Distributed Economics

Poke around in the entrails of history, and a surprising number of revolutions, and coup’s of one form or the other of etat, can be attributed at least in part to some form of underlying monetary breakdown. Typically the form of breakdown that involves at its heart,too much debt being issued, for the available supply of peasants to support payment of. It would be nice to think that the very least a communist government, formed by and on behalf of the workers and peasants of its country could achieve, would be to avoid that one.

There are two very strange things about the news out of China these days. One, is that there have been clear signs of a loan induced housing bubble for some time now. The other is the succession of increases the People’s Bank of China has made in the required reserve rate for its banks in order to constrain that bubble. The latest increase on May 10th to 17%, follows a raise to 16.5% in February 2010,  and a set of increases over the last couple of years.

According  to the existing Economic theory of how the banking system works, each one of these should have triggered a large contraction in the available money and loan supplies, given that the removal of money from  the system triggered by the reserve increases – is a multiple of the reserve change.

Despite this, there is in China today a rapidly increasing CPI, and a raging housing bubble, alongside  a steadily increasing reserve ratio. The situation gets even worse, if the  underlying non-monetary economy is considered, which in China is one of steadily increasing production. Since production increases cause deflation, as the existing money supply is used to trade and purchase more things, this suggests money and loan supply expansion, rather than the contraction that should have been triggered by the reserve changes.

All of which suggests something has gone very badly wrong indeed, in the Chinese banking system.

Monetary statistics are available on the People’s Bank of China’s web site for the period since 1999.  They are unfortunately not at the same level of detail as the USA, or indeed Iceland.  In particular since there is no break out of the M series components, it’s not possible to know how much debt instrument contamination is present in these series. There is a format change in 2005, and since the number’s don’t quite match up for the different series, the chart below is just for the last 5 years.

Chinese Money Supply

The data for the entire period, assuming that measurement has been reasonably consistent, shows that M1 has increased by approximately 4x in 10 years, about twice the quantitative  increase in the the Dollar and the Euro over the same period. It would also appear from the chart that the process has begun to accelerate.

The data shown is certainly consistent with reports of a credit fueled housing bubble, originating from uncontrolled lending within the banking sector, triggering asset inflation and commercial bank expansion of the money supply. What is perhaps most remarkable about the chart above, is the complete absence of any affects from the reserve increases that the Chinese central bank has been imposing to try and throttle the system back. It has been steadily ratcheting the reserve rate up for the last 3 years, it’s now at 17%, but there has been no corresponding contraction in the money supply. It’s probably the case that the expansion would have been even greater had they not increased the reserve requirements. But still. If economic theory was correct, what the chart should be showing is a massive contraction in the money supply – since changes in the reserve requirements theoretically  have a 10x multiplier effect on the money and loan supplies – and it’s plainly not.

Given the reports of a housing bubble, increasingly lowered lending standards, and CPI, it sounds like this is probably the Equity Capital exploit cutting loose again. Whether this  is because the banks are abusing inter-bank lending mechanisms as occurred in Iceland, or have just figured out they can stuff some form of debt into their equity capital holdings is very hard to say – there simply isn’t the kind of publicly available data to properly analyze the Chinese banking system. Given the repeated increases in the reserve ratio, it seems highly unlikely that any part of this is deliberate government policy though.

Which points to another aspect of this entire problem. Both the exploits discussed here, the Equity Capital exploit, and the Asset backed security loophole, are outlined for a system with full reserve requirements. De facto, the European and American banking systems don’t use reserve requirements for central bank control any more, and rely on market operations. Those don’t in fact work, but as China is currently demonstrating, neither do the textbook, central bank control mechanisms via the reserve requirements either.

The other interesting implication of this, particularly if the expansion continues to accelerate, is that if the Yuan were to be allowed to free float, it would probably depreciate against the Euro and the dollar, rather than appreciate as is being called for by American and European economists.

& won’t that be fun.

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cc Asset Inflation, Empirical Analysis, Exploits, Fractional Reserve System

Over in the land of the rising Volcano,  the first full report on a banking system collapse has just been released.

Interestingly, even with a report that goes into a fair amount of detail on the extraordinarily contrived web of lending and borrowing between a small circle of Icelandic  businessmen, the main Icelandic banks, and their overseas Creditors, there seems to have been relatively little attention paid to the problems in the underlying monetary mechanics that allowed it to happen. In particular, the  approximately ten times expansion in the money supply that accompanied the businessmen’s sleight of loan practices, appears to have been overlooked.

Money supply figures for Iceland are available from the Icelandic Central Bank. The following analysis is based on the “Monetary Aggregate” (Peningamagn og tengdir liðir) spreadsheet which is the only statistical series that appears to have been updated since the collapse in September 2008. It labels figures since Sept 2008 as ‘provisional’.

