> Today, we control inflation with changes in interest rates, not changes in the quantity of money.
That is also not quite correct, I believe. The FED can invest money created out of thin air any time it wants („fiat money“ — „there shall be money“), usually it buys government bonds to help the federal government run its deficit. Sometimes this scheme is called „quantitative easing“ which is a charming euphemism. This is what drove and still drives inflation directly and indirectly (through the effect of our fractional reserve system private banks amplify this about tenfold by lending out 90% of their customers‘ deposits).
The interest rates everybody is obsessed about are just the target rates for the interest earned or paid for for money in the account of private banks at the FED. It is just a secondary adjustment. At least during major crisis.
>> This is what drove and still drives inflation directly and indirectly
QE is fascinating.
On the one side of QE you have central banks, absolutely baffled by the fact they create all these reserves, we’re talking utterly un-relatable numbers for a human, numbers that belong in the field of astronomy rather than finance. And yet they fail to hit their inflation targets for over a decade.
On the other side you have a bunch of folks shouting loudly this amount of QE will cause ungodly amounts of inflation.
Now they shouted long enough that inflation eventually did show up but it’s not clear that it relates to QE. The onset of inflation correlates more closely with global energy supply shocks than with changes in QE policy or “printing” money in Covid stimulus. However, energy, despite being an input to almost everything we care about, isn’t really considered in the context of inflation by most macroeconomic models. The models are less than helpful in the face of “externalities”.
>> through the effect of our fractional reserve system
We don’t have fractional reserve in the USA, the UK, Aus etc and haven’t had for a number of years at this point.
> The onset of inflation correlates more closely with global energy supply shocks than with changes in QE policy or “printing” money in Covid stimulus.
Hmmm. [1]
> USA, the UK, Aus etc and haven’t had for a number of years at this point
Indeed, the US abolished the 10% reserve requirement in 2020. Crazy. I hope you guys also save in inflation hedges.
Canada (and other places) never had a reserve requirement, and they are doing fine.
Reserve requirements are mostly bullshit anyway. What you want is for banks to have enough loss absorbing capital. Reserves are almost meaningless.
What is the difference between a reserve and loss absorbing capital?
In a practical sense - reserves can’t be spent in the economy but you could withdraw your capital (accepting the impact on banking operations that would have) and use it to buy something. They’re different types of money. Reserves are only good for exchange by a few institutions and the central bank.
In a “model” sense for want of better phrasing that eludes me right now… One is infinite (via the discount window for reserves) and the other is very much finite.
In a hard legislation sense, capital is complicated, Basel regs recognise different types of capital and value them differently. But the tier 1 stuff is the equity you put into the bank to get it started or to support expanding its operations.
Yes. To oversimplify, capital is what's left after you take all your assets and subtract all your debt.
So you take all the investments that the bank has made (loans, but also their brand value, the office buildings they own and operate in, etc) and subtract all the deposits and outstanding bonds etc, and what's left over is their capital.
Another related way to measure that is to look at total market capitalisation. (But market cap makes economic sense, that's not the definition of loss absorbing capital that's used in the regulations.)
In the really olden days: reserves were physical gold or cash in your vault. (These days, it's a bit more complicated.)
About loss absorbing capital: companies usually finance themselves from two sources equity and debt. (Normal companies get their debt from their bank, or they issue bonds. Banks get some of their debt in the form of deposits.)
To give an example, supposed you have 2 billion dollars lying around, and you start a bank. You take another 8 billion dollars in debt (say as deposits), and you use that to make 10 billion dollars of loans and other investments.
If you investments gain in money, you keep the profit. Your accountant will count it as an increase in your capital, from 2 billion to, say, 3 billion. Basically, capital is just what's left of your assets after you subtract all your debt.
If your investments lose money, your capital shrinks. Say your investments are now worth only 9 billion dollars, but you still have 8 billion in deposits. Then you only have 9 - 8 = 1 billion in capital left.
There's never any money in the vault, ie no reserves, in our example. When a depositor wants their money, you sell some of your investments to cover that. As long as your total investments are worth more than your total deposits, this is fine.
(For convenience, real world banks keep some reserves around even when not legally required, so they can satisfy withdrawal requests directly, instead of having to sell some investments for every little withdrawal request.)
Obviously, the more capital cushion your bank has the larger a decline in the value of your investments you can absorb as losses, before your depositors and other creditors need to get nervous.
Back in Scotland's free banking era, when financial regulation was very light, banks over there routinely kept around a third of their total balance sheet as equity and two thirds as debt.
Today because of all the regulation we have accumulated and especially the too-big-too-fail expectations, banks need to be forced to even keep around 8% of their balance sheet as equity.
(It doesn't help that interest on debt can be paid with pre-tax money, but return on capital (ie dividends) comes largely out of post-tax money. So debt is cheaper.)
We're also currently in a period of Quantitative Tightening as we slowly undo the QE done during covid, which should have a deflationary effect. But who knows over what time period and with what magnitude.
> We don’t have fractional reserve in the USA, the UK, Aus etc and haven’t had for a number of years at this point.
What do you mean by that?
https://www.federalreserve.gov/monetarypolicy/reservereq.htm
EDIT hmm that doesn’t link directly to the relevant FAQ:
“Why did the Federal Reserve reduce reserve requirement ratios to zero percent?
For many years, reserve requirements played a central role in the implementation of monetary policy by creating a stable demand for reserves. In January 2019, the FOMC announced its intention to implement monetary policy in an ample reserves regime. Reserve requirements do not play a significant role in this operating framework.
As announced (Off-site) on March 15, 2020, the Board reduced reserve requirement ratios to zero percent, effective March 26, 2020, in light of the shift to an ample reserves regime. This action eliminates the need for thousands of depository institutions to maintain balances in accounts at Reserve Banks to satisfy reserve requirements, thereby freeing up liquidity in the banking system to support lending to households and businesses.”
You still have fractional reserve banking, even with zero mandatory reserve requirements.
Btw, banks still keep plenty of reserves around. See https://fred.stlouisfed.org/series/TOTRESNS for the US.
Not GP, but there are two senses in which I think it could be meant:
- Currency no longer has to be backed by some fraction of shiny objects,
- Banks do not need to arrange CB reserves before making loans -- they make loans and then secure the needed CB reserves.
That's still all fractional reserve banking.
Btw, in the US there's lots and lots of bank reserves: https://fred.stlouisfed.org/series/TOTRESNS