreaseinaggregatesupplygrowthbecause
therateofutilizationofproductivecapacitiesisbelowone(thatis,lessthan100%)evenin
thelongrun.
Notethatthemoneysupplyisabsentfromthisequation.Themoneysupplydoesnotdirectlyaffect
outputprices.Spendingmayimpactinflationbutitdependsonthestateoftheeconomy.
Onemaynotethatthegrowthrateofwagesisbyitselfnotasrelevant.Itisitsrelationtothegrowth
rateoftheaverageproductivityoflaborthatmatters.Timeseriesdataprovidesanotherinsight
intotheroleoftheunitcostoflabor(Figure12.4).Fromthemid1960stotheearly1980s,unitcost
oflaborwasamainsourceofhighinflation.Nominalwagegrowthoutpacedproductivitygrowth;
bothgrewonaverage.Theformerwasinthe510%rangewhereasthelatterwasmostlyinthe0
5% range. In the late 1960s, wage growth outpaced productivity growth because of workers
strengthinwagebargainingduetolowunemploymentandstrongunions.The1970soilshocks
boosted inflation and workers tried to maintain their real wage (they failed) by demanding an
increaseinnominalwages.Thisfurtherreinforcedinflationbecauseproductivitycouldnotkeepup
withwagedemands.Theinternationalizationofproductionprocessesandthedeclineinthepower
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CHAPTER12:INFLATION
ofunionshavetamedtheabilityofwagestooutpaceproductivity,eveninperiodsofprolonged
economicgrowth.
Figure12.3AnnualgrowthrateofunitcostoflaborandgrowthrateofPCE,percent
Sources:BureauofEconomicAnalysis,BoardofGovernorsoftheFederalReserveSystem
Figure12.4.UnitcostoflaborgrowthrateandPCEinflation,percent
Sources:BureauofEconomicAnalysis,BureauofLaborStatistics
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CHAPTER12:INFLATION
WhencombinedwiththeexplanationofmonetarycreationpresentedinChapter10,thistheoryof
inflationprovidesanexplanationofthecorrelationbetweenpriceandmoneysupplythatinvolves
a reversed causality compared to the QTM. Higher costs of production and higher demand
pressurespushupthepriceofgoodsandservices,whichincreasesthesizeofthebankadvances
thateconomicunitsrequest:higherP(gP)leadstohigherM(gM).
Abroaderpointisthatthegrowthofthemoneysupplyisnotbyitselfinflationarybecausemoney
supplygrowswiththeneedsoftheeconomicsystem;economicunitsarenotsuddenlyallocated
bagsofmoneysupplywithwhichtheydonotknowwhattodo:
Firmsrequestbankcredittostartproduction(payworkers,buyrawmaterial)andrepay
their bank debts (which destroys money supply) once production is sold: money supply
movesinpartwiththeneedoftheproductivesystem
Federalgovernmentspending(thatinjectsmoneysupply)andtaxing(thatdestroysmoney
supply) move automatically in a countercyclical fashion to tame inflationary pressures
(automaticstabilizers):duringanexpansion(arecession),thegrowthrateofgovernment
spending falls (rises) and the growth rate of taxes rise (falls). In the US, most of the
automaticstabilizereffectcomesfromwildfluctuationsinthegrowthrateoftaxes(ina
recessioneconomicunitshavelessincomesotheyaretaxedless)(Figure12.5).
Sothemoneysupplyisnotsomethingthatfallsfromthesky,itsinjectionanddestructioninrelation
totheproductionprocessmustbeexplainedandthedebtsincurredbymonetarycreationmustbe
included in the analysis (See Chapter 10). If the economy is growing, money supply grows, if
economicunitsdonotwanttoholdmonetaryinstrumentstheymayjustusethemtoaccelerate
therepaymentoftheirbankdebts.
Figure12.5Automaticstabilizers.
Source:BureauofEconomicAnalysis.
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CHAPTER12:INFLATION
Intermsofpolicy,thetheorymeansthatinflationismanagedbestby bufferstock policies and
incomepolicies,oracombinationofbothsuchasajobguaranteeprogram.3Monetarypolicydoes
nothavemuchofadirectimpactoninflation,andanincreaseininterestratescancontributeto
inflationthroughthecostanddemandimpactsofhigherinterestrates(seebelowandChapter5).
Theroleofacentralbankistopreservefinancialstabilitythroughtheprovisionofastablelowcost
refinancingsourceandthroughregulation.
TO GO FURTHER: KALECKI EQUATION OF PROFIT, INTEREST

RATEANDINFLATION
Forreaderswhowanttoknowmore,thissectiondevelopsafewpoints.Theincomeapproachto
GDPcanbedevelopedfurthertoaccountforrentiersincome,which,tosimplify,onlycomesfrom
thedistributionofprofit.Grossprofitisthesumofnetprofit,nonwageincomedistribution,and
taxesonprofit:
PQW+UW+Z+UnD+TUPw/APL+Z/Q+UnD/Q+TU/Q
WithUgrossprofitoffirms,UnDthedisposablenetprofitoffirms(i.e.profitafteraccountingfor
businessincometax,distribution,andsubsidies),Wemployeescompensations,Zthegrossnon
wageincomespaidbyfirms(dividends,interests,rentalincome),andTUbusinessincometax(tax
onprofit).ForsmallvaluesofgQandgAPL,wehave:
gP(gwgAPL)sW+(gZgQ)sZ+(gUnDgQ)sUnD+(gTugQ)sTu
Theassumptionsarethatgwresultsfromabargainingprocessbetweenemployeesandfirms.gZ
depends on monetary policy and the state of liquidity preference (Z depends on the level and
structure of interest rates). gAPL is procyclical to the state of the economy. gQ is determined by
expectationsofmonetaryprofits(Keynesseffectivedemand).Asshownbelow,gUnDisdetermined
bytheKaleckiequationofmonetaryprofit.Finally,thegrowthofprofittaxesdependsonthetax
structure and economic activity. For the sake of the argument, one can assume that national
incomesharesareconstantandsumtoone(sW+sZ+sUnD+sTu=1).
Inflation can go up and down as gUnD, gw, gZ and gTu go up and down, but their effects will be
mitigatedbychangesinproductivitygrowthandoutputgrowth.Onlywhenthelattertwoarefixed
orsluggishrelativetotheformerfourcaninflationpermanentlytakeplace;thisisastateoftrue
inflationtouseKeynessterminology.Oneeconomicconditionduringwhichthiscanoccurisfull
employment,butthisisnottheonlyone.Pricesmaygoupquicklybecauseof,forexample,an
uncontrolled wageprice spiral induced by high expectation of inflation, competition between
unionsforrelativewageimprovements,orariseincostsnotcontrolledbyresidents(e.g.,anoil
shockfornetoilimportingcountries).Risinginterestratesalsocanpromoteinflationbyraising
costsofproduction(Chapter5notedthatFOMCmembersareawareofthisinflationarychannel).
Thisexplanationofinflationdoesnotdiscardthepossibilityofamonetarysourceofinflation,but
itrequiresthatseveralconditionsbemetbecausetherelationbetweenmoneysupplyandinflation
ishighlyindirect.First,iffundsareinjectedviaportfoliotransactions(swappingofnonmonetary
assetsformonetaryassets),outputpriceinflation mayoccuronlyifdesiredstocksofmonetary
assetsarefulfilled,ifreceiversofmonetaryassetsdecidetospendtheirexcessfundsonexisting
goodsandservices,andiftheeconomyisinasluggishstate.Economicunitsmaywanttohoard
more,mayuseexcessfundstobuyfinancialassets(whichwouldlowerinterestrates)and/orto
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CHAPTER12:INFLATION
repaytheirbankdebts(whichwouldlowerthemoneysupply),andtheeconomyusuallyisableto
increaseproductionwhendemandincreases.
Second,iffundsareinjectedintotheprivatedomesticsectorviaincometransactions(e.g.,wage
payments),inflationwilloccuronlyiftheeconomyisslowtorespond(sothatUnD/Qincreases).The
Kaleckiequationofprofitexpressesthismoreformally.Chapter11showedthat
UnD=CUSH+I+DEF+NX
Thus:
gUnD=(gCusCugShsSh+gIsI+gGsGgTsT+gXsXgJsJ)/sTu
Wheresiistheshareofvariableiinnationalincome(orGDP)whichisassumedtobeconstant.As
the economy gets to full employment, any type of spending (public or private, consumption or
investment) will tend to be inflationary. Higher interest rates can contribute to demandpull
inflationifthegrowthofconsumptionbyrentiersincreasestoofastasaresultofhigherinterest
income.4Theinflationarytendenciescanbemitigatedbythegrowthrateoftax,thegrowthrateof
production,thegrowthrateoftheaverageproductivityoflaborandthegrowthrateofsaving.
1 The quantity theory of money asserts that inflation has monetary origins. The money supply
growstoofastrelativetotheproductivecapacitiesoftheeconomy.
2AccordingtotheQTM,themainroleofacentralbankistokeepinflationundercontroleither
by targeting monetary aggregates through a money multiplier process (reserve targeting) or
throughvariationsinthecostofreserves(FFRtargeting).Modernproponentsofthatviewwork
theargumentthroughaFFRtargetingview.
3Accordingtosomeeconomists,theQTMmakessomeextremehypothesesandhasaninaccurate
understandingofthemonetarycreationprocess.Theeconomyisusuallynotatfullemployment
and productive capacities are driven by demand conditions. The money supply is created and
destroyedaccordingtotheneedsoftheeconomicsystem.Itisnotsomethingthatsuddenlydrops
from the skyand exogenously determined occurrencethat the system must find a way to
assimilate.
4Someeconomistsviewtherootofinflationintheconflictoverthedistributionofincome.This
creates costpush and demandpull sources of inflation. As such, raising interest rates may be
inflationary.
5Accordingtothatapproach,thejobofacentralbankistopromotefinancialstability.Othertools
mustbeusedtodealwithinflationthathavemorefiscalaspects.
Keywords
Natural growth rate, velocity of money, unit labor cost, output gap, money multiplier, Kalecki
equationofprofit,inflation,incomedistribution
169
CHAPTER12:INFLATION
ReviewQuestions
Q1:IntheQTM,ifthelevelofmoneysupplysuddenlyriseswhathappenstothepricelevel?What
istheeconomiclogicbehindthatresult?Whatifitisthegrowthrateofthemoneysupplythatrise?
Q2:Ifthecentralbankincreasesthegrowthrateofreservewhathappensaccordingtothequantity
theoryofmoney?
Q3:Whataretheempiricalandtheoreticalproblemswiththenotionofnaturalgrowthrate?
Q4:Whatistheviewofmonetarycreationunderlyingthequantitytheoryofmoneyandhowisthat
atoddwiththewaymoneysupplyisactuallyinjectedintheeconomicsystem?
Q5:Ifwagerategrowsfasterthantheunitcostoflabor,whathappenstoinflation?Whatisthe
economiclogicbehindthatresult?
Q6: If aggregate demand growth faster than aggregate supply, what are the means for the
economicsystemtoadjustinthequantitytheoryandinthedistributiontheory?
Q7:Risinginterestratescanbeinflationaryaccordingtothedistributiontheory;why?
Suggestedreadings
Friedman,M.(1987)Thequantitytheoryofmoney,inEatwell,J.,Milgate,M.andNewman,P
(eds)TheNewPalgrave:ADictionaryofEconomics,.NewYork:PalgraveMacmillan.
Kalecki,M.(1971)Thedeterminantsofprofits,inM.Kalecki(ed.)SelectedEssaysontheDynamics
oftheCapitalistEconomy,7892,Cambridge:CambridgeUniversityPress.
Lavoie, M. (2014) Inflation theory, chapter 8 PostKeynesian Economics: New Foundations.
Northampton:EdwardElgar
Rowthorn,R.(1977)Conflict,inflationandmoneyCambridgeJournalofEconomics1(3):215
239.
1SeeChapter6ofMarcLavoiesPostKeynesianEconomics:NewFoundationsforaformaloverviewoftheliterature.
2
See Matias Vernangos Is labor productivity still procyclical? Okun's Law is still fine at
http://nakedkeynesianism.blogspot.com/2015/03/islaborproductivitystillpro.html
3SeeBillMitchellsWhatisaJobGuarantee?athttp://bilbo.economicoutlook.net/blog/?p=23719
4
See
Scott
Fullwilers
Functional
Finance
and
the
Debt
RatioPart
IV
at
http://neweconomicperspectives.org/2013/01/functionalfinanceandthedebtratiopartiv.html
170
CHAPTER 13:
Whatbalancesheetinterrelationsare
Whatthebasicprinciplesofnationalaccountingare
Whynotallsectorsoftheeconomycanbeinsurplusatthesametime
Why a government deficit is sustainable as long as monetary sovereignty
prevailsandothersectorswanttonetsave
Why taking proactive actions to reduce the public debt is unnecessary and
counterproductive
How business cycles can be explained partially by looking at balancesheet
interrelations
CHAPTER13:BALANCESHEETINTERRELATIONSANDTHEMACROECONOMY
EarlierChaptershavefocusedonthemechanicsofaspecificbalancesheet,specificallythatofthe
centralbankandofprivatebanks.ThisChapterlooksatthebalancesheetinterrelationsbetween
the three main macroeconomic sectors of an economy: the domestic private sector, the
governmentsectorandtheforeignsector.Thismacroviewprovidessomeimportantinsightsabout
issues such as the public debt and deficit, policy goals that are more likely than others to be
achieved,thebusinesscycle,amongothers.
APRIMERONCONSOLIDATION
Thebalancesheetofthedomesticprivatesectorputstogetherthebalancesheetsofalldomestic
privateeconomicunits.Thismeansthatclaimsthatthesesectorshaveoneachotherareremoved
(thatis,canceleachotherout)fromthebalancesheetofthedomesticprivatesector.Forexample,
assumethatthefollowingtwobalancesheetsexist
Households
Assets
Bankaccounts
Foreigncurrencyheldbyhouseholds
Realassetsofhouseholds
LiabilitiesandCapital
Mortgages
Networthofhouseholds
Banks
Assets
Mortgages
Treasuriesheldbybanks
Realassetsofbanks
Bankaccounts
TT&Ls
Networthofbanks
Iftheyareconsolidatedwehaveasafirststep:
Households+Banks
Assets
Bankaccounts
Realassetsofhouseholds
Mortgages
Realassetsofbanks
Mortgages
Networthofhouseholds
Bankaccounts
TT&Ls
Networthofbanks
Thetermsinboldappearonbothsidesofthebalancesheetandareeliminatedintheconsolidation
processsothebalancesheetofhouseholdsandbanksis:
Households+Banks
Assets
Realassetsofhouseholdsandbanks
TT&Ls
Networthofhouseholdsandbanks
Theonlyfinancialclaimsleftarethoseissuedto,andissuedby,sectorsoftheeconomyotherthan
households and banks. Thus, the consolidation process eliminates some important financial
172
interlinkages. This is fine as long as one is merely interested in looking at relationship between
sectors, but one should be mindful that this is a simplified picture that hides some important
aspectsoftheeconomy.
THETHREESECTORSOFTHEECONOMY
Theanalysisoffinancialinterlinkagesamongthethreemainsectorscanbedonebystartingfrom
theNationalIncomeandProductAccounts(NIPA),butthederivationfromtheFinancialAccounts
oftheUnitedStatesismoreintuitive(thederivationfromNIPAisdoneattheendofthisChapter).
ThefollowingisaquickrefresherfromChapter1.Abalancesheetisanaccountingdocumentthat
recordswhataneconomicunitowns(assets)andowes(liabilities)(Figure13.1).
Assets
FinancialAssets(FA)
RealAssets(RA)
FinancialLiabilities(FL)
NetWorth(NW)
Figure13.1Abasicbalancesheet.
Financialassetsareclaimsissuedbyothereconomicunitsandrealassetsarethingsthathavebeen
produced. Financial liabilities are claims issued to other economic units. A balance sheet must
balance,thatis,thefollowingequalitymustholdallthetime:FA+RAFL+NW.Orputdierently:
NWNFW+RA
Thismeansthatthewealthofanyeconomicsectorcomesfromtwosources,netfinancialwealth
(NFW=FAFL)andrealwealth(RA).
Eachmacroeconomicsectorhasabalancesheet(Figure13.2).DPisthedomesticprivatesector,G
isthegovernmentsector,Fistheforeignsectoralsocalledtherestoftheworld.Thegovernment
sectorincludesallthelevelsofdomesticgovernment(local,state,federal)andthecentralbank.
WhiletheFinancialAccountsoftheUnitedStatesincludethebalancesheetofthecentralbankin
thedomesticfinancialsectorthedomesticfinancialsectorincludesdomesticfinancialbusinesses
andmonetaryauthority,itismorerelevanttoincludethecentralbankinthegovernmentsector
(seeChapter6).Thedomesticprivatesectorincludesdomestichouseholds,domesticnonprofit
organizations, domestic financial businesses, domestic nonfinancial businesses, and domestic
farms.Theforeignsectorincludesanythingelse(foreigngovernments,foreignbusinesses,foreign
households,etc.).Notethattheadjectivedomesticisalwaysusedforthereferencecountrythat
isstudied.Foreignincludesallothercountries.
ADP
LDP
FADP
FLDP
RADP
NWDP
AG
LG
FAG
FLG
RAG
NWG
AF
LF
FAF
FLF
RAF
NWF
Figure13.2Balancesheetsofmacroeconomicsectors
Foreverycreditorthereisadebtor,soifoneaddstogethertheclaimsofthecreditorsandthe
debtorstheymustcancelout.Fortheworldeconomy(allsectorsconsolidatedtogether):
(FADPFLDP)+(FAGFLG)+(FAFFLF)0
173
Thisimpliesthatthesumofallnetworthequalsthesumofallrealassets,thatis,onlyrealassets
areasourceofwealthfortheworldeconomy(NW=RA):
(NWDPRADP)+(NWGRAG)+(NWFRAF)0
Foradomesticeconomy(governmentanddomesticprivatesectorsareconsolidated),thereare
twosourcesofwealth:realwealthandnetfinancialwealthobtainedfromtheforeignsector.The
publicdebtisnotasourceoffinancialwealth(orpoverty)forthedomesticeconomybecauseitis
an asset for the domestic private sector but a debt of the domestic government. The domestic
moneysupplyisnotasourceoffinancialwealthforthedomesticeconomybecauseitisanassetof
adomesticholderandaliabilityofadomesticissuer.
Giventhatthepreviousidentitiesholdintermsoflevelsatanypointintime(akastocks),they
alsoholdintermsofchangesinlevelsoveraperiodoftime(akaflows):
(FADPFLDP)+(FAGFLG)+(FAFFLF)0
And,knowingthattheFinancialAccountsdefinessavingasachangeinnetworth(S=NW)and
investmentasachangeinrealassets(I=RA),itisalsotruethat:
(SDPIDP)+(SGIG)+(SFIF)0
Thislastidentityissimilartothe NIPA identity(S I)+(T G)+CABF0 (seebelowforsome
differences).(SI)and(FAFL)arebothofficiallycallednetlending,onemeasuredfromthe
capitalaccount,(SI),andtheothermeasuredfromthefinancialaccounts,(FAFL).
Afewwordsonthewayallthisissometimespresentedbyeconomists.Bewarethateconomists
maychangethenameofthesetwoitems.(SI)maybecallednetsaving(whichisdifferentfrom
howtheFinancialAccountsdefinenetsaving)orsurplus(ifS>I)anddeficit(ifS<I),and(FA
FL)maybecallednetfinancialaccumulation(NFA).Thus,wehave:
NFADP+NFAG+NFAF0
Ifaneconomicsectoraccumulatesmoreclaimsonothersectorsthantheothersectorsaccumulate
claims on the economic sector in question, the economic sector records a positive net financial
accumulation,itisanetcreditor(akanetlender)duringtheperiod(FAFL)>0.Iftheopposite
istrue,thesectorisanetdebtor(akanetborrower)duringtheperiod.Finally,thisidentityis
sometimesrewrittenas:
DPB+GB+FB0
With DPB the domestic private balance, FB the foreign balance (the opposite of the domestic
current account balance), GB the government balance, and balance being measured either
through the capital accounts (net saving) or through the financial accounts (net financial
accumulation).
FinallyonemaynotethatgiventhatNWRAFAFL,then:
(SI)(FAFL)
Theoperationsongoodsandservicesaremirroredbyfinancialoperations.Thus,adeficit,ornet
dissaving,ismirroredbyanetfinancialdisaccumulation;tospendmorethanwhatisearnedone
mustsellassetsorgointodebt.Similarly,asurplus,ornetsaving,ismirroredbyanetfinancial
accumulationforthesector.
174
Notheory,behavioralequationsandstatementsofcausalrelations,wasusedabovetoexplainthe
accounting identities (a bit of this is done below to examine the business cycle). The identities
simplystatethatanetinjectionoffundsbyasectormustbeaccumulatedinanothersector.Every
dollarmustcomefromsomewhereandmustgosomewhere.
SOMEIMPORTANTIMPLICATIONS
They are many implications but the main one is that one must not study a sector in isolation.
Anythingthatasectordoeshasanimpactonothersectors.Whenaforecastaboutthebudgetary
trendofthegovernmentismade,theforecastermustrecognizetheimplicationsforothersectors
toseeiftheforecastisrealistic.Thisisusuallynotdone.Forexample,theCongressionalBudget
Office in the early 2000s expected the federal governments surplus to continue to grow but
neglectedtolookattheimplicationintermsofthedomesticprivatesector.1Acontinuouslyrising
governmentsurplusimpliescontinuouslyrisingdomesticprivatedeficitgiventheforeignbalance,
whichisnotsustainable.Onlythefederalgovernmentofamonetarilysovereigngovernmentcan
sustain permanent deficits (see Chapter 6). There are many other implications and uses of this
frameworksuchasmacroeconomictheory,themadnessoffiscalausterity,amongothers.2
POINT 1: THE BEGINNING OF THE ECONOMIC PROCESS REQUIRES

THATSOMEONEGOESINTODEBT.
Letusstartwithaneconomyinwhichnothinghasbeenproducedoracquiredyet.
ADP
FADP=0
RADP=0
LDP
AG
LG
FLDP=0 FAG=0 FLG=0
NWDP=0
RAG=0 NWG=0
AF
LF
FAF=0 FLF=0
RAF=0 NWF=0
Say that someone in the economy wants to build a house that costs $10 to build. In order for
domesticproductiontostart,workersmustbepaid,rawmaterialmustbepurchased(thosehadto
beproducedfirstbytheway).
Ifaprivatebusinessisinchargeofdoingallthis,itmustobtainfundsandChapter10explainshow
thisisdone.Thebalancesheetofthedomesticprivatesectorwouldlooklikethisoncethehouse
isbuilt:
ADP
RADP=10
LDP
NWDP=10
Consolidationeliminatesthedebtowedbythehomebuildertoabank,aswellaswagesandraw
material payments, because they are all internal to the sector. Once produced, if the house is
acquiredbyadomestichouseholdfor$11,thefollowingisrecordedatthemacrolevel:
ADP
RADP=11
LDP
NWDP=11
Againallthishidesquiteafewunderlyingfinancialtransactions:
1 Householdsgotamortgageandpaidthehomebuilderwhomadea$1profit
175
2 Firmrepaidits$10debtwithinterest
3 Housewastransferredfromfirmsbalancesheettohouseholdsbalancesheet.
Thenextperiodtheprocesswouldstartalloveragain.Thistimethefirmmayhavesomesavings
fromthepreviousperiodtofinancepartoftheproduction.
If,instead,thegovernmentbuysthehouse,itmustfirstfundthepurchasebyusingapromissory
note(FLG):
ADP
FADP=11
LDP
NWDP=11
AG
RAG=11
LG
FLG=11
Spendingbythegovernmenthasallowedthedomesticprivatesectortoacquireafinancialclaim.
Itisaclaimonthegovernment.
IfaforeigneconomicunitbuysthehouseandthehousebuilderrequirespaymentinUSdollars,
thereareseveralwaysthepaymentcanbedonebutalloftheminvolvetheforeignsectorgoing
intodebtindollars.Forexample:
TheforeignermayaskforabankadvanceinUSdollarsatadomesticbank
Theforeignermaywriteacheckinaforeigncurrency(sayeuros)butwhenthedomestic
bankofthehousebuilderreceivesthecheck,itwillsendthecheckbacktotheforeignbank
ofthebuyertorequestadollarpayment.TheforeignbankwillneedtoborrowUSdollars
tosettleitsdebtwiththedomesticbank.
Oncethehouseissold,thefirmmakesa$1profitthatitusestopayinterest,dividendandtaxes.
Whatisleftoverisretainedearnings,thesavingofthefirm.Householdswillalsosavesomefunds.
Butnoneofthatcanoccurunlesssomeonegoesintodebttostartproduction.Andforsavingsto
bebigger,debtmustincrease.
POINT 2: NOT ALL SECTORS CAN RECORD A SURPLUS AT THE SAME

