Banks Are Not MysticalOf

Banks Are Not MysticalOf related interest, a debate between NYT Paul Krugman and Australian economist Steve Keen and others on money/credit supply. Is it the Fed or is it the banks and involves understanding Hyman Minsky “who wrote that markets are intrinsically in a state of disequilibrium” so that is where i get lost. I am sure others here will have a better understanding and clarify things to me. Apologies for the scattered and probably unrelated links for you to follow .http://www.businessinsider.com/paul-krugman-vs-steve-keen-2012-4According to Keen “One key component of Minsky’s thought is the capacity for the banking sector to create spending power “out of nothing””  His argument is that banks lend first then seek reserves. The Fed will accommodate banks by providing enough reserves to meet any reserve ratio at its target rate; The Fed targets a rate not a quantity. Banks are constrained by capital requirements and borrower demand, not by reserve requirements. While for Krugman “the bottom line: the Fed controls credit conditions…, all the talk about banks creating money…is irrelevant to the actual economic discussion.” Krugman argues that bank lending doesn’t necessarily increase demand in the economy—it just shifts money around. Banks don’t create demand out of thin air any more than anyone does by choosing to spend more; and banks are just one channel linking lenders to borrowers. Canadian economist Nick Rowe was on the side of Krugman with a post arguing that, while commercial banks can create money out of thin air, they are contrained by their reserves. “Commercial banks promise to redeem their money at a fixed exchange rate (at par) for central bank money,” Rowe explains. Which means the central bank controls the size of the money supply, because it is the source of bank reserves. http://www.debtdeflation.com/blogs/2012/04/02/ptolemaic-economics-in-the-age-of-einstein/According to Keen, “Minsky thought that irrational market actors can exacerbate disequilibriums when they perceive future stability in the markets. For example, banks in the early 2000s continued extending loans to home-buyers with poor credit because they did not foresee (or did not want to accept) that home prices could not continue rising. Even the initially conservative activity of extending loans to creditworthy homebuyers soon became speculative, as home prices skyrocketed out of control because of unsustainable demand in the market. While it is quite conceivable that bank behavior did indeed exacerbate the housing bubble in this manner, Keen argues that this behavior demonstrates a deeper ideology: fiscal and central bank policy have far less power in controlling credit conditions than we would like to believe. He writes: We cannot rely upon laws or regulators to permanently prevent the follies of finance. After every great economic crisis come great new institutions like the Federal Reserve, and new regulations like those embodied in the Glass-Steagall Act. Then there comes great stability, due largely to the decline in debt, but also due to these new institutions and regulations; and from that stability arises a new hubris that “this time is different”—as the debt that causes crises rises once more. Regulatory institutions become captured by the financial system they are supposed to regulate, while laws are abolished because they are seen to represent a bygone age. Then a new crisis erupts, and the process repeats. Minsky’s aphorism that “stability is destabilizing” applies not just to corporate behaviour, but to legislators and regulators as well. Banks, Keen insisted, form the crux of the problem since they are in control of the monetary base. Banks’ assessments of the risks and rewards to lending grows virtually without reference to the deposits they receive, so banks—and not the government—ultimately determine credit standards.” Keen quotes “Senior Vice-President of the New York Federal Reserve, noted that the key Monetarist policy prescription of regulating the economy by “a regular injection of reserves” was based on “a naïve assumption” about the nature of the money creation process: “The idea of a regular injection of reserves—in some approaches at least—also suffers from a naïve assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.” Holmes would turn in his grave at Krugman’s naïve assertion, half a century later, that banks need deposits before they can lend ”  In the same piece Keen quotes Schumpeter who “put it clearly during the last Depression: he described the view that Krugman puts today, that investment (which is what the most important class of borrowers do) is financed by savings, as “not obviously absurd”, but clearly secondary to the main way that investment was financed, by the “creation of purchasing power by banks … out of nothing“. This is not “Banking Mysticism”: this is double-entry bookkeeping: “Even though the conventional answer to our question is not obviously absurd, yet there is another method of obtaining money for this purpose, which … does not presuppose the existence of accumulated results of previous development, and hence may be considered as the only one which is available in strict logic. This method of obtaining money is the creation of purchasing power by banks… It is always a question, not of transforming purchasing power which already exists in someone’s possession, but of the creation of new purchasing power out of nothing. (Joseph Alois Schumpeter, 1934, p. 73)Paul Krugman counters “As I read various stuff on banking — comments here, but also various writings here and there — I often see the view that banks can create credit out of thin air. There are vehement denials of the proposition that banks’ lending is limited by their deposits, or that the monetary base plays any important role; banks, we’re told, hold hardly any reserves (which is true), so the Fed’s creation or destruction of reserves has no effect…First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand.But the usual claim runs like this: sure, this is true of any individual bank, but the money banks lend just ends up being deposited in other banks, so there is no actual balance-sheet constraint on bank lending, and no reserve constraint worth mentioning either. That sounds more like it — but it’s also all wrong. Yes, a loan normally gets deposited in another bank — but the recipient of the loan can and sometimes does quickly withdraw the funds, not as a check, but in currency. And currency is in limited supply — with the limit set by Fed decisions. So there is in fact no automatic process by which an increase in bank loans produces a sufficient rise in deposits to back those loans, and a key limiting factor in the size of bank balance sheets is the amount of monetary base the Fed creates — even if banks hold no reserves. So how much currency does the public choose to hold, as opposed to stashing funds in bank deposits? Well, that’s an economic decision, which responds to things like income, prices, interest rates, etc.. In other words, we’re firmly back in the domain of ordinary economics, in which decisions get made at the margin and all that. Banks are important, but they don’t take us into an alternative economic universe.”This brought forth Scott Fullwiler, an MMT economics professor who declared that “It’s really just a matter of double entry book-keeping, Fullwiler argues. When a bank makes a loan it creates a liability for itself—a customer deposit—and an asset for itself—the loan. The customer, of course, has the mirror opposite: an asset called a bank deposit and a liability in the form of an amount owed to the bank. But what happens when the bank customer who borrowed from JPMorgan Chase spends the money he borrowed and the guy on the other end of the deal deposits the money in Citibank? The deposit gets transferred from JPMorgan Chase to Citigroup. This typically happens by having the Federal Reserve debit reserves from JPMorgan Chase and credit reserves to Citigroup. If JPMorgan’s reserves were to run short of the requirements, it would borrow the reserves on the interbank market. If the reserves were unavailable on the interbank market for some reason, the Fed would automatically credit JPMorgan with a loan of the reserves. In short, the amount of reserves would grow.  “Note that it cannot be any other way. If the central bank attempted to constrain directly the quantity of reserve balances, this would cause banks to bid up interbank market rates above the central bank’s target until the central bank intervened. That is, central banks accommodate banks’ demand for reserve balances at the given target rate because that’s what it means to set an interest rate target. More fundamentally, given the obligation to the payments system, it can do no other but set an interest rate target, at least in terms of a direct operating target.”  Another commentator writes “…banks make loans first and obtain reserves in the overnight market (from other banks) or from the Fed after the fact (if needed). New loans result in a newly created deposit in the banking system – from thin air!…Banks are capital constrained. Banks can always find reserves from the central bank so banks do not check reserve balances before making loans. Instead, they will check the creditworthiness of the borrower and their own capital position to ensure that the loan is consistent with the goal of their business – earning a profit on the spread between their assets and liabilities. Banks attract deposits because they want to maintain the cheapest liabilities possible in order to maximize this spread on assets and liabilities. Banks are, after all, in the business of making a profit! ” HUMMPHHH…I just get more bamboozled the more i try to comprehend.