Some light has been shed on the 'mystery' in the previous post. The Federal Deposit Insurance Corporation, which is in charge of exactly what it sounds like, was unable to collect insurance premiums for 10 years (1996 - 2006).
From what I can tell - the news is new to me - banks are required to pay 1.15% of deposits as premiums to the FDIC. Unfortunately, the FDIC wasn't actually given any power to collect the premiums with.
As a result, while the banks were doing well, they refused to pay the premiums, and the FDIC's holdings fell to about 0.4% of insured deposits.
Once they were no longer doing well... that was a little too late to start paying.
So, YES, given this situation, a sharp drop in the reserve ratio could very well cause a bank run with no safety net.
Also, YES, this is as silly as it sounds. As a Consumerist commenter put it, "I kind of like this logic. I mean, I've paid homeowners insurance for a good long time and it hasn't caught on fire so far--so they should just be content with the money they have collected and continue to cover my risk free of charge."
Wednesday, March 11, 2009
Why doesn't the fed lower the required reserve ratio?
One of my students came up with a very interesting question.
US banks are still logjammed with toxic assets, and the US government is spending a lot of money it doesn't have bailing them out.
The same government is spending yet more money on a stimulus package.
Why doesn't it kill two birds with one stone and lower the required reserve ratio? Currently, it's at 10% for a large class of liabilities. (Full details at the link.)
For non-economists: Banks are in the business of lending money, not storing it. They want to lend as much as possible, and charge interest for it. The problem is that every now and then, depositors knock on their door and ask for their money back. In cash. At once. Because of this, banks can't lend ALL the money they receive. They need to keep some in reserve. The reserve ratio is the percentage of the money they take in that they need to keep in storage, just in case. In the US, this is 10%, by law (with some exceptions, see the link). In Canada, we haven't had a legally mandated reserve ratio since 1994. Our banks keep about 4.5% reserves.
Suppose the US lowered its mandatory reserve ratio to 5%, which is still higher than the ratio that Canadian banks chose on their own. All of a sudden, banks would have a whole bunch of extra cash on hand to work with. Well, okay, so most of it wouldn't actually be cash, but the idea's the same.
Provided you believe that giving bailout money to the banks will help them, then you should also believe that allowing the banks to dip into their piggy banks should help them.
The main exception to this that I can think of is that if the drop in reserve requirements is too quick and too large, investors could panic and cause a bank run. Because banks have most of their money tied up in loans and such, they can get into trouble if everyone asks for their money back at once. Mind, this trouble is always present...
A fall in the reserve ratio works very much like an injection of money, and will tend to boost the economy in the short run. (SOMEONE is getting that unfrozen money, after all.) In the long run, it all washes out, because eventually prices adjust to the new amount of cash. The kicker is that lowering the reserve ratio also 'powers up' later injections of money - so, if what the government wants to do IS pour money into the economy for a short-term band-aid while they figure things out, and if they're willing to put up with higher prices later on, lowering the reserve ratio would help.
So, why DOESN'T the US use the reserve ratio as a policy instrument? It's run out of wiggle room with interest rates, but there's still at least 5 percentage points of reserve ratio to play with before reaching Canada's level.
Some possibilities:
1. The most convincing one: after years of being stuck at 10%, lowering the reserve ratio may trigger financial panic and bank runs.
2. Maybe the US wants to avoid higher prices in the future - this is odd, given that recently there was a fear of deflation (falling prices).
3. The US may have other plans for its monetary policy that require tighter cash.
4. The US government doesn't bother because it doesn't think it would be effective - after all, banks are logjammed for other reasons. (Though I AM of the opinion that US banks doing their best to dodge reserve requirements by turning mortgages, which probably count against reserves, into other securities that don't, are part of what got us into this mess.)
This is a very good question that I don't have a satisfactory answer two. Comments encouraged.
As for the student, he's earned himself a bonus mark.
US banks are still logjammed with toxic assets, and the US government is spending a lot of money it doesn't have bailing them out.
The same government is spending yet more money on a stimulus package.
Why doesn't it kill two birds with one stone and lower the required reserve ratio? Currently, it's at 10% for a large class of liabilities. (Full details at the link.)