This series covers M1, M2 and M3 statistics up until 2009. As previously discussed, the M series monetary statistics are not an entirely pure measure of the total amount of money in any given monetary system, as they can include some forms of debt instruments. In the Icelandic case, two adjustments need to be made to get a quantitative estimate purely of Icelandic Krona: the removal of Money market accounts from M3 which eventually amount to about 10%, and also foreign currency accounts which are included as part of M2. Foreign currency savings accounts incidentally, as a percentage of krona denominated M2, vary between 15-43% of total M2 over this period – which suggests there are other potential stability issues, especially for small currencies, lurking in the background connected to the fractional reserve banking system.  Iceland’s banking and currency system has never been a haven of price stability.

The issue illustrated here is both scientifically fascinating, and utterly appalling in its eventual effects. Iceland deregulated its banking system in 2001. Two of the banks, Kaupthing [nee Búnaðarbanki] and Landesbanki, were sold to private businessmen, who in at least one case used money borrowed from one bank, to purchase shares in the other. Now let’s think about that for a moment, in the context of fractional reserve banking. You borrow money from one bank, and use it to buy control in another. How does that borrowed money get treated? If – and it seems to have been the case – that money is put into Equity Capital holdings at the second bank, then the total amount  the second bank  can lend, and thereby increase the overall money supply by, has just increased. As a result of a debt somewhere else in the banking system. It’s a feedback loop entirely within the commercial banking system, increasing the money and debt supply, independent of any control by the central bank.

The statistics are divided into two series, with considerably less detail available from the earlier period. We can see from the first series below, that quantitatively the currency was relatively stable up until 1997 when M3 began to diverge from the other measures. Unfortunately, there is no detail in the first series to suggest exactly why.

The second series is over a shorter time period, slightly over 6 years. Although the most dramatic behaviour of the currency is in 2007-8, what happens before then shouldn’t be overlooked. Between September and October 2003 for example, M1 and M2 double.

Iceland is a very small country, of approximately 300,000 people, which is why these effects are so obvious. M2 as shown here is the total amount of bank deposits in the country, aside from longer term time deposits which are counted as part of M3. Iceland, as elsewhere, stores its currency electronically – physical notes are printed as needed. But the size of the country, and the electronic nature of its storage, doesn’t change the quantitative nature of what happened in September 2003.

Looking rather closely at those two months, it looks like there was approximately an 100,000 M.Kr. increase in bank deposits. At a guess, and that’s all it is, the proximate cause of the increase was probably the first payments by the Icelandic banks of the money being lent for the Icelandic Power Companies then latest venture into Aluminium production, to the tune of  $20 million in locally sourced loans. This at some level just represents how fractional reserve banking works, and if nothing else, demonstrates the dangers of making big loans within a small currency base. In terms of nuts and bolts economics, the production of things, the support of livelihoods, and general improvements in living standards,  the loan certainly made sense, in increasing total electrical power available to the economy. It’s the monetary side effects, inflation as a result of a loan, and then presumably deflation as it’s repaid -  although it seems that’s an increasingly old fashioned concept these days  -  resulting purely from the mechanics of the underlying system where the loans are created, that don’t.

The money supply continues to increase over the next 3 years. It’s masked to some extent by the rather dramatic increases in 2007, but M1 doubles by the end of 2006, M2 increases by about 1.8 times, and M3 by a factor of 1.6. CPI Inflation rises from 2% in 2004, to 8% in 2006, and this causes other problems. Icelandic krona loans are index linked, something that was introduced to deal with a previous bout of severe inflation – in fact, i’d guarantee that historically Iceland got severe inflation anytime their power company decided to expand their electricity supply, and borrowed money to finance it. Fractional reserve banking is far from problem free even when it’s not being deliberately exploited.  The increase in the last decade though, had another cause.  In the background of the Icelandic economy, a small cabal of Icelandic businessmen had effectively turned their businesses, in conjunction with their relationships with the owner’s of the three main Icelandic banks, into what appears to have been a co-ordinated exploit of the Equity Capital loophole.

As a result of this, the Icelandic money supply measures double again in the year between January 2007 and September 2008, when the collapse of Lehman Brothers intervenes, and turns Iceland into, were anyone paying any attention to the actual systemic issues behind the credit crises of the early 21st century, the canary in the goldmine.

Doubling the money supply in slightly over a year, is by any standards extraordinary. As is having it increase by an order of magnitude in  7 years. It’s not Weimar levels of increase, but neither is it something that should just be occurring without any comment. It also makes any and all economic statistics for that period from Iceland highly suspect. Money is used as an economic measurement. If the quantity of money is changing, and this isn’t corrected for, it’s akin to trying to measure with an elastic band.