TIME
Itisquitestraightforwardtonoticethatnotallsectorscanbenetcreditorsatthesametime.At
leastonesectormustbeanetdebtorifanothersectorisanetcreditorbecauseforeverycreditor
there must be a debtor. Most of the time, the domestic private sector is in surplus and the
governmentsectorisindeficit(Figure13.3,Figures13.4).From2000to2010,NewZealandwasa
particularlyoddcasewheretheprivatesectorwasindeficitwhilegovernmentandforeignsectors
wereinsurplus.Tosimplify,letusassumethatNFAF=0,therefore:
NFADPNFAG
Thatis,inaclosedeconomy,fortheprivatedomesticsector(householdsandprivatecompanies)
tobeabletorecordasurplus(NFADP>0),thegovernmentmustrunafiscaldeficit(NFAG<0).
Putdifferently,whenthegovernmentspends,itinjectsfundsintotheeconomy,andwhenittaxes
itwithdrawsfundsfromtheeconomy(seeChapter6).Ifthegovernmentspendsmorethanwhat
ittaxes,thereisanetinjectionoffundsbythegovernmentintheeconomyandthisnetinjection
mustbeaccumulatedsomewhere.Inthesimplecase,itistheprivatedomesticsectorthatmust
accumulatethefundsinjected.
176
Of course, the reverse logic applies too. When the private sector deficit spends, it injects a net
quantityoffundsintotheeconomythatcanonlygotothegovernment.Thisallowsthegovernment
torunasurplus.Apowerfulconsequenceofthissimpleaccountingruleisthatapolicythataimsat
achievingagovernmentsurplusimplies,inaclosedeconomy,thatthispolicyaimsatachievinga
domesticprivatesectordeficit.
One way to avoid this is to try to achieve a domestic current account surplus, in which case, a
countrycanachievedomesticsurplusesacrosstheboardletuscallthatthegoldenstate.The
greenareaonFigure13.4bshowshowsmallthegoldenstateisrelativetoallotherpossibilities.
AmongOECDcountries,ithasbeenachievedmainlybynorthernEuropeancountriesduringthe
firstdecadeofthenewmillennium(Figures13.4bandFigure13.4c).TheGreatRecessionhasled
mostgovernmenttodeficitspendandonlyNorwayhasbeenabletomaintainthegoldenstate
(Figure13.4d).
Thisstateisdifficulttoachievebecauseadomesticcurrentaccountsurplusmeansthattheforeign
sectorrecordsacurrentaccountdeficit(FB<0).Again,notallsectorscanbeinsurplusatthesame
timebecauseforeverynetexporter(and/ornetforeignincomeearner)theremustbeatleastone
net importer (and/or at least one net foreign income payer). Thus, for a domestic economy to
achievethegoldenstateonaregularbasis,theremustbeatleastoneforeigncountrythatiswilling
to deficit spend visvis the domestic economy. This is hardly possible to sustain given that
countriesstrivetoreachcurrentaccountsurplusmostofthetime.
More importantly, the golden state is not achievable at the world level. If all economies try to
achieveacurrentaccountsurplus,thebesttheycanachieveisabalancedcurrentaccount(FB=0),
whichbringsusbacktotheidentity:
NFADPNFAG
Ultimately policy makers should confine themselves to trying to manage what goes on in their
domesticeconomy.Ifacountryislucky,developmentsintherestoftheworldmayultimatelyallow
thatcountrytoreachthegoldenstate;butbasingpolicychoicesonthegoalofreachingthegolden
stateisaverylongshot.Inaddition,policiesthataimatachievingthegoldenstatelimittheability
ofdomesticsectorstodeficitspend,whichconstrainstheabilityofthedomesticeconomytogrow.
Indeed,thegoalbecomestoconstraintdomesticspendingbycurtailingwagegrowth,bycurtailing
governmentspendingandbyraisingtaxes.Thiskeepscostsdown(andsokeepsthepriceofexports
low to attract foreign buyers) and limits imports (a growing domestic spending usually requires
moreimportsandsomakesitdifficulttoreachadomesticcurrentaccountsurplus).
177
Figure13.3NetfinancialaccumulationintheUnitedStates,percentofGDP.
Figure13.4aSectoralbalances,aninternationalperspective,19952000average,PercentofGDP
Source:OECD
178
Figure13.4b20002005average
Source:OECD
Figure13.4c20052010averages.
179
Figures13.4d20102014averages
Note:20101015averageforItaly,Norway,SwedenandtheUK
POINT3:PUBLICDEBTANDDOMESTICPRIVATENETWEALTH
Thepublicdebtof the UnitedStatesisthefacevalueofoutstanding U.S. Treasurysecurities.It
includesbothmarketable(Tbills,Tnotes,Tbonds,TIPSs,andafewothers)andnonmarketable
securities (United States notes, gold certificates, silver certificates, U.S. savings bonds, Treasury
demanddepositsissuedtoStatesandLocalGov.,allsortsofgovernmentaccountseriessecurities
heldbyDepositFunds).
Intheearly2000s,theexpectationofthedaywasthatfiscalsurpluseswouldcontinuetogoonand
riseevenmore.3Figure13.5showstheprojectedpathofthepublicdebtandthemonetarybase.
Whataretheimplicationsofsuchatrendofthepublicdebt?
Tosimplifytheanalysis,assumethat:1thegovernmentsectoronlyincludesthefederalTreasury
andthecentralbank2atthemomenttheonlyliabilityofthegovernmentisTreasuries(nocentral
bankliabilityisoutstanding)3aclosedeconomy(noforeignsector)4thefollowingbalancesheets
prevail:
ADP
FADP(Treasuries):$100
RADP:$350
LDP
FLDP(taxreceivables):$50
NWDP:$400
AG
FAG(taxreceivables):$50
RAG:$1150
LG
FLG(Treasuries):$100
NWG:1100
180
Figure13.5Publicdebtandmonetarybase.
Source:MarshallsOriginsoftheUseofTreasuryDebtinOpenMarketOperations:Lessonsfor
thePresent
NowtheTreasurywantstoeliminateallitsfinancialliabilities:nomorepublicdebt!Whatarethe
meanstodoso?
Case1:LetTreasuriesmatureanddonotrepayholdersofTreasuries:100%taxonprincipal
=>FADP=0,thedomesticprivatesectorlossesallitsfinancialassets.
ADP
FADP:$0
RADP:$350
LDP
NWDP:$300
Case 2: Switch to a Treasurys financial instrument not considered a liability (Coins are
treatedasequitybytheFederalAccountingStandardsAdvisoryBoard):
ADP
FADP(Coins):$100
RADP:$350
LDP
NWDP:$400
AG
RAG:$1150
LG
FLG:$0
NWG:1200
Case3:Switchtoanotherliabilityofthegovernmentthatisnotincludedinthepublicdebt:
repaywithFederalReservesliabilities:
181
ADP
FADP(Reserves):$100
RADP:$350
LDP
NWDP:$400
AG
RAG:$1150
LG
FLG(reserves):$100
NWG:1100
Allthesecasesaredetrimentaltothedomesticprivatesectorbecausetheyremoveadefaultfree,
liquid, interest earning security from the balance sheetTreasuries. Treasuries are essential to
createwealthinthedomesticprivatesector,tomeetcapitalrequirements,toearninterestincome
inasafeway,andtoaccesstherefinancingchannelsofthecentralbank.Sobecarefulwhatyou
wishforwhenarguingforrepayingthepublicdebt.
POINT4:BUSINESSCYCLEANDSECTORALBALANCES
Onecangetapartialunderstandingofthebusinesscyclejustbystudyingtheinteractionsbetween
thethreebalances.First,onemaynotethatusuallyallthreesectorswishtobeinsurplus:
Domesticprivatesectorneedstorecordasurplustoavoidbankruptcy.
Stateandlocalgovernmentsneedtorecordasurplustoavoidbankruptcy.
Federalgovernment
strivestobeinsurplustoshowthatgovernmentisfiscallyresponsiblelikeother
domesticsectors.
tendstowardasurplusduringanexpansionbecauseoftheautomaticstabilizers.
Foreignsector:Politicalandfinancialstabilityreasonstoreachasurplus.
Ofcourseitisnotactuallypossibleforallofthemtobeinsurplusatthesametime,butallofthem
usuallywanttobeinasurplusatthesametime.
Startwithasituationwherethenongovernmentsector(NGistheconsolidationofDPandF)isat
thesurplusitdesires(NGBd):
Step1:thereisagrowingeconomywithNGB=NGBd>0:Nongovernmentsectornetsaves
whatitdesires.InthatcaseitmustbetruethatGB<0,thegovernmentisindeficit.
Step2:Governmentwantstobeinsurplus(GBd > 0).Inagrowingeconomy,automatic

stabilizerslowerthedeficitofthegovernment,whichiswhatthegovernmentwants.But,
ifthegovernmentisdissatisfiedwiththepaceofreturntowardasurplus,itmayimplement
austerity policies that raise taxes (T) and/or lower spending (G) (the country must live
withinitsmeans),whichcompoundstheeffectofautomaticstabilizers.ThusGB>0and
soNGB<0.
Step3:NGB<NGBdsothenongovernmentsectortriestofindwaystoincreaseitsnet
financialaccumulation:
o
182
IfDPB<DPBd:consumptionandinvestmentdecline
o
IfFB<FBd:Domesticexportsdecline(i.e.foreignimportsdecline)
Step 4: Decline in nongovernment spending (C, I, X), together with the decline in
governmentspending(G),leadtoadeclineinaggregateincome(GDP=C+I+G+NX).The
declineinaggregateincomeleadstoanautomaticriseinGandanautomaticdeclineinT,
sothegovernmentbalancefalls(GB<0).Incomestabilizes.
Step5:thefallinthegovernmentbalanceleadstoariseofthenongovernmentbalance
(NGB>0)untilNGB=NGBd.Backtostep1.
The only two ways to get a shortterm stationary state (that is, a situation where the level of
aggregateincomedoesnotchange)are:
Way1:ForGBdtobenegative,i.e.thegovernmentiswillingtobeindeficit,andthedeficit
equalstheequilibriumdeficitlevel(GB*).Theequilibriumdeficitlevelistheonecompatible
with the desired net saving of the nongovernment sector: GB* = NGBd. This is a viable
solutionforamonetarilysovereigngovernment,butpoliticiansarereluctanttoarguefora
permanent fiscal deficit given the lack of understanding of how a monetarily sovereign
government operates by the general population, politicians and most economists.
Bankruptcy,acceleratinginflation,andbondvigilantesareusuallyinvoked,althoughnone
ofthemarerelevant(SeeChapter6).
Way2:ForNGBdtobenegative:
183
DPBd negative: this did happen in the late 1990s and early 2000s in the United
States(Figure13.3),whichmadeGB>0possible.Australia,NewZealandandsome
European countries also have recorded a negative domestic private balance
(Figures13.4a,13.4b,and13.4c).However,domesticprivatesectorindeficitisnot
sustainablebecauseitimplies,ultimately,Ponzifinance(seeChapter14).TheGreat
Recessionledtomassivegovernmentdeficitsthatallowedthe domesticprivate
sectortoreachapositivenetsavinginallOECDcountriesonrecord(Figure13.4d).
FBdnegative(desirednegativecurrentaccountbalancebyforeignerssodomestic
currentaccountispositiveandlargeenoughtofulfillthedesirednetsavingofthe
government and domestic private sector): A negative FB can be tolerated by a
foreignsectorifitisadevelopingcountry,oriftheforeigncountryunderstandsthe
needtoprovidetheinternationalreservecurrencytosatisfytheneedsoftherest
oftheworld.However:
Ifacountryneedstodeficitspendvisavistherestoftheworld,itmeans
thateitherthedomesticprivatesectororthegovernmentdoso,orboth.
Ifthedomesticprivatesectordoesit,itisunstable,ifthegovernmentdoes
it,itdependsonthedenominationofthedebt(ifindomesticcurrency,no
problem).
For the country supplying the international reserve currency, negative

domestic CAB is sustainable only if the currency in unconvertible. If the
currencyisconvertible,thentheTriffindilemmaholds.Thedilemmaisthat
thecountrymusthaveadeficitinitscurrentaccountbalanceinorderto
supplythecurrencythattherestoftheworldneeds,butthecountryfaces
threats of conversion demands as the supply of reserve currency grows
amongothercountries.
CONCLUSION
The macroeconomic sectoral balance identity shows that some desires are not compatible or
extremely hard to achieve. As such, regardless of the number of economic adjustment
devaluation,changeininterestrate,aggregateincomefluctuation,etc.somedesirescannever
be achieved and it is highly destructive to continue policies that aim at achieving incompatible
desires.Itisbesttosetpolicygoalsanddesiresthatarecompatiblewithaccountingrulesandto
beawarethat:
-
Onessurplusissomeoneelsesdeficit
Onessavingissomeoneelsesdissaving
Onesexportissomeoneelsesimport
Onesspendingissomeoneelsesincome
Onesfinancialassetissomeoneelsesdebt
Onescreditissomeoneelsesdebit
Accountingrulescanbecombinedwithinsightsfromthewaymonetarysystemsworktodrawsome
importantconclusions:
Privatedomesticsectorshouldavoidbeinganetdebtorbecauseittendstoleadtofinancial
instability(seeChapter14)
Amonetarilysovereignfederalgovernmentusuallyneedstobeindeficit,unlessadomestic
current account balance can be achieved, because such a government is always able to
servicedebtsdenominatedinitsunitofaccount.
Someeconomiesneedtobenetimporters:
If they have limited economic development and resources. In that case, direct
foreignaidinsteadofprivatelendingisthewaytogo.
Iftheyprovidetheinternationalcurrency(UnitedStatestoday).Inthatcase,the
restoftheworldwantstonetsaveinthatcurrencyandsothecurrencyissuing
countrymustrecordacurrentaccountdeficit.
Giventhatsomecountriesneedtobenetimporters,othersneedtobenetexporters:there
maybeaneedtocleardebtovertimeifitaccumulatestoofast,andtosettheinterestrate
lowrelativetogrowth.
TOGOFURTHER:SECTORBALANCESFROMTHEPERSPECTIVE
OFTHENATIONALINCOMEANDPRODUCTACCOUNTS
Attheaggregatelevel,theNationalIncomeandProductAccounts(NIPA)managedbytheBureau
ofEconomicAnalysisrecordsalleconomicoperationsongoodsandservices.NIPAshowsusthat
theexpenditureapproachtogrossdomesticproduct(GDP)holdsasamatterofaccounting:
GDPC+I+G+NX
184
Thegrossdomesticproductisthesumofallfinalexpendituresongoodsandservices,including
domesticprivatefinalconsumption(C),domesticprivateinvestment(I),governmentspendingon
goodsandservices(G),andnetexports(NX).WealsoknowthattheincomeapproachtoGDPholds
asamatterofaccounting:
GDPYD+T
Thatis,withminordiscrepancies,thegrossdomesticproductisthesumofallgrossincomes,or,
statedalternatively,thesumofalldomesticdisposableincomes(YD)wages,profits,interestand
rentandtheamountofoveralltaxes(netoftransfers)onincomeandproduction(T).Thismeans
that:
YD+TC+I+G+NX
We also know that, when accounting for international income sources, the U.S. International
TransactionsAccounts(USITA)(thataccountsfortherelationbetweentheUnitedStatesandthe
restoftheworld)tellsusthat:
CABUSNX+NRA
Thecurrentaccountbalance(CAB)isthesumofthetradebalance(netexports)andnetrevenue
fromabroad(NRA)(netofunilateralcurrenttransfers).
IfonecombinestheNIPAandUSITAandnowincludesinTthetaxesearnedonforeignincome
(NRADisdisposablenetrevenuesfromabroad)wegetthefollowing:
YD+NRAD+TC+I+G+CABUS
Wealsoknowthat,intheNIPA,aggregatesaving(S)isdefinedasthedifferencebetweendisposable
incomeandconsumption,SYD+NRADC,therefore:
(SI)+(TG)CABUS0
Or,giventhatforeverynetexporterthereisanetimporter(CABF=CABUS):
(SI)+(TG)+CABF0
ThislastidentityissimilartotheoneobtainedfromtheFinancialAccountsexceptthatitisderived
from GDP and so is merely concerned with current output (that is, newly produced goods and
services).
TO GO EVEN FURTHER: NIPA AND FA DEFINITIONS OF

