Mish on the Fictional Reserve System

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Mike Shed­lock (“Mish” as he is known to all) has writ­ten an excel­lent piece on the defla­tion-infla­tion debate, focus­ing on the Achilles Heel of the latter–the fact that it is based on the belief that we live in a “frac­tion­al reserve bank­ing” mon­e­tary sys­tem. He offered to let me cross-post here, and I’ve repro­duced it in its entire­ty below (there’s only one point I’m not sure on–the com­ment that there are no reserve require­ments for sav­ings accounts. From my read­ing of the foot­notes to Table 12 in this Fed­er­al Reserve paper, that’s true of cor­po­rate accounts but not indi­vid­ual ones).

Also, there is an excel­lent arti­cle in the Guardian “The glob­al econ­o­my’s decade of debt-fuelled boom and bust” by Lar­ry Elliott (repro­duced in the Fair­fax press) that puts the debt-defla­tion and delever­ag­ing case very well.  Do read it.

And now, over to Mish!

Fictional Reserve Lending And The Myth Of Excess Reserves

In A Case for the Infla­tion Camp Robert P. Mur­phy asks When Will the Infla­tion Genie Get Out of the Bot­tle? Mur­phy’s con­cern is over “excess reserves”.

My rea­son for expect­ing large-scale price infla­tion is fair­ly straight­for­ward: I see no coher­ent strat­e­gy for Bernanke to remove the excess reserves from the bank­ing sys­tem. …

After review­ing the evi­dence and the the­o­ries offered by the two camps, I still believe that Bernanke’s unprece­dent­ed infu­sions of new reserves will lead to rapid price increas­es. These increas­es may not show up in the price of US finan­cial assets, but they will rear their ugly heads at the gas pump and gro­cery check­out. More­over, I think the genie may already be slip­ping out of the bot­tle. His escape will only be has­tened once the year-over-year CPI fig­ures show mod­er­ate infla­tion.

Steve Sav­ille’s Con­cern Over Excess Reserve

Steve Sav­ille express­es his con­cern over excess reserves in Bank Reserves and Infla­tion.

The rea­son that bank reserves aren’t added to the mon­ey sup­ply is that they do not con­sti­tute mon­ey avail­able to be spent with­in the econ­o­my; rather, they con­sti­tute mon­ey that could be loaned into the econ­o­my or used to sup­port addi­tion­al bank lend­ing in the future.

Bank lend­ing in the US has declined on a year-over-year basis, so we know that the spec­tac­u­lar increase in reserves has not YET con­tributed to mon­e­tary infla­tion.

If the pri­vate banks were to join the infla­tion par­ty then the risk of hyper­in­fla­tion would great­ly increase, and hyper­in­fla­tion — lead­ing to what Mis­es called a “crack-up boom” — would be the worst of all pos­si­ble out­comes. In par­tic­u­lar, it would be an order of mag­ni­tude worse than the defla­tion that many peo­ple still seem to be wor­ried about.

So, let’s hope that the banks don’t start lend­ing out their excess reserves. The sit­u­a­tion is bad enough already.

Gary North’s Con­cern Over Excess Reserves

Inquir­ing minds note Gary North’s con­cern over excess reserves in The Fed­er­al Reserve’s Self-Imposed Dilem­ma.

The Fed­er­al Reserve Sys­tem faces a dilem­ma of its own cre­ation: the dou­bling of the mon­e­tary base.

The only thing that is keep­ing this from cre­at­ing mass infla­tion is the deci­sion of com­mer­cial bankers to deposit the bulk of this increase with the Fed­er­al Reserve. The banks are not lend­ing out this mon­ey. Nei­ther is the FED. This mon­ey does not legal­ly belong to the FED.


There is an easy solu­tion to this prob­lem. The Fed­er­al Reserve knows exact­ly what the solu­tion is. Nobody men­tions it. The sug­ges­tion that the Fed­er­al Reserve would attempt it would prob­a­bly bust the bond mar­ket. The Fed­er­al Reserve would announce that, from this point on, all mon­ey deposit­ed by banks as excess reserves will be charged a stor­age fee. This fee could be 2%.

