The Theory that I Have Been Searching for is MMT

I have to apologize.  Some of the statements that I made in the previous post, on credit creation, were inaccurate.  I have found out there is no “multiplier effect” with credit creation.  Essentially there are multiple loans in the economy at one time, that are used in buying assets in many cases.  During that moment, the money supply has expanded.  However, when the loan is repaid, the principle amount of money has been destroyed.  The interest the bank keeps.  Only the central bank has the power to manipulate bank reserves, except for the added deposits from consumers.  Banks cannot manipulate their reserves – they are only traded and manipulated based on deposits, or transactions from the central bank.

With that out of the way.

I am going to rewind to the financial crisis of 2008.  I actually got really depressed, simply because I was so mad at the society around me.  My family is struggling financially, and institutions that are responsible for risking an entire systemic crisis, are bailed out and kept alive.  What about the American people?  Jobs were lost.  What was more displeasing was the fact that when someone was arrested for protesting, they got a felony.  There was more though.  The Fed bailed out institutions around the world for 17 trillion dollars.  There was the stimulus package.  Fox News replied by enacting fear, and started doing segments on the national debt.  Through the fear of it all, everything settled, and it occurred to me.  We didn’t collapse.  What about the federal debt?  Everything seems to be working fine with increasing government spending.  Could the government debt not matter?  How does The Fed have 17 trillion dollars?  What about spending that on the American people?

So I started to search for an explanation.  Along the way, I would piece together piece by piece what is really going on.  I would have an overall theory, and time and time again it was wrong.  But I pushed to learn more and more.  I first learned about fractional reserve banking, and contemplated an economy based upon that.  I mean, it has been the accepted theory of banking even in my macroeconomics class.  But recently, I have found out that the current theories on Quantitative Easing, which are based on fractional reserve banking, are flat out inaccurate.  My previous post, albeit with some miss information (my theorizing was inaccurate), empirically showed that banks create credit from nothing.

With more digging, it was like Neo searching for something called The Matrix.  I was searching for MMT, or Modern Monetary Theory.  The theory is complex, and will take some time to get a grasp on.  But once I have an idea on how commercial banks, central banks, and their respective governments interact with one another, I can say I have a general idea on how the economy works.  And that to me, would feel good.  To the reader, I hope you understand this is going to be a journey, and I am going to record it.  Along the way, I may say somethings that are inaccurate.  I will do my best to be as accurate as possible, but part of the process for me is to fill in the blanks so to speak, until I can verify if those blanks are accurate.  It’s part of the process.

And so, to the entree of the post.  I read a paper on the interaction of the banks among themselves, as well as on the influence of the central bank.  I learned what actual Quantitative Easing (QE) really is.


McLeay, Michael, Amar Radia, and Ryland Thomas. “Money Creation in the Modern Economy.” Quarterly Bulletin 2014.Q1 (2014): 1-12. Print.


A bank basically has assets and liabilities.  On the assets side, is paper currency and reserves – while on the liabilities side is deposits.  It makes sense.  The bank is responsible for everyone’s deposits, so therefore they are a liability.  Let’s take the first scenario, where a bank issues a loan to a consumer that banks with the same bank.  The newly credited loan, is considered an asset.  When the loan is issued to the consumer, there is a deposit matching the value of the loan.  Therefore, liabilities goes up.  And, the bank takes a percentage, the rumor on the internet is it is around 10 percent, of the loan amount to reserves.

In a more complex scenario, a loan is issued out to buy something, and then that money is deposited into another bank.  When this happens, the issued loan is still an asset to the original bank.  However the amount of the loan turns out to be deposits to the following bank.  Deposits, are a liability.  And, in order for the bank to cover this liability, about 10 percent of those deposits need to be placed in reserves.  The reserve amount is transferred from the original bank to the following bank.  Deposits are the main influence on bank reserves.  When a bank is short on reserves, or even in excess of reserves, banks can transfer reserves among themselves.  Reserves are in place by fiscal regulation, in order to satisfy consumer demand of their money.  However there is still great mystery for me the role reserves play in the whole process.

