April 7, 2014
Enquiring Minds Want to Know: Is David
Malpass Correct about Fed Tapering?
Back on March 13, David Malpass, president of Encima
Global LLC, wrote an op-ed for The Wall
Street Journal entitled “The
Fed's Taper Is Already Paying Off”. In this op-ed, Malpass argues that the
Fed’s purchases of securities, aka Quantitative Easing (QE), have inhibited
bank lending to small businesses, aka job creators. Malpass has observed that
with the Fed’s commencement of the tapering of its QE in January and February
of this year, bank lending has accelerated. Malpass argues that the slowing in
QE is the reason bank lending has
accelerated. Malpass concludes that the Fed’s tapering of its securities
purchases is, in and of itself,
bullish for the US economy.
Having mellowed (decayed?) since becoming eligible for
Medicare, I now normally would read an op-ed like that of Malpass, chuckle, and
then go practice my bass guitar. As a matter of fact, I cancelled my
subscription of The Wall Street Journal
several years ago because of the consistently poor analytical quality of its
economic-related op-eds. So, I would not
have run across Malpass’s (Strunk says to add the “s” after the apostrophe)
op-ed if it were not for some of the readers of my doggerel calling my
attention to Malpass’s op-ed. Given that I have argued in recent commentaries
that, all else the same, Fed tapering is bearish for nominal US economic activity and the behavior of
risk-asset prices, some of my readers asked my opinion of Malpass’s thesis.
Well, if enquiring minds want to know, here goes.
“Rather than
creating or printing money, as is often assumed, the Fed borrows heavily from
banks to buy bonds … In 2013 alone, the
central bank borrowed nearly $1 trillion from the banking system. It wasn't
created out of thin air. It is recorded as a liability of the Fed and an asset
for banks… The Fed didn't create any extra currency or private bank deposits.
To make their loans to the Fed, banks had
to reduce other assets.” [emphasis added]
These comments by Malpass negate an important lecture
given in every Money and Banking 101 course. That lecture explains how a
central bank can stimulate nominal spending in an economy by purchasing
securities in the open market. In a monetary system in which banks are required
to hold only a fraction of their deposits as cash reserves with the central
bank, the banking system is able to
generate new amounts of credit and
deposits that are some multiple of
the dollar amount of securities purchased by the central bank. Ever since
Professor Chester A. Phillips articulated the deposit and bank credit
multiplier back in 1920, enrollees in most Money and Banking 101 classes have
been taught that central bank purchases
of securities stimulate bank credit (the asset side of the
banking system’s balance sheet) and bank
deposit (the liability side of the banking system’s balance sheet) expansion
. So, Malpass’s argument that Fed purchases of securities “didn’t create any
extra currency or private deposits … and [t]o make loans to the Fed, banks had to reduce other assets” represents a
new theory of money and banking that certainly deserves critical scrutiny. So
let’s scrutinize.
Let’s go through the accounting of a Fed purchase of
securities. (This would be a less tedious exercise if I knew how to draw
T-accounts in Word, but I don’t. So, if you are interested in reviewing the
lecture in Money and Banking 101, brew a pot of coffee before going on.) The Fed conducts its securities purchases and
sales with certain designated (primary) government securities dealers. These
dealers are essentially conduits between the Fed and ultimate sellers/purchasers
of Treasury and Agency securities. If the Fed solicits offers on securities it
wants to purchase, these primary dealers, in turn, contact their customers
– e.g., banks, insurance companies,
pension funds, mutual funds – with bids to purchase securities from them.
Assume that Primary Dealer A purchases $100 of securities
from Pension Fund B and simultaneously
sells these $100 of securities to the Fed. Let’s follow the “money”. The Fed
credits Primary Dealer A’s bank account at Bank A for $100. On the books of
Bank A, the cash asset item “deposits at the Fed” goes up by $100 and the
liability item “deposits payable to Primary Dealer A” goes up by $100. On the
books of the Fed, the asset item “securities owned outright” goes up by $100
and the liability item “deposits payable to Bank A” goes up by $100.
Let’s pause here to contemplate what has taken place. The
Fed has purchased $100 of securities from Primary Dealer A and Primary Dealer A
now has $100 more in deposits (and
$100 less in securities) than it had
before the transaction with the Fed. From whence did this $100 increase in
Primary Dealer A’s deposits come? From me? From you? No, from the Fed. And from
whence did the Fed get these deposits? It created them figuratively “out of
thin air”.