SAVING
The National Income and Product Accounts (NIPA) definition of saving is different from that of
Financial Accounts (FA) and they are compatible only under specific conditions. 4 NIPA saving is
definedasunconsumedincome.Forexample,householdssavingisdefinedasdisposableincome
minusspendingonconsumptiongoods:S=YDC.FAsavingisdefinedastheincreaseinnetwealth:
S=NW.
Thisdifferencereflectsthedifferentpurposeofeachaccount.NIPAisfocusedonmeasuringcurrent
economicactivitywithgrossdomesticproduct(GDP)atthecoreoftheanalysis.So,forexample,
saythataneconomyproducesapplesandsomeoftheapplesareusedtomakeappletarts.GDPis
185
thedollarvalueofapplesleftforfinalconsumptionandthedollarvalueofappletarts.Thisisthe
productionfortheyear.NIPAsavingisthevalueofwhateverincomewaspaidlesspurchasesof
appletartsandapplesforfinalconsumption.
FAisbroaderinitsperspective,giventhatitaimsatmeasuringwhatgoesoninbalancesheets.
Balancesheetsareimpactedbymanymorethingsthanjustcurrentproductionbecause,among
others:
1 Theycontainrealassetsthatwerepreviouslyproduced
2 Theycontainfinancialassets
3 Thevalueofassetschangesovertimebecauseofchangesinprices(capitalgains/losses)
insteadofadditiontothestockofassetsviaproductionorissuanceofnewsecurities.
4 Someconsumptiongoodsaredurable.
5 Liabilitiesrequireprincipalrepayment.
Forexample,saythatahouseholdownsnothingandowesnothing.Thehouseholdstartstowork
andgetspaid$10soitsbalancesheetisnow:
AH
FAH(bankaccount):$10
LH
NWH:$10
Savingisequalto$10accordingtoFAbecausenetwealthincreasedby$10,andhereNIPAwould
alsoagreegiventhatnothinghasbeenconsumed.Nowthehouseholdgoestothestoreandbuys
$2worthofapplesandthatistheonlyspendingforthemonth:
AH
FAH(bankaccount):$8
Apples:$2
LH
NWDP:$10
AccordingtoNIPA,savingis$8whereasitisstill$10forFA.Oncethehouseholdeatstheapples,
thedefinitionsgivethesamevalueagain:
AH
FADP(bankaccount):$8
LH
NWDP:$8
ThesourceofdifferenceinthiscaseisthatNIPAmeasuresconsumptionbytheamountofspending
doneforthatpurpose(buyingtheappleatthestore).Consumptioninabalancesheetmeansthat
thevalueofrealassetfalls(theappleshavebeeneaten).RecentlytheBureauofEconomicAnalysis
createdtheIntegratedMacroeconomicAccountsthataimatintegratingthetwoapproachesinto
onesingleaccountingframework.
KennethBoulding5developedanentire frameworkbasedon definitions consistentwith balance
sheets.Acleardifferenceismadebetweenspending(usingfundstobuytheapples:realassets
go up and financial assets fall) and consuming (eating the apples: real assets depreciate).
Developmentsineconomictheoryhavealsoaimedatmakingsurethattheaccountingofamodel
istight.Stockflowconsistentmacroeconomicmodelingensuresthatamodelaccountsforallthe
interdependencesbetweenthesectorsthatthemodelcontains.6
186
1 Balance sheets of different economic sectors are interrelated by a web of financial claims.
Economicunitsoweandownclaimsoneachother.
2Inorderforaneconomicsectortoaccumulate financialinstruments,i.e. torecordasurplus,
another sector must issue some financial instruments, i.e. record a deficit. There cannot be a
creditorwithoutadebtor.
3 If the government sector wants to reach a surplus, this necessarily means that it effectively
desiresthatatleastonesectorbeindeficit.Unlesstheforeignsectoriswillingtodeficitspend,the
previousstatementmeansthatthedomesticprivatesectormustdeficitspend.
4Afiscalsurplusleadstoadeclineinthepublicdebt,whichmeansthatothersectorsloseTreasury
securities. Treasury securities are central to maintaining the liquidity and profitability of other
economicunits.
4 Deficit spending by the private sector is not sustainable because it means that the sector is
continuouslydishoardingassetsorgoingintodebt.Bothultimatelyleadtoinsolvency.
5Abusinesscyclecanbeexplainedinpartbythefactthatallsectorstrytoreachasurplusatthe
sametime.
6Inordertostarttheeconomicprocess,onesectormustdeficitspend.
Keywords
Publicdebt,surplus/deficit,netfinancialaccumulation/disaccumulation,netsaving/disaving,net
lending/borrowing,goldenstate,Triffindilemma
ReviewQuestions
Q1:Ifthegovernmentrunsasurplus,whatdoesthatusuallymeanforthedomesticprivatesector?
Q2:Ifthegovernmentrunsadeficit,underwhatconditionisitsustainablefinancially?
Q3:Whataretheimpactsofagovernmentsurplusonthecashflowandnetsavingofthedomestic
privatesector?
Q4:Whydoesagovernmentsurplustendtocreatetheconditionforarecession?Andwhydoesa
deficittendtopromoteprosperity?
Q5: What do national accounts tell us about the feasibility of a budgetary policy that aims at
achievingasurplus?
Q6:Ifasectorrecordsadeficitwhatdoesitimplyforitsnetfinancialaccumulation?Whathappens
tofinancialassetsgivenliabilities?Whathappenstoliabilitiesgivenfinancialassets?Findconcrete
exampleofwhatwouldhappenifyourecordedadeficit?
Q7: Why is the golden state of a fiscal surplus, domestic private sector surplus, and domestic
currentaccountsurplushardtoachieve?
187
Suggestedreadings
PapadimitriouD.,Chilcote,E.andZezza,G.(2006)Arehousingprices,householddebt,andgrowth
sustainable?,LevyEconomicsInstitute,StrategicAnalysis,January.
Papadimitriou,D.,ShaikA.,dosSantos,C.andZezza,G.(2002)Ispersonalincomesustainable?,
LevyEconomicsInstitute,StrategicAnalysis,November.
Godley,W.andWray,L.R.(1999)CanGoldilockssurvive?,LevyEconomicsInstitute,PolicyNote
No.1999/4.
Godley,W.andLavoie,M.(2007)MonetaryEconomics:AnIntegratedApproachtoCredit,Money,
Income,ProductionandWealth,NewYork:PalgraveMacmillan.
Ritter,L.S.(1963)Anexpositionofthestructureoftheflowoffundsaccounts,JournalofFinance,
18(2):219230.
DatabaseExploration
Howtoretrievetimeseriesdataaboutthesectoralbalance?Therearethreewaystodothis;NIPA,
IMA,andFA.Allmethodsarepresented(Tip:Summingacrosssectoratapointintimemustgive
youavalueofzero,unlessthereisastatisticaldiscrepancy,otherwiseyoudidnotselectallthe
necessarysectors)
WiththeFinancialAccounts
Step1:Gotohttp://www.federalreserve.gov/releases/z1/(Note:SeriesZ.1isacomplicatedand
constantlychangingdataset)
Step2:ClickonDatadownloadprogram.
Step3:SelectCategoryA.Buildyourpackage.
Step4:SelectFA
Flow,SA
Step5:SelectRestoftheworld(S2),Generalgovernment(S13)andPrivatedomesticsectors
Step 6: Select Net lending (+) or borrowing () (capital account) (Note: net lending data from
financialaccountcontainsalargestatisticaldiscrepancy)
Step7:Selectfrequencyandothersandthendownload
WiththeNationalIncomeandProductAccounts
Step1:Gotohttp://www.bea.gov/iTable/index_nipa.cfmandclickBeginusingthedata
Step2:ClickonSection5andthenTable5.1SavingandInvestmentbySector
Step 3: Select Net lending or net borrowing for the domestic private sector and for the
government.Thediscrepancywillbetheresultofstatisticaldiscrepanciesandtherestoftheworld.
WiththeIntegratedMacroeconomicAccounts
Step1:Gotohttp://www.bea.gov/national/nipaweb/Ni_FedBeaSna/Index.asp
Step2:SelectTableS.2.aSelectedAggregatesforTotalEconomyandSectors(A)
Step3:SelectNetlending(+)ornetborrowing()eitherfromthecapitalaccountofthefinancial
account.Thecapitalaccounthaslessstatisticaldiscrepancy.
188
1Papadimitriou,D.,ShaikA.,dosSantos,C.andZezza,G.(2002)Ispersonaldebtsustainable?,LevyEconomicsInstitute,
StrategicAnalysis,November.http://www.levyinstitute.org/pubs/sa/perdebt.pdf
See Scott Fullwilers The Sector Financial Balances Model of Aggregate Demand and Austerity
http://neweconomicperspectives.org/2011/06/sectorfinancialbalancesmodelof.html
SeeRobParenteausLeadingPIIGStoSlaughter,Part2http://www.nakedcapitalism.com/2010/03/parenteauleading
piigstoslaughterpart2.html
3Papadimitriou,D.,ShaikA.,dosSantos,C.andZezza,G.(2002)Ispersonaldebtsustainable?,LevyEconomicsInstitute,
StrategicAnalysis,November.http://www.levyinstitute.org/pubs/sa/perdebt.pdf
4 See Alternative Measures of Personal Saving by Maria G. Perozek and Marshall B. Reinsdorf at
http://www.bea.gov/scb/pdf/2002/04April/0402PersonalSaving.pdf
5SeeAReconstructionofEconomicsbyKennethBoulding
6 Watch two lectures by Marc Lavoie on stockflow modeling at http://neweconomicperspectives.org/tag/stockflow
consistentmodeling
2
189
CHAPTER 14:
Whathappensduringamajorfinancialcrisis
Whyfinancialcrisesexist
Whatcanbedonetostopanongoingfinancialcrisis
Howfinancialcrisescanbepreventedortamed
CHAPTER14:FINANCIALCRISES
WhilevisitingtheLondonSchoolofEconomicsattheendof2008,theQueenofEnglandwondered
"whydidnobodynoticeit?"Indoingso,sheechoedanarrativethathadbeenpromotedamong
someprominenteconomists:theGreatRecession(it)wasanaccident,arandomextremeevent
thatnoonesawcoming.1Thisnarrativeisfalse.Quiteafeweconomistssawitcominganditwas
notanaccident.2Chapter9showshowdifferenttheoreticalframeworksaboutfinancialcriseslead
todifferentregulatoryresponses.ThisChapterstudiesmorecarefullythemechanicsoffinancial
crisesandhowaneconomygetsthere.
DEBTDEFLATION
Definitionsoffinancialcrisescanbemoreorlessbroad.Someeconomistsrestrictthedefinitionto
banking crises, others may use a statistical definition that takes a specific percentage fall in a
financialindexasanindicationofafinancialcrisis.Inanycase,financialinstabilityhasincreased
sincethe1980s.3
Themostseriousfinancialcrisesinvolvereinforcingfeedbacksbetweenassetpricesandleverage,
leadingtoadownwardspiralofdebtwriteoffsanddecreasesinassetprices.Thesefinancialcrises
are called debt deflations after Irving Fishers analysis of the Great Depression. The main
implicationofadebtdeflationisthatmarketmechanismsbreakdownunderthecombinationof
overindebtednessanddeflation:lowerpricesdonotclearmarketsbutmakematterworse.
Figure14.1Anunstableequilibrium
OnewaytorepresentthatgraphicallyiswiththesupplyanddemanddiagramofFigure14.1.The
demandcurveisupwardslopingbecausehigherpricesleadtohigherwealthandsohigherdemand
for goods and services. There is an equilibrium point but it is an unstable equilibrium, i.e. price
mechanismsdonotbringthemarkettoequilibrium.Forexample,atP1thereisasurplusofgoods
andservices,thisleadstoafallinprices.Deflationdecreasesthequantitysuppliedandthequantity
demanded in such a way that the surplus grows. A similar result can be found by postulating a
downwardslopingsupplycurve.Aspricesfall,moregoodsandservicesaresuppliedtotrytoservice
debts.Therearemanyfeedbackloopsinvolvedinadebtdeflationbuttheprocessstartswithsome
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economicunitsthatbecomeoverindebted.ThefollowingpresentsFishersargumentationinhis
1932BoomsandDepressions.4
STEP1:OVERINDEBTEDNESSANDDISTRESSSALES
Some economic units, e.g. (nonfinancial) businesses, are unable to pay their debts with their
availablemonetaryassets(cashandbankaccounts).Ifrefinancingoptionsarenotavailablebanks
severely ration creditbusinesses in difficulty must find ways to sell nonmonetary assets to
recoverenoughfundstoservicetheirdebts.Theyliquidatetheirinventories,sellothertypesof
financialassetsthanmonetaryassets,andsellsomesuperfluousrealassets(Figure14.2).
Figure14.2Distresssales
Note:The+signmeansthatthingsmoveinthesamedirection:moreoverindebtednessleads
tomoredistresssales(andlessoverindebtednessleadstolessdistresssales).
STEP2:DISTRESSSALESANDDEFLATION,THEDOLLARDISEASE
Thesuddenmassivesalesofnonmonetaryassetsleadtoadeclineintheirprices.Thelowerprices
ofassetslowerstheabilityofbusinessestorecoverfundsfromthesales.Businessesarethenforced
tosellmoreatdistress,whichfurtherpushesdownprices.Thisisthefirstreinforcingfeedbackloop
ofadebtdeflation.
Figure14.3Dollardisease
Note:thesignmeansthatthingsmoveintheoppositedirection:higherdistresssaleslowers
prices,leadingtohigherdistresssales.
STEP3:DEFLATIONANDDEBTLIQUIDATION;THEDEBTDISEASE
Oncetheyhaverecoveredsomefunds,businessesservicedebtsowedtobanksandgovernment
whichreducesthemoneysupplyandservicedebtsowedtoothers(e.g.,corporatebondsheldby
192
households).Somebusinessesmayhavetodefaultandultimatelytheirdebtsarewrittenoffby
creditors, which negatively impacts the creditworthiness of businesses and the net worth of
creditors(seeChapter8).
Followingthequantitytheoryofmoney(whichFisherpromoted),thedeclineinthemoneysupply
lowerspricesevenfurther,sothereisasecondreinforcingfeedbackloop:moredistresssaleslead
tomoredebtliquidation,whichleadstoalowerquantityofmoneyandsolowerpricesandthen
moredistresssales.
Figure14.4Debtdisease
STEP4:PRICESANDPROFITANDNETWORTH,THEPROFITDISEASE
Thedebtanddollardiseasescreateadeflationaryspiralthatisreinforcedbyadditionalfeedback
loops.First,asassetpricesfall,theprofitfromsalesandnetworthofbusinessfallgiveneverything
else,whichfurtherincreasestheiroverindebtednessandsofeedsbackintothedollaranddebt
diseases.Pricesofassetsfallevenmore.
Figure14.5Profitdisease
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STEP5:THEAMPLIFIEREFFECT
Declinesinprofitandnetworthmeanthatnonfinancialbusinesseshaveanincentivetolayoff
employees.Somebanksmayalsohavetoclosebecauselossesfromdebtorsaretoohightobe
sustainedbytheirbalancesheet(seeChapter8).Households,whorecordshrinkageoftheirincome
and prospects of unemployment, lower their consumption. Rising unemployment reduces
aggregatespending,whichfurtherreducesprofitandaggregateincome.Inaddition,thedeclinein
spending further pushes down the value of goods and services and other real assets. Now
households,inadditiontobusinesses,haveproblemsinservicingtheirdebts,whichreinforcesthe
debtwriteoffsanddeclineinthenetworthofbanks.
Figure14.6Amplifiereffect
STEP6:PESSIMISM
As the economy records falling prices, declining economic activity, rising unemployment, rising
defaults,andshrinkingbalancesheets,confidenceamongeconomicunitsdeclinesandhoarding
rises.Higherhoardinglowersthevelocityofmoneyandsopricesarepushedfurtherdown(again
this presentation follows the quantity theory of money). Lower confidence also decreases the
willingnessofbankstograntcredit,andincreasestheirwillingnesstohangontotheirreservesto
meetwithdrawals,interbankpaymentsandotherduesatthelowestcostpossible;theovernight
interbankmarketfreezes(seeChapter4).
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Figure14.7Confidencecrisis
STEP7:INTERESTRATESPREAD
Withthecrisisofconfidencespreadingandwithragingdeflationarypressuresandeconomiccrisis,
interest rates shoot up. This quickly spreads through the outstanding debts if interest rates on
financialcontractsarefloatingrates,whichsqueezesnetprofit(profitdebtcommitments)andso
increasesoverindebtedness.
195
Figure14.8Riskpremiumdisease
CONCLUSION
Overindebtedness and deflation feed on each other through several feedback loops. All these
feedbackloopsmakethingsworseandworse:difficultytoservicedebtleadstolowerprices,which
increasesthedifficultytoservicedebts.
Ifleftalone,adebtdeflationstopsonlywhenthefacevalueofoutstandingdebtshasbeenlowered
sufficientlythroughrepaymentsandwriteoffstomaketheservicingofdebtsbearable.Thedecline
inthedebtburdenloosenstheneedfordistresssales(Figure14.9).Ofcourse,intheprocessbanks
close,householdslosetheirsavingsandtheireconomicallyactivemembersbecomeunemployed,
businessesclose,andresourcesarewasted(outputislefttorot,laborpowerandknowledgeare
left unused and decay quickly, capital equipment depreciates, etc.). According to market
proponents, this is fine because a debt deflation punishes all economic units that made bad
decisions. Banks that overextended credit, businesses that did not satisfy their customers,
householdswhoarenotflexibleenough,etc.AsTreasurySecretaryAndrewMellonstatedduring
theGreatDepression:liquidatelabor,liquidatestocks,liquidatefarmers,liquidaterealestateit
willpurgetherottennessoutofthesystem.Highcostsoflivingandhighlivingwillcomedown.
Peoplewillworkharder,liveamoremorallife.Valueswillbeadjusted,andenterprisingpeoplewill
pickupfromlesscompetentpeople.
Therearetwomainproblemswiththisview.First,Chapter8explainsthatwhatisconsideredin
hindsightabad/incompetent decisionmayhave beennecessaryprior tothecrisisinorder to
keep up with the competition and to avoid losing market share and income. Second, a debt
deflation is not a selective process. It destroys economic status indiscriminately by spreading
throughdeclinesinnetwealth,joblosses,lossesofsavings,declinesinconfidence,shutdownsof
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financingopportunities,andanoverallsharpdeclineineconomicactivity.Thinkofafirethatstarts
because someone smoked in bed. This person may deserve to have a destroyed home but, if
nothingisdonetostopthefire,theentiretownmaybedestroyed.
Figure14.9Astabilizingloop
ORIGINSOFDEBTDEFLATION
Whilethemechanicsofadebtdeflationarewellknownandwidelyaccepted,whatcausesthemis
subjecttodebate:whydoeconomicunitsbecomeoverindebtedinthefirstplace?Again,keeping
withthedistinctionofpreviousChaptersonmacroeconomictopics,thissectionmakesadistinction
betweentherealexchangeviewandthemonetaryproductionview.
REAL EXCHANGE
IMPERFECTIONS
ECONOMY:
EFFICIENT
MARKETS
AND
Inthisview,moneyandfinanceareneutralandfinancialmarketsareefficient.TheEfficientMarket
Hypothesis (EMH) states that markets allocate scarce resources toward the most productive
economicactivities,andallocatefinancialriskstowardeconomicentitiesthataremostabletobear
them.TheEMHalsostatesthatmarketmechanismsselfcorrectandeliminateanydisequilibrium
suchasbubblesorcrashes.Inordertointroducethepossibilityoffinancialcrises,eithermarkets
havetobeimperfect,ormarketparticipantshavetobehaveimperfectly/irrationally.
In terms of market imperfections, a lot of emphasis is put on the existence of asymmetries of
information. Banks have much less information about the quality of a project than potential
197
customers.Bankerstrytoprotectthemselvesbyrequiringcollateral.Thisissupposedtogivean
incentivetoeconomicunitswhorequestanadvanceoffundstodotheirbesttomaketheirproject
successful(otherwiseeconomicunitslosethecollateral).
Followinganegativerandomshock,thevalueofcollateraldeclines,whichleadsdebtorstolimit
theirentrepreneurialeffortbecauseadeclineinthevalueofthecollateralmeansthattheyhave
lesstolosebydefaulting,whichincreasesthechancesoffinancialdifficulties.Bankstakenotice
and start to ration credit. This generates a credit crunch, which leads to further declines in net
worthandcollateralandsolesseffortandagreaterriskofdefault.
RecentresearcheffortsbyscholarswhofollowtheREEapproachhavefocusedonthereversion
mechanisms (how a crisis occurs) instead of the propagation mechanisms (how a crisis spreads
followingashock).Crisesarerenderedendogenousbylinkingefforttothebusinesscycle.Themore
effortindividualsputintotheirbusiness,themoreproductivetheyare,whichleadstoagreater
supplyofcommoditiesandsolowerprices.Lowerpricesleadtolowernetgains,whichleadsto
lowereffortandsotoagreaterriskofdefault.
Giventhatthemathematicalmodelsdevelopedtobackthisviewareallsetinrealterms,andgiven
thattherandomshockisappliedtotheproductivityofaninput(e.g.,land),thistypeofanalysis
applies well to a precapitalist agricultural economy (see Chapter 11). Nature decides which
economicstateoccurs(goodorbadweather).Financialcrisesareequivalenttoweathercalamities
thatdecreaseagriculturaloutput.
TheimperfectionviewcanbecomplementedbytheMonetaristviewoffinancialcrisesandbythe
irrationalapproachdevelopedbybehavioraleconomics.Theformerstatesthatfinancialcrisesare
duetotheincompetenceofpolicymakers,andthelatterstatesthatbehavioralimperfectionsof
individuals contribute to the emergence of crises. People have limited cognitive capacities that
restrict their capacity to acquire and interpret information, and market participants care about
thingsthatarationaleconomicmanshouldnotcareabout.Asaconsequence,amarketeconomy
ispronetobubbles,herdbehavior,cascadeofinformation,andmisallocationofresources,leading
tooverindebtednessandultimatelyadebtdeflation.Onemaytrytocorrectforthesebehavioral
problemsbycreatingmarketsthatprovidesignalsthatallowmarketparticipantstomaketheright
decisions.
MONETARY PRODUCTION ECONOMY: THE FINANCIAL INSTABILITY

HYPOTHESIS
AccordingtotheMPEview,theprevioustypeofanalysisignoresimportantaspectsofcapitalist
economies.Forexample,governmentdeficitsdopromotefinancialstability,whichisseenasan
empiricalpuzzleintheREEview,giventhatdeficitsoughttocrowdoutinvestmentandsomake
thingsworse.TheREEviewisalsotoomicroorientedandlacksasystemviewoffinancialcrises
thatrecognizesmajorsourcesofinstabilityoutsidetherealmofindividualbehavior/effort.
TheFinancialInstabilityHypothesis(FIH)isanalternativetotheEMH.ThemainclaimoftheFIHis
thatperiodsofeconomicstabilityarefertilegroundsforthegrowthoffinancialfragility,i.e.the
growthoftheriskofdebtdeflation.HymanP.Minsky,whoreliesontheworkofFisher,Keynesand
Schumpeter, is the main developer of the FIH and provides a more detailed analysis of what
overindebtednessmeansanditsimpacts.Heconcludesthatstabilityisdestabilizing.
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FINANCIALFRAGILITY
AccordingtoMinsky,thedegreeoffinancialfragilityofeconomicunitshowbadlyoverindebted
theyarecanbeclassifiedashedgefinance,speculativefinanceorPonzifinance.Hedgefinance
meansthataneconomicunitisexpectedtobeabletomeetitsliabilitycommitmentswiththenet
cashflowitgeneratesfromitsroutineeconomicoperations(workformostindividuals,profitfrom
going concerns for companies) and monetary balances. Even though indebtedness may be high
(evenrelativetoincome),aneconomyinwhichmosteconomicunitsrelyonhedgefinanceisnot
pronetodebtdeflation,unlessunusuallylargedeclinesinroutinecashinflowsand/orunusually
largeincreasesincashoutflowsoccur.Eventhen,monetarysavingsareusuallyavailableinalarge
enoughquantitytoprovideabufferagainstunforeseenproblems.Assuch,itisnotexpectedthat
theservicingofdebtswillbeproblematicandsonorefinancing(goingintodebttoserviceexisting
debts)and/orsalesofnonmonetaryassetsisexpected.
Speculativefinancemeansthatroutinenetcashflowsourcesandmonetarybalancesareexpected
tobesufficienttopaytheincomecomponent(interest,dividend,amongothers),buttoolowto
pay the capital component (debt principal, margin calls, cash withdrawals, among others) of
liabilities.Asaconsequence,aneconomicunitneedseithertogointodebtortosellsomenon
monetaryassetsinordertoservicetheprincipaldue.Economicunitsusuallyexpectthatrolling
debtsover(i.e.payingtheprincipalonolddebtsbyissuingnewdebts)willbepossibleinsteadof
liquidatingassets.Thelengthoftimeduringwhichroutinecashflowsareexpectedtofallshortof
capitalrepaymentdependsontheeconomicunit.Chapter8explainsthatthebusinessmodelof
banksissuchthatrefinancingisusuallyneededtoservicethecapitalcomponentofliabilities;as
suchbankingrequiresareliableandcheaprefinancingsource.Otherbusinessesmayonlyhavea
temporaryneedtorollovertheirdebts.
Ponzi finance, also called interestcapitalization finance, means that an economic unit is not
expected to generate enough net cash flow from its routine economic operations, nor to have
enough monetary savings to pay the capital and income service due on outstanding financial
contracts.Asaconsequence,inordertoserviceagivenlevelofoutstandingdebts,Ponzifinance
relies on the growing availability of refinancing sources, and/or an expected liquidation of non
monetary assets at rising prices. At the microeconomic level, an economic unit that uses Ponzi
financetofunditsassetsishighlyfinanciallyfragile.Atthemacroeconomiclevel,ifkeyeconomic
units behind the growth of the economy are involved in Ponzi finance, the economic system is
highlypronetoadebtdeflation.
Notethatthiscategorizationisnotmerelyameasureoftheuseofexternalfunding,i.e.ofthesize
of leverage. It is also a measure of the quality of the leverage. At the core of this analytical
categorizationisananalysisofthemeansthatareexpectedtobeusedtofulfillfinancialcontracts.
Hedgefinanceisnotexpectedtorequireanyrefinancingoperationorliquidationofnonmonetary
assets to service debts; Ponzi finance requires a growing use of refinancing and liquidation to
servicedebts.ThishasimportantregulatoryimplicationsasshowninChapter9,becauseknowing
howonecanservicedebtbecomesasimportant,ifnotmoreimportant,thanknowingifonecan
servicedebts:lowdefaultprobability(if)doesnotmeanlowfinancialfragility(how).
Ponzi finance should be differentiated from the existence or nonexistence of a bubble. The
categorizationdoesnotaimatmeasuringtheaccuracy(however,defined)ofthepriceofassets
usedtoservicedebts.Ponzifinancemeansthatleverageandassetpricesendupgoinguptogether
andfeedoneachotherontheupside.Higherleveragerequireshighercollateralvalueandsohigher
199
assetprices,andthefundingofassetsatapricethatgrowsfasterthanincomerisesrequireshigher
leverage. This is the crucial dynamic regardless of the correctness of the value of asset prices
because,bubbleornot,thesizeofapotentialdebtdeflationgrowswiththedurationoftheuseof
Ponzifinance.WithoutPonzifinancetherecannotbeadebtdeflationbecausethereisnoleverage
involvedintheassetpriceappreciation.Withoutadebtinflation(thatisasituationinwhichasset
pricesanddebtbecomehighlyinterdependentontheupside),therecannotbeadebtdeflation.
Ponzifinanceisalsodifferentfromfraud(whichcanprevailathedge,speculativeorPonzistage).
Ponzifinanceisanunsustainablefinancialprocessregardlessofthelegalityofafinancialstructure.
Indeed,inordertopersist,itrequiresanexponentialgrowthoffinancialparticipation,whichisnot
possible because, ultimately, there is a limited number of economic agents that can or will
participate.
TheH/S/Pcategorizationdoesnotapplytomonetarilysovereigngovernments,i.e.governments
that issue their own nonconvertible currency and that issue public debt denominated in their
currency. Examples of monetarily sovereign governments are the United States Federal
Government, the Japanese national government, the United Kingdom national government, the
Chinese and Mexican central governments. Examples of nonmonetarily sovereign governments
arenationalgovernmentsoftheEurozone,theUnitedStatesunderthegoldstandardbefore1933,
state and local governments in the United States and, any country that issues securities
denominatedinaforeigncurrency.Whenagovernmentismonetarilysovereign,ithasamonopoly
overthecurrencysupplyandsoalwayscanmeetpaymentsdenominatedinitscurrencyasthey
come due. Hedge finance applies to any sovereign government that is monetarily sovereign
becausesuchagovernmentcannotbeforcedtodefault;defaultispurelyvoluntary.Inaddition,
thefederalgovernmentmayprovidebondsandotherdefaultfreeliquidsecuritiesthatboostthe
liquidity of the balance sheets of the private sector. The long period of financial stability in the
UnitedStatesafterWorldWarIIwastheresultofhighlyliquidbalancesheetsintheprivatesector
due to large government deficits during World War II that flooded the private sector with safe
assets(seeChapter8).
THEFINANCIALINSTABILITYHYPOTHESIS
AccordingtotheFIH,duringaperiodofprolongedexpansion,theproportionofeconomicunits
involvedinspeculativeandPonzifinancegrows,andsotheriskofadebtdeflationincreases.The
periodofexpansionmayrecordminorrecessionse.g.,the1991and2000downturnsintheUnited
Statesthatdonotsignificantlytamethestateofexpectationsofprivateeconomicunitsandso
donotsignificantlymakeunderwritingpracticesmoreprudent.Assuch,theFIHisnotatheoryof
thebusinesscyclebutratherfocusesonewhatcausessignificantrecessions.
Contrarytothebehavioralexplanation,irrationalityisnotattheheartofinstability.Theboom,with
its mania, just amplifies the dynamics that emerged previously during a period of prolonged
expansion. Contrary to the market imperfection explanation, market mechanisms promote
instabilitynotstability.Theheartoftheproblemisnotfoundinindividualsmakingdumb/irrational
decisions but rather in the system in which they operate. Capitalism is a much more financially
unstable economic system than those that previously existed. Capitalisms incentives and
mechanicspusheconomicunitsintoPonzifinance.
Thereareseveralchannelsthroughwhichfinancialfragilitygrowsandtheyhavetodowithanything
thatchangestherelationbetweenincomeanddebtservice.Anythingthatpushesaneconomicunit
200
fromastateinwhichincomeisgreaterthandebtservicetoastateinwhichincomeislessthan
debtservicerepresentssuchachannel.Thiscanhappeneitherbecauseincomelevel(orgrowth)
fallsand/ordebtservicelevel(orgrowth)rises.Factorsthatimpactbotharedescribedbriefly:
Structuralcauses:
-
Banks are speculative units: the maturity of banks liabilities is short relative to the
maturity date of banks assets so they need to refinance all the time. Banks aim at
loweringthematurityoftheirassetstolimitthematuritymismatch,whichpromotes
speculative finance in the nonbank sectors. For example, in the US, the 30year
mortgageisnotaproductofprivatebankingbutofgovernmentinterventionandit
must be subsidized to persist. Banks much prefer shorterterm mortgages (say 10
years) that require households to refinance, which creates a dependence on the
directionofhomeprices(Chapter7explainsthatifhomepricesfallrefinancingmay
nothappen).
Changes in banking business: move away from the originateandhold model to the
originateanddistribute model, which creates adverse incentives in terms of
underwritinganddebtreworking(seeChapter8).
Economiccauses
-
Searchforprofitandmarketshare,andmarketsaturation:ROE=ROAxleverage(see
Chapter8).
Inequalities:theneedtousedebttosustainagivenstandardofleavinghasincreased
(studentdebt,healthcaredebt,etc.)
Unexpected events: The FIH leaves some room for adverse random shocks (say a
hurricanedestroyedmanyhousesandbusinesses,whichtriggersmassivepaymentsby
insurancecompanies)
Policyreasons:
-
Deregulation, desupervision and deenforcement (see Chapter 9): fraud grows and
underwritingworsens.
Fiscal policy: A period of prolonged expansion that is led by a monetarily sovereign

governmentwillnotleadtofinancialinstability.Fiscaldeficitsboostmacroeconomic
profit(seeChapter11)andpersonalsavingsandprovidescashflowsaswellassafe
financialassetstotheprivatesector.However,asshowninChapter13,governments
desiretoreachasurplus,combinedwiththeautomaticstabilizers,meansthatnon
governmentsectorsmaybeforcedtodeficitspend.
Monetarypolicy:Duringaperiodofexpansion,thecentralbankraisesinterestrates
and that increases the debt burden. Minsky is of the opinion that fine tuning and
preserving financial stability are not compatible and argues for a central bank that
focusesonfinancialstability.
Sociopsychologicalreasons
-
201
Longperiodofprosperityleadstoadeclineinriskperceptionbecauseeconomicnews
isgoodanditistoocostlytolooktoomuchbackward(seeChapter9).
-
Uncertaintymeansthateconomicunitsrelyonnormstomakedecisions.Thesenorms
arerationalizedthroughaconvention,whichisamentalconstructionaboutthecurrent
economictrendsandaboutwhattoexpect.Thereisastrongincentivetosticktothe
conventiontoavoidlosingmarketshareordrawingtheattentionofregulators(see
Chapter 8). So if Ponzi finance is considered normal, a bank will do it and will find
comfortinthefactthateverybodyelseisdoingitsoitisok.
HOWTODEALWITHFINANCIALCRISES
Financial crises that are severe create a lot of damages if they are not managed through
governmentintervention.Thisgovernmentinterventioninvolvesbothquickfixestodealwiththe
immediateproblemsandlongtermpoliciestopreventmoralhazardandpromotestability.The
recentresponsestotheGreatRecessionprovideexamplesofwhatnottodo:
Stoptheliquiditycrisis:centralbankprovidesfundsatpenaltyrate,againstsafecollateral,
to solvent institutions. One may argue that, during a crisis, a lot of financial assets that
previouslylookedsafemaynowbeunsafebecauseofthelackofconfidenceandbecause
ofpooreconomicprospects.Forexample,primemortgageesmaydefaultbecausetheylost
theirjob.Thereisawayaroundthisissue.Centralbanksshouldacceptonlyfinancialassets
that were created by following strict underwriting, that is, those that involved hedge
financeandspeculativefinancepriortothecrisis.Centralbanksmayrecordlossesonthem
giventhatadebtdeflationalsoimpactseconomicunitswithstrongcreditworthiness,but
thatshouldbeminimal.DonotprovideliquidityagainstPonzifinanceinducingfinancial
instruments,eveniftheyarenotindefault.
Stopthesolvencycrisis:Bankholidaytoexaminethebooksoffinancialinstitutionsindetail
foragivenperiodoftime(sayaweeklikeduringtheGreatDepression)andcloseinsolvent
banks. Act to sustain income and to lower the debt burden. Lower the debt burden by
reworkingdebtsofeconomicunitswhowouldbesolventwiththereworking(duringthe
great depression, government bought interestonly mortgages from banks and replaced
themwith30yearfixedratefullyamortizedmortgages).Tosustainincome,createlarge
scale longterm fiscal policy such as a job guarantee program (Great Depression work
programswerestartedinamatterofdays).
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Recent crisis: Fed provided advances at near 0% rate, against poor to toxic
collateral(acceptedatpar),toquestionableinstitutions,tononbankentities
Recentcrisis:nosignificantanalysisofaccountingbooks(only2Fedpeoplesentat
Lehman Brothers,5superficial stress tests), insignificant and slow fiscal action to
stabilizeincome (700 billionwasnotenoughandwasimplementedoveryears),
hide losses of financial institutions by widening level3 valuation, injection of
capitalinbanksviaTreasurywithoutanyrealcongressionaloversight,nosignificant
reworkingofdebtsonnonbankagents.
Change incentives and regulation, supervise and enforce: prosecute top managers for
fraud,issueceaseanddesistorders,majorreworkingofregulationandsupervisiontodeal
withproblems,promotehedgefinanceandifnecessaryforbidPonzifinance.
Recent crisis: Not a single prosecution of top executives, even though fraud is
obvious(asktheFederalBureauofInvestigationandratingagenciesthatfinallyhad
a look at mortgage contracts), civil instead of criminal cases (the financial
institutionpaysfinesandpromisesnotdoitagain),nomajorreregulatorytrends,
noenforcementofexistinglawspriorandduringcrisis.
Eventhoughafinancialsystemmaybeonthebrinksofcollapseandpanicisgeneralized,regulatory
institutionsoragenciesmustfollowthelaw.Ifnecessary,regulatorsmayuseemergencyexecutive
powers(bankholiday)toshutdownthefinancialsystemtemporarilyandtogettothebottomof
theproblem.Lenienceleadstolongterminstabilitybecausetheexistenceofagovernmentsafety
netpromotesmoralhazard.Withoutasafetynet,suchasacentralbankactingaslenderoflast
resort,economiccriseswouldbeverysevere.
TOGOFURTHER:PONZIFINANCEANDTHEBALANCESHEET
WhenaneconomicunitisinvolvedinPonzifinance,ithastogointodebttoserviceprincipaland
interest.Saythatthereisabalanceof$100onacreditcardthatrepresentsexpensesforthemonth
andthatthereisalso$10ofinterestdue.Toservicethecreditcarddebt,onemustopenanew
creditcardtopay$110dueoncreditcard#1.Thefollowingmonth$110+$11ofinterestisdueon
thesecondcreditcard.Thedollaramountoffinancialliabilitiesgrows.Anotherwaytoservicecredit
card#1istosellsomeassetsworth$110.SoPonzifinanceimpliesthatthequantityofrealassets
(RA)fallsand/ornetfinancialaccumulation(NFA)declinesbecauseeitherthequantityoffinancial
assetsfallsorthequantityoffinancialliabilitiesrises.WeknowthatRAandNFAarerelatedtonet
wealth(seeChapter13):
NW=RA+NFA
Giveneverythingelse,Ponzifinanceleadstoafallinnetworth.Therearetwowaystomitigatethis
decline:
1 Overtime the assets funded in a Ponzi way may start to generate enough cash flows to
coverdebtservices.Saythatacompanywasjustcreatedandneedssometimetogetits
businesstoearnanincome.Inthemeantime,itneedsfinancingtopayemployees,toget
thebusinesssetup,etc.Duringthattime,thenetworthofthecompanywillfallbutitis
expectedthatultimatelythebusinesswillbeprofitableandwillgenerateenoughcashflows
to pay creditors. One may call this incomebased Ponzi finance; for a while income is
insufficientbutthereisanexpectationthatthisisonlytemporary.
2 Thepriceofrealassetsandthepriceoffinancialassetsthatarestillonthebalancesheet
goupfastenoughtomorethanoffsettheriseindebtandtheliquidationofassets.The
recent housing boom that allowed households to record massive increase in net worth
while they were going massively into debt is an example of such dynamics. The
underwritingworsenedsomuch (see Chapter8) thattheonly waytomakeamortgage
profitablewastosellthehouseatahighenoughpricetocoverinterestandotherpayments
duetocreditors.OnemaycallthatassetbasedPonzifinance,orapyramidscheme;there
isnoexpectationthatincomewilleverbeenoughtoservicedebts.Theliquidationofthe
collateralandotherassetsatrisingpricesistheonlyexpectedmeanstomakethePonzi
financingprofitableandtokeepnetworthrising.
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TO GO EVEN FURTHER: MINSKY AND INCOME VS. CASH

