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So my next question is: What is the definition of "credit expansion" ?

"Fractional reserves" covers two different but related phenomena:

- having more total face-value in banknotes liabilities outstanding than there is specie assigned as reserves

- having more total face-value in deposits liabilities outstanding than there is specie assigned as reserves

Without fractional reserves, demand-deposit accounts are where the bank acts as a storehouse and gains an income from renting vault-space and charging fees for use of its transaction facilities. A bank can then only lend out of cash put in by investors, be those investors the stockholders or the buyers of debt of various maturities. Physically, a bank can make those loans either by handing over notes to a borrower or by crediting the borrower's account. A bank can issue extra loans either by issuing notes in excess of reserves of cash put in by investors or by lending specie out of cash put in by demand-deposit customers. Either way, those extra loans are the credit expansion, which is called such in contrast to credit growth arising from increases in the real supply of capital from investors.

Among other things, von Mises was noting that the mechanics of the two types of fractional reserves are different but still arrive at the same result, and that both were different again from an increase in the quantity of gold as money where that difference of gold to fractional reserves was quantitative as well as mechanical. He was also noting that the hot-button issue was not about action of people acting rationally in a laissez-faire economy but about people arguing the relative merits of various proposals for law in a non-LFC economy combined with the manipulation of public opinion in pursuit of their sociopolitical agendas (for example, the Act of 1844 he spoke of gave the monopoly on notes issue to the Bank of England, and which law was based on recognition of the consequences of the first type of fractional reserves but failure to recognise the same consequences arising from the second type).

JJM

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those extra loans are the credit expansion

OK, so the theory seems to be saying that credit expansion is possible under laissez-faire capitalism, but wouldn't be prevalent because the gold standard is an efficacious check against it--and thus, most banks would operate with 100% reserves. Is that right?

My view is different from that. I think most banks would have less than 100% reserves; the gold standard would prevent them from lowering their reserve rates arbitrarily and encourage them to set a rational reserve target--one which is high enough to cover the level of demand for specie that can be reasonably expected, but low enough to profit as much as possible from loaning out the unneeded gold.

As for central banking and fiat money, the theory appears to be assuming that the mechanism by which the central bank lowers interest rates is the same kind of "credit expansion," right? The difference being that here there is no check against it. Again, my view is different: the operation of the central bank is based on the confiscation of gold and on treasury bonds--both of which take capital away from productive enterprises and move it into the hands of the government. This is a contraction of "credit," not expansion. When the Fed is lending its assets at low interest rates, it's acting like a robber offering to sell you back the stolen goods at a cheap price. When it demands high interest rates, it's like the same robber demaning a high price.

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OK, so the theory seems to be saying that credit expansion is possible under laissez-faire capitalism, but wouldn't be prevalent because the gold standard is an efficacious check against it--and thus, most banks would operate with 100% reserves. Is that right?

My view is different from that. I think most banks would have less than 100% reserves; the gold standard would prevent them from lowering their reserve rates arbitrarily and encourage them to set a rational reserve target--one which is high enough to cover the level of demand for specie that can be reasonably expected, but low enough to profit as much as possible from loaning out the unneeded gold.

That's fine. I don't think the theory is saying what you've described. What it is saying is that this would not cause an economic boom of the sort we are accustomed to.

As for central banking and fiat money, the theory appears to be assuming that the mechanism by which the central bank lowers interest rates is the same kind of "credit expansion," right? The difference being that here there is no check against it. Again, my view is different: the operation of the central bank is based on the confiscation of gold and on treasury bonds--both of which take capital away from productive enterprises and move it into the hands of the government. This is a contraction of "credit," not expansion.

The central bank can go into the Treasury market and buy 10 billion dollars worth of Treasuries with money is creates by debiting its account and crediting the sellers accounts. This is credit expansion. Your view may be different, but it's wrong. Central banks do not contract credit, they expand credit. As proof, you should take a look at the balance sheet of the Fed in 2005 and then take a look at it now. If the central bank contracted credit, then the Liabilities side of its balance sheet should have fallen, since it is liable for every note it creates.

This is not the case. The balance sheet of the Fed has expanded practically every year since its creation.

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Capital≠Credit
Furthermore, when the government starts to throw a spanner in the works:

Credit deserved/earned ≠Credit actually granted

Government intervention typically results in an increase in aggregate credit granted, but a decrease in aggregate credit deserved/earned.

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OK, so the theory seems to be saying that credit expansion is possible under laissez-faire capitalism, but wouldn't be prevalent because the gold standard is an efficacious check against it--and thus, most banks would operate with 100% reserves. Is that right?

Almost. Unless the practice of fractional reserves were rejected by all customers, all that a fully functional gold-coin standard will do is see that the reserve ratio is high, and so the extent of credit expansion will be low. The final step to 100% reserves is dependent on the decisions of individual banks and their customers.

the gold standard would prevent them from lowering their reserve rates arbitrarily and encourage them to set a rational reserve target--one which is high enough to cover the level of demand for specie that can be reasonably expected, but low enough to profit as much as possible from loaning out the unneeded gold.

You're asking the impossible, because there is no rational basis on which to formulate a fractional reserves policy. All reserve ratios other than 100% are arbitrary.