Not only would banks not make any inter­est on the mon­ey deposit­ed with the Fed­er­al Reserve, they would begin suf­fer­ing a loss of 2% per annum on the mon­ey held as excess reserves. …

Lots of Con­cern Over Excess Reserves

That’s a lot of con­cern over excess reserves. And if I looked around, I am quite sure I can find even more con­cern over excess reserves.

Here is a cur­rent chart that shows what every­one is con­cerned about.

Reserve Bal­ances with Fed­er­al Reserve Banks

click on chart for sharp­er image

Mon­ey Mul­ti­pli­er The­o­ry

The chart shows an unprece­dent­ed amount of excess reserves, almost $1.2 tril­lion.

Accord­ing to Mon­ey Mul­ti­pli­er The­o­ry (MMT) and Frac­tion­al Reserve Lend­ing, this amount may be lent out as much as 10 times over and when it does, mas­sive infla­tion will result.

Mon­ey Mul­ti­pli­er The­o­ry Is Wrong

The above hypothe­ses regard­ing “Excess Reserves” are wrong for five rea­sons.

1) Lend­ing comes first and what lit­tle reserves there are (if any) come lat­er.
2) There real­ly are no excess reserves.
3) Not only are there no excess reserves, there are essen­tial­ly no reserves to speak of at all. Indeed, bank reserves are com­plete­ly “fic­tion­al”.
4) Banks are cap­i­tal con­strained not reserve con­strained.
5) Banks aren’t lend­ing because there are few cred­it wor­thy bor­row­ers worth the risk.

Let’s explore each of those points in depth.

1: Lend­ing Comes First, Reserves Sec­ond

Aus­tralian econ­o­mist Steve Keen has made a strong case that lend­ing comes first and reserves lat­er in Rov­ing Cav­a­liers of Cred­it. I dis­cussed that at length in Fiat World Math­e­mat­i­cal Mod­el.

That point alone should seal the hash of the debate but it keeps com­ing up over and over. So let’s try one more time.

Inquir­ing minds are read­ing BIS Work­ing Papers No 292, Uncon­ven­tion­al mon­e­tary poli­cies: an appraisal.

Note: The above link is a lengthy and com­plex read, rec­om­mend­ed only for those with a good under­stand­ing of mon­e­tary issues. It is not light read­ing.

The arti­cle address­es two fal­lac­i­es

Propo­si­tion #1: an expan­sion of bank reserves endows banks with addi­tion­al resources to extend loans

Propo­si­tion #2: There is some­thing unique­ly infla­tion­ary about bank reserves financ­ing

From the arti­cle.…

The under­ly­ing premise of the first propo­si­tion is that bank reserves are need­ed for banks to make loans. An extreme ver­sion of this view is the text-book notion of a sta­ble mon­ey mul­ti­pli­er.

In fact, the lev­el of reserves hard­ly fig­ures in banks’ lend­ing deci­sions. The amount of cred­it out­stand­ing is deter­mined by banks’ will­ing­ness to sup­ply loans, based on per­ceived risk-return trade-offs, and by the demand for those loans.

The main exoge­nous con­straint on the expan­sion of cred­it is min­i­mum cap­i­tal require­ments.

A strik­ing recent illus­tra­tion of the ten­u­ous link between excess reserves and bank lend­ing is the expe­ri­ence dur­ing the Bank of Japan’s “quan­ti­ta­tive eas­ing” pol­i­cy in 2001–2006.

Japan’s Quan­ti­ta­tive Eas­ing Exper­i­ment

click on chart for sharp­er image

Despite sig­nif­i­cant expan­sions in excess reserve bal­ances, and the asso­ci­at­ed increase in base mon­ey, dur­ing the zero-inter­est rate pol­i­cy, lend­ing in the Japan­ese bank­ing sys­tem did not increase robust­ly (Fig­ure 4).

Is financ­ing with bank reserves unique­ly infla­tion­ary?

If bank reserves do not con­tribute to addi­tion­al lend­ing and are close sub­sti­tutes for short-term gov­ern­ment debt, it is hard to see what the ori­gin of the addi­tion­al infla­tion­ary effects could be.

