So the idea is that with higher capital ratios banks are less prone to ‘get in trouble’.

So let’s say minimum capital requirements go from 8% to 10%. Most banks try to stay about 1% over the limit to be safely compliant.

That means that when requirements were 8%, most banks had 9% to be ‘safe’ and with 10% required, banks are at 11% to be ‘safe’.

Now let’s say today’s banks have losses of 2% of capital, which brings them down to 9%, 1% under the new limit. When that happens is the regulators call it a ‘troubled bank’ and suspend new lending until ‘good standing’ is restored. And cessation of bank lending triggers a general, downward, pro cyclical credit contraction.

In other words, the increase in capital requirements didn’t prevent the same 2% drop in capital from having the same negative effect.

Yes, the increased capital may help to protect ‘tax payer money’ to some degree should banks be liquidated, but it does nothing to protect the macro economy from a contractionary pro cyclical downward spiral.

And all it takes is a drop in asset prices to shut down lending, a risk I pointed out late last year when oil prices collapsed. Stocks were the cheapest source of borrowing for many, and with that equity evaporating that lending contracts. Lending vs commodities related collateral also contracts. etc.

Abstract: This paper presents theoretical and empirical analysis of automatic fiscal stabilizers, such as the income tax and unemployment insurance benefits. Using the modern theory of consumption behavior, we identify several channels–insurance effects, wealth effects and liquidity constraints- -through which the optimal reaction of household consumption plans to aggregate income shocks is tempered by the automatic fiscal stabilizers. In addition we identify a cash flow channel for investment. The empirical importance of automatic stabilizers is addressed in several ways. We estimate elasticities of the various federal taxes with respect to their tax bases and responses of certain components of federal spending to changes in the unemployment rate. Such estimates are useful for analysts who forecast federal revenues and spending; the estimates also allow high- employment or cyclically-adjusted federal tax receipts and expenditures to be estimated. Using frequency domain techniques, we confirm that the relationships found in the time domain are strong at the business cycle frequencies. Using the FRB/US macro-econometric model of the United States economy, the automatic fiscal stabilizers are found to play a modest role at damping the short-run effect of aggregate demand shocks on real GDP, reducing the “multiplier” by about 10 percent. Very little stabilization is provided in the case of an aggregate supply shock.

All unspent income is called a ‘demand leakage’ as it means the output can’t get sold unless another agent spends more than his income. (by identity, not ‘theory’) And unsold output leads to cuts in output, cuts in employment, etc. etc. and down you go until some agent spends enough more than his income to offset the demand leakages. Invariably that agent is govt, as the automatic fiscal stabilizers increase the deficit. Of course they also work in reverse, providing an increasing headwind to the economy as it grows, via higher revenues and lower transfer payments. Like what’s happening now, which has brought the deficit down dramatically over the last few of years.

Anyway, when a bank has income and pays it out as shareholder income, that’s not a demand leakage. And if the shareholders don’t spend their income, that is a demand leakage. etc

But if a bank earns income and doesn’t pay it out or spend it, but instead lets its equity capital increase, that is a demand leakage.

So what’s happening in general is top line growth is pretty much flat, with earnings not being spent, but instead adding to net worth and therefore the earnings are demand leakages. This includes the housing agencies/banks who are now turning over their incomes to govt.

Remember this from the Fed?

Kent Jan (guest): Largely, I agree with Martin Wolf’s analysis of what went wrong and what should be done in the future to prevent the by now very familiar pattern of boom and bust in regulated financial systems. There is one aspect that I think merits more attention than it has been given, an aspect that also has some important short term effects – the equity base of the financial system. I think the equity base is currently being mismanaged, and regulators could have some tools to improve the situation.

As everyone knows, there are much more losses in the financial system than have so far been declared. I think close to USD 150 bn has been reported at this stage. That could be compared to for example the G7 comment of 400 bn in mortgage related losses, and 400-1000 bn in total losses probably covering most private sector forecasts. At the same time new risk capital has been raised to the tune of roughly 90 bn USD (ballpark number).

