Thursday, November 9, 2017

The real questions the Fed should ask itself

The real questions the Fed should ask itself.  This is a cleaned up and edited version of a previous blog post, commenting among other things on Janet Yellen's Jackson Hole speech in favor of most of Dodd Frank, that appeared in the Chicago Booth Review. When you think of the Fed, think more of the giant regulator than about where interest rates go.


  1. Well, for whatever my two cents is worth, I largely agree with your Chicago Booth Review paper.

    BTW, you might even want to ponder regulatory capture. Go to the American Bankers Association website. There is very little, if any, critique of Dodd-Frank. The industry seems to have made peace with Dodd-Frank even as pundits rail against it.

    And are there banking industry diatribes against the Fed? Rare and usually a one-off money manager (taking his book, probably), not a working banker.

    I agree, how about a fat layer of equity, another fat layer of convertible bonds, and then a layer of corporate bonds between bank insolvency and bailout? Say at combined 50% of loans outstanding, and no other rules.

    Unfortunately, I think the public has to bail out failed banks, but only after the shareholders and bondholders have been wiped out. Those parties should have control of the bank board (in stages as a bank fails) and run the bank accordingly. There is no moral hazard if investors get wiped out. I do not think ordinary depositors need to get wiped out too. There is a limit to what works in real life.

    The Fed should get out of regulating and back to promoting prosperity through a growth-oriented monetary policy.

  2. The efficacy of higher bank capital requirements is questionable. An increase in bank capital destroys the money stock $ for $ (not a good idea in a counter-cyclical economic rebound). And higher capital cushions won’t offset the Fed’s forecasting mistakes. Money is not neutral. Money flows are robust (as concentrations and lags demonstrate). They are not ex-post, they are ex-ante (you can’t run a regression test against the historical data you don’t understand).

    The distributed lag effects for money flows have been mathematical constants for over 100 years. When Bernanke drained money flows, volume Xs velocity, he did so for way too long (for 29 contiguous months the rate-of-change in money flows, proxy for inflation, was negative – less than zero). By dropping the price-level, Bernanke turned otherwise safe assets into impaired assets (upside down/underwater). People should stop grasping at straws.

    1. The deflationary effect of higher bank capital is easily dealt with by feeding more base money into the economy: i.e. a bigger deficit. I.e. as the stock of commercial bank created money declines, that can be made good by an increased supply of central bank created money.

  3. The Fed's regulating Dodd-Frank compromises its independence and FOMC operation as it is subject to political scrutiny. No one is clairvoyant! So why not just abolish the Fed? Securities traders are not seers, but succeed because they are good risk managers.

    1. "No one is clairvoyant!"

      The answers are obvious, as I've repeatedly explained.
      POSTED: Dec 13 2007 06:55 PM |

      The Commerce Department said retail sales in Oct 2007 increased by 1.2% over Oct 2006, & up a huge 6.3% from Nov 2006.

      10/1/2007,,,,,,,-0.47,... -0.22 * temporary bottom
      11/1/2007,,,,,,, 0.14,,,,,,, -0.18
      12/1/2007,,,,,,, 0.44,,,,,,,-0.23
      01/1/2008,,,,,,, 0.59,,,,,,, 0.06
      02/1/2008,,,,,,, 0.45,,,,,,, 0.10
      03/1/2008,,,,,,, 0.06,,,,,,, 0.04
      04/1/2008,,,,,,, 0.04,,,,,,, 0.02
      05/1/2008,,,,,,, 0.09,,,,,,, 0.04
      06/1/2008,,,,,,, 0.20,,,,,,, 0.05
      07/1/2008,,,,,,, 0.32,,,,,,, 0.10
      08/1/2008,,,,,,, 0.15,,,,,,, 0.05
      09/1/2008,,,,,,, 0.00,,,,,,, 0.13
      10/1/2008,,,,,,, -0.20,,,,,,, 0.10 * possible recession
      11/1/2008,,,,,,, -0.10,,,,,,, 0.00 * possible recession
      12/1/2008,,,,,,, 0.10,,,,,,, -0.06 * possible recession
      Trajectory as predicted:

    2. "BERNANKE SHOULD HAVE SEEN THIS COMING" You are talking TREND!!! Not clairvoyance! If you saw this coming, did you hedge your portfolio? Hindsight is 20-20! Our hedge fund bought puts in 1987 from Jan 1 up to Oct 16. The S&P market trend was up 28% from Feb 1 to Oct 16. I didn't see the crash coming because I'm NOT clairvoyant but rather, a good manager of risk. We not only didn't get killed we did very well for the year.

    3. @ David Seltzer:

      No dude. I cracked the code in July 1979. Everyone, technicians and fundamentalist, got Black Monday exactly right.

      This was no happenstance. See also:

      The Oct. 15th dis-equilibria was so profound and unique that the Treasury did a joint staff study on it with the (1) U.S. Department of the Treasury, (2) Board of Governors of the Federal Reserve System, (3) Federal Reserve Bank of New York, (4) U.S. Securities and Exchange Commission, and (5) the U.S. Commodity Futures Trading Commission.

      I predicted this: “Diminishing market depth and a surge in volatility were both on display Oct. 15, when Treasuries experienced the biggest yield fluctuations in a quarter century in the absence of any concrete news. The swings were so unusual that officials from the New York Fed met the next day to try and figure out what actually happened”

      From: Spencer (
      Sent: Thu 9/18/14 12:42 PM
      To: FRBoard-publicaffairs@...
      Dr. Yellen:

      ...The roc in M*Vt (proxy for real-output), falls 8 percentage points in 2 weeks. This is set up exactly like the 5/6/2010 flash crash

      I also predicted the 5/6/2010 “flash crash” (which denigrated statistician Nassim Nicholas Taleb’s “Black Swan” theory.
      Subject: As the economy will shortly change, I wanted to show this to you again – forecast:
      Date: Wed, 24 Mar 2010 17:22:50 -0500
      Dr. Anderson:
      It’s my discovery. Contrary to economic theory and Nobel Laureate Milton Friedman, monetary lags are not “long & variable”. The lags for monetary flows (MVt), i.e., the proxies for (1) real-growth, and for (2) inflation indices, are historically, always, fixed in length.
      Assuming no quick countervailing stimulus:
      jan….. 0.54…. 0.25 top
      feb….. 0.50…. 0.10
      mar…. 0.54…. 0.08
      apr….. 0.46…. 0.09 top
      may…. 0.41…. 0.01 stocks fall
      Should see shortly. Stock market makes a double top in Jan & Apr. Then real-output falls from (9) to (1) from Apr to May. Recent history indicates that this will be a marked, short, one month drop, in rate-of-change for real-output (-8). So stocks follow the economy down.
      flow5 Message #10 – 05/03/10 07:30 PM
      The markets usually turn (pivot) on May 5th (+ or – 1 day).
      I.e., the May 6th “flash crash”, viz., the second-largest intraday point swing (difference between intraday high and intraday low) up to that point, at 1,010.14 points.

  4. You'd better read Economist Phillip George:

    He comes to my (Dr. Leland James Pritchard's, Ph.D., Economics Chicago 1933, M.S., Statistics, Syracuse) same conclusion - via osmosis: "The riddle of money, finally solved" (it's about the use or non-use of savings).

    Take the “Marshmallow Test”: (1) banks create new money (macro-economics), and incongruously (2) banks loan out the savings that are placed with them (micro-economics).

    F. Scott Fitzgerald: “The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.”

    You have to retain the cognitive dissonance capacity, like Walter Isaacson described Albert Einstein’s ability: to hold two thoughts in your mind simultaneously – “to be puzzled when they conflicted, and to marvel when he could smell an underlying unity”.