INFLOW
In most presentation of the FIH, income and cash inflow are not distinguished carefully. For
example,theFIHisoftenpresentedfromthepointofviewofthebusinesssectorwithprofit(U)
reflectingtheabilityorinabilitytofulfilldebtservice(CC)sothatU>CCishedgefinance.Atthe
macroeconomiclevel,UisdeterminedbytheKaleckiequationofprofit(seeChapter11).
Atthetheoreticallevelthatmightbegoodenough,butitisnotsoattheempiricallevel.Income
andcashflowsaretwodifferentthings(seeChapter1).Incomeisaboutmeasuringgainsinnet
worth,cashflowisaboutmeasuringchangeinmonetaryassets.TheKaleckiequationofprofitdoes
notsayanythingaboutgainsofmonetarybalances.Forexample,anincreaseinunsoldinventories
raises profit because higher inventories increase real assets. Similarly for households, personal
incomeincludesquiteafewitemsthatareunrelatedtomonetarygains.Vegetablesgrowninthe
garden,serviceprovidedbyowningahouse,amongotherthings,arecountedasimputedincome.
Unfortunately, as explained in Chapter 12, creditors demand monetary payments so earning an
incomeinrealterms,asopposedtomonetaryterms,doesnothelpaneconomicunittoserviceits
debts.
WhatisreallyimportantiswhatMinskycalledthecashboxconditionandexpectationsbasedon
it:howdoesthesumofcashinflowsandmonetarybalancescomparetocashoutflowsnowandin
thefuture?Thatmayormaynotberelatedtoprofitandpersonalincome.Thecashflowstatement,
ratherthantheincomestatement,togetherwiththecashflowexpectationsembeddedinfinancial
contracts,giveabetterideaofthefinancialfragilityofaneconomicunit.
1Duringamajorfinancialcrisis,i.e.adebtdeflation,thereareseveralfeedbackloopsthatmay
develop,whichreinforcethedeflationaryforcesatplay.Adebtdeflationisnotselfstabilizing;the
longeritisallowedtoproceed,themoredestructiveitgets.
2Adebtdeflationisnotselfcleansing;itdestroyseconomicvalueindiscriminatelyuntilenough
debthasbeenliquidatedtotamethedeflationaryforces.
3Howaneconomyispushedtothebrinkofadebtdeflationissubjecttodebate.Someeconomists
believe that a debt deflation is the result of a very large adverse random shock that risk
managementmodelsdidnotaccountforbecauseitwastoocostlytodoso.Othereconomistsargue
thatthesearchforprofit andthe increasedrelianceofmarketmechanismsleadtoanunstable
economy.
4Inordertodealwithafinancialcrisis,onemustpromoteshorttermstabilitybystoppingthe
liquidity crisis and must promote longterm stability by dealing with the solvency crisis and the
outdatedregulatoryframework.
5 According to the efficient market hypothesis, markets tend to allocate resources and risks
properlyandtheonlythingthegovernmentcandoistohelpprotectagainstthemostcommon
adverseshocksthatmayimpactmarkets.Profitisagoodindicatoroffinancialhealth.Accordingto
thefinancialinstabilityhypothesis,marketstendtopromotePonzifinanceandsomeregulations
mustbeputinplaceaboutfinancialpracticesandfinancialinnovations.Profitaloneisnotagood
indicatoroffinancialhealthbecauseonemustaskthroughwhatfinancialpracticesthisprofitwas
achieved.
204
Keywords
Efficient market hypothesis, financial instability hypothesis, debt deflation, hedge finance,
speculativefinance,Ponzifinance,incomebasedcredit,assetbasedcredit,debtliquidation,profit
disease,debtdisease,dollardisease,pessimism,irrationalbehavior
ReviewQuestions
Q1:Whyisthedollardiseaseareinforcingfeedbackloop?Whataboutthedebtdisease? What
abouttheprofitdisease?
Q2:Whendoesadebtdeflationstopiflefttomarketmechanisms?Whyisthatnotasmoothand
effectivewaytocleansetheeconomy?
Q3: What are the amplifier mechanism and reversion mechanism used in the real exchange
economyviewoffinancialcrisis?
Q4:Whatarethesourcesoffinancialcrisisinthemonetaryproductioneconomyview?Isitmostly
aboutirrationalindividualbehaviorsandimproperincentives?
Q5:Whatcanbedonetodealwithafinancialcrisis?Didtherecentresponsetothe2008crisis
followtheproperguidelines?
Q6:WhyPonzifinanceintrinsicallyunstable?WhatisthedifferencebetweenincomebasedPonzi
financeandassetbasedPonzifinance?DoesPonzifinancenecessarily,orevenmostly,implyfraud
orirrationalbehaviors?
Suggestedreadings
Fisher,I.(1932)BoomsandDepressions:SomeFirstPrinciples,NewYork:Adelphy.
Minsky,H.P.(1982)Thefinancialinstabilityhypothesis:Capitalistprocessandthebehaviorofthe
economy,inC.P.KindlebergerandJ.P.Lafargue(eds)FinancialCrises:Theory,History,andPolicy,
1339,NewYork:CambridgeUniversityPress.
Mishkin,F.S.(1991)Asymmetricinformationandfinancialcrises:Ahistoricalperspective,inR.G.
Hubbard(ed.)FinancialMarketsandFinancialCrises,69108,Chicago:UniversityofChicagoPress.
Charles, S. (2016) Is Minskys financial instability hypothesis valid? Cambridge Journal of
Economics40(2):427436.
Keen, S. (2013) A monetary Minsky model of the Great Moderation and the Great Recession
JournalofEconomicBehavior&Organization,86(1):221235.
Schwartz, A.J. (1988) Financial stability and the federal safety net, in W.S. Haraf and R.M.
Kushmeider(eds)RestructuringBankingandFinancialServicesinAmerica,3462,Washington,DC:
AmericanEnterpriseInstituteforPublicPolicyandResearch.
Shiller,R.J.(2000)IrrationalExuberance,Princeton:PrincetonUniversityPress.
Suarez, J. and Sussman, O. (1997) Endogenous cycles in a StiglitzWeiss economy, Journal of
EconomicTheory,76(1):4771.
205
1 Bezemer,
D.J. (2010) Understanding financial crisis through accounting models, Accounting, Organizations and
Society,26(7):676688.
2SeeGotitRightProjectathttp://afee.net/?page=heterodox_economics&side=got_it_right_project
3Bordo,M.,Eichengreen,B.,Klingebiel,D.andMartinezPeria,M.S.(2001)Isthecrisisproblemgrowingmoresevere?,
EconomicPolicy,16(32):5182.
4 An
electronic copy of Fishers book can be found at the St. Louis Federal Reserve:
https://fraser.stlouisfed.org/docs/publications/books/booms_fisher.pdf
5A blunt testimony by William K. Black at the hearings regarding the failure of Lehman Brothers can be found here:
https://www.cspan.org/video/?c2113/clip2008lehmanbrothersfailurepanel4
206
CHAPTER 15:
Whatamonetarysystemis
Howamonetarysystemworks
Whyamonetarysystemmaybedysfunctional
Whymonetaryinstrumentsareaccepted
Whatdeterminesthenominalvalueatwhichafinancialinstrumentcirculates
Whatpromisesaremadebyissuersofmonetaryinstrumentsandhowthat
determinestheirfairprice
CHAPTER15:MONETARYSYSTEMS
Throughoutthistextbook,Chaptershaveusedbalancesheetsextensivelytogetanunderstanding
of the monetary operations of developed economies, but nothing has been said about what a
monetaryinstrumentis.Itistimetospendsometimeonthenatureofmonetaryinstrumentsand
theinnerworkingsofmonetarysystems.Amonetarysystemiscomposedoftwocoreelements:
A unit of account that provides a common method of measurement: the euro (), the
poundsterling(),theyen(),thedollar($),etc.
Monetaryinstruments:specificfinancialinstrumentsdenominatedintheunitofaccount
andissuedbythegovernmentandtheprivatesector.
ThisChapterfirstexplainswhatfinancialinstrumentsareandhowmonetaryinstrumentsfitwithin
theexistingrangeoffinancialinstruments.Itthendelvesintowhatdeterminesthenominaland
realvalueofmonetaryinstruments,andintowhatmakesthemaccepted.
FINANCIALINSTRUMENTS
Balance sheets contain many types of financial instruments. Some of them are issued by an
economicunit(financialliabilities),othersareheldbythatsameeconomicunit(financialassets).
Financialinstrumentsarejustformalpromisestomakemonetarypayments.Thewayapromiseis
structured varies widely depending on the needs of the issuer, but common questions that a
promisemustanswerare:
Whoistheissuer?Themarkoftheissuer(name,head,etc.)ispresentsobearersknow
whoissupposedtofulfillthepromiseembeddedinthefinancialinstrument.
Whatistheunitofaccountused?Financialinstrumentscannotexistbeforethereisaunit
ofmeasurementformonetarytransactionsandoutstandingbalances.
Atwhatpricewilltheissuertakebackitspromissorynote?Thereisaface/parvaluethat
specifiesthenumberofunitsofaccountthefinancialinstrumentcarries($100,$10,$1,25
cents,etc.).
Whenwilltheissuertakebackitspromissorynote?Thereisatermtomaturity:Thelength
of time it will take to fulfill the promise, at which point the issuer must take back the
financialinstrumentitissued(andthendestroyittomakesurenobodycanreacquireitto
haveaclaimontheissuer).Thetermcangofromzero(issuertakesitbackwheneveritis
presentedbybearers)toinfinity(issuertakesbackatitsdiscretion,maybenever).
Howwilltheissuertakebackitspromissorynotes?Theexpectedmeansthatwillbeused
by the issuer to fulfill his promises, called more technically the reflux
mechanisms/channels.(Chapter14showsthatthewaythisquestionisanswerediscrucial
forfinancialstability)
What is (are) the reward(s)/benefit(s) for those willing to trust the issuer? Financial
instrumentsmayrewardtheirbearers:income,votingrights,avoidprison,etc.
Are there any guarantees in case the issuer is unable or unwilling to fulfill the promise?
Financialinstrumentsmaybesecured/collateralized:iftheissuerdefaultsonitspromises,
thebearersgetpaidbytakingownershipofassetsoftheissuer(houseformortgages,etc.)
208
Isitpossibletotransferthepromissorynotetoanotherbearer?Financialinstrumentsmay
benegotiable,i.e.thepersontowhomthepromisehastobefulfilledcanbechangedby
transferring ownership of the financial instrument. Some financial instruments are not
transferablebecausetheynamethebeneficiary(e.g.savingsbondsissuedbyU.S.Treasury)
andcannotbeendorsedtosomeoneelse.Some,likechecks,havelimitedtransferability.1
Dependingonhowthesequestionsareanswered,thenameofafinancialinstrumentchanges,in
thesamewaydogsandcatshavedifferentnamesdependingontheirheight,coloroftheirfur,etc.
Forexample,aTreasurybilldoesnotprovideanyrewardandisduewithinayear.Acommonshare
providesarewarddependingontheprofitoftheissuingcompany,givesavotingright,andthe
companydoesnotpromisetotakebackitsshares.
As stated in Chapter 10, anybody can make any kinds of promise. The hard parts are, first, to
convince others of the genuineness of the promise so they are willing to accept a financial
instrumentand,second,tofulfillthepromiseonceithasbeenaccepted.Financeestablishesalegal
framework to record the creation and fulfillment of promises, and it measures, more or less
accurately,thecredibilityofthesepromisesatanypointintime.
Finally,withinacountry,thereisahierarchyoffinancialinstrumentsinthesensethatsomeare
more easily accepted. The most widely accepted financial instruments are those that are
negotiable, of the highest creditworthiness, of the highest liquidity, and of the shortest term to
maturity. In contemporary economies with a monetarily sovereign government, centralbank
monetary instruments are at the top of the hierarchy. They are followed by bank monetary
instrumentsthatweremadeperfectlyliquidfollowingtheemergenceofinterbankparclearingand
settlement and deposit guarantee. Below the previous monetary instruments are financial
instrumentstradedonanorganizedexchange(issuedmostlybygovernmentsandcorporations:
shares,bonds,notes,bills,etc.).Atthebottomofthehierarchy,thereareallsortsofpromisessuch
as local currencies and personal promissory notes. This hierarchy is not fixed and, throughout
history,thetopmonetaryinstrumentwasnotalwaysagovernmentmonetaryinstrument.
A SPECIFIC FINANCIAL
INSTRUMENTS
INSTRUMENT:
MONETARY
Someissuersmakethefollowingpromisetobearers:
Iwilltakebackmypromissorynotewheneveryouwantmetodoso:Termtomaturityis
instantaneous/zero.
Iwilltakebackmypromissorynotefromanybodywhopresentsittome:Onlytheissuers
markisontheinstrumentandnobeneficiaryisnamed(eithernonameorthebearer).
Iwilltakebackmypromissorynoteatparinpaymentofdebtsowedme:Byhandingtome
mypromissorynotes,Iwillreduceanydebtyouowemebythefacevalueofthenote.The
governmentacceptsreservestosettletaxesatfacevalue(thegovernmentdoesnotaccept
cashfromthepublicinpaymentoftaxesforsecurityandtractabilityreasons,insteadit
worksthroughbanks),banksacceptatfacevaluethefundsinbankaccountstosettlewhat
isowedtothem(seeChapter6andChapter10).
Thepromisemaycontaintwoadditionalclauses:
209
Iwillexchangemypromissorynoteforsomethingelsewheneverthebearerwantsmeto
doso:thereisaconversionclause.Bankspromisetoconvertbankaccounts(andbanknotes
when they used to issue them) into government monetary instruments on demand.
Governmentsmaypromiseconversionintogoldoraforeigncurrency.
Iwillusegoldoranotherpreciousmetaltomakethepromissorynote:thepromissorynote
issecured.Inthesamewayahouseiscollateralforamortgage,goldmaybecollateralfor
acoin.
This type of financial instruments are monetary instruments. Similarly to any other financial
instrument,thecreationofmonetaryinstrumentsinvolvessomeonebecomingliable(theissuerof
themonetaryinstrument)becausemonetaryinstrumentsembedafinancialpromise.
AT WHAT PRICE SHOULD A FINANCIAL INSTRUMENT

CIRCULATEAMONGBEARERS?
Thenominalvalue,P,atwhichafinancialinstrumentoughttocirculateamongbearersiscalledthe
fairpriceorfairvalue.Thepresentvalueofexpectedfinancialrewardsisacommonwaytojudge
thefairpriceofmanyfinancialinstruments.Itisthesumofallthediscountedstreamsofpayments
thatareexpectedbybearersuntilafinancialinstrumentmatures:

Where the subscript t indicates the present time, Pt is the current fair value, Yn is the nominal
incomepromisedatafuturetimen,FVNisthefacevaluethatwillprevailatmaturity, Etindicates
current expectations about income and face value, dt is the current discount rate imposed by
bearers,Nisthetimelapseuntilmaturity(n=0istheissuancetime)(Thecharactermeanssum
of).
There is a wide variety of financial instruments that use this formula. One can classify financial
instrumentsaccordingtothetermtomaturity(Figure15.1).
Figure15.1Financialinstrumentsandtermtomaturity
Note:Cisthecouponpayment,aformofincome
Atoneextremearemoderngovernmentmonetaryinstrumentsthatprovidenoincome(Y=0),are
redeemedatthediscretionofbearers(N=0),andareexpectedtobetakenbackbythegovernment
attheirinitialfacevalueatanytime,Pt=FV0.Governmentissuedmonetaryinstrumentsoughtto
circulateatparallthetimebecausetheyare zerotermzerocouponfinancialinstruments.Atthe
otherextremeareconsolsthathaveagivenexpectedincomeandareredeemedatthediscretion
oftheissuer(N), Pt= Et(Y)/dt.Theyare infinitetermpositivecouponfinancialinstruments.
Shareshavethesametermtomaturityasconsols.Ifacollateralexists,incaseofdefault,thefair
valuedependsontheexpectedabilityofcreditorstorecoversomeoftheunpaidduesembedded
210
inapromise.Thus,incaseofdefault,thefairvalueisequaltotheexpectedvalueofthecollateral
andavailablerecoursesdiscountedbacktothepresent.
Forexample,saythatcompanyXissues3yearbondswithafacevalueof$1000andacouponrate
of10%.ThismeansthatcompanyXwillbuybackitsbondsfor$1000inthreeyearsandwillpaya
$100couponduringthreeyears.Inthatcase,whatmarketparticipantsarewillingtopayforthe
bondtodayis(assuminganannualcouponpaymenttosimplify):
100
100
1
100
2
1000
1
Thereisamissingelementthatpreventsthedeterminationofthefairprice:whatisthevalueofd
today?drepresentstheinterestratethatmarketparticipantswant(themarketrate).Themarket
ratemaybedifferentfromtheinterestrateofferedbycompanyX(thecouponrate):
Ifd=20%thenP=$789.35.Thebondtradesatadiscount(i.e.belowfacevalue).Forthe
first $100 provided next year, market participants are willing to pay today $83.33
($100/1.2)because$83placedat20%todayprovides$100nextyear,etc.
Ifd=10%thenP=$1000.Bondtradesatpar.Marketparticipantsagreethattheinterest
rateproposedbycompanyXisenough,sotheypayfullpriceforthebond.
Ifd=5%thenP=$1136.16.Marketparticipantsaregettingmorerewardfromthecoupon
than what they wish, so they are willing to buy the bond at a premium (i.e. above face
value).Thevalueofthepremiumisjustenoughtomaketherateofreturnonthebond
equalto5%.
AsexplainedinChapter4,thevalueofddependsonanumberoffactorsincludingtheriskofdefault
by the issuer. The higher the probability that coupons and/or principal cannot be honored, the
steeperthediscountrate,andsothefurtherbelowparthe3yearbondtrades.
Fora$20unconvertibleFederalReservenote,thegovernmentdoesnotpromiseanycouponand
promisestotakebacktheFRNsatanytimeat$20,so:
20
20
The$20FRNoughttotradeatparityallthetime.Thediscountfactordoesnotmatterbecausethe
termtomaturityisinstantaneous.
Thesetwoexamplesassumethattheissuerdoesnotdefault.Saythatrightaftertheissuanceof
the3yearbonds,companyXannouncesthatitcannotmakeneitherthe$100couponpayments
nor the principal payment. Some negotiation with bondholders leads to an agreement that
companyXwillpay$70couponsand$500ofprincipal.Thenthenewfairvalueofthebondis:
70
1
70
1
70
2
500
3
Again, the fair value depends on d, and d must have increased tremendously following the
announcementofdefault,whichpushesdownPevenfurther.
The same applies with Federal Reserve note and other monetary instruments. Say that the
governmentannouncesitonlyaccepts$20FRNsfor$10atanytime,i.e.a$20FRNonlyredeems
211
$10ofdebtsowedtothegovernment.Thenthenewfacevalueisactually$10andsothefairprice
is$10.Intheeconomy,the$20circulatesamongbearersfor$10.Shopstakethe$20noteonlyfor
$10 worth of items, banks that receive a $20 note only credit $10 to the bank accounts of the
personswhohandthe$20FRNs,andrepayingbankdebtswitha$20FRNsonlyclears$10ofbank
debts.HoldersofFRNstakea50%haircut.Thismayseemstrangebutonlybecausewearenot
accustomedtothatanymore.IntheMiddleAges,kingsusedtochangethefacevalueoftheircoins
allthetimeasexplainedinChapter17.Untilthelate19thcentury,privatebanknoteswereapplied
adiscountthatvariedovertime.
FAIRVALUEANDPURCHASINGPOWER
Therearesituationsinwhichthevalueofallfinancialinstrumentschangesatthesametimerelative
tothevalueofgoodsandservices(outputpriceinflationordeflation)orrelativetoanotherunitof
account(exchangeratedepreciationorappreciation).Thesechangesinpurchasingpoweraredue
either to the decisions of a monetary authority (e.g., the government decides to devalue its
currency)ortomechanismsatworkinamonetarysystem.
Thechangesinthevalueoftheunitofaccountshouldbedifferentiatedfromthechangesinthe
fair value of a monetary instrument. While both changes lead to the same result (changes in
purchasing power), the mechanisms at play are different. Changes in the value of the unit of
account relate to expected and actual changes in macroeconomic conditions (see Chapter 11).
Changesinthefairvaluerelatetoexpectedandactualchangesinthecharacteristicsofafinancial
instrument(e.g.,default)orinthefinancialinfrastructure(e.g.,disruptioninthepaymentsystem).
For bank and government monetary instruments, this second type of changes has not occurred
sincegovernmentguaranteeshavebeenputinplace,interbankbanksettlementatparhasbeen
doneefficiently,andinconvertiblecurrencyhasbecomecommonanditssupplymadeelastic.
Onemajordebateofmonetaryhistoryconcernsthequestionofwhetheriftheissuerofamonetary
instrument, and more generally any other financial instrument, is liable for the decline in the
purchasingpowerofwhatisowedtothebearers.Saythatyouowe$100tosomeone;shouldyou
beliableifthepurchasingpowerofthat$100declines?Morebroadly,shouldtheprincipalamount
youowerise/falltocompensateforinflation/deflation?Legalscholarsdiscussthisissueintermsof
Nominalism(thatanswersno)versusValorism(thatanswersyes).Recently,thisquestionhasbeen
ofgreater concernforcreditors,given that therehasbeenan inflationarybiassincethe endof
World War Two. Governments around the world have been unwilling to let deflationary forces
developfollowingthehorribleexperienceoftheGreatDepression(Figure15.2).
Nominalismhasprevailedthroughouthistory.Assuch,financialinstrumentscannotbeconsidered
tobeclaimsongoodsandservices.Creditorsbeartheinflationrisk,debtorsbearthedeflationrisk.
Whiledebtorsmaychoosetoissueinflationprotectedfinancialinstruments(e.g.,Treasuryinflation
protectedbonds),itistheirdiscretionnottheirobligation.
An implication of the prevalence of nominalism is that the creditworthiness of an issuer is only
related to the ability to make the nominal payments promised (the Ys and FV in the fair price
formula) and creditworthiness cannot be judged by looking at purchasing power. As such,
inflation/deflationdoesnotrepresentadecline/increaseinthecreditworthinessofagovernment,
orbanks,oranyotherissuerofmonetaryinstruments.
212
Figure15.2ConsumerpriceindexintheUnitedStates:17742015(base:198284).
Sources:BureauofLaborStatisticsandHistoricalStatisticsoftheUnitedStates.
AsimplewaytounderstandwhyNominalismhasprevailedisthatissuersoffinancialinstruments
haveverylittlecontroloveroutputpricedynamics.Businessescantrytobemoreefficienttomeet
the demands of their creditors, and households have some influence over their income and
expendituresources.Governmentshavesomeparttoplayintheinflationarybias,andcoulddo
moretopromotepricestabilitybyhavingstructuralpoliciesthatdealwithemploymentandprice
stability,butevengovernmentsonlyhavelimitedcontrolovermacropricedynamics.Itwouldbe
unfairtoasktheissuersoffinancialinstrumentstoprotecttheircreditorsforsomethingoverwhich
theyhavelittlecontrolandwhichtheyhavelimitedabilitytoinfluence.
Whilecasesofhyperinflationareoftenattributedtothegovernmentrunningtheprintingpress,
one needs to look at the underlying economic conditions to get to the bottom of the problem.
Political,technologicalandnaturalcausesareusuallyunderpinningproblemsbecauseinflationis
usuallynotamonetaryissue(seeChapter11).Thegovernmentprintingmonetaryinstrumentsen
masseisjustalastdesperateresponsetoadeeperunderlyingproblem.Forexample,theGerman
postWorld War One hyperinflation had its root in the costly Versailles agreements. The recent
episode of hyperinflation in Zimbawe has its root in colonialism, land reform and decaying
infrastructure.2Table 11.1 shows inflation rates for several countries, all around the two world
wars.
Period
Averagemonthly
growthofprices
Austria
10/1921
8/1922
Germany
8/1922
11/1923
Greece
11/1943
11/1944
Hungary
8/1945
7/1946
Poland
1/1923
1/1924
Russia
12/1921
1/1924
47.1%
322%
365%
19800%
81.4%
57%
Table11.1Examplesofhyperinflation.
Source:StudiesintheQuantityTheoryofMoney.
213
Toconclude,thefinancialcharacteristicsofmonetaryinstrumentsleadtoastablenominalvalue
(parity)intheproperfinancialenvironment(seeChapter16forimproperfinancialenvironments).
This stable nominal value plays a crucial role in the stability of the financial system because it
provides a reliable means of payment, which promotes liquidity and solvency. However, these
characteristicsdonotguaranteeastablepurchasingpowerandsoamonetaryinstrumentmaynot
beareliablemediumofexchange.Agoodpartofthestoryofmonetarysystemshasbeentotryto
establish a smoothly working monetary system based on a financial instrument that is both
perfectly liquid and of stable purchasing power. This quest has been unsuccessful (only perfect
liquidity has been achieved), but it has had a tremendous influence on the views of scholars,
politiciansandthegeneralpopulationaboutmoney.
ACCEPTANCEOFMONETARYINSTRUMENTS
Anybodycancreatemonetaryinstruments.Therearemanywebsitesthatallowonetodoso,and
Figure15.3showsamonetaryinstrumentthatIcreated.LetuscallittheE.T.note.Mynameis
presentandthenoteisworth5cities.TheCityistheunitofaccount.Ideliberatelychoseaweird
namefortheunitofaccounttomakethepointthattheunitofaccountisanabstractandarbitrary
unitofmeasurementthathasnoessentialrelationtoanything.Whilesomeunitsofaccountfind
theiroriginsinweightmeasures,3they rapidlylost that connection(e.g.,apoundsterlingisnot
representedbyapoundoffinesilver,apoundsterlingisjustapoundsterling).4Othernamesof
unitsofaccountarejustmadeup,sometimestoreflectpoliticalorculturalaspirations(theEuro),
andhaveneverhadanythingtoobjectifythem.
TheE.T.noteisaformalpromise.Byissuingittobearers,Ipromisetotakethenoteatparwhenever
itispresentedtome.HowcanIgetotherstoacceptinpaymentsthatpieceofpaper?Theanswer
dependsonhowcrediblemypromiseistoothers:Whenwillbearershavetheopportunitytohand
itbacktomeandwhatarethebenefitsfordoingso?Ifpotentialbearersneverseeanyopportunity
togivethenotebacktomeoriftherewardfordoingsoisnegligible,theywillnotacceptthenote
inpayment.Assuch,therearethreewaystomakebearersrealizethatmypromiseiscredible:
Forced acceptance: I kill you/cut your hands/put you in prison/(fill up the blank for any
othermiserablethingsIcouldtodotoyou)ifyoudonottakeit.Theproblemwithforceis
thatitisdifficultandcostlytoenforce,andnotaveryeffectivewaytopromoteconfidence
inthepromiseImade.Persuasionalwaysworksbetterthanforcesobelowaretwoways
topersuade.
Convertibilityintosomethingvaluable:
214
Ifyouareoneofmystudents:youautomaticallygetanAinacourseIteachifyou
hand mesome E.T. notes(thehigherthe dollaramountinnotesto providethe
higherthedemandforthenotes).Thisisgoodasfarasitgoes,butveryfewpeople
takemycourses.
Ifyouarenotoneofmystudents:Whenyougivethenotebacktome,Iwillgive
yousomegoldworth5cities.Thatwillhelptowidenacceptanceprovidedthat5
citiesworthofgoldissignificant,andprovidedthatothersbelievethatIhavethe
meanstogetthegoldIpromised.
Impose a debt on bearers that can be paid with E.T. notes together with penalties if
paymentisnotperformed:
o
If you are one of my students: handing me some notes counts for a certain
percentageofyourgrade.Acceptancewilldependonhowmuchdoingsocounts.
For example, if handing back a certain number of notes counts for 100% of the
grade,thendemandforE.T.noteswillbehigh,if1%demandwillbelow.Iimposed
ataxonmystudents.Someeconomicsdepartmentshavedonesuchathingwith
greatsuccesstopromotecommunityservicesperformedbystudents(DVDsand
Buckaroos).5
Ifyouarenotoneofmystudents:Anydebtyouowemecanbepaidbyhanding
mesomeE.T.notes.Acceptancebypotentialbearerswilldependontheextentto
whichothersareindebtedtome,aswellasmyabilitytoenforcethepaymentsof
dues owed to me (and to punish if payment is not made). Limited number of
debtors,abilitytoevadedues,andlackofeffectiveenforcementmechanismswill
reducetheacceptanceofmynotes.
Thesemeansofcreatinganinitialandbasicdemandformonetaryinstrumentscanbecombined
buttoday,theabilityofanissuertoentice,ortoforce,othereconomicunitstobecomeindebted
totheissueristhemainmeansusedtocreateanacceptanceforamonetaryinstrument.
Inmyclassroom,myabilitytodosoisveryhighand,assuch,Icanacquiremanythingsfrommy
students(includingtheirlaborpower)bypayingthemwithE.T.notes.Icanthenusethatpowerfor
myownselfishinterest(tobuystufffrommystudentsformyownenjoyment)orformoresocial
goals(communityservicestobeperformedbystudents).Beyondmyclassroom,Ihavenoabilityto
makeothersindebtedtomeandmyabilitytoimposeforceortoprovidesomethingvaluablein
exchangeformynoteislimited.AssuchthedemandforE.T.notesissmalloutsidetheclassroom.
The same applies to a government within its borders, provided it is credible; as such the
governmentcanusethatpowertospendhoweveritlikes(hopefullyforthebenefitsofitscitizens)
tofulfillthedemandforitscurrency.Outsideacountry,leavingasideinternationalarrangements
thatmaypromoteacurrency,thedemandforanationalcurrencywillalsobelimitedbecausethe
abilityofanationalgovernmenttoimposedebtsonforeignersislimited.Ifthecurrencyallows
foreigners to obtain something valuable, either through conversion or because the economy
produces things that foreigners want (see below for other sources of demand for a monetary
instrument),foreignerswillnetsavethecurrency.
Thebroaderyourcaptivepopulation,thegreateryourabilitytoimposedebtsonthatpopulation
andtopunishitifitdoesnotcomply,andthemorewidelyyourmonetaryinstrumentisaccepted.
Guaranteeingconvertibilityintosomethingelsevaluablewillhelpfurther.
215
Figure15.3AE.T.noteworthfivecities.
Themonetaryinstrumentsissuedbythegovernmentandbanksareinhighdemandbecausethey
havealargenumberofdebtors.Governmentsabilitytoimposetaxliabilitiesandotherdues(and
tothrowpeopleinjailifthetaxisnotpaid)hasbeenthepreferredmethodtocreateaninitial
willingnesstoholdgovernmentmonetaryinstruments.Thehighertheabilitytoenforcethedues
andthelowertheabilitytoevadethedues,thehigherthedemandforthegovernmentmonetary
instruments.Whenthecredibilityofastateislow,thestatemayintroduceaconversionclausethat
promisesgoldorforeigncurrencyondemand.Whilethisoccurredquitefrequentlyinthepast,the
financial basis for this conversion clause decreased dramatically with greater political stability,
greater monetary stability, and better enforcement mechanisms. Chapter 17 shows why
convertibility into gold used to be an important means to create a demand for government
monetaryinstruments.
Banks create monetary instruments by swapping promissory notes with their customers (see
Chapter10).Assuch,theissuanceofbankmonetaryinstrumentssimultaneouslycreatesdebtors
ofbanks.Thesedebtorshaveanautomaticdemandforbankmonetaryinstrumentsaslongasbanks
havetheabilitytoenforcetheclaimstheyhaveonnonbankagents(bankscanseizeassetsorhave
otherrecoursesifpaymentisnothonored).Forthosewhoarenotindebtedtobanks,thebankalso
promisesconversionatparintogovernmentmonetaryinstruments.Today,thecredibilityofthe
convertibilityclauseisstrong,giventhatgovernmentsguaranteethebanksabilitytoconvert(FDIC
depositguarantee,lenderoflastresort,andmaintenanceofanefficientpaymentsystem).
Toconclude,inthebroadestterms,thegreaterthecredibilityoftheissuer,thegreateritsability
to find people willing to hold its promissory notes. The acceptance of a monetary instrument
dependscruciallyonthecredibilityoftheissuerintermsoffulfillingthepromiseitmade.Indeed,
morepeoplewillhavetomakepaymentstothatissuerorcangetsomethingvaluablefromthat
issuer.Thisprovidesthecorereasonwhyaspecificmonetaryinstrumentisaccepted.Ofcourse,
thesameappliestoanyotherfinancialinstruments.Bondswithahighercreditratingaremore
widelyaccepted,companieswhoareabouttogobankruptseetheirsharepricefalltowardzeroas
demandforthemplunges.Beyondthiscorereason,bearersmayholdamonetaryinstrumentto
performtransactionsnowandinthefuturewithotherbearers(seelastsection).However,ifthe
issuer decides to demonetize its promissory note, these other reasons to hold a monetary
instrumentdonotmaintainitsfairvalue.
TRUST AND MONETARY SYSTEM: TRUST IN THE ISSUER VS.

SOCIETALTRUST
216
Acceptanceintroducesthecentralroleoftrustforawellfunctioningmonetarysystem.Whenever
thereispromise,thereistrust.Butoneneedstobecarefultounderstandhowtrustmatters.The
answer to why do you accept a $20 note? is usually because I trust others to do so. To
understandwhythisdoesnotgofarenough(beyondthefactthatthisansweriscircular),letus
startwithanotherfinancialinstrument.
Goingbacktothefairvalueexamplepresentedabove.Wesawthatthenominalvalueatwhicha
bondtradesiscriticallydependentontheabilityoftheissuertofulfillthepromisesmade.Saythat
companyXnowdeclaresitcannotmakeanyofthepaymentsowedonthebond.Inthatcasethe
fairvalueofthebondis$0thereisnodemandforthebond,unlessbondholdershavetheability
toseizeassetsofcompanyX.Similarly,ifthegovernmentstatesthatitwillnotacceptits$20FRN
wheneverpresentedbybearers,thefairpriceofthe$20FRNisnow$0thedemandforitfallsto
nothing.ThereisactuallyacomplicationforFRNsbecausetheyaresecuredbytheassetsofthe
Fed,so,duringthetimeofbankruptcyproceedings,FRNswillhaveavalueequaltotheexpected
valueoftheassetsoftheFedthatareusedtobacktheFRNs.Regardingmonetaryinstruments
issuedbybanks,bearersmusttrustthat:1bankswillconvertatparintogovernmentmonetary
instruments at any time, 2 that they can clear debts owed to banks with bank monetary
instruments.
Thisbringsforwardanimportantpoint.Whilesocietaltrust(trustofbearersaboutotherbearers
willingness to hold a monetary instrument) may help financial instruments to circulate more
broadly,thetrustatthecoreofthecirculationofafinancialinstrumentisthefinancialcredibility
oftheissuer(trustofbearersabouttheissuerswillingnessandabilitytofulfillitspromise).Without
thelatter,thefairvalueofanunsecurednonrecourseinconvertiblefinancialinstrumentfallsto
zero.Asonemayexpect,Chapter17showsthatthistrustishardtoearn.
Whileallthisnecessarilyfollowsfromthelogicoffinance,itisnothardtofindhistoricalcasesthat
illustrateit.ThemostrecentoneisthetransitiontotheEurozone.Figure15.4showsa50French
francnotethattheFrenchgovernmentusedtoacceptatfacevalueinpayments.FromJanuary1
2002, the French economy moved to the Euro and its government refused French franc in
payments.Tomakethetransitionsmoother,forthenexttenyears,theBanquedeFranceallowed
conversionofitsnotesintoeurodenominatednotesattherateof1eurofor6.55957Frenchfrancs
(peoplecouldgotoanybranchoftheBanquedeFrancetogettheirfrancsconvertedintoeuros).
Since2012,theFrenchfrancnotesarenolongerconvertibleintoeuronotesandtheirfairvalueis
nowzerounitsofaccount.Frenchfrancnotesmaystillhaveavalueascollectibleobjectsbutnot
asmonetaryinstruments,theyhavebecomecommodities.
Figure15.4A50Frenchfrancnote.
217
IntheMiddleAges,coinsdidnothaveanyfacevaluemarkedonthem.Bearersofthecoinswould
havetoperiodicallylistentoroyalproclamationsinpublicspacestoknowatwhatvaluetheKing
wouldtakehiscoinsinpayments,i.e.toknowthefacevalue.Chapter17showsthattherewere
somedrawbackstothatsystem.
DuringthefreebankingeraintheUSinthemid1800s,Banksdiscouragedorrefusedconversionin
speciesondemand:
Bankssometimesusedremotelocationsastheirredemptionpointsinordertoavoidhaving
toredeemtheirnotesinspecie.Anothermethodusedbythebankstodiscouragespeciedemands
wastorefusetoaccepttheirownnotes,exceptatalargediscount.Customerswere
told that, if they waited, the notes would be later redeemed at par, but such
promiseswerenotalwayskept.Thestatesattemptedtorequirethebankstore
deematpar,butthoseeffortsdidnotmeetwithsuccess.(Markham2002,169)
Thisproblemwascompoundedbywidespreadforgerythatreinforcedthereluctanceofbanksto
taketheirnotesimmediatelyatpar,eveninpaymentsfromdebtors,becausethetruthfulnessof
the notes could not be established. As such, given that both the convertibility promise and the
payment promise embedded in banknotes were violated, banknotes traded at a discount. This
problemwascompoundedbytheabsenceofaninterbankparclearingandsettlementmechanism,
whichpreventedtheholdersofbanknotestoexercisetheirrightofimmediatematurity.
While none of us thinks about the ability to pay the issuer at face value with its monetary
instrument when we accept them, without this ability there would not be a wellfunctioning
monetarysystem.Thecredibilityoftheissuer,ifstrong,createsananchortowardwhichbearers
expectationsaboutYsandFVconvergeandprovidesstablenominalvalue.
WHYAREMONETARYINSTRUMENTSUSED?THEMONETARY
FUNCTIONS
Wenowknowwhyeconomicunitsacceptamonetaryinstrument.Whilethenecessitytopaythe
issuerandtheavailabilityofconversioncreateademandformonetaryinstruments,economicunits
alsowanttousemonetaryinstrumentsforotherpurposes,namelydailyexpenses,privatedebt
settlements,portfoliochoices,andprecautionarysavings.Amonetaryinstrumentcanbeusedas:
Meansofpayments:payingdebts
Mediumofexchange:buyingthings
Store of value: keeping some purchasing power for the future by saving monetary
instruments
Theabilitytoperformthesefunctionsisnotlimitedtomonetaryinstrumentsasdefinedabove.
Also,someauthors,whodefinemonetaryinstrumentsaccordingtotheirfunctions(seeChapter
16),broadenthedefinitionofmonetaryinstrumentstoanythingusedasmeansofpayment,and/or
mediumofexchange,and/orstoreofvalue.
Inanycase,theabilityofamonetaryinstrumenttoperformthepreviousfunctionsistiedtothe
creditworthiness of the issuer of that monetary instrument; otherwise, monetary instruments
wouldbeapoormeansofpayment,apoormediumofexchangeeventheshortrun,andaneven
218
moreterriblelongtermstoreofvaluethantheycurrentlyare.Thiswouldbethecasenotbecause
ofinflation(ordepreciation),butbecausetheirfairvaluewouldnotbeconstant.
Notethatamonetaryinstrumentcannotperformthefunctionofunitofaccountbecausethere
cannotbemonetaryinstrumentwithoutaunitofaccount.Assuch,theunitofaccountcannotbe
amediumofexchange,astoreofvalue,orameansofpayment.Statedanotherway,amonetary
systemnecessitatesaunitofaccountandcarriersofthisunitofaccount,buttheyhaveseparate
rolesonemeasures,theotherrecordsthemeasurement.
Aunitofaccountcantakethenameofanobjectbutithasanindependentexistencefromthe
object.Thismanifestsitselfintwoways.First,theobjectmaydisappearbuttheunitofaccount
persists;or,second,therelationshipbetween the unitofaccountand theobject can change.A
cowryunitofaccountmayexistwithoutanycowryshellbeingusedintransactions.Ifcowriesare
used,theirvalueintermsofthecowryunitmaychangeonecowryshellmaybeworthonecowry
atonetimeandthreecowriesatanothertime.
Finally,goingbacktoChapter13,ifa monetaryinstrument isdemandedforpurposesanduses
otherthanpayingtheissuer,thentheissuermustissuemoremonetaryinstrumentsthanwhatit
getsbackfromitsdebtors.Anetfinancialaccumulationofmonetaryinstrumentsbybearersmeans
eitherthattheissuermustbeindeficitorthatitprovidesmoreadvancesthanwhatisrepaid.Again,
balancesheetsareaneasywaytoexplainthis.Tosimplify,wemayassumethatthereisonlyone
monetaryinstrumentinaneconomythatitisissuedbythegovernment,andthatthegovernment
doesnotissueanyotherliabilitiesthanitsmonetaryinstrument.Weknowthat:
FLG(IGSG)+FAG
(IGSG)isthesizeofthefiscaldeficitandFAGisthenetchange(acquisitionminusreduction)in
thequantityoffinancialassetsheldbythegovernment.Inorderforthenetinjectionofmonetary
instrumenttobepositive(FLG>0)therearetwopossibilities:
-
One,thegovernmentspends(I)morethanittaxes(S)(taxesraisethenetworthofthe
governmentasexplainedinChapter6).
Two, the government advances (FLG > 0) more funds than what refluxes to the
government(FLG<0).Thatis,thegovernmentmustacquiremorepromissorynotesfrom
thenongovernmentsectors(FAG>0)thanthequantityofprincipalrepaidbythenon
government sectors (FAG < 0). This means that the nongovernment sectors are
increasinglyindebtedtothegovernmentsector.
Treasury issues government monetary instruments by spending and it destroys government

monetary instruments by taxing. The fiscal deficit is a net injection of government monetary
instrumentsinthenongovernmentsectors(financialassetgoup)withoutanetincreaseinthe
financialliabilitiesofthenongovernmentsector(financialliabilitiesstaythesame)(seeChapter6
andChapter13).Thispermanentnetinjectionispossiblebecauseeconomicunitswanttonetsave
thegovernmentmonetaryinstrumentsforthepurposescitedabove.Ifeconomicunitsonlywantto
holdgovernmentmonetaryinstrumentsfortaxpurposes,theequilibriumfiscalpositioniszero;
economicunitshavenodesiretonetsavethegovernmentmonetaryinstruments.
This point is very well illustrated by the Massachusetts Bay colonies that issued inconvertible,
unsecuredbillsthattheypromisedtoacceptinpaymentoftaxes.Theprovincialgovernmentnoted
theimportanceofataxsystemforthestabilityofitsmonetarysystem(thisallowedcirculationat
parofthebills);butthegovernmentalsonotedthattaxestendedtodraintoomanybillsoutofthe
219
economy compared to what was desired by private economic units (which created deflationary
forces).Thiscreatedadilemma:
The retirement of a large proportion of the circulating medium through annual
taxation,regularlyproducedastringencyfromwhichthelegislaturesoughtrelief
throughpostponementoftheretirements.Ifthebillswerenotcalledinaccording
tothetermsoftheactsofissue,publicfaithinthemwouldlessen,ifcalledinthere
wouldbeadisturbanceofthecurrency.Onthesepointstherewasapermanent
disagreementbetweenthegovernorandtherepresentatives.(Davis1900,21)
Privatesectordesiredtoholdbillsforotherpurposesthanthepaymentoftaxliabilities,but,by
drainingmostofthebillsviataxes,thegovernmentpreventedthedomesticprivatesectorfrom
accumulatingitsdesireddollaramountofbills.Atthesametime,taxeswereatthefoundationof
thatmonetarysystemsotheyneededtobeimplementedasexpected.Ultimately,theprovincial
government was unsure about how to proceed in terms of the dollar amount in bills to recall.
Chapter13showsthatsomeknowledgeofnationalaccountinghelpstosolvethisdilemma:thesize
ofthefiscalposition(surplus,balanced,ordeficit)shouldbelefttobedeterminedbywhatnon
governmentsectorswanttonetsave.
1Amonetaryinstrumentisafinancialinstrument.Allfinancialinstrumentsfollowthesamebasic
ruleoffinance:thecreditworthinessoftheissuerisatthefoundationofthenominalvalueofthose
instruments.Thiscreditworthinessisabouttheexpectedabilityoftheissuertofulfillthepromises
hemade.
2Agovernmentpromisestotakebackitsmonetaryinstrumentatanytimeatfacevalueanddoes
not promise to pay any income. This means that the fair price of a government monetary
instrumentisfacevalue.Agovernmentmayalsoapromiseaconversionofitsmonetaryinstrument
intosomethingelse.Thesamelogicappliestoanyotherissuer.
3Anybodycanissuemonetaryinstruments,i.e.zerocouponzerotermsecurities;thepointisto
get them accepted. This can be done by convincing others of the credibility of the promise
embeddedinamonetaryinstrument.
4 The acceptance of current monetary instruments at par is mostly based on the ability of the
issuerstomakeothersindebtedtothemandtoenforcethatdebt.Banksmakeothersindebtedto
themwhentheycreatemonetaryinstrumentsbecausetheyacquireapromissorynoteatthetime
ofthebankcredit.Governmentsimposetaxliabilitiesonmostoftheircitizens.
5Monetaryinstrumentsareusedmostlyintransactionswithothereconomicunitsthantheissuer.
Theycanbeusedasamediumofexchange,storeofvalue,andmeansofpayment.Insuchcases,
theissuerofmonetaryinstrumentsmustrunadeficitorthenongovernmentsectormustincrease
itsindebtednesstowardthegovernmentsector.
6Whilecreditworthinessenablesthecreationofperfectlyliquidfinancialinstruments,thisdoes
not guarantee a stable purchasing power. A stable purchasing power is not a promise made by
issuersofmonetaryinstruments,butatlongasrelativepricestabilityprevailsthisisnotaproblem
formonetarysystem.
7 There are two means for a monetary instrument worthless. One, it circulates at par but its
purchasingpowerispoor(hyperinflation).Two,pricesofgoodsandservicesdonotchangebutit
circulateataverydeepdiscount(defaultbytheissuerorproblemwiththefinancialinfrastructure).
8Anetinjectionofmonetaryinstrumentrequiresthattheissuerdeficitspendsorthatothershave
agrowingamountofdebtowedtotheissuer.
220
Keywords
Unit of account, medium of exchange, store of value, means of payment, fair price, face value,
redeemable, convertible, societal trust, reflux mechanisms, nominalism, valorism, secured,
unsecured,recourse,termtomaturity
ReviewQuestions
Q1:Whatdoyouhavetodoifyouwanttoissueamonetaryinstrumentthatfunctionsproperly?
Q2:Whyissocietaltrustnotasatisfactoryexplanationofwhymonetaryinstrumentsareaccepted?
Q3:Ifthecreditworthinessoftheissuerofafinancialinstrumentevaporates,whathappenstothe
fair price of that financial instrument, if it collateralized? If there is no collateral but there are
recourses?Ifitisanunsecured,nonrecoursefinancialinstrument?
Q4:Ifthepurchasingpoweroffacevaluefalls,howdoesthatimpactthecreditworthinessofthe
issuerofamonetaryinstrument?
Q5:Canaunitofaccountbeamediumofexchange?
Q6:Cantherebemonetaryinstrumentswithoutaunitofaccount?
Q7: What are the two means for the nongovernment sector to obtain government monetary
instruments?
Suggestedreadings
Bell, S.A. (2001) The role of the state and the hierarchy of money, Cambridge Journal of
Economics,25(2):149163
Innes,A.M.(1913)Whatismoney?BankingLawJournal30(5):377408.
________.(1914)Thecredittheoryofmoney,BankingLawJournal31(2):151168.
MacLeod,H.D.(1889)TheTheoryofCredit.London:LongmansandGreen.
Mann,F.A.(1992)TheLegalAspectofMoney.Oxford:OxfordUniversityPress.
Olivecrona,K.(1957)TheProblemoftheMonetaryUnit.NewYork:Macmillan.
Smith,T.(1832)AnEssayonCurrencyandBanking.Philadelphia:JasperHardin.
Tymoigne, E. (2014) A financial analysis of monetary systems. In Papadimitriou, D.P (ed.)
ContributionstoEconomicTheory,Policy,DevelopmentandFinance.NewYork:PalgraveMacmillan.
Wray,L.R.(ed.)(2004)CreditandStateTheoriesofMoney,223262,Northampton:EdwardElgar
1A check drawnto pay Mr.X can be used by Mr. X topay Mr.Y. See How toendorse a check to someone else at
https://www.youtube.com/watch?v=jSE6RwPOlNM
2SeeBillMitchellsZimbabweforhyperventilators101http://bilbo.economicoutlook.net/blog/?p=3773
3 See Origins of currencies: from jagged edges to flowers http://blog.oxforddictionaries.com/2014/02/origins
currencies/
4Olivecrona,K.(1957)TheProblemoftheMonetaryUnit.NewYork:Macmillan.
5 For the DVD program see http://depts.drew.edu/econ/DVD/. For the Buckaroo program see
http://neweconomicperspectives.org/2009/07/berksharesbuckaroosandbeardollars.html
221
CHAPTER 16:
Whyagoldingotisnotandhasneverbeenamonetaryinstrument
Whymoneyisnotwhatmoneydoes
Whymonetarylogicisnotcircular
Whymonetaryinstrumentscirculateatfacevalueeveniftheyareunsecured
andinconvertible.
Whaterrorshavebeenmadeinthepastwhensettingupmonetarysystems
CHAPTER16:FAQsABOUTMONETARYSYSTEMS
ThefollowinganswersafewquestioninordertoillustrateChapter15andtodevelopcertainpoints.
Q1:CANACOMMODITYBEAMONETARYINSTRUMENT?OR,
DOESMONEYGROWONTREES?
Letustackletheideathatgoldismoney.Clearly,agoldingotisnotamonetaryinstrument.There
is no issuer, no denomination in a unit of account, no term to maturity or any other financial
characteristic.Agoldingotisjustacommodity,arealasset,notafinancialasset.Goldcoinshave
beenmonetaryinstrumentsandarestillissuedattimes(Figure16.1).
Goldingots
2009$50Americanbuffalogoldcoin
Figure16.1Goldvs.goldcoin
Similarly,itisincorrecttostatethatsaltwasmoneybecausesaltisacommoditythatembedsno
promise;however,MarcoPolonotedthatintheChineseprovinceofKaindu:1
Therearesaltsprings,fromwhichtheymanufacturesaltbyboilingitinsmallpans.
Whenthewaterisboiledforanhour,itbecomesakindofpaste,whichisformed
intocakesofthevalueoftwopenceeach.[]Onthislatterspeciesofmoneythe
stampofthegrandkhanisimpressed,anditcannotbepreparedbyanyotherthan
hisownofficers.Eightyofthecakesaremadetopassforasaggioofgold.Butwhen
thesecakesarecarriedbytradersamongsttheinhabitantsofthemountains,and
otherpartslittlefrequented,theyobtainasaggioofgoldforsixty,fifty,oreven
fortyofthesaltcakes,inproportionastheyfindthenativeslesscivilized.
Itseemsthatsaltcakesissuedbyanemperor(grandkhan)mighthavecirculatedasmonetary
instruments.However,alotofdetailsaremissingfromthisdescription:
1 Whatweretheunitofaccountandfacevalue?(definitelynotthepound,itisChina)
2 Whatwasthetermtomaturity?Werethecakesacceptedinpaymentofduesatanytime
bytheemperor?
3 What were the means for the emperor to make the previous financial characteristics a
reality?I.e.,whatweretherefluxmechanics?Didtheemperorlevyduesthatcouldbepaid
withsaltcakesatpar?Didthecakesprovideconversionintosomething?Etc.Bearersneed
tobeconvinced,sotrustabouttheissuermustbeestablished.
223
4 Thebitabouttheamountofgoldthatsaltcakescouldbuyisirrelevant.Poloisjusttelling
usthatacommodity(goldbullions)wascheaperinthemountains.Hemightaswellhave
toldusabouthowdifferentthepriceofapplesandpotatoesareindifferentpartsofthe
country.
Thebroadpointisthatmonetaryinstrumentscanbemadeofacommoditybutthatcommodity
itselfisnotamonetaryinstrument.Weallknowtheexpressionmoneydoesnotgrowontrees.
Monetaryinstrumentsarenotanaturaloccurrenceandforacommoditytobecomeamonetary
instrumentsomespecificfinancialcharacteristicsmustbeadded:aunitofaccount,afacevalue,a
term to maturity, among others. All this requires an issuer who promises to implement these
financialcharacteristics.
Sayagoldminerwantshisgoldnuggetstobeamonetaryinstrument,forthattobethecasethe
goldminermustpromise:
1 Todistinguishhisgoldnuggetsfromothergoldnuggets
2 Todeclarewhattheirfacevalueisintermsofaunitofaccount
3 Toimplementthatfacevaluebypromisingtotakebackatanytimethegoldnuggetsin
paymentsatthestatedfacevalue.
Nowthethirdconditionintroducesaproblembecauseitmeansthatthegoldminer;mustbewilling
tobepaidingoldnuggetsforhisgoldnuggets.Adubiousbusinessstrategy,indeed!
MosteconomiststhatworkwithintheRealExchangeEconomyframework,doconsidermonetary
instrumentstobecommodities.Monetaryinstrumentsdogrowontreestherearefruitsandall
debtpaymentsaredenominatedinfruit.2Thiscreatesdifficultiestoconvincinglyincludemoney
inmodels,andpushestoignorethefinancialsideoftheeconomy(seeChapter10and13)andthe
roleofnominalaspects(seeChapter11).
Q2: CAN A MONETARY INSTRUMENT BECOME A

