STOCK MARKET WATCH -- Thursday, 5 April 2012

[Demeter]

23. Money, the financial system and the Federal Reserve Edward Harrison

http://www.nakedcapitalism.com/2012/04/money-the-financial-system-and-the-federal-reserve.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+NakedCapitalism+%28naked+capitalism%29

...We have been living in a world predominated by floating exchange rates and currency non-convertibility for forty years now. Nevertheless, most of economics world seems to take a fixed exchange rate, Bretton Woods, or gold standard view of money and banking. In that world, as Warren Mosler quipped, bank lending is reserve constrained with the interest rate an endogenous variable via bank competition for reserves.

I put it this way in December [emphasis added]:

In the old gold convertible system, the central bank had to jack up rates to prevent an outflow of gold. Interest rates were the release valve. But in those old days, only by adjusting the gold peg i.e. depreciating the currency, could countries under attack get away with low rates once the vigilantes were on to them. That’s what happened during the Great Depression. Once the conversion was broken, the currency depreciated and depression lessened immediately.

Today the release valve is always the currency because there is no gold tether. So the currency gives way, not interest rates.

Bond vigilantes and the currency relief valve

What this in effect means for the domestic banking system is that in a nonconvertible floating exchange rate system, lending is not reserve constrained as banks can create reserves by making a loan that creates a deposit. Any one institution can always borrow reserves from other banks or from the Fed itself if it finds itself short of reserves (See this BIS paper from 2010 for further discussion LINK IN OP).

The US government, as monopoly issuer of its own sovereign currency, has given the Fed monopoly power in the market for base money. The Fed then exercises this monopoly power by targeting the overnight rate for money, the fed funds rate. That is to say, the Fed targets a rate or a price, not a quantity. Almost all modern central banks of today operate with explicit interest rate targets, allowing the overnight rate to fluctuate within a range. Any monopolist can only control either price or quantity, not both. Now, central banks could target something else like reserves to transmit monetary policy into the economy; and they have done in the past. The Fed targeted reserves from 1979-1982. What the Fed found was that it had only a controlling influence on base money because targeting the monetary base meant volatility in interest rates (see this 2004 ECB paper for further discussion). But, more importantly, because bank loans create deposits that actually need reserves to maintain the integrity of the payments system, the Fed is forced to supply them according to its legal mandate. In short, reserves are about helping set interest rates, not about pyramiding money on a reserve base.

Under present institutional arrangements, the Fed Funds rate is dependent on the Fed’s supplying the required amount of reserves at any given reserve ratio to keep the interest rate at its target or within its target band. The Fed can’t target a rate unless it supplies banks with all the reserves that the banks need to make loans at that rate. This means that central banks must be committed to supplying as many reserves as banks want/need in accordance with the lending that they do subject to their capital constraints. Failure to supply the reserves means failure to hit the interest rate target. So in practice, if a banking system as a whole is at the reserve limit, central banks always increase the level of reserves desired by the system in order to maintain the interest rate. Not doing so means at once that the Fed cannot hit its target or that transactions fail as the payments system breaks down. In sum: In a nonconvertible. floating exchange rate system, the amount of credit in the system is determined by the risk-reward calculations of banks in granting loans and the demand for those loans. Banks are not reserve constrained. They are capital constrained. Financial institutions grant credit based on the capital they have to deal with losses associated with that activity.

MUCH MORE AT LINK...TIES INTO THE KRUGMAN-KEEN SQUABBLE