There is much addi­tion­al dis­cus­sion in the arti­cle but it is clear that MMT the­o­ry as espoused by Mur­phy, Sav­ille, North and oth­ers did not hap­pen in Japan nor is there any evi­dence of it hap­pen­ing in the US, nor is there a sound the­o­ret­i­cal basis for it.

In fiat based cred­it sys­tems, lend­ing comes first, reserves come sec­ond, and extra reserves do noth­ing much except pay banks to sit in cash in cas­es where inter­est is paid on excess reserves.

I will touch more on reserves com­ing after lend­ing in the dis­cus­sion of points 3 and 4 below.

2: There Are No Excess Reserves

Let’s now turn our atten­tion to the idea there are excess reserves. To do that, let’s con­sid­er non­per­form­ing loans, total loans and leas­es, and allowances for loan and lease loss­es.

Total Non­per­form­ing Loans

click on chart for sharp­er image

The above chart is from St. Louis Fed based on Reports of Con­di­tion and Income for All Insured U.S. Com­mer­cial Banks.

Per­cent­age of non­per­form­ing loans equals total non­per­form­ing loans divid­ed by total loans. Non­per­form­ing loans are those loans that bank man­agers clas­si­fy as 90-days or more past due or nonac­cru­al in the call report.

Non­per­form­ing loans have soared to a record five per­cent for this series.

The above chart just gives a per­cent. We need to quan­ti­fy the amount. The fol­low­ing chart will help do just that.

Total Loans and Leas­es of Com­mer­cial Banks

The above chart of total loans and leas­es shows a total of near­ly $7 tril­lion, of which five per­cent is non­per­form­ing. In oth­er words there is about $350 bil­lion of non­per­form­ing loans on the books of banks (that are admit­ted to).

That last part about admit­ted to is cru­cial. Non­per­form­ing loans do not include off bal­ance sheet garbage, var­i­ous swaps with the Fed, or ridicu­lous mark-to-fan­ta­sy val­u­a­tions of assets held on the books.

Total Loans and Leas­es of Com­mer­cial Banks Per­cent­age Change

On a per­cent­age basis the drop in loans and leas­es is unprece­dent­ed.

But wait. Banks might have made pro­vi­sions for those loan loss­es already, might they not? Well … in a sin­gle word, No (as the fol­low­ing chart shows)

Assets at Banks whose ALLL exceeds their Non­per­form­ing Loans

The above chart cour­tesy of the St. Louis Fed.

Because allowances for loan loss­es are a direct hit to earn­ings, and because allowances are at ridicu­lous­ly low lev­els, bank earn­ings (and cap­i­tal­iza­tion ratios) are wild­ly over-stat­ed.

Excess Reserves? You still think so?

3: Bank reserves are “Fic­tion­al”, there are essen­tial­ly no reserves at all.

To see if we can prove this state­ment we can look at total lend­ing vs. base mon­ey sup­ply and M2.

Karl Den­ninger at Mar­ket Tick­er has a nice chart of total lend­ing based on Fed­er­al Reserve Z.1 Flow of Funds data.

Cumu­la­tive Debt

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Base Mon­ey Sup­ply

Note the ram­pant increase in base mon­ey which is the source of those so-called excess reserves.

Let’s do a lit­tle math.

There is 2,000 bil­lion base mon­ey.
There is 52,000 bil­lion lend­ing.
The ratio of base mon­ey to lend­ing is 3.8%

Pri­or to the ramp in base mon­ey (which by the way was the Fed’s fee­ble attempt to sup­ply reserves after the fact), there was $800 bil­lion base mon­ey sup­port­ing $52,000 bil­lion in lend­ing. Not too long ago, the ratio of base mon­ey to lend­ing was a mere 1.5%.

Want to use M2 instead?

M2 Mon­ey Sup­ply

click on chart for sharp­er image

Using M2 as mon­ey sup­ply avail­able for lend­ing makes the ratios bet­ter. How­ev­er, the largest com­po­nent of M2 is sav­ings accounts at almost $5 tril­lion of that $8.5 tril­lion M2.

