Steve Keen on Forbes: Banks Can't Lend Out Reserves

Hey Joe, Banks Can't Lend Out Reserves

http://www.forbes.com/sites/stevekeen/2016/02/12/hey-joe-banks-cant-lend-out-reserves/#671e82bb3faf

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I began another post critical of Joe Stiglitz’s analysis with the caveat that I like Joe. I’ll add to that that I respect his intellect too, both because he’s very bright—you don’t win a Nobel Prize (even in Economics!) without being very bright—and because compared to some other winners, he is very capable of thinking beyond the limitations of the mainstream.
But there are some mainstream concepts that are so deeply embedded in even highly intelligent, flexible thinkers like Joe, that they continue thinking in terms of them, when a bit of really serious thought would show that the concepts are in fact nonsense.
Some of these are so deeply embedded in the psyche of economists that they even permeate the alternate economic universe I work in—known as Post Keynesian Economics (even here I’m a bit of a maverick). I attended a presentation by a non-mainstream colleague recently, and while she was critical of the mainstream, she also seemed to agree with Joe on the same topic: that private banks can lend their excess reserves to the public.

NO. THEY. CAN’T.

Here’s Joe on this subject recently in Project Syndicate, in an article entitled “What’s Holding Back the World Economy?”:

As a result, excess reserves held at the Fed soared, from an average of $200 billion during 2000-2008 to $1.6 trillion during 2009-2015. Financial institutions chose to keep their money with the Fed instead of lending to the real economy, earning nearly $30 billion – completely risk-free – during the last five years.

As I’m about to explain, banks didn’t “choose to keep their money with the Fed instead of lending to the real economy”. They have no choice but to “keep their money with the Fed” and…

THEY. CANNOT. LEND. RESERVES. TO. THE. REAL. ECONOMY.

But the fact that economists believe they can matters—really matters—to the real economy right now, because giving private banks excess reserves via QE is the main tool that Central Bankers are using to try to attempt to revive the economy. Since the economy is still pretty sick, 8 years after the global economic crisis of 2008, and because we in the public are in effect their patient, it matters that they give this patient the right medicine.

AND. QE. IS. NOT. THE. RIGHT. MEDICINE.

“Quantitative Easing”: it sounds like a bowel movement. Did you ever imagine you’d even hear such a term, let alone find yourself discussing it over a beer with friends, as many of you probably have? This is the “Magic Bullet” that Central Bankers worldwide are relying upon to restart the global economy. And because in most countries it’s been far less effective than they expected, they’re blaming bankers for not doing their job, and lending the damn stuff to the public.
THEY. CAN’T. DO. IT.
For me, watching academic economists and Central Bankers (the vast majority of whom trained as economists) tell the banks to “lend your excess reserves to the public, dammit!”, is akin to watching some delusional person in a playground watching two kids playing on a see-saw, and criticising them because they weren’t both up in the air at the same time.
So why can’t banks do what the vast majority of economists believe they can and should do—lend the excess reserves that QE has created to the public? And why don’t economists realise that banks can’t actually lend reserves?
Here’s where I’m going to have to explain something to you that is, on the surface, really, really boring: accounting.
But it’s not, really. Yes OK, the day to day life of an accountant might be less exciting than, say, that of an airline pilot. But just like a pilot, they have some arcane knowledge which makes doing what they do both intellectually challenging, and very, very useful to the public. The useful stuff pilots know is beyond me (but I implicitly and happily rely on it every time I fly); the useful stuff accountants know is double-entry bookkeeping.

