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Some Aspects Of Central Bank Behaviour

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There was a discussion last week on a social network site on Basil Moore’s book Horizontalists And Verticalists. Someone mentioned he never knew anyone who owned a copy of the book! Lucky me.

I was browsing through my copy and came across this – which I thought I should quote on central bank “defensive behaviour”.

Actually, among Post-Keynesians, Alfred Eichner was the first to understand and highlight the “defensive” nature of central bank open market operations.

Outside PKE, it was a paper of Raymond E. Lombra and Raymond G. Torto titled Federal Reserve Defensive Behaviour And The Reverse Causation Argument which started analyzing the details of the Federal Reserve defensive behaviour and supported the theory of endogenous money on which economists such as James Tobin and Nicholas Kaldor were writing at the time. The term “defensive” was coined by Robert Roosa of the Federal Reserve in the book Federal Reserve Operations In The Money And Government Securities Markets originally written in 1956.

Recently central banks around the world have been doing a lot of things (“unconventional measures”) in trying to “boost” their economies – such as “large scale asset purchases” (QE). For some, recent central bank action is the natural way to start to understand monetary economics. For me, it is first important to understand what they did before the crisis to correctly understand what they have been doing and judge if their actions have any usefulness at all – on a case by case basis.

Anyways, here is from Basil Moore’s book (pages 97-99):

Open-market operations: defensive rather than dynamic?

According to the conventional story taught in most textbooks and worked through by students in countless T-account exercises, central bank open-market security purchases have expansionary effects on the money stock by raising the high-powered base. Central bank security sales conversely lower the high-powered base, and so operate to reduce the stock of money outstanding.

Table 5.2 presents the relationship between changes in total bank reserves, the monetary base, and the Federal Reserve net open-market security purchases or sales. The data are monthly time intervals for the period October 1979 to December 1983. This is the period when quantitative targeting was purportedly at last rigorously instituted. Nonborrowed reserves were avowedly the Fed’s chief operating instrument for controlling the growth rate of the monetary aggregates.

To the student of introductory economics, and even to many economists, these results will surely be startling. On a monthly basis, Federal Reserve net open-market operations fail to explain any of the actual changes in unadjusted or adjusted total reserves! They explain only 5 percent of changes in the unadjusted and only 10 percent of the changes in the high-powered base. In all cases the coefficient on net open-market purchases and sales is extremely small. It has no statistical significance in explaining observed changes in bank reserves. Although the coefficient is statistically significant in explaining the monetary base, its magnitude implies that $1000 of open-market purchases or sales were necessary to change the value of the base by $1!

The explanation for these apparently puzzling results is not far to seek (Lombra and Torto, 1973). From the central bank’s point of view a large number of stochastic nonpolicy factors operate to add or withdraw reserves from the banking system. These factors can be analyzed by an examination of the central bank’s balance sheet identity. This documents the various financial flows that accompany any change in the base: changes in float, changes in the public’s currency holding, foreign capital inflows or outflows, changes in treasury balances held with the Fed, changes in bank borrowing from the discount window. All of these flows are completely outside the control of the monetary authorities. In order to achieve a desired level of the base, these flows must be completely offset by open-market operations.

If the Fed were to take no action in the face of these large stochastic inflows and outflows of funds, the banking system would experience sharp fluctuations in its excess reserve position. Such changes would be unrelated to the Federal Reserve’s policy intentions, and would provoke continued liquidity crises and great instability in interest rates. As a result most Federal Reserve open-market operations are “defensive” and designed to offset the effects of these nonpolicy forces. Central banks operate to make reserves available to the banking system on reasonably stable terms, from day to day and week to week.

Studies of Federal Reserve open-market operations have estimated that more than 85 per cent of Federal Reserve security purchases of [sic] sales are “defensive” (Lombra and Torto, 1973, Forman, Groves and Eichner, 1984). Such flexibility is needed to deal with the very large inherent volatility of money flows. On a week-to-week basis such “noise” in the behaviour of the narrow money supply accounts for dollar changes in reserves of plus or minus $3 billion more than two-thirds of the time. This represents nearly 10 percent of total reserves, which were concurrently in the order of $40 billion (J. Pierce, 1982). On a monthly bias, such “noise” accounts for changes in the money stock or plus or minus 5 percent about two-thirds of the time.

Open Mouth Operations

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In the previous post Is Paul Krugman A Verticalist?, I discussed the confusions economists and market commentators have on open market operations. Even top economists such as Krugman suffer from confusions on central banking and monetary matters.

