Reply to Comment on Housing--Posner

I reply to a comment on the following passage in my posting last week on housing: "The reallocation of income from consumption expenditures to very safe forms of savings reduces current consumption without increasing productive investment significantly, and so contributes to the depression." The commenter states: "surely much of the conservative savings are going into FDIC-backed bank accounts where each $100,000 backs over a million bucks of lending capability. So current consumption is reduced by one unit while lending in enhanced by 12 units?" The error in the statement is the assumption that every dollar in an FDIC-insured bank account (or any other bank account, for that matter, according to the logic of the statement) is lent. Banks do not lend all their capital, especially in a depression. If a bank is undercapitalized, if it is worried that borrowers will default at an unpredictably higher rate (and that charging them a sky-high interest rate to compensate will increase the default rate), or if the demand for borrowing is down because many consumers and producers are overindebted and have to curtail their spending and avoid taking on more debt, then the bank will hoard most or even all of any cash it receives. Excess bank reserves, which are cash or equivalent (balances in the bank's account with a federal reserve bank), rose from $2 billion in August 2008 to $725 billion in March of this year. That is money the banks could lend (a bank is not permitted to lend its required reserves), but is not lending. This is rational hoarding, but it means that people who are depositing their money in bank accounts are not doing much if anything to increase lending and thereby stimulate economic activity.

Comments

[Jack]

Professor Posner: Well let's hope that they soon tire of paying out their measly 1% for deposits with little return for themselves and begin to lend their hoards out for productive endeavors.

At the amount of hoarding you note, they are killing businesses that don't deserve the death penalty and are becoming as negative a factor as those who were "lending" (giving?) with NO criteria.

The "rationality" of lenders short-circuiting government efforts to provide lending liquidity and projects to spur employment and prevent a further downward spiraling is ........... suspect, to say the least. Are ALL bankers tone deaf imbeciles?

[Andrew]

.........Interesting

[neilehat]

It's called the "Panic & Fear Mode". Everyone is caught up in it and are trying to increase their liquid assets for the inevitable crash or pending job loss. The problem is, the whole cycle perpetuates and feeds on itself. Making the likelyhood of a Depression even greater.

This is a cycle that must be broken before it drags all of us into the Abyss. So the real question becomes, "How do we overcome Panic and Fear"?

[tyrr]

http://www.marketskeptics.com/2009/03/us-banks-operate-without-reserve.html

There is no fallacy in the gentlemans statement Posner. The Federal reserve did away with reserve requirements because they felt the FDIC obsolesces them.

The net effect of such a system is it tends to replace dollars with banknotes over time. A 7% reserve rate, if it fully plays out (it won't) creates 11 times the debt and 9 times the deposits of the originating capital. Quite literally the bank, through interest, ends up owning 1.8 times originating capital or 100% of the originating capital and some of its own banknotes.

Thus what ends up happening is the bank issues "good as cash" banknotes instead of cash to those unable to pay their debts. One of the innovations of the 90's was the ATM machine and electronic finance; this eliminates the banks requirement to transfer cash or for people to use cash, and instead they electronically transfer balances and payments.

Bank A makes a car loan; bank B makes a car loan. The customers take the checks to dealerships 1 and 2. Dealership 1 deposits A's check in B, Dealership 2 deposits B's check in A. Bank A and B will cash eachothers checks in eachothers banks; if the sums are equal, no transfer is necissary. If the sums are unequal, they must transfer capital. In this way, the loans a bank makes must be, in some way, in-tune with its cash requirements. I am sure some banks take out debts to other banks when they cannot make cash payments.

What banks have to be careful about is making sure they have enough cash to satisfy other banks calls, and that they have enough banknotes on hand to cover their deposits, and enough cash on hand to satisfy doubts of solvency. Period.

I can still go to the bank and get cash from it, but the actual cash they have is an increasing fraction of the deposits and reserves they own. They still cannot go crazy handing money out, as that would cause a banknotes to collect at some bank, but they can also get away with a lot of criminal behavior.

The reason why we can have 500 trillion derivatives bubble is because, quite literally, derivatives and wall street has become a mantrap for the rich and wealthy. If you combine nearly unlimited liquidity, an insane marketing machine, the innovations of electronic commerce, hedge funds creating localized market hyperinflation, and rich megalomaniacs you end up with all kinds of "financial innovation" occurring to bilk banknotes from competing banks through various games. The recent Oil and Food bubbles in 2007 and 8 that caused gas to plummet $2 a gallon in a month are effects of this.

Where does debt come from? Savings. Where does the value of new, printed money come from? Every dollar in the market and ultimately, savings. Savings exists to see people and companies through hard times; if I think I won't have a job or unemployment for 6 months I'd like to have 6 months of cash on hand for that, savings does not cause depressions, it ensures survival of various members. If I have a year of savings and we go into great depression 2, I am going to buy food; that will ensure the food industry's as well as my survival. Recessions are corrections; we expend too far in one direction or do something dumb like the housing market, you end up with a high demand for scarce of resources. All debt as savings does is increase the tendency towards spendthrift behavior; you're taking my savings and spending it to subsidize a distressed company, this gives the company confidence to continue doing what its always done; fail miserably. Instead of correcting its behavior, its behavior worsens in turn worsening the recession. The elderly grandmother, now no longer having retirement savings, takes out a home equity loan and...yeah. The bank spends my money on a failed company, and then for me to make it through the recession, I have to take out a loan. Sounds like a scam to me.

And believe you me, I am prepared to eat squirrel on a stick; I've got plenty of .22LR ammo and squirrels where I live.

I consider the statement "we need to print money to increase liquidity because people horde money" an archaic, Robber-Barron argument because it comes from an archaic, Robber-Barron time.

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