The story of the idle gold is a fallacy, because the extra loans are turned into someone else's income which then gets put into their demand deposit accounts. That starts the credit multiplication process, which does not end until the amount of gold in vaults "sitting idle" comes back to pretty much the same as it was before the process got started. The only difference is the extra (and undue) credit generated.

As for central banking and fiat money, the theory appears to be assuming that the mechanism by which the central bank lowers interest rates is the same kind of "credit expansion," right? The difference being that here there is no check against it.

No. The system we have today did not exist in von Mises' time. In his day, gold was the root of money and the total money supply could only be expanded through gold mining, note expansion, or private credit expansion. In that system the central bank could directly do the middle, and could encourage the third by dictating minimum reserve and capital adequacy ratios, dictating key rates, and other hands-on means. Now that we have fiat money, the distinction between gold and notes is gone, central banks are less hands-on than they use to be, and the money supply is primarily extended through the physical and electronic printing press controlled by the central bank. The central bank nowadays influences interest rates and total credit via usurpation of market mechanisms using moneys created with those presses.

Again, my view is different...

You really need to do research on the mechanics of both Treasury bond issues and Open Market Operations.

JJM

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Bait and switch.

Capital≠Credit

Furthermore, when the government starts to throw a spanner in the works:

Credit deserved/earned ≠Credit actually granted

Government intervention typically results in an increase in aggregate credit granted, but a decrease in aggregate credit deserved/earned.

Could you guys elaborate a bit more on what you mean there?

(Gotta go now; I'll read and respond to John's post when I'm back from my skiing trip on Monday.)

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The story of the idle gold is a fallacy, because the extra loans are turned into someone else's income which then gets put into their demand deposit accounts. That starts the credit multiplication process, which does not end until the amount of gold in vaults "sitting idle" comes back to pretty much the same as it was before the process got started.

Could you elaborate on this? Are you saying that there is going to be a vicious cycle of reducing reserves?

You really need to do research on the mechanics of both Treasury bond issues and Open Market Operations.

Which part of what I wrote do you disagree with?

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Could you elaborate on this? Are you saying that there is going to be a vicious cycle of reducing reserves?

It's a matter of actually following the physical process of what happens to the gold during the multiplying up of credit, as identified in any respectable book on the subject. Every time the bank lends out money (as gold or as claims to gold) the borrower eventually spends it. That spending becomes someone else's income, which that person then deposits back into the banking system. Some is kept as reserves, and some is forwarded to another borrower. From that borrower the process repeats, to yet another's income and back as deposits into the banking system again. Each time it cycles around the amount lent out gets smaller and smaller, until the total amount kept as reserves is - surprise surprise - pretty much the same amount of physical gold as existed before the banking system went fractional. Grand total reserves remain the same in absolute - which is the refutation of the fallacy of the idle gold - but they go down as a proportion of what they are reserves for when the fraction the banking system keeps is pushed down.

There is a minor complication, not often discussed in the basic treatments in the textbooks. This is the discussion I had with Adrock. In LFC the process is limited, and so it truly is a 'pretty much the same' as above because the increase in total money supply is minimal, which in turn doesn't devalue gold all that much. In non-LFC the process goes much further, can devalue the monetary component of the value of gold considerably, and cause notable reductions in total gold held in vaults as reserves because it's cheapening increases its non-monetary use. Happiness at the prospect of that, and pursuit of government intervention to do so, was one of Adam Smith's more notable deviations from laissez-faire.

As for central banking and fiat money, the theory appears to be assuming that the mechanism by which the central bank lowers interest rates is the same kind of "credit expansion," right? The difference being that here there is no check against it. Again, my view is different: the operation of the central bank is based on the confiscation of gold and on treasury bonds--both of which take capital away from productive enterprises and move it into the hands of the government. This is a contraction of "credit," not expansion. When the Fed is lending its assets at low interest rates, it's acting like a robber offering to sell you back the stolen goods at a cheap price. When it demands high interest rates, it's like the same robber demaning a high price.

...

Which part of what I wrote do you disagree with?

First, you're confusing what the Treasury does with what the Central Bank does. It is Treasury that borrows by issuing government bonds, where all the Central Bank does is act as an auction house. Via the central bank, the Treasury borrows from various institutions (predominantly banks and insurers etc, and in the US also Social Security as a constituent of that alleged lock-box, and so on) by selling them fixed-interest debt assets. So far, that much isn't credit expansion, just an example of lending for consumption. If that were all that happened then, yes, this action would act as credit contraction because it is reducing the amount of credit available for business lending. But, this is separate from the issue of the central bank changing interest rates.

Second, you're getting the sequence of cause and effect wrong as well as totally misunderstanding how Central Banks operate. Credit expansion by central banks is exactly that, an expansion. But, it does not lower rates by pursuing credit expansion - it generates credit expansion by lowering rates, and it lowers rates by inflating the money supply.

Central banks don't seek to lower interest rates in general, but usually are aimed at one in particular: the overnight cash rate that banks lend to each other at. Normal banks all have accounts with the Central Bank in its capacity as a clearinghouse, called Exchange Settlement accounts (in Australia anyway, maybe named differently elsewhere), which are used by the normal banks to settle up with each other on their customers' net drawings and deposits of cheques and transfers etc at the end of the day. If a particular bank doesn't have enough to settle up all that it owes to other banks that night it can borrow the shortfall from other banks on an overnight basis (banks can also borrow directly from the Central Bank itself, but banks try to avoid that because it is onerous and is a trigger to the Central Bank raising awkward questions).