I also mentioned the work of Alfred Eichner on bringing out more clarity on the defensive nature of open market operations. Let’s look at these matters more closely.

Before this let’s look at what people in general think. Most people think of open market operations as some kind of extra activity on the part of the central bank in collaboration with the bureau of engraving and printing and think of it as operational implementation of Milton Friedman’s helicopter drops! So when a central bank such as the Federal Reserve changes its target on interest rates – such as lowering the “Fed Funds target rate”, people start commenting as if the Federal Reserve is undertaking a mystical operation.

This is Monetarist or Verticalist intuition. It is easy to show that open market operations have nothing to do with fiscal policy and as we saw in the previous blog – very little with monetary policy itself. The open market operation of the central bank is not an income/expenditure flow such as government expenditure flows or tax flows and the former does not affect the net worth of the change the net worth of either the domestic private or the foreign sector. Hence it is hardly fiscal. Yet commentators and economists keep arguing that the central bank is “injecting money” into the economy!

Even Paul Krugman erred on some of these matters and was shown how to do good economics by Scott Fullwiler in his post Krugman’s Flashing Neon Sign. Missing everything Fullwiler was saying, Krugman wrote another post A Teachable Money Moment which has the following diagram:

Below we will see how Krugman’s Neoclassical/New Keynesian (whichever) intuition is flawed.

Setting Interest Rates

These matters (the public understanding) have become worse ever since the Federal Reserve and other central banks around the world started purchasing government debt in the open markets on a large scale – in programs called Large Scale Asset Purchases (also called “QE”). In the following I will consider cases when there is no “asset purchase program” by the central bank and tackle this issue later in another post.

A simple case to highlight how a central bank defends an interest rate (as opposed to changing it) is considering the corridor system. There target for overnight rates is usually at the midpoint of this “corridor”. At the lower end of the corridor banks get paid interest on their settlement balances they keep at the central bank while at the upper end it is the rate at which the central bank lends.

Because banks settle among each other on the books of the central bank, this gives the latter to fix the short-term rates and indirectly influence long term rates.

Why do banks need to settle with each other?

One of the first economists to understand the endogenous nature of money was Sir Dennis Holme Roberston who used to work for the Bank of England. In 1922, he wrote a nice book simply titled Money.

 From page 52:

. . . If A who banks at bank X pays a cheque for £10 to B who banks at bank Y, then Bank Y, when it gets the cheque from B, will present it for payment to Bank X: and bank X will meet its obligation by drawing a cheque for £10 on its chequery at the Bank of England. As a matter of fact, the stream of transactions of this nature between big banks is so large and steady in all directions that the banks are enabled to cancel most of them out by an institution called the clearing-house:  but the existence of these chequeries at the Bank of England facilitates the payment of any balance which it may not be possible at the moment to deal with in this way …

Because banks finally settle at the central bank finally, central banks have learned since their creation that they can set interest rates. This is strongest at the short end of the “yield curve” but directly or indirectly central banks also influence long term rates.

At the end of each day, some banks will be left with excess of settlement balances (if they see more inflows than outflows) and some banks will face the opposite situation. Because they need to satisfy a reserve requirement at the central bank (which can be zero as well), some banks would need to borrow funds from others. Borrowing means paying back with interest and this is where the central bank’s ability to target rates comes enters the picture.

For suppose some bank X needs funds and other banks wish to lend bank X at a very high interest rate. In this scenario bank X can simply borrow from the central bank, while other banks who demanded higher interest will see themselves with excess settlement balances earning less than the target rate. So it would have been better for the latter to have lent than keep excess balances. (Of course the qualifier is that these things are valid under scenarios when there is less stress on the financial system). Also with the same logic, the rate at which banks lend each other will not fall below the corridor because it will be foolish of a bank to have lent settlement balances to another bank when it could have earned higher by just keeping excess settlement balances at the central bank.

Here is a diagram from the post Corridors And Floors In Monetary Policy from FRBNY’s blog which explains central bank’s operations:

The other system as per this post is the floor system – in which the central bank’s target is the interest paid on settlement balances itself, rather than the midpoint of any corridor. This is what has been followed by the US Federal Reserve in recent times.

Back to the corridor system, an important question arises. Hopefully the reader is convinced that the overnight rate at which banks lend each other is between the corridor. However it is still unclear how and why the central bank can keep it at the midpoint.

If the central bank and the bankers understand the system well, it is possible for the central bank to be quite perfect in this. This happens for example in the case of Canada, where the bank is quite accurate in its objective.