For non-economists: Banks are in the business of lending money, not storing it. They want to lend as much as possible, and charge interest for it. The problem is that every now and then, depositors knock on their door and ask for their money back. In cash. At once. Because of this, banks can't lend ALL the money they receive. They need to keep some in reserve. The reserve ratio is the percentage of the money they take in that they need to keep in storage, just in case. In the US, this is 10%, by law (with some exceptions, see the link). In Canada, we haven't had a legally mandated reserve ratio since 1994. Our banks keep about 4.5% reserves.
Suppose the US lowered its mandatory reserve ratio to 5%, which is still higher than the ratio that Canadian banks chose on their own. All of a sudden, banks would have a whole bunch of extra cash on hand to work with. Well, okay, so most of it wouldn't actually be cash, but the idea's the same.
Provided you believe that giving bailout money to the banks will help them, then you should also believe that allowing the banks to dip into their piggy banks should help them.
The main exception to this that I can think of is that if the drop in reserve requirements is too quick and too large, investors could panic and cause a bank run. Because banks have most of their money tied up in loans and such, they can get into trouble if everyone asks for their money back at once. Mind, this trouble is always present...
A fall in the reserve ratio works very much like an injection of money, and will tend to boost the economy in the short run. (SOMEONE is getting that unfrozen money, after all.) In the long run, it all washes out, because eventually prices adjust to the new amount of cash. The kicker is that lowering the reserve ratio also 'powers up' later injections of money - so, if what the government wants to do IS pour money into the economy for a short-term band-aid while they figure things out, and if they're willing to put up with higher prices later on, lowering the reserve ratio would help.
So, why DOESN'T the US use the reserve ratio as a policy instrument? It's run out of wiggle room with interest rates, but there's still at least 5 percentage points of reserve ratio to play with before reaching Canada's level.
Some possibilities:
1. The most convincing one: after years of being stuck at 10%, lowering the reserve ratio may trigger financial panic and bank runs.
2. Maybe the US wants to avoid higher prices in the future - this is odd, given that recently there was a fear of deflation (falling prices).
3. The US may have other plans for its monetary policy that require tighter cash.
4. The US government doesn't bother because it doesn't think it would be effective - after all, banks are logjammed for other reasons. (Though I AM of the opinion that US banks doing their best to dodge reserve requirements by turning mortgages, which probably count against reserves, into other securities that don't, are part of what got us into this mess.)
This is a very good question that I don't have a satisfactory answer two. Comments encouraged.
As for the student, he's earned himself a bonus mark.
Friday, February 6, 2009
Zimbabwe's self-destructing currency
Zimbabwe suffers from inflation of about 231 million percent a year. (Roughly, 5.5% a day.) There are many reasons for this, the most obvious being that the government keeps printing money. Like other goods, the value of money depends on the interaction of supply and demand. If the world is flooded with dollars, dollars fall in value.
The traditional first step toward slowing or stopping inflation is to stop printing money. Zimbabwe's central bank had a different idea... they'll keep the presses running, but the money will be printed with a built-in expiry date.
Very clever, even if didn't work.
The traditional first step toward slowing or stopping inflation is to stop printing money. Zimbabwe's central bank had a different idea... they'll keep the presses running, but the money will be printed with a built-in expiry date.
Very clever, even if didn't work.
Do banks create money?
(This is Tuesday's post, delayed due to midterms.)
There is a lingering belief among certain sections of the general public that the business of banks is to keep money safe. This belief is held alongside the knowledge that banks are in the business of lending money for profit. The money they lend is, in large part, that which they receive from their depositors.
The end result is that the sum of deposits is almost always greater than the sum of hard currency - banks 'expand' the money supply.
Often, this is explained as banks 'creating money' - while in some sense true, this is a very misleading description. Money is no more created by the banking system than water is created by freezing a lake. The density of water changes with heat, so that ice occupies a volume about 9% greater than the same mass of water at room temperature. While one could argue that this represents an increase in the 'amount' of water, to say water was created would be misleading.
Unfortunately, few articles take the time to explain in detail how the expansion of money works. This article, available free of charge from the Richmond Fed, is an exception. From its abstract:
"Beginning students of banking must grapple with a curious paradox: the banking system can multiply deposits on a given base of reserves yet none of its member banks can do so. Let the reserve-to-deposit ratio be, say, 20 percent and the system can, by making loans, create $5 of deposit money per dollar of reserves received. By contrast, the individual bank receiving that same dollar on deposit can lend out no more than 80 cents of it. How does one reconcile the banking system's ability to multiply loans and deposits with the individual bank's inability to do so?"