For one, reserves don’t have to be cash.  As this paper in particular put it, some banks have Treasury Bonds in their reserves for the appropriate amount of cash.  I also read from a different source, that banks essentially have Mortgage-Backed Securities in their reserves.  (ring a bell?)  In other words, when money is put into the reserves, a “portfolio” is constructed, as I understand it.  It is true that the interest on loans is a way the bank makes money.  However, I’m starting to wonder if the banks uses its reserves as a means to accrue more wealth with financial instruments.  It is true, that the reserves cannot be created nor destroyed by the bank, however I am wondering if the principle amount of the reserves are used to accrue more wealth, and the only way the principle amount is adjusted, is when there are new deposits.  This, I am unsure of.  Also, something noted that the paper didn’t cover, is the reserves are a fraction of the deposits.  Where do the rest of the deposits go?  If they remained to satisfy money demand, would that not make them reserves as well?  But reserves are a fraction of total deposits.  Where does all the deposit money go?  It doesn’t go to loans, because loans are issued from fabricated credit.  Does it go to the bank to be used?  How do they use it?

As you can see, this paper does a great job showing the process of banking, but there is bad explanation in other areas.  There is knowledge that is assumed to be known, that I don’t know.  And as with anything when learning about MMT, once I learn more, I have more questions to be asked.  It is going to be a long process.  But it is a bear that I really want to tackle, and I’m going to record this growth over this blog.

With those questions aside, the paper makes a thorough case as to why banks have a limit to what they can loan out.  The limits are:

  1. Market forces constrain lending because individual banks have to be able to lend profitably in a competitive market.
  2. Lending is also constrained because banks have to take steps to mitigate the risks associated with issuing new loans.
  3. Regulatory policy acts as a constraint on banks’ activities in order to mitigate a build-up of risks that could pose a threat to the stability of the financial system.

-page 4.

This is important to understand.  Because if you think about it, if banks can issue loans with fabricated credit, why couldn’t they just lend out as much as possible, to get the most interest?

First banks not only get paid through interest on their assets (loans), but they also pay interest on their liabilities (savings accounts).  The whole idea is to receive more money from loans than they have to pay to their liabilities.  This interest rate, the rate on the loans and savings accounts, are determined by the central bank, which we will learn is the ultimate “constraint” to money creation.  Also one has to realize, it is very possible that loans created from a bank is deposits (liabilities) for the other.  In which case, reserves change accordingly.  I am going to assume for now the banks uses their money for themselves and invests with it, simply because why have fractional reserves?  If the bank can’t use the rest of the liabilities, why have reserves?  Reserves are rumored to be around 10 percent of deposits.  So why not just keep all of the bank’s liabilities as reserves?  The 10 percent rule I believe is in place to be able to provide money demands to the consumer base, while the rest the bank uses as means to accrue more wealth or pay for expenses.

Remember the interest rate on the loans vs. the savings accounts or deposits?  Well if for instance, a bank were to issue out loans at a lower value to compete, they may receive more assets (the loans) but deposits are sent to another bank, whereby the first bank lowers their bank reserves.  When looking at reserves, as well as the interest coming in and the interest paying out, they may have to start charging more interest on their loans, in order to make sure they can satisfy their consumer base.  If a bank were to continually loan under market value, eventually they would run out of reserves, and could not function as a bank.

Another variable on what determines when and how much a bank lends, is their cash flow.  Overtime, how much deposits does the bank receive?  Over time, what usually is the amount withdrawn?  If most of the bank’s deposits are withdrawn at one time, there is what is called “liquidity risk.”  Since banks loan out for months to even a year, they very well could not have the money to satisfy the demands for the deposits.

And this is what I don’t get.

What about the reserves?  If strictly speaking, reserves are a fraction of your deposits, once deposits are taken out of the bank, what happens to the reserves?  I’m thinking that reserves are taken from the deposits.  So if I deposit 100 dollars, 10 dollars are put in reserves.  If I withdraw all of my 100 dollars, 10 dollars are removed from the reserves to satisfy the withdraw.  So if many people are withdrawing most of their deposits at one time, most of the reserves are lowered.  This lowers the power of the banks to lend (assuming this is correct).  Because once a loan is issued, deposits are created somewhere else.  They would have to send reserves to the bank receiving deposits.  And if they are short on reserves, they are at risk to not being able to satisfy the demand on their liabilities.