Okay, let’s get back to the story. Remember that Primary
Dealer A simultaneously purchased
$100 of securities from Pension Fund B while selling $100 securities to the
Fed. Pension Fund B needs to be paid for the $100 of securities. Primary Dealer
A, immediately upon notice that its deposits at Bank A have been increased by
the Fed, orders Bank A to transfer $100 to the deposit account of Pension Fund
B at Bank B. On the books of Bank B, the cash item “deposits at the Fed” goes
up by $100 and the liability item “deposits payable to Pension Fund B” goes up
by $100. From whence did the $100 increase in Pension Fund B’s deposits come?
From the deposits of Primary Dealer A. From whence did the $100 of deposits of
Primary Dealer A come? From the Fed. And from whence did the $100 from the Fed
come? From thin air.
Alright, let’s complete the bookkeeping. With the payment for securities to Pension
Fund B, on the books of Bank A, the cash item “deposits at the Fed” goes down
by $100 and the liability item “deposits payable to Primary Dealer A” goes down
by $100. The only change on the books of the Fed is that the liability item
“deposits payable to Bank A” changes to “deposits payable to Bank B”.
Pension Fund B and the economy as a whole now have $100
fewer securities and $100 more deposits. More than likely, but not
definitively, Pension Fund B will want to purchase some new earning assets to
replace the $100 of securities it sold via Primary Dealer A to the Fed. Given
that the Fed has bid down the yield
on government/agency securities as a result of its QE purchase of such, maybe
the pension fund will want to replace the $100 of securities it sold with some
higher-yielding (and, thus, riskier) securities – say corporate bonds or
securities backed by auto loans. Whatever securities purchased by Pension Fund
B to replace those ultimately sold to the Fed, Pension Fund B will be paying
for its new securities acquisition with funds ultimately created out of thin
air. This means that the Fed’s securities purchase has added $100 of net new credit to the economy, credit
created out of thin air. And that means that the recipients of this net new
credit can increase their current spending on something – a good, a service, an
asset – while no other entity need pare back its current spending.
If, for some reason, Pension Fund B chose not to replace the $100 of securities it
ultimately sold to the Fed with acquisitions of new securities /loans, then
credit to the economy would not decline,
but rather, would be unchanged. The
sale of securities to the Fed does not
reduce credit to the economy. It simply changes the name of the creditor from Pension Fund B to the Fed. No credit has been withdrawn as a result of this. So, at worst, Fed purchases of securities in
the open market do no harm with
respect to credit creation for the economy. If Pension Fund B chooses to
replace some or all of the securities it ultimately sold to the Fed with the
acquisition of new securities/loans, then Fed purchases of securities will have
resulted in a net increase in
thin-air credit to the economy.
Now let’s see what the net effect of the Fed’s $100
purchase of securities has had on the balance sheet of the banking system. For
the banking system, the cash asset item “deposits at the Fed” (aka, bank
reserves at the Fed) increased by $100. For the banking system, the liability
item “deposits” has increased by $100. What has happened to bank loans and
securities, i.e., bank credit? Nada.
What has happened to total bank
financial assets -- deposits at the Fed
plus bank credit? Total bank assets increased by $100. So, for the Fed to
increase its securities holdings, banks did not
need to reduce their securities
holding or their loans.
In a fractional required reserve monetary system like
ours and almost every economy’s, the banking system, which is required to hold
only some fraction of the extra $100 of deposits it now has on its books as
deposits at the Fed (cash reserves), could, in theory, expand its holdings of
loans/securities by some multiple of
the extra $100 of deposits at the Fed (cash reserves) it has on its books –
deposits at the Fed created by the Fed
out of thin air. Capital and/or regulatory constraints could prevent the
banking system from further increases in its loans/securities. But even if this
were the case, the Fed’s purchase of $100 of securities still would have resulted in a $100 net increase in thin-air credit
to the economy (assuming Pension Fund B replaced the securities it ultimately
sold to the Fed with others) and total banking system assets would have increased
by $100.
Now let’s look at a slightly different scenario. Instead
of Primary Dealer A acquiring $100 of securities from Pension Fund B in order
to sell to the Fed, assume that Primary Dealer A acquires $100 of securities
from Bank B. The net effect of this
is that Bank B’s asset item “securities” decreases by $100 and its asset item
“deposits at the Fed” increases by $100. Thus, for Bank B and the banking system at this point, total financial assets are
unchanged. The banking system did decrease its holdings of securities in this case, but it ultimately was not required to, as will be explained in
the next paragraph. For the banking system in this case, loans and securities
would have decreased by $100 while total
financial assets would have been unchanged because the asset item “deposits at
the Fed would have increased by $100, countering the $100 decrease in the asset
item “loans and securities”.