A back of the envelope calculation shows that a large part of the equity of the financial system has been wiped out, much more than has been reported. The market knows, the regulators know and the banks themselves certainly know that even though they are far from bankrupt, they are on average in truth operating at equity/capital adequacy ratios clearly below both legal requirements and sound banking practices.

Currently, the banks are responding by reporting losses little by little, keeping up the appearance of reasonable capitalization. At the same time, they try to reduce their balance sheet, especially from items that carry a high charge to capital. This way they hope (but hope is never a strategy) that time will heal their balance sheet; earnings will over time be able to offset continued writedowns. High vulnerability to negative surprises, but no formal problems with minimum capital adequacy ratios and control of the bank, “only” weak earnings for some time.

That is all very nice and cosy for bank´s directors, but not for the economy in general. If a small part of the banking sector has specific problems and rein in lending, so be it. That probably has little impact on the rest of the economy. However, if the entire financial sector postpone reported losses and contract their balance sheet, that is another question altogether. The cost to rest of the economy could be very high indeed.

I am less concerned about ‘loanable funds’ with today’s non-convertible currency. I see the issues on the demand side rather than the supply side of funding. Capital ’emerges’ endogenously as a supply side response to potential profits. The reducing lending is largely a function of increased perception of risks.

So, what should be done? Pretending that banks are OK and sweat it out over time is dangerous to economy as a whole, but so is being too harsh on the banks right now.

I actually think there is an answer – the banks should be made to recapitalize quickly and aggressively. Accepting new equity capital would minimize social cost of their current mistakes. There is an obvious practical problem with that, the price at which that capital is available is not necessarily the price at which current shareholders want to be diluted. So, in essence, the banking system continues to push the cost of their mistakes to others by not coming clean on their losses and recapitalize, rather they try to muddle through by not declaring their losses in full and pull in lending to the rest of the economy.

You hit on my initial reaction here. It’s up to the shareholders to supply market discipline via their desire to add equity, and it’s up to the regulators to make sure their funds – the insured deposits (most of the liability side, actually, when push comes to shove) – are protected by adequate capital and regulated bank assets. I think they are doing this, and, if not, the laws are in place and the problem is lax regulation.

I think regulators should be tougher here, banks that clearly are below formal capital adequacy ratios with proper mark to market should be armtwisted to accept new money.

Yes, as above.

I am also looking with dismay on the fact that even some of the weaker banks are still paying dividends to their shareholders – on a global scale I think the financial system has paid out more in dividends since the start of the crisis than they have raised in new capital

Also, a regulatory matter. Regulators are charged with protecting state funds that insure the bank liabilities.

My proposals have been to not use the liability side of banks for market discipline. Instead, do as the ECB has done and fund all legal bank assets for bank in compliance with capital regulations.

Printing counterfeit banknotes is illegal, but creating private money is not. The interdependence between the state and the businesses that can do this is the source of much of the instability of our economies. It could – and should – be terminated.

It is perfectly legal to create private liabilities. He has not yet defined ‘money’ for purposes of this analysis.

I explained how this works two weeks ago. Banks create deposits as a byproduct of their lending.

Yes, the loan is the bank’s asset and the deposit the bank’s liability.

In the UK, such deposits make up about 97 per cent of the money supply.

Yes, with ‘money supply’ specifically defined largely as said bank deposits.

Some people object that deposits are not money but only transferable private debts.

Why does it matter how they are labeled? They remain bank deposits in any case.

Yet the public views the banks’ imitation money as electronic cash: a safe source of purchasing power.

OK, so?

Banking is therefore not a normal market activity, because it provides two linked public goods: money and the payments network.

This is highly confused. ‘Public goods’ in any case aren’t ‘normal market activity’. Nor is a ‘payments network’ per se ‘normal market activity’ unless it’s a matter of competing payments networks, etc. And all assets can and do ‘provide’ liabilities.

On one side of banks’ balance sheets lie risky assets; on the other lie liabilities the public thinks safe.