Quantitative changes in the ratio’s between currencies don’t necessarily play themselves out in immediate adjustments to currency trading, the relationships themselves seem to be quite sticky with sudden, abrupt changes. The Icelandic Krona’s exchange rate was relatively stable up until the crisis hit in 2008 in an 80-100 band. The high interest rates being paid because of central bank attempts to control the monetary expansion acted to attract foreign investment, and damp down the quantitative impacts of the increase.  In Iceland as elsewhere, a lot of the quantitative increase in the money supply is essentially getting trapped within the monetary system, which limits the impact on general inflation. Iceland did experience a severe housing bubble though, and there as elsewhere, the shells of uncompleted luxury condominium projects litter the countryside.  What is clear today, is that anybody holding Icelandic Krona at the 2008 rate of 90 to the Euro, has lost about half of their purchasing power with the current, capital control protected rate of 172.

The total quantity of Icelandic M1 and M2 in circulation over the 2003-2009 period in fact increased by about 10 times. Measurements of M2 can’t be compared exactly between countries, because they aren’t consistently defined, but driven by similar systemic factors, US M2 doubled in roughly the same time frame, and the Euro increases by about 50%. This would counterbalance the Icelandic increase to some extent, and any increased production would also have had a counterbalancing deflationary effect.  While it’s also certainly not the case that all currency is local, neither is all currency available for foreign currency trading.

Although the Icelandic Central Bank has been heavily and rightly criticised for its role in this, it has a  simple defense on the behaviour of the monetary mechanics. It followed the Economics textbook. It raised interest rates, to try and control the money supply expansion being created by a business culture that had devolved to simply making as many loans as possible, and extricating the proceeds abroad. All this achieved though, was to attract more foreign currency into the economy in pursuit of higher interest rates. Enabling increased expansion, and more loans, rather than the careful control and regulation suggested by Economics theory.  The Economics textbook is wrong at a very basic level, but since its false assumptions are so embedded and central to the discussion itself, it seems impossible to break its hold on the debate.

But perhaps we can start with a simple question.  In Economics’ textbooks, control of the money supply is consistently described as being solely the responsibility of the Central Bank, and for very good reason. Changes in the total supply of money effect everybody, double the money supply, halve the value of people’s savings. Weimar was just the extreme case.  So perhaps somebody could ask the Icelandic Central bank if they deliberately increased their money supply by ten times over the last 7 years?

And if they didn’t, who did?

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cc Credit Crises, Empirical Analysis, Exploits, Out of Real Time

When debugging complex systems, it can be useful to ask, “What’s missing?”. Especially when looking at  the available monitoring information, which tells you not only what the designers of the system thought it was important to know, but also by omission, what wasn’t. Critical realtime systems, we’re talking Nuclear Power plants and their ilk, are monitored fairly closely, but if the right information isn’t provided to the operator, then that won’t necessarily help all that much.

In this sense, it’s quite interesting that  Economics doesn’t seem to have  a definition of what money is, in any satisfactory, scientific sense. Rather it seems to have various descriptions of what money does. The “Money is a matter of functions four, a medium, a measure, a standard, a store.” dogeral that is found in some textbooks and on Wikipedia is the perfect illustration of this. This is not a definition of what money is, it’s simply a list of the things money is used for. This confusion can also be found in the various measures used to quantify the total amount of money in the Economy, which are variously M0, M1, M2, and depending on which country you’re in M3 or M4.

Interestingly, and perhaps damningly in the context of the current credit crisis, no single, monitored central bank measure appears to completely capture the information that is of most interest today – which is what is the total quantity of money that commercial banks and reserve based savings institutions are allowed to create loans against.

M0/Monetary Base

This is the “narrowest” definition of the money supply. The British, who technically invented the entire system, used to use M0, but since 2006 it’s the “Notes and coins and reserve balances” figure (YWMB43D), whilst the Federal Reserve simply refers to this as the Monetary Base, and reports it in the H3 Aggregate Series.  It is defined as the reserves from the Banks held on deposit by the Central Bank, and the total amount of physical currency. This measure probably made more sense under the Gold Standard than it does now, when a significant number of bank deposits don’t in fact carry a reserve requirement, and physical currency is simply printed to meet day to day demand.

Reserves held at the central bank used to be a very fixed, and important part of the system’s regulation, since this directly controlled lending. In that implementation of the system, the Commercial Banks had to deposit the reserve on deposits they were required to hold behind for each loan (i.e. the 10% fractional reserve requirement), at the central bank. For two simple reasons. It kept them honest, and it gave the Central Bank complete control, and indeed visibility, on the monetary expansion that was occurring. Assuming for example, that the Banks were correctly depositing their reserve on deposits at the central bank, then if that amount started growing, the central bank immediately knew that the loan supply was increasing and vice versa.