Bank B, in theory,
could have replaced the $100 of securities it sold to the Fed via Primary
Dealer A with the purchase of some other securities from some nonbank entity or
the granting of some new loans to a nonbank entity, just as Pension Fund B was
assumed to do in the first scenario. If Bank B did choose to replace the $100
of securities it ultimately sold to the Fed, then for Bank B and the banking system, total financial assets would have
increased by $100, with deposits at the Fed increasing by $100 and
loans/securities on the books of Bank B and the banking system having a net change of zero – Bank B sold $100 to
the Fed via Dealer A and then acquired $100 of new securities and/or loans.
Why might not Bank B have chosen to replace the $100 of
securities it ultimately sold to the Fed with the acquisition of some new
securities and/or loans? For starters, Bank B can earn 0.25% annualized on
overnight deposits held at the Fed. So, if the $100 of securities it ultimately
sold to the Fed did not earn much above 0.25%, then it would have little
incentive to replace them. One problem with this explanation is that the Fed has not been purchasing short-maturity
Treasury/agency securities that might have a yield close to 0.25%. Rather, the
Fed has been purchasing longer-maturity Treasury/Agency securities with yields
considerably higher than 0.25%. In 2013, the yield on the Treasury 10-year
security averaged 2.35%. (As an aside, banks typically do not hold
longer-maturity Treasury and Agency securities because of the interest rate
risk involved in such portfolio items.)
A better explanation as to why Bank B might not replace
the $100 of securities it ultimately sold to the Fed is that Bank B might be constrained by its capital in increasing its assets. Regulators have increased required capital
ratios on banks since the failure of Lehman Brothers in 2008. Regulators are
restricting banks’ decisions to pay dividends or buy back their own equities
depending on the capital positions of banks. If, in fact, banks have been
reluctant to replace securities ultimately sold to the Fed with new
acquisitions of securities/loans, it is not
because banks had to reduce
securities/loans “to make room” for “loans” to the Fed. In other words, the
failure of banks to accelerate the growth in their loans and securities in 2013
had nothing to do with the Fed’s QE
program. More likely, it had much to do
with “tighter” regulatory issues. And
that, precisely, is the rationale for QE. If banks are unable to increase their loans and securities because of
capital and/or regulatory constraints, the Fed can temporarily increase its
credit provision to the economy as banks repair their balance sheets.
Let’s look at some data. Let’s try to get an idea of exactly
from whom the Fed has been purchasing Treasury and Agency securities -- from
banks or from others? Chart 1 shows the Q4/Q4 dollar change in Treasury/Agency
securities holdings of the Fed, depository institutions (primarily banks but
also S&Ls and credit unions), and all other holders of these securities,
including foreign entities. In 2009, when
QE I was in full swing, holdings
of Treasury/Agency securities by depository institutions actually increased from 2008. In contrast,
holdings of Treasury/Agency securities by all other sectors contracted. So, during QE I, the net
sellers of Treasury/Agency securities were not
banks, S&Ls and credit unions and, obviously the Fed, but everyone else.
During QE II in 2011, everyone was a net buyer of Treasury/Agency securities, but depository institutions
increased their holdings by less than they did in 2010. Now we come to QE III
in 2013, the main focus of Malpass’s op-ed. As during QE I, during QE III, the
net sellers of Treasury/Agency securities were everyone other than the Fed and
depository institutions. It should be
noted that depository institutions increased their holdings of these securities
by less in 2013 than they did in 2012, but they were not net sellers. Notice also
that net annual acquisitions of Treasury/Agency securities by depository
institutions have been trending down since 2009, QE or not.
Chart 1
|
|
Let’s get a bit more granular by looking at the
month-to-month dollar changes in commercial bank holdings of Treasury/Agency
securities and dollar changes in their holdings of loans, leases and securities
other than Treasuries and Agencies. These data for 2013 are plotted in Chart 2.
Notice that in each of the last three months of 2013, when Fed tapering had not yet commenced, bank holdings of both Treasury/Agency securities and the
aggregate of all other elements of bank credit – loans, leases and “other”
securities – increased. If Fed
open-market purchases of Treasury and Agency securities necessitated banks to reduce other assets, as Malpass asserts, how
would he explain the fact that in the
last three months of 2013 bank holdings of Treasury and Agency securities, the
very securities that the Fed was purchasing, increased along with increases
in all other assets included in bank credit?
Chart 2
“In 2013, the
banking system's total assets grew less than $900 billion, requiring roughly
$100 billion in reductions in other types of bank assets to make room for loans
to the Fed.”