Central banks lower this interest rate by printing money (today, in the form of book-keeping entries) and using it to buy (*) assets from the normal banks at above-market prices in Open Market Operations. As it happens, the assets so bought by the Central Bank are the private banks' holdings of Treasury bonds. This puts more money in the banks' ES accounts, which lowers their demand for overnight credit, and so puts downward pressure on the overnight cash rate. The Central Bank keeps on throwing in more and more book-keeping money, continually buying assets, until the overnight rate is at its official target as set by Board policy in those infamous rates-setting meetings they have. The net result, in a disgustingly convoluted manner, is that the Central Bank monetises Treasury debt and the extra money becomes additional funds for private banks to lend. There is thus increased lending in total (ie credit expansion), both of lending to the government (the purchase of T-bills and bonds) and to the private sector.

(* Technically, it is not buying but a more complicated transaction called a repurchase agreement, repo for short, but it works out to be the same thing with churn thrown in)

In the more uncommon event that is genuine credit contraction, the Central Bank does the opposite. It sells assets back to the banks who have excess amounts in their ES accounts (at below-market prices), which puts upward pressure on the overnight cash rate. The Central Bank keeps on soaking up money from ES accounts by selling assets until, again, the actual overnight cash rate becomes the target rate. The banking system as a whole then has less left over to lend to the private sector. This is what is true credit contraction, but it is associated with rising rates rather than falling rates.

None of this is about the Central Bank setting any interest rates by direct diktat. They used to do that, but not so much any more. Today it is the jawboning of the market and the flashing of cash as required so as to lower interest rates to suit Treasury's desires not to pay high rates. As I said, it is now done by the manipulation of market mechanisms, via OMO's. The force involved is still there, but is at the much deeper level of the damn capital adequacy rules that give special preference for Treasury debt. It is because of those capital adequacy rules - the Basel I and Basel II accords - that the private banks (and others like insurance companies) will 'voluntarily' buy Treasury debt in the first place even though the returns are very low. A bank can choose not to buy those debts, but it is penalised for it in its ability to lend and also misses out on the opportunity to sell them to the Central Banks for capital gains. Those who toe the line will have more freedom and more opportunities to make money.

JJM

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Normal banks all have accounts with the Central Bank in its capacity as a clearinghouse, called Exchange Settlement accounts (in Australia anyway, maybe named differently elsewhere),

Great post John! By the way, for Cap and others, these accounts are called Reserve Accounts in United States Fed jargon, and the overnight rate between banks is called the Fed Funds Rate.

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It's a matter of actually following the physical process of what happens to the gold during the multiplying up of credit, as identified in any respectable book on the subject. Every time the bank lends out money (as gold or as claims to gold) the borrower eventually spends it. That spending becomes someone else's income, which that person then deposits back into the banking system. Some is kept as reserves, and some is forwarded to another borrower. From that borrower the process repeats, to yet another's income and back as deposits into the banking system again. Each time it cycles around the amount lent out gets smaller and smaller, until the total amount kept as reserves is - surprise surprise - pretty much the same amount of physical gold as existed before the banking system went fractional. Grand total reserves remain the same in absolute - which is the refutation of the fallacy of the idle gold

I do not find this result surprising at all, so I have to ask what you refer to as "the fallacy of the idle gold" in the first place. My premise has not been that the gold will somehow disappear from the banking system, but simply that the same amount of gold can serve as more money.

but they go down as a proportion of what they are reserves for when the fraction the banking system keeps is pushed down.

Yes, precisely--in other words, the supply of gold becomes a smaller proportion of the money supply, i.e. the money supply increases without the supply of gold having to increase. None of this is very surprising.

First, you're confusing what the Treasury does with what the Central Bank does. It is Treasury that borrows by issuing government bonds, where all the Central Bank does is act as an auction house.

But both are agencies of the same government, so the actions of both are really just the government acting. And the long-term net effect of the government's actions, through borrowing and then causing inflation to make repayment easier, is to suck away the nation's wealth from productive investments.

Credit expansion by central banks is exactly that, an expansion.

What is the essential defining characteristic of "credit expansion" ? You explained it in terms of the actions of a private bank under the gold standard, so I'm not sure how it translates into a central banking scenario.

it generates credit expansion by lowering rates

This is another way in which central bank "credit expansion" seems to differ from the private kind.

Central banks lower this interest rate by printing money (today, in the form of book-keeping entries) and using it to buy (*) assets from the normal banks

[...]

(* Technically, it is not buying but a more complicated transaction called a repurchase agreement, repo for short, but it works out to be the same thing with churn thrown in)

Which brings us to another disagreement I have with not only Austrians but most economists in general: I think a repurchase agreement is something very different from an outright purchase. The former is essentially a loan (and a temporary monetization of the assets in question), while the latter is a permanent monetization of the assets involved. Therefore, the former puts a downward pressure on interest rates (and temporarily swells the money supply), while the latter acts to permanently increase the money supply--and does not have any more effect on interest rates than an increase in gold mining would in a laissez-faire economy. (Which is to say: if anything, it increases interest rates in the longer run, by raising inflation expectations.)

This puts more money in the banks' ES accounts, which lowers their demand for overnight credit, and so puts downward pressure on the overnight cash rate.