Only net transaction accounts in the US Banking system carry a reserve requirement currently, so that part no longer works very well. Even so – when the Federal Reserve saw the non-borrowed reserves drop by 25% in December 2007, and indeed go negative the following month, it was a clear warning sign of major systemic issues. The Bear Stearns collapse into bankruptcy would occur 3 months later in March 2008. How significant it is that there is also a fall in the British reserve measure, beginning in July 2006 and reaching its nadir in September 2007 before an abrupt recovery, is hard to say.

M1

M1 is technically physical currency and checkable deposits. Quite what it will be when it is no longer possible, as it will be and to a large extent already is in Europe, to write a cheque on a bank account, is an interesting question. It’s reported by the Federal Reserve as part of the H.6 dataset, along with its cohort M2, and they also helpfully break out the different components of M1 if you scroll down a little.

Broadly then, it’s physical currency and demand, or instant access checkable deposit accounts, which appear to be the Net Transaction Accounts for which there is still a reserve requirement. I have an HSBC internet savings account, it has no cheque book, pays a (very) small interest rate, and which i can transfer to and from using the Internet at will. Is it classified under M1 or M2? Does it have a reserve requirement? Does that even matter?

The last question is perhaps the most interesting. The answer appears to be both yes and no as it happens. Since reserve requirements are no longer used to directly regulate loan expansion – equity capital does that – then it doesn’t strictly matter if an account has a reserve requirement or not. Except of course, that the Banks can at the moment get quite a nice interest rate from the Federal Reserve on their reserves, which is why reserves so dramatically increased a year ago. Now there’s no correspondingly dramatic shift in the components of M1, so it looks like the Banks just dumped all their spare money onto the federal reserve – which lends some credence to the claim that this has inhibited lending. Except of course, that they’re still as busy as ever creating and  selling Asset Backed Securities.

M2

Strictly, M2 is all of M1 plus Bank savings accounts and Retail Money Funds. The Federal Reserve helpfully breaks out the non-M1 components of M2 as part of its H6 dataset, which makes life a little easier.

Now this is where it gets quite interesting. Retail Money Funds, which were a non-existent category at the beginning of 1959, and peaked in October 2008  at slightly over $1 trillion are around 15% of the total quantity of M2. Retail money funds are funds that generally provide an extremely safe return, that is expected to track the safest form of investment (government securities), and never not return their capital investment. They’re also expected to be very liquid, i.e. you can get your money back more or less on demand. This essentially means that they invest in short term debt securities, although only ones of very high quality. Like triple A rated, insured, top of the tranche Mortgage Backed Securities for example?

Leaving aside the interesting co-incidence that the growth of retail money funds begins in the same period as MBS were introduced (late 1973, sales don’t really kick off until the S&L crisis in the early eighties); just the total quantity of retail money funds indicates that some of them must be in MBS securities. There simply aren’t enough other suitably ’safe’ instruments paying a suitable rate of return otherwise. Which means that some proportion of the M2 money supply measure, is actually debt.

This helps to explain the divergence in the growth between M1 and M2, in the USA and other countries, since thanks to the Asset Backed Security loophole, debt is currently growing faster than money within the banking system. It also i think, provides a measure of proof, that the Central Banks really don’t understand what’s going on in the system these days. Because if they did, they would not publish statistics that obviously confuse money with debt, especially in a system where money is regulating the total quantity of debt, and vice versa. Of course, if they did understand that, then Banks wouldn’t be allowed to hold debt instruments in their equity capital holdings either.

M3

And then there’s M3. Which was somewhat notoriously, and to the great delight of the FRLF, discontinued by the Federal Reserve in 2006. If you want proof that many of the critics of the current banking system also have no idea how it actually works, threads on the Federal Reserves  discontinuance of M3 can be quite enlightening, if for no other reason than their blind assurance that it was a valid measure of the money supply.

But no, if you look at the largest, and towards its end, most rapidly growing components of M3, it’s Institutional Money Funds, followed by something called “RPS”. Institutional money funds are retail money funds writ large, and stuffed with those wonderful top tranche Asset Backed Securities. RPS are,  i believe i’m correct in saying, Repurchase agreements owned by the banks. Repo’s as they’re otherwise called are one of those interesting pieces of financial alchemy, whereby you sell a financial instrument to somebody, for cash, along with a guarantee that you will buy it back at a specified amount sometime in the future. It’s essentially a loan in return for an agreement to buy a loan.

Quite how you can get away with calling that part of any money supply measure, I have no idea.