How­ev­er, mon­ey in sav­ings accounts is not there. Reserve require­ments on sav­ings accounts are zero. It has all been lent out. More­over, Greenspan autho­rized sweeps in 1994 to specif­i­cal­ly allow banks to “sweep excess reserves” from check­ing accounts into sav­ings accounts so the mon­ey could be lent out.

There is no mon­ey in sav­ings accounts or check­ing accounts oth­er than an elec­tron­ic mark that says there is. Both con­tain mon­ey only in the­o­ry. That mon­ey that has already been lent out and rede­posit­ed, over and over and over.

Reserves? There are no reserves. Indeed, reserves are best thought of as neg­a­tive.

Frac­tion­al Reserve Lend­ing is real­ly Fic­tion­al Reserve Lend­ing.

4: Banks are cap­i­tal con­strained not reserve con­strained

Num­ber four gets down to the heart of the mat­ter. Banks are not lend­ing because they are cap­i­tal con­strained, not because of any reserve issues.

The Bank of Inter­na­tion­al Set­tle­ments (BIS) sets stan­dards that per­tain to asset qual­i­ty and required cap­i­tal that the banks must hold.

Here are some resources:

The first doc­u­ment is a whop­ping 284 pages long while the sec­ond is 150 pages long. I do not advise read­ing either. I include them for com­plete­ness.

Cap­i­tal require­ments

Wikipedia explains Cap­i­tal Require­ments and Cap­i­tal Ade­qua­cy Ratio in brief form but the arti­cles need work. Nonethe­less, they seem to be a rea­son­able although com­plex overview.

From Wikipedia: The cap­i­tal ratio is the per­cent­age of a bank’s cap­i­tal to its risk-weight­ed assets. Weights are defined by risk-sen­si­tiv­i­ty ratios whose cal­cu­la­tion is dic­tat­ed under the rel­e­vant Accord.

Here is a chart on risk weight­ings. Remem­ber what hap­pened to those AAA rat­ed loans?

Risk Weight­ings

Fed Can Pro­vide Liq­uid­i­ty Not Cap­i­tal

Flash­back March 01, 2008: Poole, Paul­son, Bernanke on Bailouts and Bank Fail­ures

Fed Gov­er­nor William Poole on Moral Haz­ards:

I am more skep­ti­cal of the finan­cial strength of the GSEs, and believe that we could see sub­stan­tial prob­lems in that sec­tor. Accord­ing to the S&P Case-Shiller home val­ue data released ear­li­er this week, as of Decem­ber 2007 aver­age prices had declined by 15 per­cent or more over the past 12 months in Phoenix, San Diego, Mia­mi and Las Vegas. We can add Detroit to the dan­ger list as the home price index for that city is down by almost 19 per­cent over the 24 months end­ing Decem­ber 2007. With house prices falling sig­nif­i­cant­ly in a num­ber of large mar­kets, many prime mort­gages issued a few years ago with a loan-to-val­ue ratio of 80 per­cent may now have rel­a­tive­ly lit­tle home­own­er equi­ty, which increas­es the prob­a­bil­i­ty of default and amount of loss in event of default.

As I have empha­sized before, the Fed­er­al Reserve can deal with liq­uid­i­ty pres­sures but can­not deal with sol­ven­cy issues. I do not have any infor­ma­tion on the GSEs that the mar­ket does not also have. Nev­er­the­less, in assess­ing the risk of fur­ther cred­it dis­rup­tions this year, I would put the GSEs at the top of my list of sources of poten­tial­ly seri­ous prob­lems. If those prob­lems were real­ized, they would be a direct result of moral haz­ard inher­ent in the cur­rent struc­ture of the GSEs.

First Nation­al­ized Bank Of Fan­nie

Poole hit the nail on the head. Fan­nie Mae and Fred­die Mac blew up and were nation­al­ized. They did not run into reserve con­straints. They ran smack up against cap­i­tal con­straints.

