Home > Bloom of Doom, Currency, Debt, Deflation, Economics, Financial Crisis, Inflation, Uncategorized > Bloom of Doom VII: The Borrower of last Resort

Bloom of Doom VII: The Borrower of last Resort

Not so very long ago the idea had firmly taken root that the Fed was the “lender of the last resort”, meaning that if no one else would lend to banks, the Fed would, thus preventing bank runs. Now it always struck CrisisMaven as odd that banks under any circumstance should be so little creditworthy that they couldn’t get credit. After all, aren’t banks the “eponym” of creditworthy, so to speak? But that the Fed one day would need to borrow from these banks no one else would lend to is an irony of fate we need to chew on a little to fathom all its dire implications.

(Statistical resources in our References section!)

Former chairman Greenspan now has gotten the idea that the crisis was precipitated by too little regulation. Again this strikes CrisisMaven as a bit odd. Where on earth do you know of a profession that cannot get its act together unless closely supervised? During training and apprenticeship, yes, but in daily operations? Something’s amiss here. But if one Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco can maintain a straight face when arguing that the Fed’s economic forecasting abilities are “second to none” then probably tight regulation of the whole profession is expedient – maybe in some closed institution. There are board games where you can play with paper money as your whim takes you, including prison, boom and bust without the populace at large suffering.

There are various camps discussing hotly if we’ll get inflation, deflation, stagflation or one of these first, the other later and so on. CrisisMaven is in none of these camps. He can see the rationale of the deflationists arguing that credit will contract at a far faster pace than the Fed can inflate, he sees the inflationists’ position that the money supply has risen so tremendously that Zimbabwe style hyper-inflation is in the offing. All he has argued so far is that debt default per se does not cause deflation, as the credit that is not repaid is still circulating rather than being retired as in orderly repayments plus, if recapitalised e.g. by the Fed, the credit sum is effectively even doubled. CrisisMaven has not committed himself on the final outcome, however, he has argued, that the money supply surely has risen to epic and unprecedented proportions (no one in any camp denies that, not even the Fed, whose own figures we actually show).

St. Louis Fed - Series: AMBSL, Adjusted Monetary Base (Money  Created)

However, most of that money is held in so-called excess reserves with the Fed, again a phenomenon that is unprecedented in history:

St. Louis Fed, Series XRCB, Bank's Excess Reserves

As you can see from the chart, banks never used to keep excess reserves but seek to lend whatever they can to generate interest income from lending. Inflationists argue they will, some argue, they must lend again eventually as the banks need to pay (far higher) interest on deposits and if they don’t earn more interest than they pay on deposits they will incur losses which is not sustainable for long.

The Fed and the stimulus politicians are of two minds here. On one hand they bemoan the “credit squeeze” which they blame for the slow (if any) economic recovery, on the other hand they fret that these reserves could be lent and, at 10% reserve requirements actually could trigger a nine-fold increase in credit volume and spending. No one in any camp would deny that if that happened considerable (some say: hyper-) inflation would soon follow.

So, second to none, the Fed’s Yellen and the other designers and schemers at the central bank have come up with a brilliant idea: why, banks only lend to other banks and the private sector to generate revenue from interest received. Right, we remember, wasn’t that chase after ever higher returns what led to the bubble and the financial crisis in the first place?

Now we have the Fed’s work cut out for us: the mistake was it’s role as lender of last resort – instead it should have been borrower of the last resort! Of course, how could we have been so blind for almost a hundred years! These excess reserves need to earn interest and, bingo, no need for the banks to turn to insecure borrowers that could default, just pay interest directly to the banks on the deposits they hold with the Fed!

On second thoughts though, why on earth do we then need the banks at all? If the banks need interest paid on their reserves in order to pay their employees and esp. pay interest to their depositors, then in actual fact the Fed pays Americans’ interest on their deposits … and pays (part) of the banks’ profits to boot – why not does the Fed directly pay everyone interest on their deposits and does away with private banks altogether?

Or why do banks still accept deposits with which they then have to share the hard-earned Fed interest on their Fed reserves?

But weren’t those reserves originally generated through bail-outs, stimulus and quantative easing to make up for defaults and shortfalls caused by these banks’ “normal” operations? So that they could resume those operations?

Maybe no one has yet thought the whole operation through because there’s more than first meets the eye:

This stands the Fed’s role on its head! From lender of last resort to borrower of last resort! Installing a money creation merry-go-round all for its own sake! Unbelievable! I’m sure when Bernanke would have had this in an exam from a student before he became chairman he would have let that student fail. But these are extraordinary times calling for extraordinary measures or are they?

Why the Fed can’t tie up excess reserves without creating even more (money) inflation

So, the theory (if we may call it that, coming from Yellen) is that those excess reserves, currently “parked” at the Federal Reserve can only cause inflation if they began (nine-fold at least) to circulate in the economy chasing goods and bidding up prices. Banks would be tempted if not forced to finally lend those holdings out in order to earn enough interest to pay their bills and pay their own creditors (the depositors).