    John Maynard Keynes couldn’t do it:

    In "The General Theory of Employment, Interest and Money", John Maynard Keynes’ opus ", pg. 81 (New York: Harcourt, Brace and Co.), gives the impression that a commercial bank is an intermediary type of financial institution (non-bank), serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor & 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 non-bank in order to make his statement correct, viz., the Gurley-Shaw thesis.

    See e-mail response from former senior economist and V.P. FRB-STL:
    Re: Savings are not a source of "financing" for the commercial bankers
    Dan Thornton
    Thu 3/9, 2:47 PMYou
    See the graph below.
    Daniel L. Thornton
    D.L. Thornton Economics LLC
    My reply: "Never are the commercial banks intermediaries (conduits between savers and borrowers), in the savings-investment process."
    Or take George Selgin’s: Testimony on July 20, 2017 Before the U.S. House of Representatives Committee on Financial Services Monetary Policy and Trade Subcommittee Hearing on “Monetary Policy v. Fiscal Policy: Risks to Price Stability and the Economy” Director, Center for Monetary and Financial Alternatives, Cato Institute
    July 20, 2017
    "This is nonsense, Spencer. It amounts to saying that there is no such things as 'financial intermediation,' for what you claim never happens is precisely what that expression refers to."

    I.e., the universal misconception (BuB’s theoretical rror), that the payment’s system is capable of loaning out existing deposits. The remuneration of IBDDs will cause a protracted economic depression (longer and deeper than the Great Depression).

  5. All savings originate within the framework of the payment's system. The source of commercial bank time "savings" deposits, is demand deposits, directly or indirectly via the currency route, or thru the DFI's undivided profits accounts. An increase in time/savings deposit account classifications depletes transactions deposits by an equivalent amount - and the source of demand deposits can largely be accounted for by the concomitant expansion of commercial bank credit.

    Saver-holders never transfer their savings outside the system, unless they hoard currency, or convert to other national currencies. DFIs pay for their new earning assets, from the standpoint of the payment's system (macro-economics), by creating new deposits, not by using existing ones.

    Whether the public saves, dis-saves, chooses to hold their savings in a DFI, or transfers their savings through a NBFI (invest directly or indirectly), does not determine the lending capacity of the DFIs. The lending capacity of the DFIs is determined by monetary policy, not the savings practices of the non-bank public. The DFIs could continue to lend even if the non-bank public ceased to save altogether.

    The use or non-use of savings held by the commercial banks is a function of the velocity, not the volume, of their deposit liabilities. The parameters of economics are not those of mathematics – the whole is much larger than the sum of its parts. The decisions of the public to invest their bank-held savings will not, per se, change the aggregate liabilities, or the existing assets, of the payment’s system. The expansion of time “saved” deposits adds nothing to N-gDp.

    The oligarchic redistribution of savings deposits (derivative deposits from a system’s perspective), thru the attraction of savings (primary deposits to the recipient bank), un-necessarily increases that particular commercial bank’s costs, without a concomitant increase in income.

    Therefore all bank-held savings are un-used and un-spent, lost to both consumption and investment (indeed to any type of expenditure or payment)- until their owners spend/invest directly or indirectly via non-bank conduits. All bank-held savings are never activated when so held, and never put back to work, completing the circuit income velocity of funds.

    Voluntary savings require prompt utilization if the circuit flow of funds is to be maintained and the deflationary effects avoided. This is the sole and unique source of both stagflation c. 1965, and secular strangulation c. 1981.

  6. Assuming John Cochrane’s claim that banks should have no runnable liabilities is correct (and I think it is), that renders all other arguments about bank capital irrelevant. The capital ratio becomes 100%. End of argument. JC argued that point here:

    And there’s plenty of others who argued likewise, e.g. Milton Friedman, Irving Fisher, Adam Levitin, Laurence Kotlikoff, etc.

    Plus money market mutual funds have recently switched to a “no runnable liabilities” system (i.e. full reserve banking).