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cc Credit Crises, Empirical Analysis, Fractional Reserve System

The latest Bank of International Settlement Figures are out for Asset Backed Security Issuance for September 2009. The total amount of outstanding international securitized loans  increased by approximately $1 trillion in the 3 months between June and September 2009. Based on the  USA’s stock market performance this last three months, I wouldn’t expect there to be a drop in issuance this quarter either, especialy since the Federal Reserve Banks are still the buyer of last resort. That puts the world on track for a total increase in issuance this year of around $3 trillion. There are some rather interesting questions hanging around relative valuation of financial instruments given that the unit is american dollars, and the dollar hasn’t being doing well of late, but that doesn’t effect the impact for the USA.

The Federal Reserve  expects to be able to stop buying Mortgage Backed Securities next March. It will certainly be quite entertaining if they try.

The gross figures are quite interesting. They do show that up to this point, securitization is predominantly a problem of developed countries, although issuance is starting to increase in the developing countries. The first credit crisis period also stands out clearly, and stands out as a drop in securitization. So a naive approach to the problem, would be to simply worry about that drop, and find ways to “restart the securitization pipeline”, which is pretty much the policy that has been both advocated and followed over the last year.

Consequently, the Federal Reserve Bank of America, wittingly or unwittingly, has put itself in an interesting situation. They can’t stop buying Mortgage Backed Securities, as soon as they do, the lending pipeline collapses again, and we get Credit Crisis II. Like all sequels, bigger and much worse than the first release. On the other hand, how long can they continue? Especially as the world’s financiers then turn around and just sell more of them. Thereby increasing the total amount outstanding by $1 trillion a quarter.

Any increase in the outstanding amount of Asset Backed Securities, increases the ratio of debt in the system, to money. Money is ultimately what has to be available to pay debt, so as the proportion of debt within the monetary system increases, there is less money to pay more debt. It’s a complex relationship, especially when variable rate interest payments start to get factored in, and it’s fair to say, one that the world’s financial authorities clearly don’t understand very well, if they think increasing the amount of securitized loans is a way out of this.

Outstanding securitization actually peaked in June 2008 at $25,300 trillion, and didn’t return to that peak until June 2009 this year, at $25,900 trillion. We’re now at $26,900 trillion.  However, trying to predict the next crisis point isn’t as simple as looking at the outstanding figures, and going gulp. In the background, the movement of debt instruments into equity capital is also wreaking its own share of havoc.

This is total liabilities and assets for the US Commercial Banks. It is not as simple as liabilities equals deposits, and assets equals loans, since for one thing the equity capital reserve is listed under assets (hence the excess over liabilities.) But it’s close enough for government work. These figures show the other side of the credit crisis, the debt failure induced contraction in the money supply – total deposits, and also the recovery this year, as the securitisation pipeline was restarted.

The contraction in the money supply as debt was removed from the system, either by foreclosure, or by loan repayment – is pure monetary mechanics – it’s a side effect of the other problems in the economy and a consequence of the linkage between money and debt created by the fractional reserve banking process. However, it has its own repercussions. In particular, it worsens the imbalance between money and debt being created by securitization. So in some sense, it’s just as well that didn’t continue too long.

But the price of an at most half trillion dollar increase in the US money supply, appears to have been over $1 trillion of securitized loans. And the money to buy those loans , was provided as a direct claim on the US tax payer. So it would seem, that ignorant of the underlying causes of the problem, the Federal Reserve is failing, to run the red queen’s race, as it tries to stop the housing market in the USA completely collapsing  from a fisher debt deflation.

Quite how long they can continue to sustain the banks with interest payments on their central bank reserves, presumably being funded from the proportion of securitized loans that they are receiving capital and interest repayments on is a very interesting question. What they’re doing to the rest of the economy in the process, even more so.

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cc Credit Crises, Empirical Analysis, Out of Real Time

In the textbook presentation of the Fractional Reserve Banking System, the example of the reserve redeposit process typically shows the expansion from the starting condition of an initial deposit. This is more than slightly misleading. The banking system that we have has been running more or less continuously, depending on which country you’re in, for several hundred years. The expansion from initial conditions can be presumed to be long past.

Theoretically then, we should be in a state where the money and loan supplies are fairly constant, or varying between known limits, and where the total commercial bank debt is 90% of the total money supply, assuming a 10% reserve requirement.

Clearly not in the world we’re living in. Especially the known limit part.

The explanation this blog is exploring, is that the primary reason for this is an interaction between the effects of  allowing loans to be sold in the form of Asset Backed Securities, and using equity capital rather than reserves to control total bank lending.