If a bank has an above-target amount of money on its reserve account, you can rest assured that it won't let it stay that way for long. It may use the surplus reserves to buy some stocks, or bonds, or to make additional loans, or to run an advertising campaign--but whatever it ends up doing, the extra cash is going to be invested some way, and the bank's reserve level is going to be reduced back to the target. The further fate of the extra cash is then going to depend on the decision of whoever sold whatever the bank bought--and so on, similarly to what I said about newly-mined gold in a previous post (starting from "Anyway, the reason I asked...")

So an outright purchase of Treasury Bonds by the Fed is not going to have a direct effect on the demand for or supply of overnight credit and therefore on the overnight funds rate; all it does is increase the money supply. What does influence the supply of overnight credit is when the Fed supplies some overnight (or similar) credit itself, by the means of repurchase agreements.

A repurchase agreement represents no permanent addition to the money supply because it includes a clause mandating its own extinguishment. It would be possible for the Fed to be a ready supplier of overnight credit through repurchase agreements, keeping interest rates at a healthily low level, while at the same time avoid increasing the money supply too much by abstaining from outright purchases.

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So an outright purchase of Treasury Bonds by the Fed is not going to have a direct effect on the demand for or supply of overnight credit and therefore on the overnight funds rate; all it does is increase the money supply. What does influence the supply of overnight credit is when the Fed supplies some overnight (or similar) credit itself, by the means of repurchase agreements.

This is incorrect, and it may be because of a bit of ambiguity in John's post.

The Fed has a trading desk in NY that communicates with the trading desks of the so-called "primary dealers" (keep in mind that the Open Market Ops of the Fed are only done with an approved list of 18 or so primary dealers...you can find the list on the NY Fed's website here). Let's say that the Fed wants to lower the Fed Funds rate through credit expansion. How would this transaction occur?

First, the Fed's trading desk would call the primary dealers and say that they want to buy (say) 10 billion of Treasury notes. The primary dealer and the central bank will negotiate a price for the bonds based on prevailing market prices. This is a requirement of the primary dealer's agreement with the Fed. Here are the specific requirements, taken from the NY Fed's website here:

As in the past, all primary dealers will be expected to (1) make reasonably good markets in their trading relationships with the Fed's trading desk; (2) participate meaningfully in Treasury auctions and; (3) provide the trading desk with market information and analysis that may be useful to the Federal Reserve in the formulation and implementation of monetary policy.

Ok, so the Fed has called the primary dealer and stated that it wants to inject reserves into the banking system by purchasing 10 billion of Treasuries, and the primary dealer has to do business with the Fed by nature of its status as a primary dealer. So, after negotiating a price, the Fed will credit the reserve account of the primary dealer by the amount of the purchase. The Fed's balance sheet will change in the following manner:

Asset Side: Security Holdings +10 billion

Liability Side: Reserves +10 billion

The balance sheet of the primary dealer will change like so:

Asset Side: Securities -10 billion, Reserves +10 billion

Liability Side: No effect

In effect, the liabilities of the Fed have increased by the additional 10 billion of reserves that it created out of thin air, while its assets have increased by the 10 billion of additional securities that it now holds. It's balance sheet has simply expanded. Note that the Fed is the only entity in the world that can expand or contract its balance sheet at will. No private corporation would be able to do this, but the Fed can because it has the ability to create reserves (money) from nothing. The net effect of the entire purchase is a 10 billion increase in reserves in the banking system, and the corollary 10 billion increase in the Monetary Base (remember that MB=R+C, where R is 'reserves' and C is 'currency in circulation').

The transformation of the additional reserves into credit is an effect of the realization on the part of the primary dealer that it now has reserves in excess of its reserve requirements. Holding onto the reserves by keeping them in their account at the Fed will cost them the associated opportunity cost of not lending them out. Therefore, the primary dealer will choose to use its excess reserves either to make loans, or to purchase securities. Regardless of which is choosen, the effect on credit expansion is the same. The Monetary Base has increased because reserves have increased, and M1 increases in proportion to the magnitude of the so-called money multiplier. Another way to say this is that the supply of loanable funds has increased (i.e. a bunch of money was created from nothing), and therefore the overnight (Fed Funds) rates will decrease.

The primary source of credit expansion is NOT repurchase agreements (John McVey is wrong here, right now its actually through the Term Auction Credit Facility and through the mysterious 'other loans' entry). You can see the Fed's balance sheet here. You will need to scroll down to item 7 titled, "Consolidated Statement of Condition of All Federal Reserve Banks." Here is a picture of the asset column from last Wednesday (Dec 3) with the relevant item highlighted in red:

post-4304-1228864313_thumb.jpg

As you will note, Repos account for 6.54% of the Fed's assets (80,000/1,223,186) as of Dec. 3. The week of Nov. 26 they were zero.

Edited by adrock3215
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The primary source of credit expansion is NOT repurchase agreements

I'll have to ask you too for your definition of credit expansion. I am interested in knowing:

  • What you think is its essential defining characteristic;
  • Whether it means an increase of the money supply; and/or
  • Whether it means a lowering of some interest rate.

I think the process you described is how the Fed increases the money supply, which is distinct from how it manipulates interest rates.

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I think the process you described is how the Fed increases the money supply, which is distinct from how it manipulates interest rates.
To be precise, the Fed does not actually expand credit itself; rather, it sets in motion a process that typically leads to credit expansion. It only takes the first step; the banks typically do the rest.