Why don’t economists know this themselves? Today’s economists simply don’t study it—just like they don’t study history either (“Great Depression? Never heard of it.”). Economists of Joe’s generation often did learn accounting as undergraduates—it was often then required as part of an economics degree—but very few of them ever integrated accounting concepts with their economics.
There are good reasons for that in general: economics can’t be reduced to accounting, just as biology can’t be reduced to organic chemistry (if it could, we’d know how to create life). But just as you can make mistakes in biology if you have a theory that requires chemically impossible reactions to take place, you can make mistakes in economics if your economic theory relies on processes that defy the laws of accounting.
And there is a “Law of Accounting”: that “Assets equal Liabilities plus Capital”. And the belief that banks can lend out their reserves (excess or otherwise) violates the Law of Accounting.
I didn’t learn accounting at University; instead, I’ve learnt it the hard way as I designed an Open Source software package to simulate monetary flows that I named Minsky (in honor of the great non-mainstream economist Hyman Minsky; you can read about and download Minsky for free from here).
Minsky implements this Law, so it lets me show that banks can’t do what Central Bankers (and Joe Stiglitz) think they can do—lend reserves to the public. Most economists, on the other hand, believe in a model of money creation known as “the money multiplier”, which is an intimate part of the concept of “Fractional Reserve Banking”, in which lending reserves to the public is what banks actually do.
In this model, if the Central Bank creates say $1 trillion, and the “Required Reserve Ratio” is 10%, then that $1 trillion of new reserves in banks will create $10 trillion worth of money in the real economy—so that the value of the “money multiplier” is 10. This is the model that Obama’s economic advisors used to convince him that the best way to rescue the economy from the crisis in 2009 was not to give money directly to the public, but to give it to the banks, and for them to then lend to the public:

And although there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks – “where’s our bailout?,” they ask – the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth. (“Obama’s Remarks on the Economy”, April 14 2009)
That is poppycock. The actual amount of money that banks can lend to “families and businesses” out of $1 trillion of new reserves is not $10 trillion, but $0. Zip. Nada. Nil.

THE. MONEY. MULTIPLIER. IS. ZERO.

Therefore, the $1.4 trillion of excess reserves that QE has created in the USA alone  has added precisely $0 to the lending power of banks.
To understand why, you’re going to have to follow me down the arcane path of double-entry bookkeeping.
Double-entry bookkeeping is a set of conventions that mean that financial transactions are accurately recorded. One part of it, the so called Accounting Equation, is easy enough to follow: it simply says that if you subtract your Liabilities from your Assets, what’s left over is your Capital:
Assets minus Liabilities Equal Capital.
The hard bit to follow is the set of conventions that accountants have developed to make sure that each transaction they record is done so correctly. This involves the use of the terms DR (for Debit) and CR (for Credit), and rules about which term is used which vary depending on whether the account is an Asset, a Liability, or Capital.
I’ve implemented those in Minsky, but because I find them confusing—as many students of accounting do—I’ve developed another convention that is also quirky, but I think easier to follow. It has two rules:

1. All transactions are shown as a positive entry for the originator, and a negative entry for the recipient; and
2. Assets are shown as positive sums, while Liabilities and Capital (which I normally call Equity, since the word “Capital” has very different meanings in economics than in accounting) are shown as negative sums. Showing a Liability as a negative makes sense: from the point of view of the entity represented by the table, a liability is a negative. The counter-intuitive bit is showing equity as a negative too, but if you do that then you get the check on your logic that every row must sum to zero. 

So a double-entry bookkeeping view of lending $100,000 by a bank, payment of $5,000 in interest, and repayment of $50,000 of the debt, looks like Table 1:

Table 1: A double entry view of lending, interest payments, and debt repayment

Action	Assets (+ive)		Liabilities  (-ive)	Capital  (-ive)	Row Sum
	Loans	Reserves	Deposits	Bank
Starting position	0	0	0	0	0
Lend money	+100000		-100000		0
Pay interest			+5000	-5000	0
Repay money	-50000		+50000		0
Final position	50000	0	-45000	-5000	0

Note that every row sums to zero—as it should—and creating a debt increases the bank’s assets (and liabilities) while repaying the debt reduces them.

Now what about the idea that banks can—and should—lend out the excess reserves that QE has created for them? How does that idea look in a double-entry bookkeeping table? In a word, it looks impossible.
The first stage is the Central Bank makes a loan to the Private Bank—say of $1 million. That is shown in Table 2, and at this point the accounting is accurate. QE itself is both an asset for the banks, and a liability: they get the reserves from the Central Bank, and they are liable to return them to the Central Bank if it asks for them. So that row—“QE from Central Bank”—sums to zero as it should.