At the macro-economic level Asset Backed Securities have effectively increased the total amount of loans outstanding in the economy, and have done that within the part of the loan supply that comes from fractional reserve operations, rather than say somebody going out and buying a Corporate bond or government security. The end effect of this is that the ratio of commercial bank originated loans to deposits is no longer a fraction of total deposits, but rather a multiple. For example, in addition to the approximately $10 trillion commercial bank assets (loans to the rest of us)  held by the United State’s commercial banks, must be added the outstanding amount of Asset Backed Securities that have been sold on by the commercial banks. The net outstanding total for Asset Backed Securities for the USA as of June 2009, was $6,5 trillion. Back of the envelope, and assuming that most ABS is held as part of equity capital, then probably at least $5 trillion is being held outside of the commercial banking system, by pension funds, insurance companies, and other entities that need a store of money.

The immediate question this raises then, is how many of these things are there out there, and which currencies or countries are worst effected?

I’m personally convinced you can get a rough idea just by counting building cranes and uncompleted luxury condo blocks in any major city at the moment. Tracking down actual figures is a little tricky. Most Central Banks don’t seem to publish separate statistics on ABS sales, or if they do they’re not readily identifiable. However, the Bank of International Settlements does put out some high level aggregated data. Quite what their source for it is, I have no idea, but it seems to be the best there is at the moment.

The chart above shows the quarterly totals of newly issued debt securities from table 12a, which includes Asset Backed Securities and Pfandbriefe (covered bonds). The data is quite interesting. For one thing, it indicates that the 2008 credit crunch was primarily a failure in issuance of Asset Backed Securities. The drop, early in the year, suggests that at $1 trillion in capacity was removed from the system, which is a lot of loans. Even though the visible symptoms of the credit crunch were in areas like letters of credit, and revolving credit, it was very probably a knock on effect from the removal of Asset Backed security credit. The other takeaway from the chart is the subsequent, central bank and government financed recovery to 2006 levels. Somewhat akin to treating gangrene with a band aid, really.

Working out which are the worst afflicted countries is problematic. Whilst $6.5 trillion is a lot of debt, the USA is a lot of country, and a very powerful economy. Ireland on the other hand, is a rather soggy island on the left hand side of Europe, and they’re currently sitting on $546 billion of the things. With a population of 5 million, that’s just over $100,000 each.

An alternative to normalizing by population is to normalize by GDP. The problem there is that loan financed activity, building luxury condominiums for example, is counted as part of GDP. It’s the Exon Valdez disaster problem again – measured purely by its contribution to GDP, cleaning up an ecologically catastrophic oil spill was economically beneficial because of the extra work and spending it caused. Normalised by population Ireland comes out 4 times worse than the USA, normalised by GDP the USA is twice as bad as Ireland. On either measure, Greece, Iceland, Ireland, the Netherlands, Spain and the United Kingdom, and of course the USA, all stand out. No surprises there.

So where does this all end up? Asset backed securities have proliferated throughout the western developed economies, so almost all countries are involved to a greater or lesser degree. Norway for example, which is sitting on the proceeds from their share of North Sea Oil, has still managed to accumulate an outstanding, per head of population amount of around $35,000. The closest the banking system has ever come to generating this kind of situation before, was probably in 19th century America, a period known for rampant bank failure. There were assorted reasons for this, but a fair amount of it was caused by deliberate fraud, in the form of banks making loans that exceeded their deposits, typically to colluding cronies, sorry, ‘business associates’ of the men controlling the banks. It seems possible that the total loan supply might at some points have exceeded the total money supply in the US during this period, even with the gold standard, but who knows. The American financial system at that period was regarded as a thieves charter by British economists, and even by some Americans.

In our modern age, though it is strictly illegal for individual Banks to lend more than their deposits; Asset Backed Securities have unfortunately managed to allow the entire banking system to do it.

No collusion required.

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cc Empirical Analysis, Lending

Central banks  are charged with regulating the money supply. Regulating not in the sense of rules, and laws, although they do form part of the framework it operates in. Regulating in the sense of controlling the quantity of. This is from the leaflet,  Modern Money Mechanics, published by the Federal Reserve Bank of Chicago in 1968, and last revised in June 1992:

From the standpoint of money creation, however, the essential point is that the reserves of banks are, for the most part, liabilities of the Federal Reserve Banks, and net changes in them are largely determined by actions of the Federal Reserve System. Thus, the Federal Reserve, through its ability to vary both the total volume of reserves and the required ratio of reserves to deposit liabilities, influences banks’ decisions with respect to their assets and deposits.

Bank’s assets are for the most part their loans.

The  commercial banking fractional reserve system introduces a rather strange money particle/loan anti-particle recursive relationship between some, but not all, of the loans in the monetary system.  This isn’t true for loans made to companies that borrow money through the bond market for example. They borrow money by selling an IOU, as does the Government when it borrows money using treasury certificates.  It’s only within the commercial banking system that money takes on this strange duality, and can expand and contract with the extension and default of loans.