Really this reserve system puts more risk on the bank, but I guess there is a chance that it makes more money, because they only have to have a fraction of reserves on hand.  But yes, I’m still confused.  It’s the learning process, right?

The obvious reason is next.  Credit risk.  If people have bad credit, a bank shouldn’t lend money out to them, because that would be too high a risk of the loan not being repaid.

There are two possible outcomes to money when it is issued out by banks.  First, a loan that is paid to someone else, could use that money to payback their loans.  This is called the “reflux theory”, because essentially money is being destroyed, and therefore having no effect on the economy.  On the other hand, the loans to pay for something, when that person or business receives that money, if they don’t have outstanding loans, the money is spent through the economy.  And, as it passes hands, it will continually be spent through the economy.  It is the view in this paper, that this is an inflationary process.  In other words, if bank loans aren’t destroying money, it is put out into the economy and expands the money supply, resulting in higher prices.

Onto the central bank.  As with England’s policy, as this paper was written in the context of the British economy (economies with central banks essentially work the same), the government wants inflation to be at around two percent.  So the central bank does practices to try and meet that two percent goal.

One interest rate that the central bank influences is the interest rates paid on the bank reserves that banks deposit into the central bank.  Therefore, the amount of money that they make from reserves deposited to the central bank influences their issuance of loans.  Also, the central bank is able to influence interest rates on loans that are sent through the money markets, which is basically banks and financial institutions.  These different interest rates have different “maturities” and are felt throughout the banking sector.  Ultimately, the interest rates put on reserves and the money markets have an impact on how much a bank is willing to lend.

Maturities – the state of being due.

The last section discussed in the paper, has to do with Quantitative Easing, or QE.  In England, the central bank went to the private sector, and bought assets from corporations.  It could of been an insurance policy, pensions, or what have you, and the central bank bought these assets with cash.  The central bank therefore has assets to accrue wealth, and in turn these corporations have this access cash that they do not particularly want.  Most will reinvest, while same may spend into the economy.  In both cases, this stimulates the economy.

In the states I have heard things are done differently with QE.  The Fed actually, by a mechanism that I can’t remember, increases the reserves of banks.  This is in hopes will create a incentive for banks to lend out more money, and therefore stimulate the economy.

Here are the main questions that I have after this reading:

  • With the reserves being a ratio to deposits, what is done with the rest of the deposits?
  • Do banks pay an interest to the central bank for depositing their reserves, or does the central bank pay an interest on the reserves deposited to it?  From the language of the paper, it is hard to discern either way.  I hope one day I will find out.
  • Why is spending money inflationary?  I got to get a pdf on variables that affect inflation.
  • How does The Fed increase bank reserves?
  • Are banks able to make their reserves a portfolio equal to the amount of reserves?  Whenever reserves have to be released, they can either sell to get cold cash, or just trade the asset, assuming this is what they do.  If they make a profit off of the assets, they can sell, but they cannot add to the principle of the reserves.
  • When banks send reserves to one another, is there interest associated with it?  Does the bank that transfers the reserves, do they get an interest payment or does the bank receiving the reserves?  I just don’t know from the paper that I read.

It seems as when there is anything you are trying to tackle intellectually, especially something as complicated as this, more questions are provided once you read the paper, and it seems more questions arise than questions that are answered.  I’m not done reading about banks.  I need a more thorough read on the practice of banks, but I think I’m going to dive deep into my next paper that is prepared, and it is over the central bank and the treasury.  I don’t know if it is written in the context of The United States, but it has been told to me from multiple people, that really any economy that uses a central bank does the same thing.  So I’m going to put this on hold, and learn how the central bank and treasury print money indefinitely.  A key component to the Modern Monetary Theory.

As you see, it is a process.  As I have stated earlier in this blog, I’m going to record the process of understanding this very complex theory.  Getting into it, is showing to be intimidating.  Every single time I read something I just have so much questions.  I just hope one day I can read something about MMT and say, “Interesting.  I get it.”  And leave it at that.  Only time will tell.

Thanks for reading!

 

 

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