Table 2: QE increases both the assets and the liabilities of the Private Banks

Action	Assets (+ive)		Liabilities  (-ive)		Capital  (-ive)	Row Sum
	Loans	Reserves	Debt to CB	Deposits	Bank
Starting position	0	0		0	0	0
QE from Central Bank		+$1mn	-$1mn			0
Final position		+$1mn	-$1mn			0

But “lending from reserves?”. If a bank lends its reserves, its assets fall: it has to make a negative entry in its Reserves column. But to show that the money has been lent to the public, you need a negative entry in the Deposits column as well. So the row sum for that operation in Table 3 is not zero, as it should be. The bank simply can’t lend out its reserves.

Table 3: How “lending out excess reserves” looks in a double-entry bookkeeping table

Action	Assets (+ive)		Liabilities  (-ive)		Capital  (-ive)	Row Sum
	Loans	Reserves	Debt to CB	Deposits	Bank
Starting position	0	0		0	0	0
QE from Central Bank		+$1mn	-$1mn			0
Lend out excess reserves		-$1mn		-$1mn		-2000000
Final position		0	-$1mn	-$1mn		-2000000

Notice another problem. While the bank has—somehow—given money to its depositors, according to Table 2, it hasn’t recorded that it’s lent them the money. As it stands, as well as bad accounting, this is a free gift from the banks to the public (heaven forbid that that might happen!).

What if the bank tries to fix up this mess by adding an additional row to record the loan? Then you get the mess shown in Table 4. It shows that the impact of a bank attempting to “lend out its Reserves” results in the bank’s assets remaining constant (loans have risen by $1 million while Reserves fall by the same amount) and its liabilities rising by $2 million (the $1 million received from the Central Bank in QE and the $1 million it’s “lent” to the public).

Table 4: Attempting to fix the error simply creates a bigger mess

Action	Assets (+ive)		Liabilities  (-ive)		Capital  (-ive)	Row Sum
	Loans	Reserves	Debt to CB	Deposits	Bank
Starting position	0	0		0	0	0
QE from Central Bank		+$1mn	-$1mn			0
Lend out excess reserves		-$1mn		-$1mn		-2000000
Record Loan	+$1mn	-$1mn
Final position	+$1mn	-$1mn	-$1mn	-$1mn		-2000000

What if the bank lends from its excess reserves liability to the Central Bank, rather than from its assets? That, at least is technically feasible, as shown in Table 5: the Law of Accounting is not violated. But just as with Table 4, so far the Bank has given money to its depositors but not recorded that it’s made loans to them: can’t have that!

Table 5: Lending from reserves as a liability

Action	Assets (+ive)		Liabilities  (-ive)		Capital  (-ive)	Row Sum
	Loans	Reserves	Debt to CB	Deposits	Bank
Starting position	0	0		0		0
QE from Central Bank		+$1mn	-$1mn			0
Lend out excess reserves			+$1mn	-$1mn		0
Final position	0	+$1mn	0	-$1mn		0

Table 6 records the loan, by adding a $1 million asset in the Loans column. To balance the row, the bank has to record minus $1 million in the “Debt to CB” column—thereby undoing the effect of “lending from reserves” in the first place.
The final situation has Reserves increasing by $1 million (because of QE) and Loans increasing by $1 million as well (because of the loan to the public), but Reserves have now played no role in the lending: they are back to where they were after QE.

Table 6: Bank records the loan and the lending from Reserves disappears

Action	Assets (+ive)		Liabilities  (-ive)		Capital  (-ive)	Row Sum
	Loans	Reserves	Debt to CB	Deposits	Bank
Starting position	0	0		0	0	0
QE from Central Bank		+$1mn	-$1mn			0
Lend out excess reserves			+$1mn	-$1mn		0
Record Loan	+$1mn		-$1mn			0
Final position	+$1mn	+$1mn	-$1mn	-$1mn		0

This is, if you’ll pardon the pun, the bottom line: reserves play no role in lending at all, regardless of QE. The “Money Multiplier” model is a myth.
But that myth is the basis of the attempt by Central Banks to rescue the world from the economic crisis. It’s little wonder that that rescue attempt isn’t going as smoothly as planned.