In an effort to salvage a comatose credit market after the Lehman collapse, the Fed set the target rate for Fed funds – the funds that banks borrow from each other – at an extremely low 0.25 percent. Paying interest on reserves at that rate was intended to ensure that the Fed funds rate did not fall below the target. The reasoning was that banks would not lend their reserves to other banks for less, since they could get a guaranteed 0.25 percent from the Fed. The medicine worked, but it had the adverse side effect of killing the Fed funds market, on which local lenders rely for their liquidity needs.
It has been argued that banks do not need to get funds from each other, since they are now awash in reserves; but these reserves are not equally distributed. The 25 largest US banks account for over half of aggregate reserves, with 21 percent of reserves held by just three banks; and the largest banks have cut back on small business lending by over 50 percent. Large Wall Street banks have more lucrative things to do with the very cheap credit made available by the Fed that to lend it to businesses and consumers, which has become a risky and expensive business with the imposition of higher capital requirements and tighter regulations.
This is from Ellen Brown, “Why Banks Aren’t Lending: The Silent Liquidity Squeeze.”
What’s interesting, given that Ms. Brown is on the left, as will be clear if you read her proposal at the end of her otherwise-excellent piece, is that this is the first time in a long time that I had any hope for a possible alliance between those of us libertarians who want to do away with a central bank and some of the left who see some of the problems with a central bank.
HT to Jeff Hummel.
READER COMMENTS
Milton
Jul 16 2011 at 9:24pm
Ellen clarifies a complicated topic. Its ironic that banks are requiring more capital and are getting tighter with credit. Consumers need to borrow to buy houses and companies need to borrow to invest. The tightening of credit prevents the growth that would improve the economy and improve the quality of bank loans.
Tom Hickey
Jul 17 2011 at 10:44am
Proponents of Modern Monetary Theory like Warren Mosler have explained how the central bank function and the treasury function are informally consolidated in the US and they should be formally consolidated under the treasury, eliminating the need for a separate agency with political independence and separate accounting.
An independent central bank puts control of the nation’s monetary policy in the hands of a small group of unelected and unaccountable technocrats with vested interests and connections with the financial sector, which are a conflict of interest. Th is is both undemocratic and anti-capitalist. In a liberal democracy, monetary and fiscal policy must in the hands of elected representatives accountable to their constituents.
Under a non-convertible floating rate system such as is now in place in the US, the sole purpose of bank reserves, created only by the central bank function, is for settlement of interbank accounts, e.g., clearing checks drawn on one bank and deposited in another. Reserves never leave the interbank system and are used only by institutions with access to this system. Banks exchange reserves for notes and coin to meet their window demand.
This settlement function that reserves play is already computerized and can be spun off to the private sector or contracted out. The rest of monetary operations can also be computerized within the Treasury once policy is established.
The question we need to be asking is who should establish monetary policy, a smal group of politically independent technocrats, Hayek’s nightmare, or elected officials accountable to the public. Whoever controls the nation’s monetary system controls the country. Do we want this in the hands of private bankers with vest interests, or do we want this in the hands of elected representatives accountable to the people?
See Warren Mosler, The Seven Deadly Innocent Fraud of Economic Policy, “Soft Currency Economics,” “The Natural Rate of Interest Is Zero,” as well as his proposals for banking and financial reform, available here and here.
[html fixed–Econlib Ed.]
Tom Hickey
Jul 17 2011 at 11:02am
Ms. Brown’s premise in the quote above is incorrect. Banks do not lend out reserves and they do not lend against reserves. They lend against capital, and loans create deposits. Reserves are obtained afterward for interbank settlement and to meet reserve requirements. There is never a shortage of reserves because the Fed is the lender of last resort that always stands by to provide reserves at the discount window at the penalty rate.
Ms. Brown misunderstands the function of reserves under the present monetary system. In a non-convertible floating rate system, bank reserves are not a constraint on lending, nor are reserve requirements. The cost of obtaining reserves (Fed funds rate and discount rate) determines the interest rates that banks charge on loans, since they are in the business of making a profit.
Banks lend based on demand by creditworthy customers and their expectation of reward based on risk, not availability of reserves. Moreover, banks are not restrained by capital requirements in making loans either, If the profit on banking exceeds the cost of capital, they will simply seek more capital to increase their loan business.
Ms. Brown is correct in her implication that present policy favors the big banks and further consolidation over the small banks and diversification of systemic risk. This is not related to reserves, but rather bias toward big due to political influence, as well as intellectual and regulatory capture. This bias endangers the banking system and the financial sector as a whole, and puts the economy and country at risk in order to advance the interests of the few.
Curt Doolittle
Jul 17 2011 at 3:16pm
@Tom Hickey:
Agree with everything you say above (as I usually do). Except that I do not see how democratically elected individuals, even if we elect them expressly for that ‘house of government’ we call the central bank, helps whatsoever. What evidence do we have the monetary policy would not be even worse under democratically elected officials? What evidence do we have that anything other than a parliamentary no-confidence structure would make them accountable? What evidence do we have that the population, if they held the politicians accountable, would do so other than as the result of additional political rhetoric that is divorced from reality? It’s not like there is consensus on a solution that the Fed is blocking. Just the opposite. Non-rhetorical question. Thanks.
Blissex
Jul 18 2011 at 6:45am
“What evidence do we have the monetary policy would not be even worse under democratically elected officials?”
You and other completely misunderstand the purpose of democracy, it is not to achieve better outcomes (directly at least).
The purpose of democracy is to hold *voters* (not politicians!) accountable for their choices.
If they vote for bad policies and bad candidates the outcomes will be miserable and too bad for the voters and the country.
If the voters are stupid and corrupt, the country will be mismanaged and poorer, and they will have themselves to blame.
If one forgets that, then arguments about being ruled by philosopher-kings or technocrat-managers become seductive, because in the short term and in special circumstances it can work.
As to the Fed, stupid and corrupt voters have been enormously pleased in the past 20-30 years with Fed policies targeted at keeping salaries low and asset prices high, because most voters think that they are speculators and rentiers rather than workers and earners.
They could not care less about the details of the governance of the Fed, as long as their elected representative have an understanding with the fed that asset price bubbles and lower salaries are what “the people” want.
[Minor coding edit: quotation marks substituted for non-functioning characters demarcating a quote.–Econlib Ed.]
Curt Doolittle
Jul 20 2011 at 12:17pm
I understand that democracy is an insufficient limit on the behavior of voters, because the voters are insufficiently equal in their knowledge and interests, and as such, the majority vote predatorily on the productive minority. Or they vote to undermine the entire economy, either out of ignorance, envy, or intention.
So it is not I who fail to understand democracy: The purpose of democracy is to prevent violence by enfranchising a sufficient percentage of the population such that a government can maintain legitimacy.
“Purpose” as you state it, is a form of idealism. Empirical results are a measure of reality rather than ideals. For example, Democracy among small farmers in a village is one thing. Democracy among shareholders who vote according to the size of their investment is another. But democracy across a population with dissimilar interests and investments is simply mob rule: predation.
Since voters canot then be ‘held accountable’ but instead, can commit ‘transfers’ by voting, then the entire premise behind the ‘purpose’ of democracy as you state it, is false. Your definition would require a unanimity of interests. And therefore it cannot be true. And so it must be an ideal.
So what you mean to say, is that one set of voters cannot hold another set of voters accountable. And competitive predation is the only possible outcome of a democratic process. And that those of us who are producers must slave away to produce faster than the predators can consume our production via way of the government.
That is, perhaps, a better analysis. Voters do not hold voters accountable. Voters predate other voters who are then accountable for those who prey upon them.
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