    One good argument for full reserve is thus. If one assumes a “base money only” system (i.e. full reserve) and then allows commercial banks to lend out their home made money, that will be inflationary. Ergo the state has to impose some sort of deflationary measure, like raising taxes (i.e. confiscating base money from the private sector). Ergo private money creation is subsidised. And subsidies reduce GDP. Ergo privately issued money should be banned.

    I sent a 1,500 article off to Forbes earlier today enlarging on that point. Will put a link here if it is published.

    1. Knowing a debit from a credit makes full reserve banking irrelevant. Instituting full reserve banking is completely absurd and absolutely destroys money velocity - by destroying the vital savings-investment process.

      It is a confusion of stock vs. flow (Nobel Laureate Dr. Milton Friedman was “one-dimensionally confused”). He pontificated that: “I would (a) eliminate all restrictions on interest payments on deposits, (b) make reserve requirements the same for time and demand deposits”. Dec. 16, 1959.

      Since time/savings (investment) deposit classifications originate within the commercial banking system, there cannot be an “inflow” of time (savings) deposits and the growth of time deposits cannot per se increase the size of the banking system. In the politics of life, the ABA is public enemy #1.

      Net changes in Reserve Bank credit (since the 1951 Treasury-Reserve Accord) are predetermined by the policy actions of the Federal Reserve. Note: the Continental Illinois bank bailout provides a spectacular example of William McChesney Martin Jr.’s “bartending” (net free or net borrowed reserve positioning).

    2. Flow 5,
      I wrote a book on full reserve and dealt with a large number of criticisms of it by dozens of economists. See:

      About 95% of those criticisms were perfectly clear and well set out, though mistaken (in my view).

      Your criticisms, by contrast, are meaningless waffle.

    3. I know the Gospel. You have misread the tea leaves. If you don't understand the fundamentals, all you have to do is look at the Elephant Tracks.

      Full reserve banking will absorb savings. It is not about the math, it is about the economics of savings' redistribution.

      If you understood macro, you'd also be able to predict economic outcomes. You can't.

      Monetary policy objectives should be formulated in terms of desired rates-of-change, RoC's, in monetary flows, M*Vt (volume X’s velocity), relative to RoC's in R-gDp. RoC's in N-gDp (though "raw materials, intermediate goods and labor costs, which comprise the bulk of business spending are not treated in N-gDp"), can serve as a proxy figure for RoC's in all transactions, P*T, in Professor Irving Fisher's truistic: "equation of exchange".

      And Alfred Marshall's cash-balances approach (viz., a schedule of the amounts of money that will be offered at given levels of "P"), viz., where at times "K" is the reciprocal of Vt, or “K” has the dimension of a “storage period” and "bridges the gaps of transition periods" in Yale Professor Irving Fisher’s model. RoC's in R-gDp have to be used, of course, as a policy standard.

      Neither financial transactions nor “animal spirits” are random:

      American, Yale Professor Irving Fisher – 1920 2nd edition: “The Purchasing Power of Money”:

      “If the principles here advocated are correct, the purchasing power of money — or its reciprocal, the level of prices — depends exclusively on five definite factors:

      (1) the volume of money in circulation;
      (2) its velocity of circulation;
      (3) the volume of bank deposits subject to check;
      (4) its velocity; and
      (5) the volume of trade.

      “Each of these five magnitudes is extremely definite, and their relation to the purchasing power of money is definitely expressed by an “equation of exchange.”

      “In my opinion, the branch of economics which treats of these five regulators of purchasing power ought to be recognized and ultimately will be recognized as an EXACT SCIENCE, capable of precise formulation, demonstration, and statistical verification.”

      The most pronounced decline in inflation occurs in March and April of 2018. However, the most pronounced decline in economic activity occurs between January and March (a full quarter).

    4. "Your criticisms, by contrast, are meaningless waffle."