COMMODITY?
Yes.Numismatistsarespecialistsattreatingcurrentandformer3physicalmonetaryinstrumentsas
commodities by determining the price of banknotes and coins as a function of their rarity,
peculiarity, etc. For example the $1 FRN in Figure 16.2 is worth $1200 currently because of its
peculiarserialnumber.Butthatisnotitsfairvalueasamonetaryinstrument.Ifonebuysthisnote
andgoestoastoreortoagovernmentoffice,thepersontowhomonehandsthenotewillonly
takeitfor$1.Thesameappliestothebuffalogoldcoinabove.Onecanuseittopaydebtsowedto
thegovernmentbutonly$50worth,notmorenorless,eventhoughthecoinisworththousands
ofdollarsasacollectibleitem.
224
Figure16.2A$1FRNworth$1200ascollectibleitems
Source:www.collectorscorner.com
Thesameappliesalsotogoldandsilvercertificates.HereishowtheU.S.Treasuryputsit:
Althoughgoldcertificatesarenolongerproducedandarenotredeemableingold,
theystillmaintaintheirlegaltenderstatus.Youmayredeemthenotesyouhave
through the Treasury Department or any financial institution. The redemption,
however,willbeatthefacevalueonthenote.Thesenotesmay,however,havea
"premium"valuetocoinandcurrencycollectorsordealers.(U.S.Treasury)
OnecanredeemthemattheTreasury(topaydebtsowedtotheTreasuryortogetFederalReserve
notes)ordepositthematbanks,butonlyatfacevalue.Thatistheirvalueasmonetaryinstrument.
Theirvalueasacollectibleitemissometimesmuchhigher.
Finally,afunexampleisthecurrentcaseofthepenny,whichbringsusbacktodarkertimesof
monetaryhistory(seeChapter17).Awhileback,NationalPublicRadioranasegmentonpenny
hoarders.4Thesearepeoplewhosehobbyistohoardpre1982pennies.Someevengototheirlocal
banksandspendtheireveningstriagingboxesofpennies.Whywouldtheydothatwouldyouask?
Pre1982penniesweremademostlyofcopperand,giventhatthepriceofapoundofcoppertripled
overthepasttenyears,thefacevalueofapennyishalftheintrinsicvalue(i.e.valueofthecontent
ofcopper):facevalueis1cent,intrinsicvalueis2cents,100%profitfromsellingpenniesfortheir
coppercontent!Currently,thereisonesmallproblemwiththisportfoliostrategy:Itisillegalto
destroy government currency. However, the government is considering the possibility of
demonetizingthepennycoinbecauseitcostsmoretomakethanitsfacevalue,andbecauseUS
residentsmostlyfinditcumbersometouse.Ifthegovernmenteverdemonetizesthepennycoin,
pennyhoardersarereadytorushtotheirlocalscrapmetaldealers.
Q3:ISMONEYWHATMONEYDOES?
FrancisAmasaWalkerconcludedinthelate19thcenturythatmoneyiswhatmoneydoes.This
hasbeenanextremelyinfluentialwayofanalyzingmonetarysystemsinmanydifferentdisciplines:
economics,anthropology,law,amongothers.
It is used in a narrow way by economists who use the Real Exchange Economy framework (see
Chapter11)andwhofocusonthefunctionofmediumofexchange.Inordertoavoidtheproblem
225
ofdoublecoincidenceofwantsinducedbybarter(Joehasapplesandwantspears,Janehaspears
but wants peaches), a unique commodity was progressively sorted out as best for market
exchanges,thestorygoes.Thus,amonetarysystemcanbedetectedbycheckingforthepresence
ofamediumofexchange.Anthropologists,amongothers,rejectthisnarrowfunctionalapproach.
Inprimitivesocieties,exchangewasnotdoneprincipally,orevenatall,foreconomicreasonsand
sothenonexistenceofadoublecoincidenceofwantswasnotaproblem.5Thebroadfunctional
approach classifies anything as a monetary instrument as long as it performs all or parts of the
functionsattributedtomonetaryinstruments.Thedistinctionbetweenallpurposemoneyand
specialpurposemoneyfollows.
A main issue with the functional approach is that it does not explicitly define what money is,
whichcreatesseveralissues:
Inquirermaypickandchoosedependingonthecircumstances,whichmayleadtheinquirer
toimposeinappropriatelyhisownexperiencetoexplaintheinnerworkingsofcompletely
differentsocieties.
Inquirermaytendtoassumethatmonetaryinstrumentsmusttakeaphysicalformwhen
theymaybeimmaterial.
Inquirermayexcludethingsthataremonetaryinstrumentsbutarenotusedforanyofthe
preferredfunctions.Collectiblecoinsandnotesaremonetaryinstrumentsaslongasthe
issuerdoesnotdemonetizethem.
Morebroadly,toomuchemphasisisputondetectingthingsthatfulfilltheselectedfunctionand
notenougheffortwillbedevotedtoadetailedaccountofthefinancialmechanicsatplayandtheir
relation to the sociopoliticoeconomic context: unit of account used, how the fair value was
determinedandifitfluctuated,howtherefluxmechanismswereimplemented,etc.Theexample
ofthesaltcakesaboveisanillustrationofthatpoint.Justnotingthatsomethingisusedasmedium
ofexchange ormeansofpayment,andmovingon tosomethingelse,isapoorwaytoperform
monetaryanalysis.
Finally,inquirersusingthisapproachmayconfusemonetarypaymentsandinkindpayments,may
assumethatthereisamonetarysystemwherethereisnone,maymakeatruncatedanalysisof
monetarysystemsconsistingmostlyinamererecollectionofobjects,andmaymissthepresence
ofamonetarysystem.Forexamples,byrelyingonthewordsofanArabmerchantandanArab
historianofthe9thand10thcentury,Quigginreportsthatmorethanathousandyearsagocowry
shells:
formedthewealthoftheroyaltreasury[][and]whenfundsweregettinglow,the
sovereignsentoutservantstocutbranchesofcoconutpalmandthrowtheminto
the sea. The little mollusks climbed on to the branches and were collected and
spreadoutonthesandtodryuntilonlytheemptyshellswereleft.Sotheroyal
bank was filled again. Ships from India brought goods to the Maldives and took
back millions of shells packed up in thousand in coconut palm leaves. It was a
profitabletrade,forevenintheseventeenthcenturywehearof9,000or10,000
cowriesbeingboughtforarupeeandsoldagainforthreeorfourtimesasmuchon
themainlandofIndia.(Quiggin,1963,2526)
However,fromthisdescription,onecannotconcludethatcowriesweremonetaryinstrumentsused
bythekingtofinancethepurchaseofforeigngoodsandservices.Indeed,itisnotexplainedwhat
226
theunitofaccountoftheMaldiveswasandhowcowriesweremonetized,thatis,who,ifanybody,
issuedthemasfinancialinstruments(didtheroyalauthorityissuethemandwastheroyalbank
readytoacceptcowriesinpayments?),andwhattheirrelationtheunitofaccountwas.Inaddition,
theroleofcowriesasmonetaryinstrumentsisdoubtfulfortheMaldivesbecausecowryshellswere
worthnothingagainstgoodsexceptbyshipload(Polanyi1966,190)anextremelyinconvenient
meansofpaymentandmediumofexchange.Whatonecanconcludefromthedescriptionisthat
theMaldivesauthoritieswereinvolvedinthetradeofcowrieswithIndianandArabmerchants.
Theywereexportingcowriesagainstimportsofothergoodsasituationofbilateraltrade,nota
situationofacowrymonetarysystem.
Q4: ARE CONTEMPORARY GOVERNMENT MONETARY

INSTRUMENTS IRREDEEMABLE? OR, IS THE FAIR VALUE OF
CONTEMPORARY GOVERNMENT MONETARY INSTRUMENTS
ZERO?
No. A wellfunctioning monetary system requires that all monetary instruments be redeemable.
FederalReservenotesareredeemable,silvercertificatesareredeemableeventhoughtheyareno
longerconvertibleinsilver(seetheTreasuryinQ2),andbankaccountsareredeemable.Theyare
redeemableaslongastheycanbereturnedtotheissuer,hopefullyattheirinitialfacevalue(see
Chapter15).Theycanbereturnedtotheissuerthroughtwochannels:
Bearersdemandconversionintosomethingelseatagivenrate:governmentcurrencyfor
bankaccounts,foreigncurrencyforgovernmentcurrency,etc.
Bearerspaytheissuer:governmentstaketheircurrencyinpaymentsofduesowedtothem,
asdobanks.Thepaymentallowsbearerstoavoidjailtimeandotherlegalproblems.
Sotoberedeemableamonetaryinstrumentdoesnothavetobeconvertible.Assuch,thefairvalue
of a monetary instrument, its present value, is face value (see Chapter 15). In the past, some
governmentsdidforgettoinclude,orremoved,aredemptionclause:
Papermoneyhasnointrinsicvalue;itisonlyanimputedone;andtherefore,when
issued, it is with a redeeming clause, that it shall be taken back, or otherwise
withdrawn,atafutureperiod.Unfortunately,mostofthegovernments,thathave
issued paper money, have chosen to forget the redeeming clause, or else
circumstanceshaveintervenedtopreventtheirputtingitintoexecution;andthe
paperhasbeenleftinthehandsofthepublic,withoutanypossibilityofitsbeing
withdrawnfromcirculation(Smith1832,49)
Probably, no government paper money was ever sent forth which was not
expected to be redeemed in full value, at some time, although that might be
distant. [] Nevertheless, the issues of government money that have not been
redeemed,orthepaymentofwhichhasbeeneitherformallyortacitlyrenounced,
havebeenverynumerous.(LangworthyTaylor1913,309)
Inthatcase,thefairvalueofamonetaryinstrumentisindeedzerobecauseitstermtomaturityis
infinity,whichmeansthatitsfairvalueis(seeChapter15):
P=C/i
227
Giventhatnocouponwaspaid,P=0.Butthisdoesnotapplytodaybecausemonetaryinstruments
areredeemableondemandbybearersatastablefacevalue.
Allthisdoesnotseemtobewellunderstood.Forexample,recentlyAdairTurnerwrote(andheis
farfromtheonlyonetohavesaidso):
Monetary base is an asset for the private sector, but for the government it is a
purelynotionalliability(withNPVequaltoZero)sinceitisirredeemableandnon
interestbearing.(Turner2015)
Thisconfusesirredeemableandinconvertible.Themonetarybaseisredeemable,thatis,itcanbe
returnedtotheissueratfacevalueatanytime.Thispointofviewalsoraisesotherproblems:
Rememberthatbalancesheetsareinterrelated(seeChapter13)soifafinancialliabilityis
worth zero in one balance sheet, then a financial asset must be worth zero in another
balancesheet.Turnermakesanaccountingerror.
Whywouldtheprivatesectorbewillingtoholdsomethingthatisworthzero?Thereisno
benefitthatcomesfromacceptingsuchamonetaryinstrument,notevenavoidingprison,
becausetaxescannotbepaidwithsuchgovernmentmonetaryinstruments.
Ifvaluedatzerothenbalancesheetsshouldrecordalargelossofassets(andnetworth)
for banks, firms, and households: Your monetary balances would be worth nothing in
nominalterms!
Q5:ISMONETARYLOGICCIRCULAR?
No.Aswithanyotherfinancialinstrument,theacceptanceofamonetaryinstrumentbyanybody
ultimatelyrestsontheconfidenceintheissuer,notontheconfidencethatotherpotentialbearers
will accept it. While bearers may never think about the creditworthiness of the issuer when
accepting a monetary instrument from another bearer, one cannot infer from that that
creditworthinessisnotessentialforacceptance.Onemerelyhastostudythestockmarkettosee
that this conclusion is incorrect. Most trading of stocks is done just for the sake of trading by
humans or by computers focused on millisecond price movements. This does not neglect the
centralroleofthecreditworthinessofthefirmthatissuedthestockinsustainingthefairpriceof
thestock.Financialmechanicscannotbedenied.
Q6: DO ISSUERS OF MONETARY INSTRUMENTS PROMISE A

STABLEPURCHASINGPOWER?
No.Ifthatwerethecase,issuersofmonetaryinstrumentwouldhavedefaultedontheirpromise
continuously since the beginning of financial times. They never were able to provide a stable
purchasingpower,evenlesssosincetheendofWorldWarTwo(seeChapter15).Assuch,the
demand for monetary instruments would be nil if a stable purchasing power was a promise
embeddedinmonetaryinstrumentbecausethecreditworthinessoftheissuerwouldbenil.
Astablepurchasingpowerisnotapromiseofanyissuerofmonetaryinstruments.Thisisfinefor
mostbearersaslongasthepurchasingpowerofmonetaryinstrumentsisrelativelystableinthe
228
shortterm.Ifonewantssomethingthatholdspurchasingpoweroverthemediumtolongrun,then
oneshouldswitchtootherassets.
Q7:AREMONETARYINSTRUMENTSNECESSARILYFINANCIAL
INNATURE?
Yes,remember:moneydoesnotgrowontrees.Whilemonetaryinstrumentscanbemadeofa
commoditythatcommodity,doesnottellusanythingaboutthemonetarynatureofathing.Agold
coin is a monetary instrument not because it is made of gold but because of its financial
characteristics.Goldisthecollateralembeddedinthecoin.Similarlyahouseisnotamortgage,a
house is the collateral for a mortgage and nothing can be learned about the inner workings of
mortgagesbystudyinghowahouseismade.
Theprimitivemoneyswouldneedtobestudiedmuchmorecarefullytodetermineifsomeof
themweremonetaryinstruments.Justcheckingiftheypassedhandsinexchangeofgoodsand
services,iftheywereusedtopayforabride,etc.isapoormeansofdeterminingthemoneyness
of something, given that one cannot differentiate between inkind payments and monetary
payments.WesawabovethatcowryshellswerenotmonetaryinstrumentsintheMaldivesbut
theywereinAfricaandadetailedanalysiswasnecessaryanddonetoestablishthatfact.
Q8: ARE CREDIT CARDS MONETARY INSTRUMENTS? WHAT

ABOUT PIZZA COUPONS? WHAT ABOUT PRETENDPLAY
BANKNOTESANDCOINS?WHATABOUTBITCOINS?
Notoallquestions.
Acreditcardisnotafinancialinstrumentitdoesnothaveamaturity(issuersofcreditcardsdo
notacceptcreditcardsinpayment)anditisnotrelatedtoaunitofaccount(itisnotacarrierof
the unit of account). The underlying credit line is not a financial instrument either. The line
represents the maximum dollar value of a customers promissory note (called credit card
receivables)thatacreditcompanyiswillingtotakeonitsbalancesheet.
Say that household #1 wants to get a credit card from Bank A. #1 fills up the required
documentationsoAcancheck#1screditworthiness.#1isapprovedbyAandgetsa$1000credit
line.Whereisthatrecordedonthebalancesheet?Nowhere,itisanoffbalancesheetitem.The
lineisjustsayingthatAwilltakeonitsbalancesheetupto$1000of#1spromissorynoteswithout
askingagaintocheck#1screditworthiness.Chapter10showswhathappenswhenacreditlineis
used:Asassetsrisebytheamountofthecreditlinedrawnby#1,#1sliabilitiesrisebythatsame
amount.
Whataboutapizzacoupon?Ithasaninstantaneousmaturity(onecangotothepizzashopatany
timetoclaimapizza),itisaconvertible,butitisnotafinancialinstrumentbecauseitdoesnot
involve monetary payments but merely inkind payments: it converts into a commodity. If the
couponcouldbeusedtopaydebtsowedtothepizzashopatanytimeand,ifthepizzashopstated
atwhatvalueitwouldtakethecouponinpayments,thenitwouldbeamonetaryinstrument.
229
Figure16.3showsasetofplaynotesthatmysongotwithhistoycashregister.Inorderforthe
notestobecomemonetaryinstruments,thecompanythatcreated themwouldneedto dothe
following:
1 Changethedesign:tooclosetothedesignofFederalReservenoteseventhoughitisa
crudeimitation.TheUnitedStatesofAmericashouldbeeliminatedbecausetheyarenot
issuedbytheUnitedStatesGovernment.
2 Promisetotakethenotesinpayment:Bearerscanpaythecompanywiththenotestobuy
thingsfrom,andcleardebtsowedto,thecompany.
Finally,bitcoinsdonothaveanyissuerandareirredeemable.Thefirstproblempreventsthemfrom
being a monetary instrument, the second problem makes them valueless as monetary
instruments.6Bitcoinsarecommodities/realassets,notfinancialassets.
Figure16.3Pretendplaymonetaryinstruments
Q9: WHAT WERE SOME ERRORS MADE IN PAST MONETARY

SYSTEMS?
Given the characteristics of monetary instruments, they should circulate at parity all the time;
however,actualcirculationatpardoesnotdefineamonetaryinstrument.Parcirculationisonly
theresultoftheinnercharacteristicsofafinancialinstrument,theabilityandwillingnessofthe
issuertoimplementthesecharacteristics,andtheexistenceofaproperfinancialinfrastructurethat
230
allowsthesecharacteristicstobeexpressedinthefairvalue.Onlyrecentlyhavetherebeenwell
functioning monetary systems. They are not without problems, but, in general, they ensure a
smoothprocessingofpayments(seeChapter14whenthatisnotthecase)andcanbeusedasa
reliablemediumofexchange(seeChapter12whenthatisnotthecase),bothofwhichhelpto
promoteeconomicprosperitytosomeextent.
Forreasonsrelatedtopoortechniquesofproduction,inexperience,politicalinstability,frauds,and
poorly developed banking systems, it took quite a long time for the proper characteristics and
infrastructuretobeestablished.Belowaresomeerrorsthatweremadealongtheway:
Nostampedfacevalue:IntheMiddleAges,kingscriedupordown(i.e.changedbydecree)
thefacevaluetoomanytimes.
Freecoinage:Anybodywithgoldcangotothemintandgetcoinsstampedoutofingots
(governmentkeepsaportionoftheingots:seigniorage)
231
Whatistheproblem?Thetermtomaturityisnolongerinstantaneousaspromised
but depends on the expectations of bearers. As such the discount factor comes
backintothevaluationofthefairpriceandsothefairpriceisunstableandvaries
withtheconfidenceofbearersabouttheissuer.
Fullbodiedcoins:Atissuancethefacevalue(FV)isthesameasthemarketvalueofthe
goldcontent(PgGwithPGthepriceofgoldperounceandGtheouncesofgoldinthecoin)
Whatistheproblem?Fairpriceiszerounlessthereisacollateralorarecourse.
Thereisaredeemingclausebutnoactualmeanstoimplementitbecausenopaymentis
duetotheissuer(Chapter17showsthattaxesduringthetimeofcolonialbillswerenot
alwaysimplementedwhentheyweresupposedtobe),orconversionisverydifficult(banks
duringthefreebankingera).
Whatistheproblem?Kingslegalizedcounterfeiting.Anybodywithgoldcouldissue
a debt of the king, i.e. make the king liable. Today, in the United States, an
equivalent would be for the Bureau of Engraving and Printing to print Federal
Reserve notes for anybody who came with paper that respected the Bureaus
specifications!
Noredeemingclause:Thereisnowaytoreturntotheissueritsmonetaryinstruments
Whatistheproblem?Nobodyhadanyideawhatfacevaluewas:therewereso
manyedictsinforcereferringtochangesinthe[face]valueofthecoins,thatnone
butanexpertcouldtellwhatthe[face]valueofvariouscoinsofdifferentissues
were,andtheybecamehighlyspeculativecommodities(Innes1913,386).
Whatistheproblem?ifPg>0=>PgG>FV=>coinsdisappearfromcirculation
(meltedintoingotsorexportedascommodities)
Lackofaproperinterbankpaymentsystem:inthatcaseinterbankdebtsaredifficultto
clear and settle. This creates all sorts of problems going from delays in processing
payments,tolossofpurchasingpowerbecausesomebankmonetaryinstrumentstradeat
a discount relative to other bank monetary instruments, to full blown financial crises
becausepaymentscannotbeprocessedandsocreditorsdonotreceivewhattheyareowed
andinturncannotpaytheirowncreditors.
Q10: DO LEGAL TENDER LAWS DEFINE MONETARY

INSTRUMENTS?WHATABOUTFIXEDPRICE?
Legaltender lawsstatethat,incourtsettlements,creditorsmustacceptwhateverisdefinedas
legaltenderinpaymentsofwhatisowedtothem.Iftheydonotacceptit,theycannotsuetheir
debtorsforunpaiddues.Thisdoesnotmeanthatalegaltendercannotberefusedduringpetty
transactions.ThecurrentlegaltendersintheUnitedStatesareFederalReservenotes,butplenty
ofshopsandgovernmentofficesrefusecashpayments.
Somethingthatislegaltenderisnotnecessarilyamonetaryinstrument.Inthepast,commodities
havebeenincludedinthelegaltenderlaws,thereby,compellingcreditorstoacceptpaymentsin
kind.Chapter17developsthecaseoftobaccoleafsintheUnitedStates,whichcameaboutbecause
ofashortageofmonetaryinstruments.
Somethingthathasafixedpriceisalsonotnecessarilyamonetaryinstrument.Itmayjustbea
commodity managed by an economic unit via the use of a buffer stock; the economic units
accumulateslargeinventoriesofthecommoditytooffsetdownwardpressuresofitsprice,andsells
offitsinventoriestooffsetupwardpressuresofitsprice.
Q11: IS IT UP TO PEOPLE TO DECIDE WHAT A MONETARY