This first step is: increasing bank reserves. The idea is that when banks find they have more reserves than they are required to hold, they will lend more. [Lend more = credit expansion, in this usage.]

Today, we're in a situation where banks are not stepping up their lending even though the Fed has increased bank-reserves. One reason is that other than the reserve-ration, banks must also adhere to a capital-requirement ratio. Since banks were writing down billions, and expecting billions more to be written down, they were fearful that their capital would go below the legal limit. So, even though their reserve ratio was looking good (after the Fed's short-term reserve pumping), they still did not lend. This is the reason the government then decided to put money into banks in the form of capital.

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I have to ask what you refer to as "the fallacy of the idle gold" in the first place.

It is refutation of one of the original justifications proposed for the practice of fractional banking, the idea that most people aren't going to withdraw in specie all at once, so rather than it sitting in the vault doing nothing it might as well be out in the economy circulating instead. I thought you were raising this argument again by reference to making use of unneeded gold. If that is not what you had in mind then we're talking past each other.

But both are agencies of the same government, so the actions of both are really just the government acting.

No, the Central Bank in a modern economy is supposed to be independent of Treasury. People get upset if there is suspicion of Treasury interfering with that independence (I'm presuming a similar attitude in the US as I find down here, but I've had my fingertips singed on that score in this thread before now). It is as foolish to blithely lump them together as "just government acting" as it is to do the same with say the Supreme Court and the White House. The Central Bank's priorities may be quite different to those of Treasury, including to the great consternation of the latter at times, just as the Supreme Court may sometimes derail the White House's plans.

And the long-term net effect of the government's actions, through borrowing and then causing inflation to make repayment easier, is to suck away the nation's wealth from productive investments.

Yes.. and this capital destruction is distinct from monetary flows as you yourself have noted. The destruction of real capital (seeds, machinery, etc) is caused by the expansion of financial capital (inflation-generated extra debt and equity) because the messing around with the latter causes malinvestments of the former. The ABCT is a description of how there is a connection between the two that exhibits a hysteresis effect, and of what influences the size of that hysteresis. That hysteresis is the basis of the economic cycle, and is made possible only by the heavy use of some variant of fractional reserves.

What is the essential defining characteristic of "credit expansion" ? You explained it in terms of the actions of a private bank under the gold standard, so I'm not sure how it translates into a central banking scenario.

Credit expansion is the expansion of the debt component of financial capital ahead of investor's increase in provision for supply of real capital as intended for use at a risk-return level associated with debt funding. This causes those who demand real capital (businesses and consumers) to mistake the increase in financial capital for an increase in the supply of real capital.

Private banks do it by funding credit expansion directly via fractional reserves, and increase the money supply as a consequence of those actions. The Central Bank does it by increasing the basis of the money supply directly and then getting the private banks to do the overt act of credit expansion by lending out of that increased money supply. The Central Bank is thereby taking advantage of the normal bank's pre-existing (and further encouraged) fractional reserve practices, further increasing the money supply some more, and setting them up to take the blame when it all goes sour.

This is another way in which central bank "credit expansion" seems to differ from the private kind.

It is a difference of motivation and details on mechanics, but not so much of result. The lowering of a particular interest rate by the Central Bank is part of the motivation, or at least the rationalisation for the motive. By lowering the cost of capital there will be more demand for it and hence more jobs as it gets invested. Private banks don't care about the rate of interest being at any particular level, they just want to make money and use lower costs of debt as the means to attract borrowers. Either way, the lowering of interest rates below what investors are happy with at a given risk level and using credit expansion to maintain that lowness in defiance of investors leads to malinvestment of real capital.

I think a repurchase agreement is something very different from an outright purchase.

On the face of that alone, you're right, yes, it is different. What I said was that its use in practice in bulk amounts to the same thing as an outright purchase PLUS CHURN. To maintain the improperly low interest rate the Central Bank will have to continually renew expiring repos plus initiate more, at an accelerating pace. It amounts to the same effect as the Central Bank merely buying some outright and adding to its holdings over time with new money it creates. But anyway, Adrock corrected my mistaken assumption that the details of your Federal Reserve System's OMO's were the pretty much the same as those of the Reserve Bank of Australia.

while the latter acts to permanently increase the money supply--and does not have any more effect on interest rates than an increase in gold mining would in a laissez-faire economy.

You're missing it because you're focusing on individual transactions while overlooking the accelerating churn with the continual-net-expansion direction.

(Which is to say: if anything, it increases interest rates in the longer run, by raising inflation expectations.)

AHHA! The magic words, "in the longer run"! There is a difference between the short run and the long run, which is the basis for the above hysteresis effect. The Central Bank has to accelerate its expansion of the money supply because the flow-on effects of that expansion eventually causes people's inflation expectations to rise, which causes them to increase their required ROR's. What the Central Bank is doing is trying to stay ahead of those expectations' effects on the interbank overnight loan market. It can do so for a while, but not - as you note - in the long run. The long run then finally catches up with the Central Bank, and so it has to make the stark choice between raising the Fed Funds target on the one hand or descending into hyperinflation in the other. I swear, Roland, we'll make an Austrian out of you yet :)

If a bank has an above-target amount of money on its reserve account, you can rest assured that it won't let it stay that way for long.