The reason is that the central bank can easily add and subtract settlement balances by various means.

Take an example. Suppose the interest on reserves is 2.25%, the target is 3.00% and the discount rate – the rate at which the central bank lends overnight – 3.75%. If the central bank observes that banks are lending each other at 3.25% – slightly away from the target of 3.00%, it can simply create excess balances. Among the many ways, there are two –

  1. purchase/sale of government securities and/or repurchase/reverse repurchase agreements.
  2. shifts of government deposits from the central bank account into the Treasury’s account at banks or the opposite.

So the central bank knows how the curve in the figure above looks like and adds/subtracts settlement balances by the above methods (mainly). So banks are lending each other at 3.25%, the central bank will add settlement balances; if they are lending each other at 2.75% – the central bank will drain settlement balances.

More generally the “threat” by the central bank is reasonably sufficient to make banks lend at the target!

Open Mouth Operations

Let us suppose the central bank had been targeting 3.00% for three months now and decides to decrease rates.

What does it do?

Almost nothing!

The announcement itself will make banks gravitate toward the new target!

In his paper Monetary Base Endogeneity And The New Features Of The Asset-Based Canadian And American Monetary Systems, Marc Lavoie says:

When they [central banks] are not accommodating—that is, when they are pursuing “dynamic” operations as Victoria Chick (1977, p. 89) calls them—central banks will increase (or decrease) interest rates. As shown above, to do so, they now need to simply announce a new higher target overnight rate. The actual overnight rate will gravitate toward this new anchor within the day of the announcement. No open-market operation and no change whatsoever in the supply of high-powered money are required.

Hence the term “open mouth operations” which was coined by Julian Wright and Greame Guthrie in their paper Market-Implemented Monetary Policy with Open Mouth Operations.

Open Market Operations

The above paper by Marc Lavoie is an excellent source for open market operations and looking at central banking from an endogenous money viewpoint.

I mentioned in the previous post that the open market operations are defensive. In my analysis in this post till now, I ignored the factors which cause settlement balances of the banking sector as a whole to change. Let us bring in this complication.

Apart from banks, the Treasury – the domestic government’s fiscal arm – and other institutions such as foreign central banks, governments and international official institutions (such as the IMF) also keep an account at the (domestic) central bank. When these institutions transact, there is an addition/subtraction of banks’ settlement balances at the central banks.

Here’s one example. Suppose the Treasury transfers funds of $1m to a contractor for settlement of a project done by the latter. When the funds are transferred, the contractor’s bank account increases by $1m and the bank in which he banks sees its deposits and settlement balances rise by $1m while the central bank will reduce the Treasury’s deposits by $1m.

This may lead to a deviation of banks’ lending rate to each other and the central bank needs to drain reserves. The central bank can achieve this by shifting government funds at a bank into the central bank account. If the central bank transfers $1m of funds, banks’ deposits and settlement balances reduce by $1m and the Treasury’s account at the central bank will increase by $1m.

This is not an “open market operation” but another way of adding/draining reserves. In general, depending on institutional setups, the central bank may also do purchase/sale of government securities and/or repurchase agreements.

But this has nothing to do with policy itself – rather it is to maintain status quo. (Of course “large scale asset purchases” is a slightly different matter – first one needs to understand the corridor system).

In other words, this is a defensive behaviour on part of the central bank.

Alfred Eichner

In the previous post and in Alfred Eichner And Federal Reserve Operating Procedures, I mentioned about the contribution of Eichner. In an essay in honour, Alfred Eichner, Post Keynesians, And Money’s Endogeneity – Filling In The Horizontalist Black Box, (from the book Money And Macrodynamics – Alfred Eichner And Post-Keynesian Economics) Louis-Philippe Rochon says:

For Eichner, the overall or “primary objective [of the central bank], in conducting its open market operations, is to ensure the liquidity of the banking system,” which applies to either the accommodating or defensive roles. In either case, Eichner argues that “the Fed’s open market operations are largely an endogenous response to . . . the need both to offset the flows into and out of the domestic monetary-financial system and to provide banks with the reserves they require”; that is, resulting from the demand for money and the demand for credit respectively (1987, 847, 851).

And while the accommodating argument has been debated at length by post-Keynesians, the defensive role has been virtually ignored and only recently rediscovered (see Rochon 1999). Yet it is certainly Eichner’s greatest contribution to the post-Keynesian theory of endogenous money. . .