INSTRUMENT IS? WHO DECIDES WHEN SOMETHING IS
DEMONETIZED?
Publicopinionaboutwhatisorwhatisnotamonetaryinstrumentdoesnotmatterandpopular
beliefbyitselfcannotturnsomethingintoamonetaryinstrument.Touseananalogy,onecanuse
ashoetohammernailsbutitdoesnotmaketheshoeahammer.Thefactthateverybodythinks
thatshoesarehammersdoesnotturnshoesintohammers.Ifeverybodyisdelusionalenoughto
believethecontrary,therewillbemanymoreworkrelatedaccidentsandproductivitywilldrop
becauseshoesarenotbuiltproperlytohammernails.Inasimilarfashion,ifeverybodywantsto
believethatgoldnuggets,tobaccoleafs,orgrainsofsaltaremonetaryinstruments,thepayment
systemwillnotworksmoothlyandeconomicactivitywillsuffer.
AsexplainedinQ2,somemonetaryinstrumentsareusedmerelyascollectibleitems.Somepersons
mayalsousemonetaryinstrumentsasornamentsandforothernoneconomicuses.Theseother
usesdonotdemonetizeamonetaryinstrument.Thatcanonlyhappenifamonetaryinstrument
seizestobeapromiseandthatisuptotheissuertodecide.
Q12:CANANYBODYCREATEAMONETARYINSTRUMENT?
Yes,aslongasonedoesnotcounterfeitexistingmonetaryinstruments,onecandoso.7Oneshould
thenhaveamonopolyovertheissuanceofsuchaninstrument.Goodluckgettingitaccepted!
232
1 A commodity cannot be a monetary instrument by itself, it needs additional financial
characteristicsfittedontoit.
2Inordertodetectamonetaryinstrumentonemuststudythefinancialcharacteristicsofwhatis
saidtobeafinancialinstrument.Thefactthatsomethingisalegaltender,amediumofexchange,
orcirculatesatastablepricedoesnottellusmuchaboutthemonetarynatureofthatthing.
3 A proper monetary analysis involves dissecting the financial characteristics of a monetary
instrument and determining if the means are available to make these financial characteristics a
reality. In doing so, one must study the reflux mechanism and the issuers ability to fulfill the
promisesmadeinafinancialinstrument.
4Amonetaryinstrumentisacceptedbybearersforthesamereasonsthatastockorabondis
acceptedbybearers:theytrusttheissuersabilitytofulfillthepromiseembeddedinthefinancial
instruments. While on a daily basis bearers trade stock, bonds, cash and other monetary
instrumentswithoutthinkingabouthowcreditworthytheissueris,ifthelatterannouncesadefault
thathasanimmediateimpactonthefairprice.
5Goldcoinsarenotmonetaryinstrumentsbecausetheyaremadeofgold.Goldisjustacollateral
embeddedinthecoin.
6 Inflation and deflation do not reflect a change in credit risk for the issuer of monetary
instruments.
Keywords
fairprice,facevalue,legaltenderlaws,debasement,cryingdown/upthecoinage,termtomaturity,
collateral,freecoinage,fullbodiedcoin,redeemingclause,convertible,redeemable,
ReviewQuestions
Q1:Explainwhybitcoinsandpretendplaynotesarenotmonetaryinstruments?
Q2:Whymayalegaltendernotbeamonetaryinstrument?
Q3: If the issuer of a monetary instrument defaults, what happens to the fair price of that
instrument?Whatdoesitmeanfordaytodaytransactionsofthatinstrument?
Q4:Whodeterminesthatsomethingisamonetaryinstrument?
Q5:Whyisagoldnuggetnotamonetaryinstrument?
Q6: What was the problem with free coinage? Fullbodied coins? The absence of a redeeming
clause?
See section on salt currency at the Encyclopedia of Money blog: http://encyclopediaof

money.blogspot.com/2011/10/saltcurrency.html
2Kiyotaki,N.andMoore,J.(1997)CreditCycles,JournalofPoliticalEconomy105(2):211248.
3Seehttp://www.theguardian.com/money/2016/may/14/zimbabwetrilliondollarnotehyerinflationinvestment
4
Listen to Penny Hoarders Hope For The Day The Penny Dies by Zoe Chase at
http://www.npr.org/2014/05/21/314607045/pennyhoardershopeforthedaythepennydies
5SeeIlanaE.StrausssTheMythoftheBarterEconomyhttp://www.theatlantic.com/business/archive/2016/02/barter
societymyth/471051/
6SeeEricTymoignesFairpriceofbitzoingiszeroathttp://neweconomicperspectives.org/2013/12/fairpricebitcoin
zero.html
233
7Forexampleofproundcounterfeiterswhotaketheirartveryseriously,see'Counterfeitingisanart':Peruviangangof
masterfabricatorschurnsout$100billsathttp://www.theguardian.com/world/2016/mar/31/counterfeitingperuvian
gangfabricatingfake100bills
234
CHAPTER 17:
Whatsomeoftheproblemshavebeeninsettingupamonetarysystem
Howafunctionalapproachtomonetarysystemscanmisleadaninquirerinto
theexistenceofamonetaryinstrument.
Whymedievaltimesweredarktimesformonetarysystems
CHAPTER17:HISTORYOFMONETARYSYSTEMS
Thegoalofthischapterdoesnottopresentacompletehistoryofmonetarysystemsbutratherto
illustratethepointsandframeworkpresentedinthetwopreviouschapters.Thegoalofthischapter
istoshowhowtostudythehistoryofmonetarysystembytakingafewexamples.Thefinancial
mechanicsatplayareemphasizedandlinkedtothesociopoliticoeconomiccontext.
MASSACHUSETTS BAY COLONIES: ANCHORING OF

EXPECTATIONSANDINAPPROPRIATEREFLUXMECHANISM
MassachusettsBaycoloniesrespondedtothelackofcurrencybyissuingbillsofcreditthatshall
beaccordinglyacceptedbythetreasurerandreceiverssubordinatetohim,inallpublickpayments,
andforanystockatanytimeinthetreasury(Davis1900,10).Thegovernmentspentbyissuing
thebillsandleviedataxtoallowbearerstoredeemthem.Initially,trustinthebillwaslowbecause
ofthepoliticalandfinancialrisks:
Whenthegovernmentfirstofferedthesebillstocreditorsinplaceofcoin,they
werereceivedwithdistrust.[]theircirculatingvaluewasatfirstimpairedfrom
twentytothirtypercent.[]Manypeoplebeingafraidthatthegovernmentwould
inhalfayearbesooverturnedasto converttheir billsofcreditaltogetherinto
waste paper, []. When, however, the complete recognition of the bills was
effectedbythenewgovernmentanditwasrealizedthatnoeffortwasbeingmade
tocirculatemoreofthemthanwasrequiredtomeettheimmediatenecessitiesof
thesituation,andfurther,thatnoattemptwasmadetopostponetheperiodwhen
they should be called in, they were accepted with confidence by the entire
community[][and]theycontinuedtocirculateatpar.(Davis1900,10,15,18,20)
Thepopulationwasunsurethatthegovernmentwouldbewillingorabletofulfillthepromiseto
takebackthebillsatanytimesatparintaxpayment.Thislackoftrustwascompoundedbythe
factthat,whilethepromisestipulatedthatbillscouldbereturnedatanytime,inpracticethetax
leviedtoredeemthebillswasinitiallyimplementedonlyonceayear.Thus,whenbillswereissued
initially,dwaspositiveandbearersexpectationsaboutthetermtomaturity(E(N))compounded
thediscountappliedtothebills.
1
ThegovernmentaskedforthehelpofBostonmerchantswhoagreedtotakethebillsatasmall
discount in payments from the government. Ultimately, the bills circulated at par as the
governmentretiredthebillsasexpectedinatimelyfashion.
However,asexplainedinChapter15,tyingtheissuanceofbillsofcreditstoaspecifictaxcreateda
dilemma.Theprivatesectorwantedtoaccumulatethebillsbuttaxespreventtheaccumulationof
thedesireddollaramountofbills.Atthesametime,taxeswereatthefoundationofthemonetary
systemsotheyneededtobeimplementedasexpected.Ultimately,theprovincialgovernmentwas
unsureabouthowtoproceed.Onedrasticmethodwastobreachthepromisedtermtomaturity
bypostponingtheimplementationofthetaxlevyforseveralyears.Thiswasaneffectivedefault
relativetothetermsofthebillsandasuremeanstodecreasetheconfidenceinthebillsandso
their fair value (ibid., 108); this fact alone would have caused them to depreciate, even if the
amountthenincirculationhadbeenproperlyproportionedtotheneedsofthecommunity(Ibid.,
236
20).Thediscountratebecamepositiveagainwhichloweredthepurchasingpowerofbillsgiven
output prices. Later on, the provincial government found a more appropriate solution to the
dilemmabybroadeningthetypesofduesthatcouldbepaidwiththebills.
From this example, one can learn several useful lessons. First, trust in the issuer of a monetary
instrument requires some work to be earned but is central for the ability of that instrument to
circulateatpar.Second,iftherefluxmechanismsinplaceareinconsistentwiththepromisemade,
therewillbeproblemstofulfillthepromisemade.Colonialgovernmentspromisedredemptionat
thewillofbearersbutpaymentsowedtothegovernmentwereonlyimplementedoccasionallyand
narrowly.Third,onceonehasmadeapromise,onehadbetterkeepupwithit;otherwise,bearers
loseconfidencequitequickly.
MEDIEVALGOLDCOINS:FRAUD,DEBASEMENT,CRYINGOUT,
ANDMARKETVALUEOFPRECIOUSMETAL
Themostcomplexhistoricalcaseregardingthefairvalueofmonetaryinstrumentsconcernsthe
medievalcoinsmadeofpreciousmetal.Therearethreebroadproblemsinthiscase.Onerelates
tothefacevalueofthecoins,anotherrelatestotheintrinsic/bullionvalueofthecoins(i.e.,the
marketvalueofthepreciousmetalcontent),andathirdonerelatestotheinteractionbetweenthe
firsttwoproblems.
Upuntilrecently,thefacevaluewasnotstampedsoitwascarriedoutbyroyalproclamationinall
thepublicsquares,fairs,andmarkets,attheinstigationoftheordinaryprovincialjudges:bailiffs,
seneschals,andlieutenants(BoyerXambeuetal.1994,47).Thisannouncementdeclaredatwhat
nominal value the King would take each of his specific coins in payments due to him, thereby
establishing their face value. Frequent changes in face value led to confusion among bearers,
especiallysogiventhatthespreadofinformationwasslowandinadequate.
Coinsmadeofpreciousmetalswereawaytopartlydealwiththeuncertaintysurroundingtheface
valueofcoins.Coinswithhighpreciousmetalcontentwouldbedemandedfromsovereignsthat
couldnotbetrusted,eitherbecausetheycrieddowntoomuch,orrefusedsomeoftheircoinsin
paymentstoooften,orwereweakpolitically.Thehigherthecontentofpreciousmetalrelativeto
thefacevalue,themorelimitedthecapacityofKingstocrydownthecoinagebecausecoinswould
disappearifthefacevaluefellbelowthemarketvalueofthepreciousmetalcontent.Coinswould
bemelted(orexportedasbullions)toextractthepreciousmetal,becausemoreunitsofaunitof
accountcouldbeobtainedpercoinbysellingthepreciousmetalinsteadofhandingovercoinsto
theKing.Finally,others(e.g.,mercenaries)demandedpaymentsinsuchaformbecausetheydid
notexpecttobedebtorstotheKingortomeetsomeoneindebttotheKing,ortomeetsomeone
whowouldexpecttomaketransactionswithsomeoneelseindebtedtotheKing.
Whiletheissuanceofsuchcoinswaswarrantedgiventhepoorpoliticalandfinancialstabilityofthe
time,theycreatedseveralissuesrelatedtotheirintrinsicvalueanditsimpactonthefairvalue.If
circumstancesinthepreciousmetalmarketpushedthevalueofthepreciousmetalhigherthanthe
prevailing face value, mint masters and money changers would melt or illegally debase (e.g.,
clippingandsweating)thecoinageevenifthecreditworthinessofaKingwasexcellent.Intheory,
illegaldebasementswouldoccuruntiltheintrinsicvaluewasbroughtbacktothefacevaluebutit
becamesuchahabitthatitcontinuedevenwhenthevaluedifferentialwasnil.Expectationsabout
futureincreasesinthepriceofthepreciousmetal(orfuturecryingdown)alsoencouragedillegal
237
debasements, even if no profit could be made right now. Fraud was further encouraged by the
imperfect production methods. Coins with the same denomination and date of issuance had
differentweightandfinenessevenunderthebestcircumstances.Coinsalsohadunevenedgesthat
madeclippingdifficulttonotice,ifdonemoderately.
FraudwasproblematicbecauseitdisturbedtheuniformityandorderthatKingswantedtoestablish
togiveconfidenceintheircoinage;thestampwasacertificateofauthenticityoftheweightand
finenessofthecollateralembeddedincoins.TheKingsreputationwasatstake.Ifallowedtogo
on, the country would be left with a coinage of an insufficient quantity and quality to promote
smootheconomicoperations,andclumsyanddeformedcoinageencouragedforgery.Inorderto
preventthisfromhappening,Kingsactivelyfoughtanyfraudulentalterationoftheintrinsicvalue
ofcoins.Theydidsothroughseveralmeans.Onewastopunishseverelyfraudsters:
The coins were rude and clumsy and forgery was easy, and the laws show how
commonitwasinspiteofpenaltiesofdeath,orthelossoftherighthand.Every
local borough could have its local mint and the moneyers were often guilty of
issuingcoinsofdebasedmetalorshortweighttomakeanextraprofit.[][Henry
I] decided that something must be done and he ordered a roundup of all the
moneyersin1125.Achroniclerecordsthatalmostallwerefoundguiltyoffraud
andhadtheirrighthandsstruckoff.(Quigguin1965,5758)
Anothermeanswastoweighthecoinsthatwerebroughttopaydues,andtorefuseinpayments
allcoinsthathadalowerweightthanatissuance.Finally,twootherwayswereeithertodebase
(decreasethequantityofpreviousmetaltodecreasetheintrinsicvalue)ortocryupthecoinage
(increasethefacevalue):
debasementswereonlynecessaryalterationsinthequantityofsilverinthecoins,
inordertokeeppacewiththeriseinthepriceofsilverbullioninthemarket;[]It
hasalwaysbeennecessarytoregulatethequantityofmetalinthecoins,because,
iftoomuchwasputin,theywouldimmediatelybewithdrawnfromcirculationand
soldforbullion,[];iftoolittlewasput,theymightbeimitated.(Smith1832,34)
Inthiscase,debasementwasnotameanstoincreasethefinancingcapacityoftheKing.Itwasa
legitimate means to preserve the stability of a monetary system in which the value of precious
metalplayedaroleascollateral.However,debasementwasalimitedsolutiontooffsettherising
priceofpreciousmetalsbecausetheriskofforgerygrewwithfurtherdebasement.Debasement
alsonegativelyimpactedtheKingscreditworthinesseventhoughhemayhavehadnothingtodo
withtheproblemandwastryingtopromoteastablemonetarysystem.
Cryingupthecoinswasnotconstrainedbytheriskofforgery,butitcreatedanotherproblem,as
potentialinflationarypressuresemergedwhenthemoneysupplywasraisedunilaterallyovernight
innominalterms.Pricepressuresinthepreciousmetalmarketscouldcreepintothemarketfor
goodsandservices,and,onceagain,theKingwouldbeblamed.Finally,frequentcryingupcreated
furtherconfusionamongthepublicaboutthefacevalueofcoins;thereby,itreinforceddistrust
anddemandsforcoinswithahighcontentofpreciousmetal.
Ifonecombineschangesinfacevalue,changesinintrinsicvalue,aswellastheirinteractions,the
determinationofthefairvalueofmedievalcoinsbecomescomplicated.Ontheonehand,abusing
cryingdownledtotwotypesofspeculation;oneregardingtheoccurrenceofafuturecryingdown;
anotherconcerningthefacevalueofthecoinsrelativetotheintrinsicvalue.Ontheotherhand,
238
developmentsinthepreciousmetalmarketsaffectedexpectationsaboutfuturedebasementsor
cryingupofcoins.
Whatcanwelearnfromthispartofmonetaryhistory?First,anissuershouldhavesomecontrol
over when a collateral can be seized by bearers. If the collateral is embedded in the monetary
instruments,ariseinthevalueofthecollateralabovefacevaluemayleadbearerstoseizeiteven
iftheissuerhasnotdefaulted.Second,ifamonetaryinstrumentismadefrompreciousmetal,the
intrinsic value of the coins should be lower than the face value by a margin large enough to
accommodatesignificantincreasesinthemarketvalueofthepreciousmetal.Third,anchoringthe
expectationsofbearersaboutthefacevalueisimportantforawellfunctioningmonetarysystem.
TOBACCO LEAFS IN THE AMERICAN COLONIES: LEGAL

TENDERLAWSANDSCARCITYOFMONETARYINSTRUMENTS
ThecaseofVirginiaandotherU.S.coloniesinthe17thand18thcenturiesisusuallyputforwardto
makethecasethattobaccoleafwasamonetaryinstrument:
Tobaccowasanacceptedmediumofexchangeinthesoutherncolonies.Quitrents
andfineswerepayableintobacco.Individualsmissingchurchwerefinedapound
oftobacco.In1618,thegovernorofVirginiaissuedanorderthatdirectedthatall
goodsshouldbesoldatanadvanceoftwentyfivepercent,andtobaccotakenin
paymentatthreeshillingsperpound,andnotmoreorless,onthepenaltyofthree
years of servitude to the Colony. [] Virginia was using tobacco notes as a
substituteforcurrencyby1713.Thesenotesoriginatedaftertobaccofarmersin
Virginiabegantakingtheirtobaccocropstowarehousesforweighing,testing,and
storage[].Theinspectorsattherollinghouseswereallowedtoissuenotesor
receipts that represented the amount of tobacco being held in storage for the
planter. These notes were renewable and could be used in lieu of tobacco for
payment of debts. []Fines in Virginia were payable in tobacco. For example, a
mastercaughtharboringaslavethathedidnotownwassubjecttoafineof150
pounds of tobacco. The Maryland Tobacco Inspection Act of 1747 was modeled
aftertheVirginiastatute.TheMarylandstatuterequiredtobaccotobeinspected
andcertifiedbeforeexportinordertostoptrashfrombeingputinthetobacco.
[]Inspectionnotesweregivenforthetobaccothatwasinspected.Thosenotes
werepassedasmoneyinMaryland.Theuseofwarehousereceiptsfortobaccoand
othercommoditieswouldspreadtoKentuckyassettlersbegantocultivate that
region.(Markham2002,4445)
Hence, tobacco leafs served as media of exchange and so, following the narrow functional
approach,wereamonetaryinstrument.However,whattheprecedingdescriptionactuallyshows
is that the colonies of Virginia and Maryland were at the center of a trading system of tobacco
whichwascentraltotheeconomyofthesestates.Byacceptingtaxpayments,oranyotherdues,
in tobacco at a relatively high fixed price, governments could influence tobacco output, could
centralizeoutputcollectionandredistribution,andmakeiteasierforfarmerswhousuallydidnot
haveenoughmonetaryinstrumentsbecauseoftheirscarcitytopaytheirtaxes.This,however,
doesnotqualifypaymentsintobaccoleafsasamonetarypayment,butratherasapaymentinkind
atapricethatwasadministered.Likeinfeudaltimes,taxescouldbepaidinkind.
239
However,thepreviousquotegivesussomecluesaboutthemonetarysystemthatexisted.First,
whereastobaccowasnotafinancialinstrument,tobacconoteswereafinancialinstrumentofthe
governmentwarehousesworthacertainnumberofpoundsandcollateralizedbythevalueofthe
weightoftobaccothateachnoterepresented.Thus,tobacconotesmayhavebecomemonetary
instruments;nothingclearissaidaboutthat.Second,theprovisionofcreditthroughbookkeeping
wasacommonwaytoavoidtheproblemsofbarter:
Onemethodforfinancingprivatetransactionsinthecolonieswasthroughrecords
ofaccountkeptbytradesmenandplanters.Creditsanddebitsweretransferred
amongothermerchantsandtraders.Thiswasaformofbookkeepingbarterin
whichgoodswereexchangedforothergoods,andexcesscreditswerecarriedon
account.Thebartereconomythatprevailedinthecoloniesrequiredvoluminous
recordkeepingtocarryoveroldaccountsformanyyears.Thispracticewould
continuethroughtheeighteenthcentury[].(Ibid.,46)
The bookkeeping system was actually more complicated because credits on an account were
sometimestransferableatpar.Thus,amonetarysystembasedinitiallyonaunitofaccountnamed
poundwaspresentinthecolonies,eventhoughitsfunctioningwasnotverysmoothgiventhe
excessivelyhighscarcityoftopmonetaryinstrumentsandthelocalizedemergenceofbookkeeping
transfers.Tobaccoleafswerenotpartofthismonetarysystem.
SOMALIAN SHILLING: THE DOWNFALL OF THE ISSUER AND

CONTINUEDCIRCULATIONOFITSMONETARYINSTRUMENT
In1991,theSomaliangovernmentcollapsedbutitsmonetaryinstrumentscontinuedtocirculate.1
Onecanexplainwhybynotingthat:
1. Thestatewascentralinestablishingthetrustaboutthecurrencypriorto1991.Thisiswhat
anchoredtheexpectationsaboutthefacevalueoftheSomalianshilling.
2. Giventheconfusionatthetimethestatecollapsed,citizensjustreliedonhabits,anchoring
inducedbytheinertiaprovidedbyhistoricalacceptancecreatedbythestate.
3. Ifcitizensbelievethatthecollapseofthestateisonlytemporaryandtheshillingwillbe
reissuedlaterthenthereisanincentivetocontinueusingit.Thisisverydifferentfromthe
caseofthetransfertotheEurozonewhenstatesspentyearseducatingandinformingtheir
populationaboutthedemonetizationoftheircurrency,andgaveacleardateaboutwhen
demonetizationwouldoccur.InSomalia,everybodywasleftinthedark.
4. Thebeliefthatshillingwouldbeagainthenationalcurrencywasreinforcedbytwoaspects:
a) local governments did accept them for tax payments at least temporarily b) armed
militia,thatsubstitutedforgovernment,startedtoforgesomeshillingnotestofillupthe
voidleftbythecollapseoftheofficialgovernment,and,inaddition,mayhavealloweddues
tobepaidinthatcurrency.
Allthisissimilartosharesthatcontinuetotradeevenasacompanygoesthroughliquidationand
reorganization.Bearersarehopefulthatthecompanywillcomebackandbegreatagain.
240
1 The use of tax liability and tax enforcement as means to create a demand for government
monetaryinstrumentshasbeenacommonpracticeofgovernmentforhundredsofyears.
2 A monetary system based on gold or other precious metal is very inelastic and subject to
monetaryinstabilityifgoldisgiventoomuchimportance.
3 While an issuer of a financial instrument may default, it does not mean that its financial
instrument will disappear if there is an expectation that the issuer will be able to restore its
creditworthinessinthefuture.
4TobaccoleafswerenotmonetaryinstrumentsintheUSbecausenobodyissuedthem,i.e.nobody
madepromisesembeddedinthetobaccoleafs;theyhadnoissuer.
Keywords
Debasement,legaltenderlaws,fraud,refluxmechanism
ReviewQuestions
Q1:Howdidtheinclusionoftobaccoleafsinlegaltenderlawshelpthepaymentsystem?
Q2:Whyiscryingdownthecoinageproblematic?Howdidtheexistenceofcoinsmadeofprecious
metallimittheabilitytocrydownthecurrency?
Q3:Wasdebasementmostlyaboutimprovingthefinancesofthekingbybeingabletoissuemore
coinswiththesameamountofpreciousmetal?
Q4:Howdidtheissuanceofpreciousmetalcoinshelptodealwiththeuncertaintyofthetimebut
alsocreatedsomeinstability.
Suggestedreadings
Bell,S.A.(2001)TheroleofthestateandthehierarchyofmoneyCambridgeJournalofEconomics
25(2):149163.
BoyerXambeu,M.T.,Deleplace,G.andGillard,L.(1994)PrivateMoneyandPublicCurrencies.New
York:M.E.Sharpe.
Forstater, M. (2005) Taxation and primitive accumulation: The Case of Colonial Africa. In The
CapitalistStateandItsEconomy:DemocracyinSocialism,ResearchinPoliticalEconomy,Volume
22,5165.
Henry,J.F.2004.Thesocialoriginsofmoney:Thecaseofegypt.inWray,L.R.(ed.)Creditand
StateTheoriesofMoney.Northampton:EdwardElgar.
Hudson,M.andWunsch,C.(2004)CreatingEconomicOrder.Bethesda:CDLPress.
Ingham,G.(2000)Babylonianmadness:Onthehistoricalandsociologicaloriginsofmoney,in
Smithin,J.(ed.)WhatIsMoney?NewYork:Routledge.
Littleton,A.C.(1956)StudiesintheHistoryofAccounting.Homewood:RichardD.Irwin
1 For a summary of the topic see David Andolfattos Fiat money in theory and in Somalia at
http://andolfatto.blogspot.ca/2011/08/fiatmoneyintheoryandinsomalia.html
241
GLOSSARY
Bearer: A person who holds a
financialclaimontheissuer.Inmost
cases,thebearercansuetheissuer
if the promise embedded in the
claiminnotfulfilled.
Collateral: Assets held by debtors

that can be taken by creditors in
case of default. Assets are usually
sold to try to recover some of the
fundsowed.
Board of Governors: The head

institution of the Federal Reserve
System. It is composed of at most
sevengovernors.
Commercial paper (CP): A security

issuedbyprivatecompanieswitha
shorttermtomaturity(oneyearor
less).
Asset:Anythingthatisownedbyan
economicunit.
Bond: A security with a relatively

long term to maturity. It pays a
couponperiodically.
Assetbased credit (also collateral

based credit): A promissory note
underwritten with the expectation
thatincomeoftheissuerwillnever
beenoughtoservicethedebt.
Borrowed reserves: Reserves

obtained by going through the
Discount
Window
(reserves
borrowedfromtheFed).
Conforming mortgage:A mortgage