What am i trying to say there. If a loan goes bad in the corporate bond market, then the company goes bankrupt, and my ownership of that bond gets me into the queue of creditors for a claim of assets and not much else. There are no money supply implications. The money i gave the company in return for a bond, is out there somewhere with whoever the company gave it to in return for goods, services, or a passport for tax free exile.  If a bank loan based on my bank deposit defaults however, I still have my deposit. But there is a deposit out there somewhere that should really disappear. That the current implementation doesn’t allow this to occur is one of the stresses on the system.

The bigger problem though, is that since there isn’t a fixed quantity of money within the commercial banking system, it depends after all on how much lending they’re allowed to do, it’s critically important to scrutinise what’s happening within the system quite carefully.  For example, if an expansion of credit is occurring, is it because the system is expanding within it’s allowed limits, or has it found a a way to circumvent them?

The Federal Reserve seems to believe that by controlling the money supply, it also controls the loan or credit supply.  It controls the money supply, by requiring the banks to hold a small portion of their total deposits either in physical bank notes, or on deposit with the federal reserve bank. Let’s look at money supply regulation first.

Leaving aside the banking system’s day to day liquidity issues in terms of satisfying customer’s demands for access to the funds in their deposits, it is arguably the case that it doesn’t matter how much the banks keep in reserve, or how much of that is on deposit at the central bank, as long as it is a fixed portion of the local bank’s reserves.

As long as some known fraction of the money represented in deposits is required to be held at the Federal Reserve (or in bank notes and coins), then the Federal Reserve can calculate what the total money supply is simply by multiplying. It can set what level it thinks is appropriate for that total, and adjust the reserve amount appropriately, or it can inject money to increase it, again by the known percentage that is anchored by the reserve. The only difference from that simplistic perspective, between a 1% and 10% requirement is how much you have to multiply by to get the total money supply. This is the textbook presentation of the reserve based system.

The statistics on commercial bank reserves, and the Monetary Base for the United States of America, are reported in Report H3 by the Federal Reserve. The Monetary Base is the simplest statistic on the quantity of money in the system, and is defined as the total  of commercial bank reserves held at the Federal Reserve, plus the total of printed/coined currency. To wit:

As you can see, things start to get a little funky on the right hand side there when the Federal Reserve starts trying to resolve the 2008 credit crisis. Let’s look at things before that happens though. This graph is showing the totals for all physical currency and the reserves. It is the reserves that are supposed to be regulating the money supply, “through its ability to vary both the total volume of reserves and the required ratio of reserves to deposit liabilities”. So all other quantities of money, within the fractional reserve system, should be derivable as some multiple of the reserve. (This incidentally, is i suspect where the Rothbard fallacy may originate. Individual banks lend a fraction of their deposits, however the federal reserve regulates their deposits, as a multiple of the reserve.)

Which unfortunately is not what is being shown in the chart above. Then again, what relationship should the total quantity of physical currency have, to the bank reserves? Physical currency isn’t controlled any more, in terms of a fixed relationship to reserves, rather it’s printed as needed. Even so, it’s reasonable to expect that that need would in some sense reflect a somewhat consistent percentage of the total quantity of money – which is essentially physical currency plus the sum total of all bank accounts. So the chart seems to show that the federal reserve is successfully keeping bank’s reserves constant, but either there has been a consistently growing demand for physical notes over bank accounts in the last four decades, or something else is going on.

The consistently growing demand for physical banknotes theory isn’t entirely discountable as it happens. The US dollar is accepted world wide, and a significant amount of physical cash is held outside the USA. That can be deduced simply from the large amounts that were found during and after the invasion of Iraq.

Digging a little deeper. M1 is the base measure of the actual money supply, and includes physical currency, demand deposits and other checkable deposits. Demand deposits are all bank deposits which allow immediate access, rather than savings accounts and similar, which require deposits to remain for a specified period of time. Looking at the historical data on the components of M1, from the Federal Reserve’s H6. Table 4, and please note the y-axis on this chart is in $ billions, whereas for the other two it is $ millions:

Interestingly, demand and checkable deposits do look like they are holding approximately stable in the last couple of decades at least. In fact they’re holding stable at roughly 10 times the reserves held by the central bank. So, the reserve requirement does appear to be successfully regulating the quantity of money held in demand and chequeing accounts. These in other words appear to be the Net Transaction Accounts, for which the banks are required to keep 10% either on deposit with the federal reserve, or present as physical cash in the bank vaults. So why then, is physical cash going up so much? After all, if the Federal Reserve is actually printing physical cash to increase the Money Supply, then the deposits wouldn’t be staying relatively constant, but would in fact be increasing to match.

Or in other words. Is physical cash being printed in order to increase the money supply, or is physical cash being printed because the money supply is increasing?  One last chart.