      Milton Friedman was a competent mathematician, but a lousy economist. And Fisher’s idea has already been denigrated: “each commercial bank would be split into two departments, one a warehouse for money, the checking department”

      You need to take an accounting course: “Our laws, it is true, attribute and therefore, unfortunately relate certain types of bank earning assets, for instance mortgages, to the volume of a bank’s time deposits; but no economist should be a party to fostering or sanctioning these pseudo-economic relationships. If the commercial banks were suddenly denied the ability to carry on demand –deposit operations, commercial banks would, in essence, be instantaneously transformed into savings banks-financial intermediaries, pure and simple. And, it should be added, if this were done, the present economic characteristics of time deposits would be completely altered. The funds for setting up tie deposits would then originate outside the bans, just as the funds for setting up share accounts originated outside the savings-and-loan associations. Tie-deposit growth would then not signify a transfer from demand deposits in the same institutions, ab bottling-up of existing money; rather, its growth would be evidence of the activation, the actual transfer from saver to borrower, of money which had been saved.”

      October 1960, The Journal of Political Economy

  7. Commercial bank-held savings/investment accounts reduce money velocity and effective monetary demand, or AD. The interest-bearing character of the deposits results in the larger proportion of commercial bank deposits in the interest-bearing category. These DFI deposit classifications are an excellent device for the banking system to reduce its aggregate profits.

    It is hard for the average person to believe that banks do not loan out savings or existing deposits – demand or time deposits. However from a system’s belvedere, the DFIs always create the money by making loans to, or buying securities from the non-bank public.

    See: BOE “Working Paper No. 529 - “Banks are not intermediaries of loanable funds —and why this matters” by Zoltan Jakab and Michael Kumhof

    This results in a double-bind for the Fed. If it pursues a rather restrictive monetary policy, interest rates tend to rise. This places a damper on the creation of new money but, paradoxically drives existing money out of circulation into the stagnant savings deposits. In a twinkling, the economy begins to suffer.

    The bank lending channel thus does not represent the credit channel nor the interest rate channel nor intermediated credit.

  8. The question is not whether net earnings on CD assets are greater than the cost of the CDs to the bank; the question is the effect on the total profitability of the commercial banking system. This is not a zero sum game. One bank’s gain is less than the losses sustained by the other banks in the System. The whole (the forest), is not the sum of its parts (the trees), in the money creating process.

    See the Fed’s propaganda in their own "Bible": by R. Alton Gilbert (retired senior economist and V.P. at FRB-STL) – who wrote: “Requiem for Regulation Q: what it did and why it passed away”, 2/1986 Review.

    Dr. Gilbert asked the wrong question. His implicit and false premise was that savings are a source of loan-funds to the banking system. Gilbert assumed that any potential primary deposit (funds acquired from other CBs within the system), were newfound funds to the banking system as a whole.

    Thereby in his analysis, Gilbert also assumes that every dollar placed with a non-bank deprives some commercial bank of a corresponding volume of loanable funds.

    Gilbert asked: Was the net interest income on loans/investments derived from "attracting" these savings deposits (viz., outbidding other CBs), greater than the interest attributable to the direct and indirect operating expenses of retail and this wholesale "funding"?

  9. There are several antecedents and paradigms, viz., the 1966 S&L credit crunch, where the term credit crunch originated, the DIDMCA of March 31st 1980, the S&L crisis, the failure of 1,043 out of the 3,234 savings and loan associations in the United States from 1986 to 1995, as well as the July 1990 –Mar 1991 recession, and the remuneration of IBDDs - which destroyed non-bank lending/investing (where the size of the NBFIs shrank by $6.2 trillion, but the size of the DFIs remained unaffected, expanding by $3.6 trillion).

    The DFIs and their customers, the NBFIs, have a symbiotic fiduciary relationship. The soundness and prosperity of the DFIs is dependent upon the NBFIs putting savings back to work. And savings flowing through these non-banks (mis-named shadow banks), never leaves the payment’s system. There is simply an increase in the supply of loan-funds, but no increase in the money stock.

