Saturday, August 23, 2008

The "Inflation Threat" and the Strength of the Economy

Today's article in the Wall Street Journal reporting on the speech of Federal Reserve Chairman Ben Bernanke at the Jackson Hole conference ( contains this paragraph:

"Some Fed officials have called for raising rates before long to address worries about inflation. Consumer prices rose 5.6% in July from a hear earlier, a 17-year high. However, most officials believe a weak economy will lessen the inflation threat, and they want to keep rates lower for now to offset tightening credit conditions."

This speaks precisely to the point I made in my post of August 22, 2008, "It's the Supply Side, St....". If you believe that the problem being faced by the policy makers is one of insufficient aggregate demand, then there certainly should be pressure for inflation to weaken.

However, if you believe that the weakness in economic growth comes because of a shift in aggregate supply then there WILL NOT be pressure on the general rate of inflation to decline.

Of course, both aggregate demand and aggregate supply shift. Thus, it is a question of which one of the two dominates. If shifts in aggregate demand dominate then the economy will weaken and inflation will lessen. However, if the shifts in aggregate supply dominate then the economy will weaken but inflation will not lessen.

How the current situation is interpreted is IMPORTANT both for the policymakers in Washington, D. C., but also for business leaders and investors!


Flow5 said...

The utilization of bank credit to finance real investment or government deficits doesn't constitute a utilization in savings since financing is accomplished by the creation of new money.

I.e., Savings do not equal investment in this case. Savings are impounded (lost to investment).

As in 66, get the CBs out of the savings business (impose ceilings & gradually lower them for the cbs but not for the non-banks/thrifts).

Flow5 said...

“Banks have long contended that the costs of reserve requirements (i.e., forgone earnings) put them at a competitive disadvantage relative to non-bank competitors that are not subject to reserve requirements – Testimony of Treasury

“These measures should help the banking sector attract liquid funds in competition with non-bank institutions and direct market investments by businesses” Testimony of Treasury

The most egregious error in Keynesian economics is the insistence that commercial banks are financial intermediaries:

A commercial bank becomse a financial intermediary only when there is a 100% reserve ratio applied to its deposits.

Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, by data networks, checks, or similar types of negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

From a systems viewpoint, commercial banks as contrasted to financial intermediaries: prior to the DIDMCA; (S&Ls, MSBs, CUs), never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity or any liability item.

When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) and every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (TRs).

The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free gratis legal reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (transaction accounts), as fixed by the Board of Governors of the Federal Reserve System.
Since 1942, money creation is a system process.

No bank, or minority group of banks (from an asset standpoint), can expand credit (create money), significantly faster than the majority banks expand. If the member banks hold 80 percent of all bank assets, an expansion of credit by the nonmember banks and no expansion by member banks will result, on the average, of a loss in clearing balances equal to 80 percent of the amount being checked out of the nonmember banks.

From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, and probably its free gratis legal reserves, not a tax [sic] – and thereby it’s lending capacity. But all such inflows involve a decrease in the lending capacity of other commercial banks (outflow of cash and due from bank items), unless the inflow results from a return flow of currency held by the non-bank public, or is a consequence of an expansion of Reserve Bank credit. Hence, all CB liabilities are derivative.

That is, CB time/savings deposits, unlike savings accounts in the “thrifts”, bear a direct, one-to-one, unvarying relationship, to transactions accounts. As TDs grow, TRs shrink pari passu, and vice versa. The fact that currency may supply an intermediary step (i.e., TRs to currency to TDs, and vice versa) does not invalidate the above statement.

Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries, for the funds never leave the commercial banking system.

Consequently, the effect of allowing CBs to “compete” with S&Ls, MSBs, CUs, MMFs, IBs and other intermediaries (non-banks) has been, and will be, to reduce the size of the intermediaries (as deregulation did in the 80’s) – reduce the supply of loan-funds (available savings), increase the proportion, and the total costs of CB TDs.

Contrary to the DIDMCA underpinnings, member commercial bank disintermediation is not, and has not been, predicted on interest rate ceilings. Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of currency withdrawals. The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its "open market power", to prevent any outflow of currency from the banking system.