This chart shows the Total Reserve, the Monetary Base, M1, and the Total Liabilities of the US Commercial Banks from the H8 data series, table b1152a. Total Liabilities, is the sum of all the money deposited at the Banks by their customers, plus loans from other Banks. That table starts in 1973, and yes those are the right units.

What is the money supply? Is it just the checking accounts most people use for day to day cash, the Net Transaction accounts? Does it include savings as well? Physical cash in Iraq and elsewhere? There are economic arguments for and against counting each of those in fact, that’s why there are the different measures, Monetary base, M1, M2 and before it was discontinued M3.

If the money supply is just the amount held in Net Transaction Accounts, then the Federal Reserve is regulating it successfully. But that’s the only thing that is being regulated. Physical cash is clearly expanding, but that’s nothing besides the total amount of cash represented by deposits with commercial banks. The electronic money supply, the money that is represented as electronic 0’s and 1’s in a computer database somewhere is clearly growing exponentially. And has been for some time.

One definition of the money supply that isn’t explitly reported, but would seem to be fairly important in a fractional reserve system, would be the amount of money that the banks can lend a fraction of. As you might guess from the above chart, it certainly isn’t the amount held in Net Transaction Accounts.

So just as this post attempted to dissect the deposit side of the fractional reserve money/loan dichotomy in the context of the larger system, next time, we’ll look at the loan supply.

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cc Empirical Analysis, Prologue

All Banks licensed to operate within the United States of America have to file detailed quarterly reports on their lending and deposit status with the Federal Financial Institutions Examinations Council (FFIEC). These are known as banking Call Reports, and since 2001, are available for download, and public examination.

If there’s any kind of guide to reading and understanding them, I’ve yet to find it. Still, it’s amazing what can be done with python scripts, and a little patience.

There are two ways to get call reports – either as a consolidated set of files for all the banks per quarter, or individually per bank. It’s easier to understand call reports by looking at the individual consolidated ones, but for systemic analysis, the consolidated files can’t be beaten. It’s also useful to know that in the consolidated files, the Bulk POR report has the names, addresses and FDIC/IDRSSD numbers for all the Banks, which can otherwise be quite hard to find.

So, taking the Citibank FDIC #27606 call report for December 2001, we can  find the ratio of deposits, reserve and loans – at least, we can with a little decoding.

Deposits are known as liabilities in the alternative universe of Bank accounting. Total liabilities, are RCON2948; Total Equity Capital is RCON3210, and Total loans and leases are RCON2170. The forms aren’t completely consistent. For Wachovia, the RCON3210 field is missing, but RIAD3210 is listed as Total Equity Capital, Total Liabilities come under RCFD3300, Total loans are still under RCON2170 though. So in tabular form:

Then there is the question, which Citibank? For the big banks, there often seem to be several separate listings. There is also Citibank Delaware, Citibank New York State, Citibank Nevada, Citibank (South Dakota), and a couple of others.27606 is Citibank USA, using the form for a Bank with domestic offices only.

Another interesting question, in which field are the reserves? Equity capital is normally used to refer to the capital invested in a firm by its owners. So this would presumably be the capital reserve, which is the money used to found the Bank. It also matches the Tier 1 Capital entry, RCON8274.  Presumably then, the reserve of deposits referred to in textbooks, is not listed separately, but is simply the excess of deposits over loans. For which, for Citibank at least in December 2001, would appear to be  -$109,040,000. Interesting.

Actually, it gets worse further down the form. In RC-R the Regulatory Capital section, where Total Risk Weighted Assets are $2,470,549,000 (RCONA223).

Wachovia’s numbers also seems a little strange, since and at least in 2001, they were somewhat over capitalised. However, they seem to be reporting some kind of change to Equity Capital of $6,819,394,000 and it looks like they spent 2001 merging with First Union, which might explain it.Their Total Assets (loans) really are exactly equal to their Total Liabilities(deposits). I’m afraid most engineers, almost innately, tend to find exact matches like that suspicious as hell.

So from the empirical evidence, it seems that Banks can lend out as much as they have on deposit, and the Equity Capital reserve is in fact, the shareholders capital investment into the Bank, and is completely separate to the money deposited by the customers. Banks are required by the Basel treaties to maintain a minimum leverage ratio between theri Equity Capital and their Loans, which Citibank is within the limits of. (RCON7204-6). Presumably this explains why Citibank can get away with lending more money than it has on deposit, it’s still within its ratio with respect to its equity capital.

All the same, it seems a little strange. So, pausing only to drop this lot into a nice little sqlite database, next time I think we’ll look at the figures for some of the banks that have failed this year, versus some hopefully healthy ones, and also look at the situation across the eight years of data available.

One thing can be said though. The Murray Rothbard claim, that Banks can lend ten times their deposits, is shall we say, not supported by the available data.

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cc Empirical Analysis, Fractional Reserve System, Prologue