Crawl Across the Ocean

Tuesday, March 17, 2009

Two Digressions

This post takes a break from my buildup to a discussion of ethics in order to highlight a couple of excellent posts that I didn't want to let slip by without mentioning.

1. Karl Denninger talks about fractional reserve banking. Finding good commentary on this topic is hard because the mainstream won't discuss it and the non-mainstream that discusses tends to just take it as given that it is a bad thing (and a fraud) without needing to go into any more detail.

Denninger first explains what fractional reserve banking is (see wikipedia for a more basic intro), and then shows that it is not a fraudulent system because at any given moment, the deposits at the bank are matched by some combination of cash in the vault and loans to other people.

I'm a bit skeptical of his belief that if people came for their deposits en masse, the bank could simply liquidate its loans (sell them to other banks, I suppose) and repay the depositors with no harm done. Certainly the history of banking prior to the institution of deposit insurance was one of bank runs and people getting little, if any, of their money back.

Furthermore, there is an element of, if not outright fraud, then at least deception in that most people who deposit money at a bank expect it to stay there and be there when they need it. If they were explicitly asked if they wanted the bank to lend their money out to other people such that getting their deposit back was contingent on enough of the bank's debtors not defaulting, I'm not at all sure they would agree.

Denninger then moves on to explain the primary advantage of fractional reserve banking which is that, by allowing banks to increase their leverage, it allows them to lend money with a lower interest rate than would otherwise be necessary, and these lower interest rates support a much greater level of entrepreneurial activity than would otherwise be the case.

Then he talks about the downside of this leverage. The only way the interest on this leveraged money can be repaid is if the money that was loaned out is invested for productive purposes that more than cover the interest. Given that the interest rate charged by banks is always higher than the rate of economic growth, this is impossible (unless we create new money to pay the interest with).

As the unpayable interest piles up, eventually the economy has to have a recession in order to reset debt levels back to a lower level (from which they can be increased again). [Or, I suppose, the central bank could just force interest rates lower and lower to allow people to carry more and more debt until finally even with central bank interest rates at 0, the debt load is still too much and we have a depression instead of a recession, but I digress.]

Denninger sees the implicit cyclicality (debt expands then crashes) as a benefit of the system in that it allows those that borrow to invest productively to survive, while wiping out (bankrupting) those who borrow for unproductive purposes. Provided, of course, that the cyclicality is kept from becoming excessive, which he feels can be done by maintaining and enforcing reasonably high reserve requirements for all institutions that lend money.

Note: There's a followup post by Denninger reiterating his points here.

Overall, I agree with Denninger's analysis and with his assessment of what the pros and cons are, but I disagree with his assessment of the magnitude of the pros and cons. I am more optimistic than him that we could find a way to provide funding for investment at reasonable interest rates without having to rely on fractional reserve banking, and I weigh more heavily the costs of the instability associated with the system and I'm more skeptical about the ability/willingness of the authorities to actually enforce reserve requirements.

Notwithstanding my disagreements, it's an excellent post, and one of the best summaries of the topic that I've seen.

2. Steve Keen gives Rory Robertson a valuable and entertaining lesson on why you often need to compare stocks and flows in a dynamic system.

Stocks represents quantities of things (e.g. the amount of water in a reservoir) whereas flows measure the movement of something from place to place (e.g. water flowing out of the reservoir and down a river).

In accounting, the balance sheet keeps track of the stocks (of assets and liabilities) and the income statement keeps track of the flows (of revenue and expenses).

Keen is taking on a pet peeve of mine which is when economists argue that some analysis or argument or concern is invalid because it involves comparing a stock to a flow as if there was some rule that you should never compare stocks to flows (e.g. It is meaningless to compute how many months of interest payments (flows) a company could make from current cash (stocks)) because that involves comparing a stock to a flow.

It's true that, as Keen is well aware and explains, you need to be careful with your measurement units when comparing a stock to a flow, but any time you have a system that is dynamic (in motion, in some way), you often need to compare stocks and flows and, as Keen says, the economy is nothing if not a dynamic system.

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  • Sure, but whenever you compare a stock to flow, you are making an implicit assumption about a certain rate - interest rate, rate of gasoline consumption, depreciation rate. Usually, the assumption is that the relevant rate is constant.

    It's fine to compare GDP to debt if you say that the interest rate is constant - even approximately. In that case, debt payments will be a flow that is proportional to debt, and that flow can be compared to GDP. So movements in debt/GDP ratios will correspond - up to a scale factor - to movements in payments/GDP ratios.

    But it's still a supplementary hypothesis that should be made explicit. Sometimes people get sloppy, and bad habits spill over to other cases.

    By Blogger Stephen Gordon, at 5:59 PM  

  • Oh yes, that last paragraph of Keen is egregiously stupid. He clearly doesn't have a clue about what we teach.

    By Blogger Stephen Gordon, at 6:15 PM  

  • As usual, there is no doubt a gap between the economics that goes on in the classroom and the economics that shows up on blogs and in the newspapers (while they last).

    But the non-academic economics that shapes the debates and the politics is killing us. I often run into the same problem Keen does when I try to explain the problem of too much debt to economists, either silence or comments about how debt to gdp is irrelevant because it compares a stock to a flow. Often enough that I'd started to wonder if I was missing something because that argument never made much sense to me (so part of my appreciation for Keen's post was that it reassured me I wasn't going crazy)

    Is there any agreement in influential circles (imf/world bank/bis/central banks/major economists) that we need to reduce our debt levels in order to resume growth? I haven't seen any. At best, you might get an admission that we should reduce debt levels *after* growth resumes.

    As for your first comment, you're certainly correct but I don't think it makes a lot of difference. I think people mostly understand, for example, that if you talk about how many months of interest a company can cover, then that number will change if the rate of interest changes.

    By Blogger Declan, at 6:47 PM  

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