Actually, in 2013, a full year of no-tapering QE, the
banking system’s total assets grew by $934 billion on a Q4/Q4 basis. But let’s
not quibble over a few billions of dollars. What Malpass failed to tell you but
what you can see in Chart 3 is that 2013 marked the largest Q4/Q4 dollar increase
in commercial bank total assets since 2008:Q4! Also, commercial bank holdings
of loans, leases and securities other than Treasuries and Agencies increased by
$217 billion. Admittedly, the 2013 increase
in commercial bank holdings of loans, leases and “other” assets was $17
billion less than the 2012 increase,
but I fail to see any data that would support Malpass’s claim that banks
reduced any assets “to make room for loans to the Fed”.
Chart 3
“The data are
clear that credit has been channeled away
from growth, in effect rationed to the safest and best-connected creditors
(government and big business) at the expense of those more likely to create
jobs.” [emphasis added]
Did Fed securities purchases result in “channeling away”
credit from small businesses or was it banks’ inability to lend to small
businesses because of capital and regulatory constraints? Perhaps the Fed’s
quarterly Senior Loan Officer Opinion Survey on Loan Practices might shine some
light on this issue. Chart 4 shows the results of these surveys with regard to
banks’ lending terms to small businesses. As the last recession took hold, the
percentage of bank respondents in the survey tightening their lending terms jumped from 20% in 2008:Q1 to 60% in
2008:Q4. By the end of 2011, the percentage of bank respondents who were
tightening lending terms to small businesses had drifted down to zero or close
to zero. If only a very small percentage of bank respondents were reporting a
tightening in lending terms, does this necessarily
imply that a correspondingly large percentage were easing their lending terms to small firms? It ain’t necessarily so.
A large percentage of bank respondents tightened their lending terms during the
last recession and although not
tightening those terms further, they might have just kept them “bar tight”
thereafter. This is what appears to have happened. As shown in Chart 4, as the
percentage of bank respondents reporting tightening terms began to decline, the percentage reporting unchanged began to ascend. The percentage of bank respondents reporting
an actual easing in lending terms has moved up, especially in the second half
of 2012, but in absolute terms, remains low.
Chart 4
So, I would argue that a logical explanation for the reason that less bank credit has been
“channeled” to small businesses is that because of the inherently larger credit
risk involved with of small business loans in an era in which bank regulators
have a diminished tolerance for bank risk, banks have chosen to channel relatively little credit toward small businesses.
Logically, there is nothing in Fed securities purchases that
would preclude banks from stepping up their lending to small businesses if they
chose to.
Although Malpass’s argument that Fed purchases of
Treasury and Agency securities has “channeled” credit away from job creators is
fallacious, I would posit that if the Fed had lent directly to small businesses rather than purchasing Treasury/Agency
securities, this would have had a more stimulative effect on nominal goods/services
spending. But, of course, this would put the Fed in the position of “picking
winners and losers”, something Malpass abhors. And forget about Malpass
abhorring it. Senator Rand Paul would have become apoplectic!
I would like to close this section with a criticism – not
of David Malpass, but of the staff of the editorial page of The Wall Street Journal. Back in the
days when Lindley Clark was associated with The
Wall Street Journal, an article as devoid of logic and unsupported by data
as this one by Malpass doubtfully would ever have been printed. There was a
time in my life when the editorial page of The
Wall Street Journal was my first read of the day. The op-eds related to
economics were logical and supported by facts. Sadly, in my opinion, the quality
of The Journal’s economic op-eds
deteriorated significantly sometime not long after Lindley Clark’s retirement
in 1995. As I mentioned at the outset, I canceled my subscription to The Wall Street Journal several years
ago and now my first read of the day is The
Financial Times. After reading Malpass’s op-ed, I am even more confident in
the correctness of my decision.
A Picture of Economic Relief from a
Harsh Winter
And March still was much colder than normal. The blast of
thin-air credit that has been created in recent months – not for the reason Malpass has given – ought to really propel
economic activity in the second quarter when temperatures start to rise!
And Now a Sad Note
My 1995 Subaru went to donation heaven a few weeks ago. I
guess it was time. For four years, the only thing illuminating the interior at
night was the “check engine” light for some known minor issue. Several weeks
ago, the “Stink-Mobile”, as my family affectionately referred to Old 95, was
sideswiped by a pickup truck with a snowplow while I was at band practice. The
next week, as I was driving Old 95 to band practice, suddenly, another light
brought illumination to the interior – the “oil pressure” warning light. That
marked a repair too far. Perhaps I have not learned my lesson, but despite the
fact that the old Subaru gave me only 18-3/4 years of service, I opted to buy a
new Subaru, thus contributing to that March spike in new light vehicle sales.
Another lesson not learned – I still am going to band practice!
The views expressed above solely reflect
those of Econtrarian, LLC.
Paul L. Kasriel
Econtrarian, LLC
Senior Economic & Investment Adviser to Legacy
Private Trust Co. of Neenah, WI
1-920-818-0236
Sturgeon Bay, WI