Largely because of federal deposit insurance in the case of the US, for example. Uninsured liabilities of all types carry ‘risk premiums’.

This is why central banks act as lenders of last resort and governments provide deposit insurance and equity injections.

All that matters for public safety of deposits is the deposit insurance. ‘Equity injections’ are for regulatory compliance, and ‘lender of last resort’ is an accounting matter.

It is also why banking is heavily regulated.

With deposit insurance the liability side of banking is not a source of ‘market discipline’ which compels regulation and supervision as a simple point of logic.

Yet credit cycles are still hugely destabilizing.

Hugely destabilizing to the real economy only when the govt fails to adjust fiscal policy to sustain aggregate demand.

What is to be done?

How about aggressive fiscal adjustments to sustain aggregate demand as needed?

A minimum response would leave this industry largely as it is but both tighten regulation and insist that a bigger proportion of the balance sheet be financed with equity or credibly loss-absorbing debt. I discussed this approach last week. Higher capital is the recommendation made by Anat Admati of Stanford and Martin Hellwig of the Max Planck Institute in The Bankers’ New Clothes.

Yes, a 100% capital requirement, for example, would effectively limit lending. But, given the rest of today’s institutional structure, that would also dramatically reduce aggregate demand -spending/sales/output/employment, etc.- which is already far too low to sustain anywhere near full employment levels of output.

A maximum response would be to give the state a monopoly on money creation.

Again, ‘money’ as defined by implication above, I’ll presume. The state is already the single supplier/monopolist of that which it demands for payment of taxes.

One of the most important such proposals was in the Chicago Plan, advanced in the 1930s by, among others, a great economist, Irving Fisher.

Yes, a fixed fx/gold standard proposal.

Its core was the requirement for 100 per cent reserves against deposits.

Reserves back then were ‘real’ gold certificates.

The floating fx equiv would be 100% capital requirement.

Fisher argued that this would greatly reduce business cycles.

And greatly reduce aggregate demand with the idea of driving net exports to increase gold/fx reserves, or, alternatively, run larger fiscal deficit which, on the gold standard, put the nation’s gold supply at risk.

end bank runs.

Yes, banks would only be lending their equity, so there is nothing to ‘run’

and drastically reduce public debt.

If you wanted a vicious deflationary spiral to lower ‘real wages’ and drive net exports.

A 2012 study by International Monetary Fund staff suggests this plan could work well.

No comment….

Similar ideas have come from Laurence Kotlikoff of Boston University in Jimmy Stewart is Dead, and Andrew Jackson and Ben Dyson in Modernising Money.

None of which have any kind of grasp on actual monetary operations.

Here is the outline of the latter system. First, the state, not banks, would create all transactions money, just as it creates cash today.

Today, state spending is a matter of the CB crediting a member bank reserve account, generally for further credit to the person getting the corresponding bank deposit. The member bank has an asset, the funds credited by the CB in its reserve account, and a liability, the deposit of the person who ultimately got the funds.

If the bank depositor wants cash, his bank gets the cash from the CB, and the CB debits the bank’s reserve account. So the person who got paid holds the cash and his bank has no deposit at the CB and the person has no bank deposit.

So in this case the entire ‘money supply’ would consist of dollars spent by the govt. But not yet taxed. That’s called the deficit/national debt. That is, the govt’s deficit would = the (net) ‘money supply’ of the economy, which is exactly the way it is today.

Customers would own the money in transaction accounts.

They already do.

and would pay the banks a fee for managing them..

:(

Second, banks could offer investment accounts, which would provide loans. But they could only loan money actually invested by customers.

So anyone who got paid by govt (directly or indirectly) could invest in an account so those same funds could be lent to someone else. Again, by design, this is to limit lending. And with ‘loanable funds’ limited in this way, the interest rate would reflect supply and demand for borrowing those funds, much like and fixed exchange rate regime.