. . . The “defensive” behavior is defined by Eichner as the “component of the Fed’s open market operations [consisting] of buying or selling government securities so that, on net balance, it offsets these flows into or out of the monetary-financial system,” leaving the overall amount of reserves unchanged. This is the result of changes in portfolio decisions and increases or decreases in bank (demand) deposits. As a result of an increase in the nonbank’s desire to hold currency, for instance, “in order to maintain bank reserves at the same level, the Fed will need to purchase in the open market government securities equal in value to whatever additional currency the nonbank public has decided to hold” (Eichner 1987, 847).

In making the distinction between temporary and permanent open market operations, Rochon also quotes Scott Fullwiler:

Outright or permanent open market operations are primarily undertaken to offset the drain to Fed balances due to currency withdrawals by bank depositors. . . . Temporary open market operations are aimed at keeping the federal funds rate at its target on average through temporary additions to or subtractions from the quantity of Fed balances. Temporary operations attempt to offset changes in Fed balances due to daily or otherwise temporary fluctuations in the Treasury’s account, float, currency, and other parts of the Fed’s balance sheet, in as much as is necessary to meet bank’s demand for Fed balances. (2003, 857)

Paul Krugman

All this is completely opposite of Paul Krugman’s position that

. . . And currency is in limited supply — with the limit set by Fed decisions.

And Krugman’s mistake is not minor – it seems he is completely unaware of the huge difference money endogeneity makes.

So what is the difference between Krugman’s diagram and the one from FRBNY blog – even though they look similar? The difference is that the latter is descriptive of behaviour when policy is unchanged and is useful for describing open market operations etc while Krugman uses the same to describe policy changes – which in reality happen via open mouth operations. Paul Krugman confuses open market operations and open mouth operations. So much for a “teachable money moment”.

Krugman also shows his Monetarist intuition by claiming:

And which point on that curve it chooses has large implications for the economy as a whole. In particular, the Fed can always choke off a private-sector credit boom by moving up and to the left.

implying that the central bank in reality controls the monetary base and thence the money stock.

Some Post Keynesians argued since long ago that the central bank cannot control the money stock:

Here’s on Wynne Godley from from The Times, 16 June 1978:

(click to enlarge)

Is Paul Krugman A Verticalist?

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24 years back, Basil Moore wrote a book Horizontalists And Verticalists: The Macroeconomics Of Credit Money (Cambridge University Press, 1988) which begins like this:

The central message of this book is that members of the economics profession, all the way from professors to students, are currently operating with a basically incorrect paradigm of the way modern banking systems operate and of the causal connection between wages, prices, on the one hand, and monetary developments, on the other. Currently, the standard paradigm, especially among economists in the United States, treats the central bank as determining the money base and thence the money stock. The growth of the money supply is held to be the main force determining the rate of growth of money income, wages, and prices.

… This book argues that the above order of causation should be reversed. Changes in wages and employment largely determine the demand for bank loans, which in turn determine the rate of growth of the money stock. Central banks have no alternative but to accept this course of events, their only option being to vary the short-term rate of interest at which they supply liquidity to the banking system on demand. Commercial banks are now in a position to supply whatever volume of credit to the economy their borrowers demand.

The book built on his own work and that of Nicholas Kaldor and Marc Lavoie among others goes on to describe the banking system, horizontalism and endogenous money. Money is credit-led and demand-determined was his message. Economists believing in the “incorrect paradigm” are Verticalists in Moore’s terminology.

Paul Krugman whom Post Keynesian have more respect than other mainstream economists probably disappointed them when he was arguing with Steve Keen in a 3-post blog series. Arguing like a Verticalist, Krugman claims (among other Verticalist claims) in his post Banking Mysticism, Continued:

… And currency is in limited supply — with the limit set by Fed decisions. So there is in fact no automatic process by which an increase in bank loans produces a sufficient rise in deposits to back those loans, and a key limiting factor in the size of bank balance sheets is the amount of monetary base the Fed creates — even if banks hold no reserves.

The Defensive Nature Of Open Market Operations

The reason there is widespread misunderstanding of what the central bank does is because it carries out open market operations where it buys or sells government securities or does repurchase agreements. The orthodox view is that the central bank is acting the way it is to increase or decrease the amount of banks’ settlement balances and this affects the money supply – allowing banks to expand lending or leading them to contract – and thence the whole economy. The view is that the central bank has a direct control these operations and are purely volitional.

This is an incorrect view because no central bank claims to be “controlling” the money stock.

If money is truly endogenous, the question is why the central bank does these operations often. The reason is that operations of the central bank are defensive. 