Also note that the Fed did not bail them out. Tax­pay­ers did, autho­rized by Con­gress. The loss­es might hit $400 bil­lion.

Fan­nie Mae is not a bank, but for all prac­ti­cal pur­pos­es it may as well be. Much lend­ing growth comes from the GSEs. Mon­ey (cred­it real­ly), is bor­rowed into exis­tence, and rede­posit­ed else­where, and lent out over and over again.

When Fan­nie Mae and Fred­die Mac ran into prob­lems, cap­i­tal was pro­vid­ed after the fact, not by the Fed but by tax­pay­ers. The same applies to Cit­i­group, Bank of Amer­i­ca, Wells Far­go on down the line.

In the March 2008 Poole post, I also com­ment­ed on Bernanke.

Bernanke Expects Bank Fail­ures

Tes­ti­fy­ing before Con­gress on Thurs­day, Bernanke stat­ed Banks should seek more cap­i­tal.

Among the largest banks, the cap­i­tal ratios remain good and I don’t antic­i­pate any seri­ous prob­lems of that sort among the large, inter­na­tion­al­ly active banks that make up a very sub­stan­tial part of our bank­ing sys­tem,” he said in response to a ques­tion dur­ing semi-annu­al con­gres­sion­al tes­ti­mo­ny.

They have already sought some­thing of the order of $75 bil­lion of cap­i­tal in the last quar­ter. I would like to see them get more,” Bernanke said.

They have enough now cer­tain­ly to remain sol­vent and remain … well above their min­i­mum cap­i­tal lev­els. But I am con­cerned that banks will be pulling back and not mak­ing new loans and pro­vid­ing the cred­it which is the lifeblood of the econ­o­my. In order to be able to do that … in some cas­es at least, they need to get more cap­i­tal,” Bernanke added.

Bernanke cer­tain­ly blew it about the large banks being well cap­i­tal­ized. How­ev­er, he was cer­tain­ly cor­rect with “In order to be able to [lend] … in some cas­es at least, they need to get more cap­i­tal

Note that this was a cap­i­tal con­cern not a reserve con­cern.

Cap­i­tal Is The Prob­lem At Vir­tu­al­ly All Banks

Flash for­ward August 19, 2009: Emails from a Bank Own­er regard­ing FDIC and Under-Cap­i­tal­ized Banks.

Here is an inter­est­ing fol­lowup email from ABO [a Bank Own­er and CEO] regard­ing bank cap­i­tal.

ABO Writes:

I talked to a friend this morn­ing who is retired from both the Fed­er­al Reserve of Kansas City and RSM McGladrey. He now does con­sult­ing work with the FDIC, due dili­gence and oth­er reg­u­la­to­ry work. He said the pic­ture he is see­ing is worse than at any time in his life and CAPITAL is the prob­lem with vir­tu­al­ly all banks.

Inquir­ing minds will also be inter­est­ed in an August 24, 2009 post Crit­i­cal­ly Under-Cap­i­tal­ized Banks Direct Result of “Won­der­ful Chain of Stu­pid­i­ty”. That post also shares some emails with “ABO” includ­ing …

Hid­ing The Loss­es

ABO Writes:

Take a look at how the FDIC is sell­ing failed banks. It is a lit­tle dif­fer­ent than in the past. The FDIC is using a loss shar­ing agree­ment that is usu­al­ly around 80–20 and has cer­tain guide­lines on tim­ing of the loss­es. I would guess that the loss­es on the failed banks are dragged into the future some­what rather than being rec­og­nized at the time the bank is closed. This method would be less of an imme­di­ate hit to the fund and would prob­a­bly cre­ate a con­tin­gent lia­bil­i­ty rather than a direct one. The banks that agree to this loss shar­ing plan are rely­ing on the promise of the FDIC to make good on future guar­an­tees for loss­es. The loss­es are not backed by the full faith of the gov­ern­ment.

The Fed and FDIC always want to delay address­ing the prob­lems, hop­ing they will go away. Such struc­tur­al prob­lems sel­dom do.