Quite. The banks draw down those accounts for other uses (including this being the mechanism by which - in Australia at least - physical notes and coins are taken from the Central Bank and put into the general economy), which is why there is routinely a need to cover shortfalls when they overdo it! But...

The further fate of the extra cash is then going to depend on the decision of whoever sold whatever the bank bought--and so on, similarly to what I said about newly-mined gold in a previous post (starting from "Anyway, the reason I asked...") ... So an outright purchase of Treasury Bonds by the Fed is not going to have a direct effect on the demand for or supply of overnight credit and therefore on the overnight funds rate; all it does is increase the money supply.

... but you're missing the context in which those repos / purchases are made and why the proceeds are put into those ES/reserve accounts. The proceeds lower the Fed Funds rate because they lower the demand for debt to pay off the shortfalls. That means those with an excess in those accounts then have to go to the trouble of withdrawing funds for use elsewhere, but there will still be at least some market for lending to other banks - just at a lower rate so as to attract banks with shortfalls to borrow from them instead of selling assets / repos to the Central Bank.

A repurchase agreement represents no permanent addition to the money supply because it includes a clause mandating its own extinguishment. It would be possible for the Fed to be a ready supplier of overnight credit through repurchase agreements, keeping interest rates at a healthily low level, while at the same time avoid increasing the money supply too much by abstaining from outright purchases.

Again, you're missing how churn will be on the march. The Fed is there, every night, increasing its repo book or making net purchases, constantly adding in new dollars to do so, in order to maintain the interest rate on overnight interbank credit at the Fed Funds target. The 'too much' will come about eventually.

JJM

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I'll have to ask you too for your definition of credit expansion. I am interested in knowing:

  • What you think is its essential defining characteristic;
  • Whether it means an increase of the money supply; and/or
  • Whether it means a lowering of some interest rate.

I think the process you described is how the Fed increases the money supply, which is distinct from how it manipulates interest rates.

This is an incorrect statement. These two actions are not distinct, they are intimately connected. Here's how: The Fed manipulates the interest rate through its control of the monetary base. There are three ways that the Fed implements its policy decisions:

  • Open Market Operations
  • Setting Reserve Requirements for the banking system
  • Loaning directly to financial institutions through the Discount Window

Several more mechanisms are currently in effect during this financial crisis, but it is said that these are temporary and will be eliminated when the crisis passes. Therefore, they are not in any sense a primary way of conducting monetary policy. Moreover, the last two are not used often to implement policy. That leaves Open Market Operations. You can see on the NY Fed's website here the importance of these. I will bold the important parts. Let me quote from it:

Open Market Operations: The Bank implements monetary policy primarily by conducting temporary and permanent open market operations. By buying and selling government securities, the Bank affects the aggregate level of balances available in the banking system, and thus impacts the federal funds rate.

This statement right here, taken directly from the Fed's website, already disproves the final statement of your post. Probing the site deeper, it tells us what the Fed Funds rate actually is: "The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight." Then, the site shows the two channels of Open Market Operations:

  • "Temporary open market operations involve repurchase and reverse repurchase agreements that are designed to temporarily add or drain reserves available to the banking system."
  • "Permanent open market operations involve the buying and selling of securities outright to permanently add or drain reserves available to the banking system."

I detailed this process in my post above, and showed that the overwhelming percentage of Open Market Ops are the so-called "permanent open market operations."

I hope this is clear. If not, I present the following graph comparing the growth in percentage terms of the Monetary Base (remember MB=R+C, as I defined above). As you will notice, the Monetary Base growth rate is high when the FFR is low, and vice versa. That's why one is at a peak when the other is at a trough. Conclusion: Growth in the Monetary Base and the FFR are intimately connected.

post-4304-1228920054_thumb.gif

Now, I am going to answer your question about credit expansion while disagreeing with softwareNerd. He wrote: "To be precise, the Fed does not actually expand credit itself."

The Fed does create the initial expansion of credit. The key point is that fiat money IS credit. Whether or not the Fed is creating reserves or running the printing press, it is creating bills of credit, i.e. dollar bills, and it is liable for them in the future. It used to be that the Fed was liable for redemption of a bill in gold; now, the Fed will take your dollar bills and give you more dollar bills, because we are not on any hard money standard anymore. Regardless, the fact remains that the printed bills are a liability of the central bank. The central bank is liable for the dollar bills in the economy, and the reserves that financial institutions hold in accounts at the Fed--that is why both are subsumed as credit.

A credit expansion means an increase in the supply of credit in the economy. Since fiat notes are bills of credit, when they are printed, credit expansion is occuring. Since reserves are credit, when reserves are injected into the banking system, credit expansion is occuring. The Fed itself is the primary source of credit expansion. The secondary source is financial institutions, who transform the MB into M1 (MB+demand deposits) in accordance with the magnitude of the money multiplier, as I showed in the above post. In a gold-standard economy, the medium of exchange is not in and of itself a bill of credit, it is a tangible asset with intrinsic value. This is the primary difference. We can go on a discuss a free, gold-standard economy, but I really do think that you should look around on the NY Fed's website and really understand at least how monetary policy is decided upon and subsequently implemented in the context of our current fiat system.

Edited by adrock3215
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The idea is that when banks find they have more reserves than they are required to hold, they will lend more.