    Any “running” is simply a monetary policy error. Instead of late in the business cycle, where savings progressively accumulate, the commercial banks should be driven out of the savings business altogether.

  10. "ECB Proposes End To Deposit Protection" = genius!

  11. The mind boggling errors of macro have very dark and sinister pasts.

    Historical FDIC's insurance coverage deposit account limits:
    • 1934 – $2,500
    • 1935 – $5,000
    • 1950 – $10,000
    • 1966 – $15,000
    • 1969 – $20,000
    • 1974 – $40,000
    • 1980 – $100,000
    • 2008 – $unlimited
    • 2013 – $250,000

    Thus, “in a twinkling…” R-gDp is swallowed up." Vt has historically been almost 3 times as important as money.

    This isn’t the 1974 “case of missing money” (the upsurge in Vt), nor is it: “[t]he biggest surprise in the US economy this year has been inflation” (downswing in Vt) – Janet Yellen 2017.

    Nonetheless oil has hit $57 / barrel (as Vi has accelerated in the 2nd, 3rd, and 4th qtrs. of 2017.

    DFI’s Time deposits vs. demand deposits:
    1939........15~~~~~~ 33
    1954........47~~~~~ 121
    1964......126~~~~~ 156
    1974......421~~~~~ 274
    1979......676~~~~~ 401
    1986...1,215~~~~~ 491
    1996...1,271~~~~~ 420
    2006...3,696~~~~~ 317
    Ratio of TD/DD in 1939 = 0.45
    Ratio of TD/DD in 2016 = 6.67

  12. The current economic blue print was accurately advanced over 60 years ago, in the late 1950s, by Leland J. Pritchard, Ph.D., Economics Chicago, 1933, MS, Statistics, Syracuse. Unfortunately the Gurley-Shaw thesis, a Keynesian abstraction (that there is no difference between money and liquid assets, viz., the “liquidity test” of an asset), overshadowed the gospel. You'd better read economist Phillip George (even if his underpinnings are wrong):

    "The riddle of money, finally solved" (it's about the use or non-use of savings).

    As Princeton Professor Lester V. Chandler, Ph.D., Yale, Economics, originally theorized in 1961, viz., that in the beginning: “a shift from demand to time “savings” accounts involves a decrease in the demand for money balances (Keynes’ fallacious liquidity preference curve), and that this shift will be reflected in an offsetting increase in the velocity of money”.

    His conjecture was correct up until 1981 – up until the plateau of financial innovation for commercial bank deposit accounts (the sweeping monetization of commercial bank time “savings” deposits).

    The saturation of DD Vt according to Chicago Professor Marshall D. Ketchum:

    Ketchum: “It seems to be quite obvious that over time the demand for money cannot continue to shift to the left as people buildup their savings deposits; if it did, the time would come when there would be no demand for money at all”.

    Thus, as Professor emeritus Pritchard predicted in May 1980 issue of IMTRAC (a publication by Dr. Christopher Thomas), began the secular decline in money velocity (and secular strangulation) as money velocity climaxed in the 1st qtr. 1981, from the “time” bomb (savings deposit’s), resulting in a 19.1 % 1st qtr. 1981 N-gNp figure:

    As Dr. Pritchard proposed in the late 1950’s:

    “Savings require prompt utilization if the circuit flow of funds is to be maintained and deflationary effects avoided…The growth of time “savings” deposits shrinks aggregate demand and therefore produces adverse effects on gDp…The stoppage in the flow of funds, which is an inexorable part of time-deposit banking, would tend to have a longer-term debilitating effect on demands, particularly the demands for capital goods.”

    The remuneration of IBDDs exacerbates this reversal in the savings-investment process (hence QE’s muted impact), i.e., it destroys money velocity (where savings are matched with borrowers and investments). While velocity, Vi, has increased since the 2nd qtr. of 2017, it won’t be offsetting (and it won’t last). Money flows contract in the first qtr. of 2018 (which will cause an equity sell off). However, inflation contracts for the entire first half of 2018.


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