So all the Fed has to do is make up for the shortfall by paying interest to those banks from its own coffers. Yellen be forgiven if she misses a finer point that we will not unduly trifle with, after all, she and her team are second to none: when you lend someone money you expect to eventually get it back. Some credit runs for thirty years like in real estate, normally not much longer, most credit far shorter; Fed reserves really even are call money. Anyway, after a credit matures it has to be paid back. Just think it through: the Fed borrows from its depositor banks and eventually pays them back … and then? Just think it through, maybe CrisisMaven has missed the rationale …

With this finer point out of the way let’s look at the practical implications:

Let’s say the excess reserves at the Fed stand at two trillion (US, yes, US, dollars). Interest is, say, 2% per year. So at the end of the year (if not daily, given the nature of central bank reserves)  the Fed pays out this interest, what happens? With every interest payment inflation, understood as expansion of money supply, goes up, diluting the value of the very interest “payments” the Fed feigns to make, increasing demand for a (inflation) premium which further dilutes the money supply which in turn raises the premium and so forth. This “excess reserves at interest” policy is itself necessarily inflationary and certainly no way to get rid of, not even realistically contain, excess money supply. If anything, like with carry trades, where money is borrowed cheaply in one place and invested at high rates in another, this excess reserve tie-down policy is part of the greater problem, not a solution.

So at best the Fed can try to keep the genie in the bottle by continuously widening the bottle but it can’t shrink it back to its former size (a size which was inflationary already or we wouldn’t have had a dotcom followed by a real estate bubble – that money is still “out there somewhere”). From a cybernetician’s standpoint this looks terribly like another extra fountainhead of pent-up inflation.

There’s a good video by khanacademy here (Hat Tip lowprice.blogs.keeptaperrelief.com) explaining the “lender of the last resort” ideology:

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  1. Mel
    2011-09-21 at 08:39 | #1

    i’m never good in talks like this. but i’m trying to understand the discussion you are having. i’d like to ask for your opinion about the article entitled: “The Borrower of Last Resort:
    International Adjustment and Liquidity in Historical Perspective*
    by: Ramaa Vasudevan

  2. Mel
    2011-09-21 at 08:36 | #2

    i’m never good in economics. but i’m trying my best to understand things in here. i’d like to ask about your opinion regarding the article on THE BORROWER OF LAST RESORT: International adjustments and liquidity in a historical perspective by Ramaa Vasuduan.

  3. 2010-03-30 at 08:05 | #3

    C.Maven. I look forward to your proving that the money supply does not need to grow commensurate with the expansion of the economy in real terms. How far will you take this? For example will you claim that Britain in 2010 could function with the money supply that we had in the middle ages: roughly £20 per person at present day prices?

    Also there is the brute fact of Keynes’s paradox of thrift. That is, never mind what anyone THINKS the total money supply ought to be, the brute fact is that if people and firms are deleveraging i.e. trying to get out of debt and expand their cash holdings (which they are at the moment), then to that extent their spending is reduced. And when people reduce spending, demand declines, and unemployment is the result, as Keyes rightly pointed out.

  4. 2010-03-29 at 14:25 | #4

    C.Maven: Sorry I missed the satire: I’m just simple soul.

    I agree with your statement “then something’s amiss.”. This chimes with the question in your original article “, why on earth do we then need the banks at all?” My answer is that we DO need them but they’ve had far too much stimulus and far too many privileges, which they abuse. If more stimulus had gone to Main Street we’d have businesses and households with ample cash, which means they’d have no need to resort to banks for loans. Plus more wealthy individuals at the local level would do what banks do: take a stake in local firms.

    Re your point “But surely there should not be room for a lender of the last resort if the banks are so rotten that they require outside help.” My feeling is some sort of lender of last resort is desirable, but it needn’t be on the present scale. Economies collapse not just because banks are “rotten” but also because free markets are inherently unstable.

    Re your question “begs the question why QE started it in the first place”. My answer: first to get interest rates down and second to ensure that crowding out didn’t push them up again, and third to flood the market with liquidity, and forth because central banks are clueless and couldn’t think of anything else to do.

    Re reversing QE, assuming the economy picks up, then QE can be reversed without harm being done. If there is insufficient pick up then the monetary base expansion that resulted from QE becomes more or less permanent, and perhaps should even be extended. And I see nothing wrong with that. “Functional finance” or “Modern monetary theory” to give it another name advocates expanding the monetary base in a recession, and contracting it, if need be, when the economy overheats.

    Hope that comment is not too long. Perhaps you should stipulate a max number of words.