Yes, the supply of overnight credit is going to increase in nominal terms--but so is the demand for overnight credit, since the entire money supply has increased.

To give an example with simple numbers: Suppose that the monetary base is initially $100, and the money multiplier 10, making a money supply of $1000. Suppose further that at the interest rate of 2.5%, both the demand for and the supply of overnight reserve loans equals $40, making that rate the equilibrium rate. Now, if the Fed injects an additional $50 of reserves, the monetary base will be $150, and the money supply $1500--making everything 1.5 times as expensive as before. The demand and supply curves for overnight reserve loans would also be expanded by the factor of 1.5 along the $ axis, meaning that the equilibrium would be at 2.5% and $60.

Obviously, this is a very simplified and unrealistic example--but I think it does illustrate the essence of what happens in reality: the eventual effect is to increase the supply of money, not of overnight credit.

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Obviously, this is a very simplified and unrealistic example--but I think it does illustrate the essence of what happens in reality: the eventual effect is to increase the supply of money, not of overnight credit.
Yes. Essentially, the Fed pumps in high-powered money, hoping that banks will multiply it into a deposit base via credit creation.
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The destruction of real capital (seeds, machinery, etc) is caused by the expansion of financial capital (inflation-generated extra debt and equity)

This real/financial capital distinction is another Austrian thing whose connection to reality I'm not sure about. What exactly does the theory say is the relationship of the two? In an ideal laissez-faire world, would all capital be "real," or is there room for "financial" capital there? My own position is that all debt and equity instruments are claims to some real wealth (although it is possible, of course, for that real wealth to change in value, so the nominal value of the instruments is just that: nominal).

The ABCT is a description of how there is a connection between the two that exhibits a hysteresis effect, and of what influences the size of that hysteresis.

Whoa, and I thought I was beginning to understand the theory. I've never heard it described from this angle before. Could you write some more on the nature of this connection, and how it relates to your previous account of the business cycle?

Credit expansion is the expansion of the debt component of financial capital ahead of investor's increase in provision for supply of real capital as intended for use at a risk-return level associated with debt funding.

OK, so this is another thing for which I need to know what is meant by the real/financial capital distinction (and also by "the debt component of financial capital"), so I'll wait for your response on that. Plus, I am curious about what is the "investor's increase in provision for supply of real capital"--is that simply the making of investments (via things like CODs and bonds, presumably?) or is it something else?

To maintain the improperly low interest rate the Central Bank will have to continually renew expiring repos plus initiate more, at an accelerating pace.

Renew, I understand--but why does it need to initiate more? Because of the rising inflation expectations? But that presupposes that there is inflation, but I don't think there would be any if the Fed just maintained the same level of repos, without doing outright purchases.

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This statement right here, taken directly from the Fed's website, already disproves the final statement of your post.

Not quite, because there are two different kinds of open market operations:

  • "Temporary open market operations involve repurchase and reverse repurchase agreements that are designed to temporarily add or drain reserves available to the banking system."
  • "Permanent open market operations involve the buying and selling of securities outright to permanently add or drain reserves available to the banking system."

I maintain that the eventual effect of permanent operations is just a permanent addition to the money supply, and that it is the temporary operations (i.e. repurchase agreements) that are used to manipulate the overnight lending rates.

I detailed this process in my post above, and showed that the overwhelming percentage of Open Market Ops are the so-called "permanent open market operations."

(Chuckle) What you showed is that the Fed's balance sheet contains a lot of securities held outright and not as many repurchase agreements, which is not at all surprising given that an outright purchase becomes a permanent addition to the balance sheet, while a repurchase agreement only stays there until it expires. So the current balance sheet includes all outright purchases ever made (minus any outright sales, which I think are rare), but only those repurchase agreements that have been made recently and have not yet expired. The figures we would need are the ones showing the total dollar value of outright purchases within a given period, vs. the total (not net) dollar value of repurchase agreements made in the same period.

I hope this is clear. If not, I present the following graph comparing the growth in percentage terms of the Monetary Base (remember MB=R+C, as I defined above). As you will notice, the Monetary Base growth rate is high when the FFR is low, and vice versa. That's why one is at a peak when the other is at a trough.

Actually, the chart seems to make my point: the two graphs are not always symmetric, and in fact both appear to exhibit a distinct downward trend in the long term.

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I maintain that the eventual effect of permanent operations is just a permanent addition to the money supply, and that it is the temporary operations (i.e. repurchase agreements) that are used to manipulate the overnight lending rates.

The point is that monetary base is increased by injecting reserves into the banking system. When banks have excess reserves, they lend them out in the various credit markets, but primarily to other banks and financial institutions via the Fed Funds market.

(Chuckle) What you showed is that the Fed's balance sheet contains a lot of securities held outright and not as many repurchase agreements, which is not at all surprising given that an outright purchase becomes a permanent addition to the balance sheet, while a repurchase agreement only stays there until it expires. So the current balance sheet includes all outright purchases ever made (minus any outright sales, which I think are rare), but only those repurchase agreements that have been made recently and have not yet expired. The figures we would need are the ones showing the total dollar value of outright purchases within a given period, vs. the total (not net) dollar value of repurchase agreements made in the same period.