So imagine a car company with a dip in sales and a bit of extra unsold inventory, that has to borrow to finance that inventory. It has to compete with the rest of the economy to borrow a limited amount of available funds (limited by the ‘national debt’). In a general slowdown it means rates will skyrocket to the point where companies are indifferent between paying the going interest rate and/or immediately liquidating inventory. This is called a fixed fx deflationary collapse.

They would be stopped from creating such accounts out of thin air and so would become the intermediaries that many wrongly believe they now are. Holdings in such accounts could not be reassigned as a means of payment. Holders of investment accounts would be vulnerable to losses. Regulators might impose equity requirements and other prudential rules against such accounts.

As above.

Third, the central bank would create new money as needed to promote non-inflationary growth. Decisions on money creation would, as now, be taken by a committee independent of government.

As above.

Third, the central bank would create new money as needed to promote non-inflationary growth. Decisions on money creation would, as now, be taken by a committee independent of government.

What does ‘create new money’ mean in this context? If they spend it, that’s fiscal. If they lend it, how would that work? In a deflationary collapse there are no ‘credit worthy borrowers’ as they system is in technical default due to ‘unspent income’ issues. Would they somehow simply lend to support a target rate of interest? Which brings us back to what we have today, apart from deciding who to lend to at that rate, the way today’s banks decide who to lend to? And it becomes a matter of ‘public bank’ vs ‘private bank’, but otherwise the same?

Finally, the new money would be injected into the economy in four possible ways: to finance government spending.

That’s deficit spending, as above, and no distinction regards to current policy.

in place of taxes or borrowing.

Same as above. For all practical purposes, all govt spending is via crediting a member bank account.

Same thing- net fiscal expenditure.

to redeem outstanding debts, public or private.

Same.

or to make new loans through banks or other intermediaries.

As above, that’s just a shift from private banking to public banking, and nothing more.

All such mechanisms could (and should) be made as transparent as one might wish. The transition to a system in which money creation is separated from financial intermediation would be feasible, albeit complex.

No, it’s quite simple actually, as above.

But it would bring huge advantages. It would be possible to increase the money supply without encouraging people to borrow to the hilt.

Deficit spending does that.

It would end “too big to fail” in banking.

That’s just a matter of shareholders losing when things go bad which is already the case.

It would also transfer seignorage – the benefits from creating money – to the public.

That’s just a bunch of inapplicable empty rhetoric with today’s floating fx regimes.

In 2013, for example, sterling M1 (transactions money) was 80 per cent of gross domestic product. If the central bank decided this could grow at 5 per cent a year, the government could run a fiscal deficit of 4 per cent of GDP without borrowing or taxing.

In any case spending in excess of taxing adds to bank reserve accounts, and if govt doesn’t pay interest on those accounts or offer interest bearing alternatives, generally called securities accounts, the consequence is a 0% rate policy. So seems this is a proposal for a permanent zero rate policy, which I support!!! But that doesn’t require any of the above institutional change, just an announcement by the cb that zero rates are permanent.

The right might decide to cut taxes, the left to raise spending. The choice would be political, as it should be.

And exactly as it is today in any case.

Opponents will argue that the economy would die for lack of credit.

Not if the deficit spending is allowed to ‘shift’ from private to public.

I was once sympathetic to that argument. But only about 10 per cent of UK bank lending has financed business investment in sectors other than commercial property. We could find other ways of funding this.

Govt deficit spending or net exports are the only two alternatives.

Our financial system is so unstable because the state first allowed it to create almost all the money in the economy.

The process is already strictly limited by regulation and supervision.

and was then forced to insure it when performing that function.

The liability side of banking isn’t the place for market discipline, hence deposit insurance.

This is a giant hole at the heart of our market economies. It could be closed by separating the provision of money, rightly a function of the state, from the provision of finance, a function of the private sector.

The funds to pay taxes already come only from the state.

The problem is that leadership doesn’t understand monetary operations.

This will not happen now. But remember the possibility. When the next crisis comes – and it surely will – we need to be ready.

Agreed!!!!!