The article then explains the historical development of our understanding of the concept, and does it all with a minimum of algebra. Highly recommended reading.
There is a lingering belief among certain sections of the general public that the business of banks is to keep money safe. This belief is held alongside the knowledge that banks are in the business of lending money for profit. The money they lend is, in large part, that which they receive from their depositors.
The end result is that the sum of deposits is almost always greater than the sum of hard currency - banks 'expand' the money supply.
Often, this is explained as banks 'creating money' - while in some sense true, this is a very misleading description. Money is no more created by the banking system than water is created by freezing a lake. The density of water changes with heat, so that ice occupies a volume about 9% greater than the same mass of water at room temperature. While one could argue that this represents an increase in the 'amount' of water, to say water was created would be misleading.
Unfortunately, few articles take the time to explain in detail how the expansion of money works. This article, available free of charge from the Richmond Fed, is an exception. From its abstract:
"Beginning students of banking must grapple with a curious paradox: the banking system can multiply deposits on a given base of reserves yet none of its member banks can do so. Let the reserve-to-deposit ratio be, say, 20 percent and the system can, by making loans, create $5 of deposit money per dollar of reserves received. By contrast, the individual bank receiving that same dollar on deposit can lend out no more than 80 cents of it. How does one reconcile the banking system's ability to multiply loans and deposits with the individual bank's inability to do so?"
The article then explains the historical development of our understanding of the concept, and does it all with a minimum of algebra. Highly recommended reading.
Thursday, January 29, 2009
Overlapping generations... of jellyfish
So there's an immortal jellyfish...
Theologians and philosophers must be having a field day. Economists? I'm worried about whether the jellyfish pension system is fully-funded or pay-as-you-go.
Theologians and philosophers must be having a field day. Economists? I'm worried about whether the jellyfish pension system is fully-funded or pay-as-you-go.
Tuesday, January 27, 2009
A fun-to-read primer on banking and finance
19th century citizens were as bewildered and dismayed by 'modern' finance as we are. Enter Walter Bagehot, man of letters and editor of The Economist, who decided to clear up the confusion by writing a down-to-earth guide on what really goes on in the money market. His classic, 'Lombard Street', is surprisingly relevant and brisk reading today. The full text is available online.
For modern audiences, I recommend the following chapters:
1. Introductory - this chapter shows how a money market, for all its faults, can be of benefit to a country. It also explains how fractional reserve banking works.
2. A general view of Lombard Street - explains how reserves are managed by the central bank and other banks. This is done for both gold-standard and unbacked, fiat currency.
5. The mode in which the value of money is settled in Lombard Street - the title says it all. This short chapter explains how the value of money is determined in a money market, and goes into detail about exactly how much power the central bank has in this regard.
6. Why Lombard Street is often very dull, and sometimes extremely excited - this chapter explains business cycle fluctuations: booms and busts, good times and recessions. All from the point of view of the money market, of course.
The rest of the (short) book, while very interesting, relies too much on the particular circumstances of the time and country in which it was written for me to be able to recommend it as general reading.
For modern audiences, I recommend the following chapters:
1. Introductory - this chapter shows how a money market, for all its faults, can be of benefit to a country. It also explains how fractional reserve banking works.
2. A general view of Lombard Street - explains how reserves are managed by the central bank and other banks. This is done for both gold-standard and unbacked, fiat currency.
5. The mode in which the value of money is settled in Lombard Street - the title says it all. This short chapter explains how the value of money is determined in a money market, and goes into detail about exactly how much power the central bank has in this regard.
6. Why Lombard Street is often very dull, and sometimes extremely excited - this chapter explains business cycle fluctuations: booms and busts, good times and recessions. All from the point of view of the money market, of course.
The rest of the (short) book, while very interesting, relies too much on the particular circumstances of the time and country in which it was written for me to be able to recommend it as general reading.
Friday, January 23, 2009
An early beer ad
Advertising jingles are not new. Watkin's Ale is a beautiful beer ad from 1580, often played in concert by early music groups. Then, as now, sex sells: the ballad is a description of how a maiden surrendered her virtue for Watkin's Ale, finding it a fair trade.
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