Amaz­ing­ly Finan­cial Group was con­sid­ered “well cap­i­tal­ized” right up to the brink of fail­ure. When the bank did fail, the hit to FDIC was not imme­di­ate­ly tak­en but stretched into the future.

The WSJ arti­cle notes ‘There are 1,400 banks that own mort­gage-backed secu­ri­ties that aren’t backed by gov­ern­ment-relat­ed enti­ties such as Fan­nie Mae and Fred­die Mac.” What we don’t know is how many of those banks are lev­ered up enough in garbage mort­gages to fail.

Note too that those garbage trust-pre­ferred secu­ri­ties prob­lems are on top of the wide­ly expect­ed fall­out from com­mer­cial real estate prob­lems affect­ing small to medi­um-sized region­al banks. Thus, bank­ing woes are much deep­er in many areas than either the FDIC or Fed is admit­ting.

FDIC Allows Banks To Hide Insuf­fi­cient Cap­i­tal

Let’s flash for­ward once again.

Date­line Decem­ber 15, 2009: FDIC Approves Giv­ing Banks Reprieve From Cap­i­tal Require­ments

The Fed­er­al Deposit Insur­ance Corp. gave banks includ­ing Cit­i­group Inc., Bank of Amer­i­ca Corp. and JPMor­gan Chase & Co. a reprieve of at least six months from rais­ing cap­i­tal to sup­port bil­lions of dol­lars of secu­ri­ties the firms will be adding to their bal­ance sheets.

Bank reg­u­la­tors includ­ing the FDIC and Fed­er­al Reserve want to per­mit a phase-in of cap­i­tal require­ments that rise start­ing next month under a change approved by the Finan­cial Account­ing Stan­dards Board. The rule, passed in May, elim­i­nates some off- bal­ance-sheet trusts, forc­ing banks to put bil­lions of dol­lars of assets and lia­bil­i­ties on their books.

Exec­u­tives from Cit­i­group, JPMor­gan, Bank of Amer­i­ca, Wells Far­go & Co., Cap­i­tal One Finan­cial Corp. and the Amer­i­can Secu­ri­ti­za­tion Forum met FDIC offi­cials Dec. 2 to dis­cuss cap­i­tal require­ments relat­ed to the FASB mea­sure.

The exec­u­tives pro­posed that “the tran­si­tion peri­od should extend beyond 2010 to a point in the econ­o­my where unem­ploy­ment is low­er and issuers are less cap­i­tal-restrained from grow­ing their bal­ance sheet and pro­vid­ing cred­it,” accord­ing to a paper the ASF pre­sent­ed the FDIC.

Cit­i­group sug­gest­ed three years to off­set assets and lia­bil­i­ties brought onto bal­ance sheets, Chief Finan­cial Offi­cer John Gerspach said in an Oct. 15 let­ter to reg­u­la­tors. Requir­ing banks to “assume the risk-based cap­i­tal effects imme­di­ate­ly, or even over one year, is an unde­ni­ably severe penal­ty,” he wrote.

Fic­tion­al Cap­i­tal

Not only are there no reserves, the above should prove with­out a doubt there is insuf­fi­cient cap­i­tal for banks to lend.

Amaz­ing­ly, the Fed and banks have the gall to pro­claim banks are well cap­i­tal­ized.

Glob­al Impli­ca­tions Of
Stronger Cap­i­tal Rules From Basel

Just to prove cap­i­tal is not just a US con­cern, please con­sid­er Japan Banks Fall on Stronger Cap­i­tal Rules From Basel.

Glob­al reg­u­la­tors have been wrestling with plans to tight­en bank super­vi­sion fol­low­ing the worst eco­nom­ic cri­sis since World War II. The Basel Com­mit­tee said yes­ter­day banks’ core cap­i­tal should exclude stock or instru­ments that may require lenders to make pay­ments to third par­ties, as these could reduce reserves need­ed for meet­ing loss­es.

The tight­en­ing of Tier 1 qual­i­ty stan­dards is over­all neg­a­tive for the Japan­ese banks because they have weak Tier 1 qual­i­ty,” said Stephen Church, a research part­ner at Japan­in­vest KK, an inde­pen­dent research firm, in Tokyo. “The stock mar­ket is dif­fer­en­ti­at­ing between those banks which have stronger Tier 1 and those which are weak­er.”