However, disintermediation for financial intermediaries-S&Ls, MSBs, CUs, (non-banks), etc., is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); earning assets with historically lower fixed rate and longer term structures. In other words, competition among commercial banks for TDs has: 1) increased the costs and diminished the profits of commercial banks; 2) induced disintermediation among the "thrifts" with devastating effects on housing and other areas of the economy; and 3) forced individual bankers to pay higher and higher rates to acquire, or hold, funds.

Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries. Shifts from TDs to TRs within the CBs and the transfer of the ownership of these TRs to the thrifts involves a shift in the form of bank liabilities (from TD to TR) and a shift in the ownership of (existing) TRs (from savers to thrifts, et al). The utilization of these TRs by the thrifts has no effect on the volume of TRs held by the CBs or the volume of their earnings assets.

In the context of their lending operations it is only possible to reduce bank assets and TRs by retiring bank-held loans, e.g., the only way to reduce the volume of demand deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.

The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can make loans (if monetary policy permits and the opportunity is present) which amount to server times the initial excess reserves held.

Financial intermediaries (non-banks) lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the CBs lend no existing deposits or savings; they always, as noted, create new money in the lending process. Saved TRs that are transferred to the S&Ls, etc., are not transferred out of the CBs; only their ownership is transferred. The reverse process, which is called “disintermediation”, has the opposite effect: the intermediaries shrink in size, but the size of the CBs remains the same.

Professional economists have no excuse for misinterpreting the savings investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.

From a System standpoint, time deposits represent savings have a velocity of zero. As long as savings are held in the commercial banking system, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.

From a system standpoint, TDs constitute an alteration of bank liabilities, their growth does not per se add to the “footings” of the consolidated balance sheet for the system. They obviously therefore are not a source of loan-funds for the banking system as a whole, and indeed their growth has no effect on the size or gross earnings of the banking system, except as their growth affects are transmitted through monetary policy.

Lending by intermediaries is not accompanied by an increase in the volume, but is associated with an increase in the velocity of money. Here investment equals savings (and velocity is evidence of the investment process), where in the case of the CB credit, investment does not equal savings but is associated with an enlargement and turnover of new money.

The difference is the volume of savings held in the commercial banking system is idle, and lost to investment as long as it is held within the commercial banking system. Such a cessation of the circuit income and transactions velocity of funds, funds which constitute a prior cost of production, cannot but have recessionary effects in our highly interdependent pecuniary economy. Thus, the growth of time deposits shrinks aggregate demand and therefore produces adverse effects on GDP and the level of employment.

It began with the General Theory, John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make the statement correct. Perhaps this is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, Reg Q, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, etc.

How does the FED follow a "tight" money policy and still advance economic growth.? What should be done? The commercial banks should get out of the savings business (REG Q in reverse-but leave the non-banks unrestricted-compensated for transition). What would this do? The commercial banks would be more profitable - if that is desirable. Why? Because the source of all time deposits within the commercial banking system, is demand/transaction deposits - directly or indirectly through currency or their undivided profits accounts. Money flowing "to" the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of the intermediaries/non-banks cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.

Dr. Leland James Pritchard (MS, statistics - Syracuse, Ph.D, Economics - Chicago, 1933) described stagflation 1958 Money & Banking Houghton Mifflin,

“The Economics of the Commercial Bank Savings-Investment Process in the United States” -- “Estratto dalla Rivista Internazionale di Scienze Econbomiche & Commerciali “ Anno XVI – 1969 – n. 7
“Profit or Loss from Time Deposit Banking” -- Banking and Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.

The influencial commercial banking lobby, i.e., American Bankers Assocation has controlled both the 1) House Committee on Financial Services, and 2) the U.S. Senate Committee on Banking, Housing, and Urban Affairs.

Regulation?? The conspiratorial titans, among other innovations, guaranteed the elimination of REG Q ceilings. It was a pyrrhic victory. Commercial banks compete for deposits by out-bidding their competition. But all of these deposits come from other commercial banks within the System.

I.e., the commercial banks cannot expand unless the FED decides to increase the money supply. However, the thrifts do compete for loan-funds. But even when they succeed, they cannot take money away from the commercial bankers.

The net of it is, lending by CBs is inflationary, lending by non-banks is not. And money flowing to the non-banks actually never leaves the CB System as anyone who has applied double-entry bookkeeping on a national scale should know.

So why should commercial bankers pay for something they already have? – interest on their deposits (REG Q in reverse). They would be much more competitive, and much more profitable, if they did not.