    • 2010-03-29 at 15:25 | #5

      Hi Ralph, no I don’t want to cut anyone short, the longer, if to the point, the better, so thanks once again for your comment.
      As for the monetary theories that advocate, even see a necessity, to expand the monetary base to “keep up with overall growth” I beg to differ and will eventually lay out why in a more detailed post. But one of my more allegorical arguments goes like this: if you were a bricklayer and built a house, day in and day out you would see that house grow. However, to build it, to move your limbs etc., you need oxygen and to take in and metabolise oxygen you need blood. So while the “economy” a.k.a the house, grows, does your blood supply? Not really, if you’re past, say, twenty. In my opinion, without being an old-school physiocrat, I believe (and hope to theoretically prove it) that money acts as a catalyst of exchange and need not increase in volume, even if the rate and size of transactions grew (lung volume and muscle mass in athletes goes up, but hardly their blood volume – but one shouldn’t overstretch analogies either, I only use the blood allegory because it keeps cropping up in literature in comparing baby and adult and hence deriving an argument for monetary growth from that etc.). And indeed in such a scenario there would be an observable tendency of money to appreciate over time (misnamed “deflation”) although, if e.g. based on gold, higher money valuations tend to draw more gold into circulation thus inherently stabilising monetary real value by equally, but at a far slower rate than now, expanding the (backed) money supply.
      But I will let this rest for the moment until I come to that, as my Economic Law and Fallacy series are designed to dovetail with the Economics Study Guide so that at the end it should make up a complete edific of economics “from first principles” that can even be tested but, like geometry, should rather be falsified or proven on the basis of formal logic, not by measuring triangles to “see if Pythagoras was right”.

  5. 2010-03-29 at 05:29 | #6

    Good article. thank you

    If you want read more about 2012 year and about end of the world predicted at this year, you can do this here


  6. 2010-03-28 at 21:35 | #7

    “Now it always struck CrisisMaven as odd that banks under any circumstance should be so little creditworthy that they couldn’t get credit.” What????? Banks have been going bust in large numbers on a regular basis for the last century and a half at least. Banks are no better than drunks. I’ve got doubts about CM’s claim that they are “creditworthy”. Citigroup has been rescued by taxpayers about four times in the last twenty years.

    “So at best the Fed can try to keep the genie in the bottle by continuously widening the bottle but it can’t shrink it back to its former size.” Why can’t it do the latter? As CM rightly points out, it was QE that caused the rise in reserves. QE can always be put into reverse. That would involve substantial interest rate rises, which would be deflationary, but what of it? The purpose of reversing QE, if and when that happens will be to dampen economic activity, thus the deflationary effect will be just what is wanted.

    Plus there is always the possibility of imposing heftier reserve requirements on commercial banks. China has just done this.

    • 2010-03-28 at 22:15 | #8

      Hi Ralph, thanks for commenting. As for banks’ creditworthyness: I think you may have overlooked the satire in that statement. By accounting standards though esp. banks’ creditworthyness should be beyond question; and yet it isn’t, it’s worse than the average tailor’s or butcher’s. Now, if their overseers, the central banks amongst others, are not capable of ensuring that nor do their auditors or shareholders and non-executive directors, then something’s amiss. But surely there should not be room for a lender of the last resort if the banks are so rotten that they require outside help.
      Equally, you are of course right that they could reverse quantitative easing. But this begs the question why they started it in the frst place and if reversing it would not result in exactly the same quandary that was the reason for beginning it. That’s what I was driving at.

  7. 2010-03-26 at 17:31 | #9

    “Last resort bankers” are the designers of the credit crisis, methinks.

    CrisisMaven, I can’t wait to get your comments on my little 10-year analysis of the UK budget which covers the crisis since 2008. See http://bit.ly/aYhEnT

    I guess it will be worthwhile to use the UK data as a template for other such budgetary comparisons… Or has the IMF standardised such terms already?

  8. 2010-03-25 at 14:32 | #10

    Obviously, the banks value the excess reserves for another reason and would be very distressed if the Fed were to “mop them up”. The simple truth is that banks (complicit with the Treasury) are using “creative accounting” to make their balance sheets look “ok”. In truth, their balance sheets are in tatters and thus the need to keep large amounts of cash in excess reserves to cushion the potential losses. They are zombie banks. I don’t think we’ll see see an economic turn-around until these excess reserves decline again, perhaps not until the commercial property bomb exacts its toll.

    • 2010-03-25 at 15:01 | #11

      Thanks David for commenting, this is absolutely true. The repo will only work (if handled honestly, but who cares nowadays …) if the collateral the banks would give to the central bank in exchange for its last-resort liquidity lending still had at least the same value as the liquidity that is threatened to be withdrwan in a “run” or that they can’t currently refinance due to a credit freeze in interbank lending. Of course, if short term deposits are seen not as for safe-keeping but as just another source of cheap credit to lend out long-term and if banks then purchase dodgy assets the Fed and other central banks can only “recapitalise” such banks or offer them liquidity if they do not discount the collateral as low as the market would. Of course, if two friendly bankers in “normal” times would engage in such shenanigans the lender would be indicted with embezzlement and both be tried under the RICO act. But the Fed and government seem above the constitution or can the latter be discounted too?

  1. 2010-03-24 at 11:41 | #1
  2. 2010-03-24 at 23:18 | #2
  3. 2010-03-25 at 06:52 | #3
  4. 2010-04-25 at 10:19 | #4

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