that has financial characteristics
that conform to criteria set by
Fannie Mae, Freddie Mac, and
GinnieMae.
A
Advance: Quantity of funds
providedbyabanktoacustomerin
exchange of the customers
promissorynote.
Applied vault cash: The dollar
amount of Federal Reserve notes
thatbankschoosetousetocomply
withreserverequirements.
Asymmetry of information: A
situationinwhichaneconomicunit
knows less than another economic
unit at the time of a contractual
negotiation.
Automatic stabilizers: Changes in
the level and growth rate of
governmentspendingandoftaxing
that occur because of change in
economicactivity,andnotbecause
government decided to change its
spending or taxing habits. For
example, unemployment insurance
goesupautomaticallyinarecession
andgoesdownautomaticallyduring
an expansion. Similarly, tax
revenues fall (rise) automatically
during a recession (an expansion)
because less (more) income is
earnedbytheprivatesector.
Borrowing: Temporarily using the

assetsofsomeoneelse.
C
CAMELS rating: A rating that
measuresthesoundnessofabank.
Capital:Seenetworth.
Capital requirement: Quantity of
capital that a financial institution
must keep relative to the size and
quality of its assets in order to
protect its balance sheet against
unexpectedlosses.
Cash flow: Inflow or outflow of
Cash management: A deliberate
management of the level and
structure of monetary balances to
reachaspecificgoal.
Balance sheet: An accounting

document that shows what is
owned and owed by an economic
unit.
Certificate of deposit (CD): A

promissory note issued by banks
withatermtomaturityvaryingfrom
shorttomediumterm.Itissimilarto
a savings account, except that it is
illiquiduntilmaturity.
Basis point: A onehundredth of a

percentagepoint,0.01%.
Clipping coins: The act of cutting

bitsoutofcoins.
242
Consolidation: The act of merging

two or more balance sheets into
one.
Consumption
(also
final
consumption):Theuseofgoodsand
serviceforpersonalenjoyment.
Contingent liability: A claim that is
duewhenaspecificeventoccurs.
Conventional mortgage: Any
mortgage
issued
by
non
government financial institutions.
Unconventional mortgages are
those insured by government
agencies (such as the Federal
Housing Administration) and that
haveunconventionalcharacteristics
that accommodate the needs of
economicunitswithahigherchance
ofdefaulting(e.g.,lowinterestrate
eventhoughcreditworthinessisnot
verygood).
Convertible: The ability to hand
back to the issuer its promissory
note and to get something else in
exchange.
Coupon:Theincomereceivedfrom
abondandothersimilarsecurities.
It is an interest income, that is, its
payment is due periodically and
representsaproportionoftheface
valueofabond.Bondsusedtobein
GLOSSARY
paper form with small coupons
attachedtothemthatneededtobe
detachedandhandedbackedtothe
bond issuer to receive the interest
paymentdue.
Creditcard receivable: Amount of
debtoutstandingonacreditcard.
Credit risk: The probability that an
economic will default on its
promise.
Credit standards: Criteria used by
bankers to determine how
creditworthyaneconomicunitis.
Creditworthiness: Expected ability
of an economic unit to service its
debtsontimeinfull.
Currencyincirculation:Officially,it
is mostly the value of Federal
Reserve notes in the hands of
economic units others that the
Federal Reserve banks, the U.S.
Treasury, and banks. Theoretically,
coins held by others than the
previouslycitedeconomicunitsare
alsoincludedinthedefinition.
Debt management: The deliberate

changeinthelevelandstructureof
outstandingdebttoreachaspecific
goal.
Debtization: The growing use of
debtindailyeconomicactivities.Itis
the
counterpart
of
the
financializationoftheeconomy.
Default:Theactionofdeclaringthe
inability or unwillingness to service
debts, either at all or according to
thepreviouslyagreedtimetable.
Deficit: A budgetary situation for
whichspendingexceedsincome.
Demandliability:Aclaimthatisdue
atthewillofthebearer.
Discounttrading:Themarketprice
ofasecurityisbelowfairprice.
DiscountWindow:Ameansforthe
Federal Reserve System to provide
collateralizedadvancestobanks.
Discount Window operation: An

advanceofreservestobank.Banks
sign a promissory note and in
exchange get reserves. All
promissory notes must be
collateralizedsoifbanksdefault,the
Fed takes the assets banks put as
collateral.
Datedliability:Aclaimthatrequires
payments at specific periods of
time.
Dividend:Theincomereceivedfrom
astock.Itspaymentisaproportion
oftheprofitofacompany.
Debasement: A legal or illegal

decreaseinthequantityofprecious
metalincludedinacoin.
Crying up/down the coinage: The

act of increasing/decreasing the
facevalueofcoinsbydecree.
Debt deflation: An economic

situationinwhichoverindebtedness
and prices interact in such a way
thatitresultsindeflation,defaults,
and a general decline in economic
activity.
Debt liquidation: The act of
reducing
the
quantity
of
outstanding debts either by
repaying them or by writing them
off.
243
Economicunit:Aneconomicentity
that, depending on the level of
analysis,canbeahousehold,afirm,
a government, a country, or other
entitythatmakesdecisions.
Elasticcurrency:Acurrencythatcan
be injected and ejected from the
economicsystemasneeded.
Excess reserves: Quantity of
reserves that is kept by banks
beyondwhattheFedrequiresthem
tohold.
F
Face value: The price at which the
issuer promises to take back its
financial
instrument.
The
outstanding principal due by the
issuer.
Fairprice(alsofairvalue):Theprice
atwhichasecurityoughttotrade.It
may or may not be the price at
whichasecurityactuallytrade(the
marketprice).
Fannie Mae: A government
sponsored enterprise that buys
conventional and government
insured mortgages from banks as
long as they conform to a set of
standardsitsets.Itdoessoinorder
toencouragethemtoacquiremore
mortgagesatmoreaffordablerates.
It buys mortgages by issuing
mortgagebackedsecurities.
Federal funds: The dollar value of
theaccountsattheFederalReserve
banks.
Federal funds market: A market in
whichparticipantsborrowandlend
federalfunds.
Federalfundsrate:Theinterestrate
that is paid (received) by an entity
thatborrows(lends)federalfundsin
thefederalfundsmarket.
Federal funds rate target: The
federal funds rate that the central
bankwantstoseeinthemarket.
Federal Open Market Committee
(FOMC):AcommitteeoftheFederal
Reserve System composed on the
board of governors and the
presidents of the Federal Reserve
banks. It formulates monetary
policybymeetingeverysixweeksor
so and voting on the course of
actionintermsofthefederalfunds
rate target. Presidents (except the
president of the New York Federal
Reserve bank) rotate their voting
GLOSSARY
power and only five out of the 12
canvoteatanytime.
Federal Reserve Bank: One of the
twelve banks part of the Federal
ReserveSystem.
Federal Reserve System (Fed): A
government agency created to
providethecurrencyofthenation,
tofacilitateinterbankpayments,to
regulatememberbanks,topromote
anelasticcurrency,andtomanage
economic activity. While it is
structured with some forprofit
features,itsactivitiesandgoalsare
orientedtowardfulfillingthepublic
purpose expressed in its functions.
Also the Fed can operate without
makinganyprofit.
Financialasset:Aclaimheldagainst
someone that involves contractual
monetarypayments.
Financialization: The growing
importancethatthefinancialsector
playsindailyeconomicactivity.
Financing phase: A phase of
economic activity in which bank
creditisneededtostartproduction
Finetuning the economy: Policy
strategy used by the central bank
andtheU.S.Treasurytoensurethat
an economy stays close to full
employment with stable prices. It
involves nudging incentives in the
private sector and the use of
automatic stabilizers to move the
economyinaspecificdirectionand
to ensure it is neither too hot
(inflation pressures) nor too cold
(highunemployment).
Fiscaldeficit:Seedeficit.Itresultsin
theissuanceofnewTreasuries.
Fiscalsurplus:Seesurplus.Itresults
in the repayment of existing
Treasuries.
Forward guidance: A monetary
policy that involves influencing
expectations of the future path of
244
federalfundsratetargetthrougha
specific wording of current
monetarypolicydecisions.
Fraud:Theactofgainingthetrustof
a person and then abusing that
trust. It is the act of deceiving for
personalbenefit.
Freddie Mac: A government
sponsoredenterprisethatcompetes
withFannieMae.
Free reserves: Nonborrowed
reserves held beyond what is
required.
Funding phase: A phase of the
economic process in which finance
plays a role for the acquisition of
whathasbeenproduced.
Funds: An outstanding quantity of
G
Ginnie Mae: A governmentowned
companythatguaranteesthetimely
paymentofprincipalandintereston
mortgagebacked
securities
collateralizedbyfederallyinsuredor
guaranteed mortgages. These
mortgagesareissuedmostlybylow
tomoderate income households
and by veterans. By doing this,
Ginnie Mae encourages banks to
fund homeownership for veterans
andthepoorersectionofAmerican
households.
Governmentsponsored enterprise
(GSE): A forprofit firm created by
Congresstofulfillapublicpurpose.
Suchenterpriseshavebeencreated
to promote homeownership,
education,theelectrificationofthe
country, among other goals that
havebeendeemedrelevanttofulfill
the public purpose. They do so by
encouraging banks to lower the
interest rate and underwriting
requirements on promissory notes
issued to fulfill the activities that
comply with the public purpose.
That is done by buying those

promissorynotesfrombanksorby
insuring banks against defaults on
thepromissorynotes.
H
Hedgefinance:Afinancialsituation
in which an economic unit is able
nowandinthefuturetoserviceits
debtswithitsincome.
Household: A person of group of
personslivinginthesamedwelling.
I
Illiquidity: Temporary inability to
paycreditors.
Incomebased credit:A promissory
note underwritten with the
expectationthattheincomeofthe
issuer will be sufficient to service
the debt, if not now at least
sometimeinthefuture.
Income
distribution:
The
distribution of national income
among, wage earners and profit
earners.
Inconvertible: A promissory note
thatisnotconvertible.
Inflation risk: The probability of a
substantial fall in the purchasing
power of future cash flows and
outstandingfinancialassets
Interest on reserves: Interest rate
paidonreservebalances.
Intrinsicvalue:Themarketvalueof
material(paperforbanknotes,gold
forgoldcoins,etc.)usedtomakea
monetaryinstrument.
Insolvency: Permanent inability to
paycreditors.
Investment:Thepurchaseofgoods
and services for the purpose of
producinggoodsandservices.
Irrational behavior: Behavior that
deviates from the standard
neoclassical hypothesis about
GLOSSARY
behaviors (maximization
preferenceranking).
and
Issuer: An economic unit that

createdapromissorynoteandgave
it to others. That economic unit
must now fulfill the promise
embeddedinthenote.
J
Job guarantee program: An
economic policy that provides the
opportunitiestoworkforallpersons
willingandabletodoso.Thishelps
make a person more employable,
use her skills for more social
purpose while unemployed, and
providesometrainingexperience.
L
Lease:Theloanofanassetwiththe
option to buy it after a period of
time.
Legaltenderlaws:Lawsthatdictate
what is/are the ultimate means of
payment. A creditor cannot pursue
further legal actions against its
debtorsifitrefusespaymentinlegal
tender.
Lending: Temporarily parting with
anasset.
Level1 valuation: Financial assets
are valued based on their market
price.
arevaluedbasedonaproxymarket.
Maybe because there is no readily
available organized market for the
assetsheld.
are valued according to a model
created by the economic unit that
holdsthem.
Leverage: A measure of the
indebtednessofaneconomicunit.
Liability: Anything that is owed by
aneconomicunit.
245
Liquid asset: An asset that can be

traded quickly without incurring
largelossesofcapital.Anassetwith
a relatively stable fair price. A
perfectly liquid asset has a stable
nominalvalue.
Liquidity risk: The probability that
the price of an asset will fall
substantiallywhenitsownertriesto
sellitquickly.
M
Monetaryaggregates:Measuresof
the money supply. M1 is the
narrowestindicator.
Monetary base: The sum of
reservesandcashincirculation.
Monetary instrument: A security
withspecificfinancialcharacteristics
suchthatitsfairpriceisparity.
Moneysupply:Thesumofcurrency
in circulation and other monetary
instrumentsheldbythepublic.
Moral hazard: An increase in the
risktakingofaneconomicunitonce
it knows it is protected against
specific adverse events. The
increaseinrisktakingincreasesthe
probability that such specific
adverseeventswilloccur.
Mortgage: A promissory note
backed by a residential or a
commercialproperty.
Mortgagebackedsecurity(MBS):A
bond that is backed by mortgages.
The cash flow for the interest and
principal payments for the bond
comes from the servicing of
mortgages.
N
Natural growth rate: The growth
rate of productive capacities
inducedbyagivensetofallocation,
preference and technique of
production.
Net acquisition: Acquisition minus

reduction in the quantity of assets
orliabilities.
Netborrowing:Theoppositeofnet
lending.
Netcapitalgain:Capitalgainsminus
capitallosses.
Net cash flow: Cash inflow minus
cashoutflow.
Net clearing of debt: The act of
acknowledgingwhattwo(ormore)
economic units owe to each other
andtocalculatethenetamountdue
byoneoftheeconomicunit.Xowes
$10toY,Yowes$3toX,thenXowes
$7 to Y. Net clearing allows to
simplify the settling of debts by
reducing the number of transfers
betweendebtorsandcreditors.
Netfinancialaccumulation:Seenet
lending.
Net lending: A positive difference
betweenthechangeinthequantity
financial assets and the change in
the quantity of financial liabilities.
Overaperiodoftime,aneconomic
unitacquiresmoreclaimsonothers
than others acquire claims on that
economicunit.
Net income:
expenses.
Income
minus
Netsaving:Seenetlending.
Net worth (also net wealth): The
difference between the value of
assetsandthevalueofliabilities.
Nominalism:Alegalviewthatstates
that changes in the purchasing
power ought not to impact the
amountofprincipalowed.
Nonborrowed reserves: Reserves
obtained through openmarket
operations with the Fed or
borrowedfromotherbanks.
Nonfinancial asset: Something
owned by an economic unit that
does not involved contractual
GLOSSARY
monetary payments to its owner.
That includes machines, software,
andgoodwill,amongothers.
Normalization: A monetarypolicy
strategy that aims at bringing the
FFRbacktomorenormallevelsinan
environmentofanabnormallylarge
quantity of excess reserves. The
strategyalsoaimsatremovingmost
ofexcessreservesinthelongrun.
O
Openmarket operations: The sale
or purchases of securities by the
central bank, on a permanent or
temporary basis, respectively to
remove or add reserves. The
frequency
of
this
market
intervention varies depending on
the central bank, with the Federal
Reserve intervening daily while the
European Central Bank intervening
weekly.
Originate and hold model: Banks
acquire promissory notes and hold
themtomaturity.
Originate and distribute model:
Banksacquirepromissorynotesand
sellthemalmostimmediately.
Output gap: The difference
between the growth rate of
aggregate demand and the growth
rateofaggregatesupply.
Outright purchase: The action of
permanently buying a financial
asset,i.e.buyingwiththeintention
ofholdingit.Thisisdonewhenthe
Fed expects that some of the
reserves available will not be
needed for an extended period of
time.
Overdraft: A negative balance in a
bankaccount.
Overnight interbank market: The
market in which banks lend and
borrow reserves to each other for
thenight.
246
P
Parvalue:Seefacevalue.
Parity:Seeparvalue.
Ponzi finance: A financial situation
in which an economic unit is not
ablenowandinthefuturetoservice
its debts with its income. It must
refinance or must sell assets to
service the interest and principal
due,atleastforaperiodoftime.
Portfolio:Thesetofassetsheldona
balancesheet.
Position: The dollar value of a
specific asset held on the balance
sheet.Thispositioncanbelong(one
owns the specific assets) or short
(oneborrowedthespecificasset).
Premiumtrading:Themarketprice
ofasecurityisaboveitsfacevalue.
Principal: Outstanding amount of
debtlefttoberepaid.
Promissory note: A contractual
agreement to make one or several
monetarypayment(s)inthefuture.
Public debt: The face value of
outstanding Treasury securities. It
goes up with a fiscal deficit and it
goes down when Treasuries are
repaid.
R
Rate of return: A measure of
monetarygainsinpercentagerather
than dollar amount. The amount
earnedrelativetothecostofgetting
accesstothatearning.
RealBillDoctrine:Aviewaccording
towhichthefinancialassetsofthe
Fed should only be composed of
selfliquidating
assets,
i.e.
promissory notes that are issued
and destroyed in relation to
economic activity. Firms issue
commercial papers to finance
production and take back the
paperswhentheymakeaprofit.
Recourse:Theabilityofcreditorsto
ask for more funds from debtors if
the sale of collateral has not been
sufficient to recover the funds
expected.
Redemption:Whentheissuertakes
back its promissory note from the
bearer(s).
Redeemable: A security can be
returnedtoitsissueratsomepoint
in time through some reflux
mechanisms.
Reflux mechanisms: The means
availabletothebearerstogiveback
afinancialinstrumenttoitsissuers.
Refinance: The act of repaying an
olddebtbyissuinganewdebt.
Repurchase agreement: When a
party agrees to sell/to buy
somethingtodayandtobuy/tosell
itbackinthefuture.
Required reserves: Quantity of
reservesthatabankmusthave.
Reserves:Seetotalreserves.
Reserve balances: Accounts of
banksattheFederalReserve.
Reserve requirements ratio:
Proportion of total reserves that a
bank must have in relation to its
transactionaccounts.
Return on asset: The value of
monetarygainsrelativetothevalue
ofassets.
Return on equity: The value of
monetarygainsrelativetothevalue
ofnetworth.
Risk management: Means used to
protect a balance sheet against
expected and unexpected adverse
shocks.
S
Saving:Dependingonthecontext,it
can be the unconsumed monetary
incomeorthechangeinnetworth.
GLOSSARY
Scarcity: An economic situation in
whichtherearelimitedresourcesto
fulfillunlimitedpreferences.
Secured: Backed by a piece of
collateral.
Security: A promissory note that is
tradable.Dependingonitsfinancial
characteristics,asecuritycantakea
differentnamesuchasstock,bond,
orcommercialpaper.
Settlement of debts: The act of
payingdebts.
Speculative finance: A financial
situationinwhichaneconomicunit
isnotablenowandinthefutureto
service its debts with its income. It
mustrefinancetheprincipaldueat
leastforaperiodoftimeormustsell
assetstodoso.
Speculation: The act of buying an
assetwiththeviewofresellingitto
makeacapitalgain.
Stock (also equity or share):
Security that represents a share of
the company. The bearer is the
owner of the company. Common
stocksallowthebearerstovoteon
themajorstrategicdecisionsofthe
company. Preferred stocks do not
giveavotingrightbutguaranteethe
paymentofadividend.
Surplus:Theoppositeofdeficit.
Surplusvaultcash:FederalReserve
notes that banks have in excess of
what they use to meet reserve
requirements.
Sweating coins: The act of shaking
coinsinabagtoremovetinybitsof
precious metal. A less easily
detectable means of debasement
thanclipping.
T
Tax receivable (or payable): Taxes
that recorded as due but not yet
paid.
247
Tbill: A security issued by the U.S.

Treasurywithatermtomaturityof
atmostoneyearandthatdoesnot
provideacouponpayment.
Tbond:AsecurityissuedbytheU.S.
Treasurywithatermtomaturityof
morethantenyears.Moreloosely,
the term is used to mean any
treasuries with a term to maturity
greaterthanoneyear.
Termtomaturity:Timeleftbefore
theprincipalonasecurityisdue.
Total reserves: The sum of reserve
balancesandappliedvaultcash.
Treasurys general account (TGA):
Account of the Treasury at the
Federal Reserve that Treasury uses
tospend.
Treasurysecurities:SeeTreasuries.
Treasurys tax and loan account:
Account of the Treasury at private
banks that Treasury uses to collect
funds received from taxes and the
issuanceofTreasuries.
Treasuries:Securitiesissuedbythe
U.S.DepartmentoftheTreasury.
Triffindilemma:Ifacurrencyisboth
convertible and in high demand by
the rest of the world, the issuer of
that currency must supply enough
butasitsuppliesmorethepromise
ofconvertibilitybecomesharderto
fulfill.
U
Underwriting:
The
act
of
determiningthecreditworthinessof
aneconomicunit.
Unit labor cost: The ratio of wage
overtheproductivityoflabor.
Unsecured: Financial claims that is
not backed by any collateral (e.g.,
creditreceivables).Theymaystillbe
somerecoursesforbearers.
V
Vault cash: The Federal Reserve

notesinthevaultofbanks.
Valorism: A legal view that argues
that the principal owed should be
adjustedtomaintainitspurchasing
powerconstant.
Volcker experiment: A change in
monetarypolicyoperationstoward
a looser targeting of the federal
fundsrateandafocusontargeting
monetaryaggregates.
Y
Yield:Seerateofreturn.
Yield to maturity: The yield
obtainedifasecurityishelduntilit
matures.
Z
Zerocoupon security: A security
thatdoesnotpayanycoupon.
ABOUTTHEAUTHOR
EricTymoigneisanAssociateProfessorofEconomicsatLewisandClarkCollege,Portland,Oregon;and
ResearchAssociateattheLevyEconomicsInstituteofBardCollege.Hisareasofteachingandresearch
include macroeconomics, money and banking, and monetary economics. His current research agenda
includesthenature,history,andtheoryofmoney;thedetectionofaggregatefinancialfragilityandits
implications for central banking; the coordination of fiscal and monetary policies; and the theoretical
analysisofmonetaryproductioneconomies.Hehaspublishedinnumerousacademicjournalsandedited
volumes.Hismostrecentbook,coauthoredwithL.RandallWray,isTheRiseandFallofMoneyManager
Capitalism:MinskysHalfCenturyfromWorldWarTwototheGreatRecession.TymoigneholdsanMAin
economic theory and policy from the Universit ParisDauphine and a Ph.D. in economics from the
UniversityofMissouriKansasCity.
248

The Financial System and The Economy

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The Financial System and The Economy

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THE FINANCIAL

Money Markets: Securities with a maturity of one year or less

Insurance Markets (Forwards, Futures, Options, Swaps)

Government-Sponsored Enterprises (FAMC, FCS, FHLBS, FHMLC, FNMA,

POINT 4: BANKS CANNOT DO ANYTHING WITH RESERVE BALANCES

The monetarybaseisnotthesamethingasthemoneysupply. Moneysupplymeansmonetary

RESERVES: REQUIRED, EXCESS, FREE, BORROWED, NON

Lower L4: US exports, governmentsponsored enterprises buy mortgages from

CAN THE FED ISSUE AN INFINITE QUANTITY OF MONETARY

WHAT DOES THE FED DO IN TERMS OF MONETARY POLICY

A GRAPHICAL REPRESENTATION OF THE FEDERAL FUNDS

Q2: DID THE VOLCKER EXPERIMENT NOT SHOW THAT

Q9: HOW DID CENTRAL BANKERS JUSTIFY USING NEGATIVE

Q12: WHAT ARE NONO SENTENCES FOR WHAT THE FED

OTHER EXAMPLES OF TREASURYS INVOLVEMENT IN MONETARY

A NECESSARY COORDINATION OF TREASURY AND CENTRAL

TO GO EVEN FURTHER: WHAT ARE THE RELEVANT

Credit services: Swapping promissory notes to allow liquidity, creditworthiness, and

Creditworthiness of the issuers of promissory notes (credit risk): households,

WHY ARE THERE STILL FREQUENT AND SIGNIFICANT

THEORIES OF BANK CRISES AND BANKING REGULATION:

MONETARY CREATION BY BANKS: CREDIT AND PAYMENT

POINT 2: THE BANK DOES NOT NEED ANY RESERVES TO PROVIDE

POINT 3: THE BANK IS NOT USING OTHER PEOPLES MONEY: IT IS

HOW DOES A BANK MAKE A PROFIT? MONETARY

WHAT LIMITS THE ABILITY OF A BANK TO PROVIDE CREDIT

LIMITS TO MONETARY CREATION BY THE CENTRAL BANK

TO GO FURTHER: A SIDE NOTE ON ALTERNATIVE VIEWS OF

His theoretical position is untenable: if causality is known with certainty to be

WHY MONETARY INCENTIVES MATTER? AND WHAT ARE OTHER

THE QUANTITY THEORY OF MONEY: MONETARY VIEW OF

TO GO FURTHER: KALECKI EQUATION OF PROFIT, INTEREST

POINT 1: THE BEGINNING OF THE ECONOMIC PROCESS REQUIRES

POINT 2: NOT ALL SECTORS CAN RECORD A SURPLUS AT THE SAME

Step2:Governmentwantstobeinsurplus(GBd > 0).Inagrowingeconomy,automatic

For the country supplying the international reserve currency, negative

TO GO EVEN FURTHER: NIPA AND FA DEFINITIONS OF

MONETARY PRODUCTION ECONOMY: THE FINANCIAL INSTABILITY

Fiscal policy: A period of prolonged expansion that is led by a monetarily sovereign

TO GO EVEN FURTHER: MINSKY AND INCOME VS. CASH

AT WHAT PRICE SHOULD A FINANCIAL INSTRUMENT

TRUST AND MONETARY SYSTEM: TRUST IN THE ISSUER VS.

Treasury issues government monetary instruments by spending and it destroys government

Q2: CAN A MONETARY INSTRUMENT BECOME A

Q4: ARE CONTEMPORARY GOVERNMENT MONETARY

Q6: DO ISSUERS OF MONETARY INSTRUMENTS PROMISE A

Q8: ARE CREDIT CARDS MONETARY INSTRUMENTS? WHAT

Q9: WHAT WERE SOME ERRORS MADE IN PAST MONETARY

Q10: DO LEGAL TENDER LAWS DEFINE MONETARY

Q11: IS IT UP TO PEOPLE TO DECIDE WHAT A MONETARY

See section on salt currency at the Encyclopedia of Money blog: http://encyclopediaof

MASSACHUSETTS BAY COLONIES: ANCHORING OF

TOBACCO LEAFS IN THE AMERICAN COLONIES: LEGAL

SOMALIAN SHILLING: THE DOWNFALL OF THE ISSUER AND

Collateral: Assets held by debtors

Board of Governors: The head

Commercial paper (CP): A security

Bond: A security with a relatively

Assetbased credit (also collateral

Borrowed reserves: Reserves

Conforming mortgage:A mortgage

Borrowing: Temporarily using the

Balance sheet: An accounting