You made another mistake in this paragraph. It is not rare for the Fed to outright sell securities. They do that all the time. In fact, the Fed has actually sold 300 billion of Treasury securities since July. The expansion of the balance sheet is occuring right now via the new channels put in place during this financial crisis. Either way, when Greenspan was raising rates a few years back, Treasuries were being sold by the Fed. What will happen after this crisis passes is that the Fed will again sell Treasuries and raise interest rates in order to cool the coming inflation. That's why the smart money is shorting Treasuries right now.

Regardless, there is no such thing as a "permanent addition" to a balance sheet. All entries are susceptible to change. If you've taken accounting, you know that a balance sheet captures only a particular moment in time, not a period of time. It therefore reflects all of the current assets, liabilities, and capital of the firm (Fed in this case). If you think that balance sheets never change, you should take a look at the balance sheet of GM...that thing is total garbage. Balance sheets change every day if a company is publicly traded, because the value of the total equity worth of the company changes. For instance, since Assets=Liabilities+Equity, either Liabilities have to fall, or Assets have to rise when the stock value increases.

Now, you can look at the Fed's balance sheet at different points in time historically (week by week, every Wednesday), and see that Repo's are a very minor part of monetary policy implementation, and as such, have little to do with the manipulation of the Fed Funds rate.

Actually, the chart seems to make my point: the two graphs are not always symmetric, and in fact both appear to exhibit a distinct downward trend in the long term.

Cap, I feel like we're on different planets here. The chart should not be symmetric. If money growth is correlated to the FFR, then a higher % growth rate in the monetary base should correspond to a lower FFR, and a lower % growth rate in the monetary base should correspond to a higher FFR. That is precisely what the graph shows. When the Fed has a low target FFR, the rate of growth in the MB has been high, and vice versa. That's why the peaks on one line correspond with the troughs on the other.

Edited by adrock3215
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This real/financial capital distinction is another Austrian thing whose connection to reality I'm not sure about. What exactly does the theory say is the relationship of the two?

It is not a peculiarly Austrian distinction. Real capital is the physical stuff, composed of all the various assets a business uses to produce value. Financial capital is claims to a share in the real capital or fruits of its use, based on how each claimant contributed funding to pay for the real capital, and is composed of debt and equity.

In an ideal laissez-faire world, would all capital be "real," or is there room for "financial" capital there?

They go together. One cannot have real wealth without someone having a claim upon it of some kind. The movement of one type of capital affects and causes movement in the other. It happens, however, that the movements of one type of capital can be influenced by factors independent of what is happening to the other, but because they are connected those movements affect the other in due time too. In the LFC world those external influences would all only be the respective market forces for each type and subtype of capital, and the relationship between the two main types would be much easier to sort out and act upon.

My own position is that all debt and equity instruments are claims to some real wealth (although it is possible, of course, for that real wealth to change in value, so the nominal value of the instruments is just that: nominal).

Of course the instruments are claims to real wealth. Part of the issue at hand is that the printing up of more claims to real wealth does not increase the total amount of viable real wealth. It just dilutes the value of each claim, and messes around with the flow of real wealth. The extra real assets produced aren't actually viable, so they are wasted. That process of wastage continues for so long as that dilution hasn't spread and settled.

Whoa, and I thought I was beginning to understand the theory. I've never heard it described from this angle before. Could you write some more on the nature of this connection, and how it relates to your previous account of the business cycle?

I knew it was a mistake to mention hysteresis. Don't worry about it, it would make things worse trying to explain a bad analogy.

I am curious about what is the "investor's increase in provision for supply of real capital"--is that simply the making of investments (via things like CODs and bonds, presumably?) or is it something else?

Each year there is yay much physical resources produced, which could be directed towards the production of consumer goods or the production of producer goods. How people spend their money determines the relative proportions. The supply of real capital means the desire to direct resources in favour of the production of the real capital, which investors do by turning their money to the buying of new financial capital (and also by allowing businesses retain some or all of the earnings). The businesses then use the proceeds of the sale of that financial capital, or the earnings so retained, to buy resources to make production goods with, ie more real capital.

Credit expansion is the increase in one of the subtypes of financial capital other than by investor's desires to shift their balance of spending towards the production of real capital. It makes the users of real capital think that investors want to supply more funding for real capital than they actually do, causing those users to invest in the wrong real assets in detail and too much real assets in aggregate, both causing the resources to be wasted and thus the assets not represent true additions to real capital.

Renew, I understand--but why does it need to initiate more? Because of the rising inflation expectations? But that presupposes that there is inflation, but I don't think there would be any if the Fed just maintained the same level of repos, without doing outright purchases.

Yes, because of inflation expectations. The whole thing starts when the Fed first acts to push the actual funds rate below its natural rate, and it necessarily spirals from there for so long as that actual rate is lower than the natural rate. The increase in money supply will show up eventually in the form of increasing general prices. That consequence, and the expectation of that consequence, push up the natural rate of interest because people increase their inflation premiums to compensate. That then becomes felt in the reserve accounts because of people's actions affecting the bank's activities. So, to keep the actual funds rate down at the official target the Fed has to push harder and harder against a rising natural rate, which they do by creating more and more money to buy up assets from the banks. But that is adding fuel to the fire! It cannot be a one-off, and cannot be sustained merely by maintaining the same repo book or net holdings of T-bonds. It becomes a cycle triggered by the first appearance of the gap between the funds rate and the natural rate of interest, and which accelerates as the gap increases because the action to maintain that funds rate is pushing up the natural rate.

JJM

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