The com­mit­tee also said banks should have an “appro­pri­ate” peri­od of time to replace such instru­ments.

Hope­ful­ly that proves beyond a shad­ow of a doubt that banks are cap­i­tal restrict­ed. Thus, even if banks had excess reserves (which they clear­ly don’t), banks would not be lend­ing any­way.

Of course, the idea that banks need reserves in the first place is fal­la­cious.

Let’s tie a bow on this five point pack­age with …

5: Banks aren’t lend­ing because there are few cred­it wor­thy bor­row­ers worth the risk.

Even if banks had the cap­i­tal to dra­mat­i­cal­ly increase lend­ing (which they don’t), banks would still have to make the deter­mi­na­tion they want to lend.

Back­drop Banks Face

If you were a bank would you be anx­ious to lend into that? If you were a busi­ness would you want to expand into that?

Please con­sid­er the lat­est Fed Senior Loan Sur­vey.

Demand for C&I loans from small firms

Lend­ing Stan­dards For Small Firms

85.5% of banks respond­ing to the sur­vey have lend­ing stan­dards that basi­cal­ly remained the same yet 44.6% of banks report mod­er­ate­ly weak­er demand for loans, with only 8.9% report­ing mod­er­ate­ly stronger demand for loans.

In spite of all the claims that banks are not will­ing to lend, the data sug­gests that the pre­dom­i­nant fac­tor is there are few­er busi­ness­es want­i­ng loans.

Arguably (but there is no way to tell from the tables) few­er still cred­it wor­thy busi­ness­es want loans.

Those who want banks to increase lend­ing, I have to ask “For What? To Who? At What Rate?”

There are actu­al­ly plen­ty of rea­sons for banks not want­i­ng such as ris­ing unem­ploy­ment, ris­ing tax­es, uncer­tain­ty over health care costs, pro­posed cap-and-trade costs, increas­ing con­sumer fru­gal­i­ty, ram­pant over­ca­pac­i­ty, and boomer demo­graph­ics.

One Unad­dressed Point

Gary North pro­pos­es Bernanke can force banks to lend. Real­ly? When Bernanke knows banks are cap­i­tal con­strained? When it is obvi­ous that it would be sui­ci­dal?

Bear in mind that Bernanke has recent­ly talked about upping the inter­est on reserves, not mak­ing it neg­a­tive. More­over, by pay­ing inter­est on reserves, the Fed can very slow­ly recap­i­tal­ize banks over time while simul­ta­ne­ous­ly and sub­tly sug­gest­ing that banks not take excess risks.

With that in mind, let’s try and stay with­in the solar sys­tem of 99.9% prob­a­bil­i­ty rather than the uni­verse of the­o­ret­i­cal­ly pos­si­ble neg­a­tive 2% rates on reserves.

Excess Reserve Recap

1) Lend­ing comes first and what lit­tle reserves there are (if any) come lat­er.
2) There real­ly are no excess reserves.
3) Not only are there no excess reserves, there are essen­tial­ly no reserves to speak of at all. Indeed, bank reserves are com­plete­ly “fic­tion­al”.
4) Banks are cap­i­tal con­strained not reserve con­strained.
5) Banks aren’t lend­ing because there are few cred­it wor­thy bor­row­ers worth the risk.

Reserves? There are no reserves. Indeed, reserves are best thought of as neg­a­tive. Instead, in cas­es of “too big to fail”, cap­i­tal (not reserves), is sup­plied after the fact by tax­pay­ers (not the Fed).

Thus, con­cern that excess reserves will lead to lend­ing and infla­tion is total­ly unfound­ed in the­o­ry and prac­tice.

Frac­tion­al Reserve Lend­ing is real­ly Fic­tion­al Reserve Lend­ing. In prac­tice, the major con­straints to lend­ing are insuf­fi­cient cap­i­tal and will­ing­ness of cred­it wor­thy bor­row­ers to seek loans.

Mike “Mish” Shed­lock

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