In his article Endogenous Money: Accomodationist, Marc Lavoie argues:

Some post-Keynesians have pointed out long ago that open market operations had little or nothing to do with monetary policy.

For instance, It is usually assumed that a change in the Fed’s holdings of government securities will lead to a change, with the same sign attached, in the reserves of the commercial banking system. It was the failure to observe this relationship empirically which led us, in constructing the monetary financial block of our model, to try to find some other way of representing the effect of the Fed’s open market operations on the banking system. (Eichner, 1986, p. 100)

That other way is that ‘the Fed’s purchases or sales of government securities are intended primarily to offset the flows into or out of the domestic monetary-financial system’ (Eichner, 1987, p. 849).

So the central bank purchases government bonds and/or does repos to neutralize the effects of transactions which change the settlement balances. One example is the flow of funds into and out of the government’s account at the central bank. Another is the demand for currency notes by banks to satisfy their customers’ needs. The central bank has no choice but to provide these notes.

Here’s a preview via Google Books:

click to view on Google Books

Also see this post Alfred Eichner And The Federal Reserve Operating Procedures.

Krugman is partly right when he says, “Banks are important, but they don’t take us into an alternative economic universe.” However he fails to see that money is endogenous and the way the banking system works show this endogeneity.

Of course, Steve Keen has issues with his models and accounting with which Krugman has troubles. Keen defines aggregate demand to be gdp plus “change in debt”. As much weird this definition is, it is double counting when investment expenditure is financed by borrowing rather than internal sources of funds. Also, if a person sells a home to another person who has financed this purchase by borrowing and the former does not make expenditure from this income, this does not increase aggregate demand – a point raised by Marc Lavoie here (h/t “Circuit” from Fictional Reserve Barking). But as per Keen’s definition it does. In his first post, Krugman seems to say the same thing as Lavoie – but in a roundabout way.

The resulting debate has however highlighted the Verticalist intuition of Krugman!

Alfred Eichner And Federal Reserve Operating Procedures

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Alfred Eichner was a Post-Keynesian economist known for his text Macrodynamics of Advanced Market Economies published 3 years after his death in 1988. He died at the age of 50 in an accident and at the time he was preparing to include an analysis of open economy macroeconomics in his story of how economies work.

This post is about an article/chapter he wrote (with Leonard Forman and Miles Groves)* in 1984 in a book titled Money And Macro Policy edited by Marc Jarsulic. It is a fantastic book with chapters written by Basil Moore and Marc Lavoie as well on the endogeneity of money. I discussed this previously in my post More On Horizontalism.

Google Books allows a preview of the chapter and embedding it on a webpage and I have done so at the end of this post. If it doesn’t appear properly in your browser, please let me know. Else, like me, you can buy the book 🙂 Of course G-books won’t allow a preview of all pages due to copyright restrictions.

Eichner’s chapter (#2) is titled The Demand Curve For Money Further Considered. 

The authors start off the description with

First, the amount of bank reserves, and thus the monetary base, is not the exogenously determined variable assumed in both orthodox Keynesian and monetarist models but instead depends on the level of nominal income. This is because the central bank, in order to maintain the liquidity of the financial system, is forced to purchase government securities in the open market so as to accommodate, at least in part, the need for additional credit as the pace of economic activity quickens. With the amount of unborrowed bank reserves, and thus the monetary base, to a significant extent endogenously determined, it follows that the money supply is, to no less an extent endogenously determined as well. It is therefore a misspecification to assume that the money stock, or any of its components, is entirely exogenous, subject to the control of the monetary authorities, and then to derive a demand curve for money based on that assumption. In reality, the demand for and supply of “money” are interdependent, with no possibility in practice of being able to distinguish between the two.

Second, it is the demand for credit rather than the demand for money which is the necessary starting point for analyzing the role played by monetary factors in determining the level of real economic activity…

The authors then point out the neutralizing nature of open-market operations of the Fed. Usually this – open market operations – is presented in textbooks and in some old Federal Reserve publications as causing the amount of reserves to rise and allowing banks to increase the supply of reserves. Eichner had earlier worked with data and failed to see open market operations increasing the amount of reserves in practice. He realized that the open market operations neutralize flows:

… Thus, in the face of a fluctuating public demand for currency, flows of gold into and out of the country, variations in the amount of deposits held at the Fed by foreigners and others, changes in the amount of float and fluctuations in the Treasury’s cash holdings, the Fed must engage in open-market operations just to maintain bank reserves at a given level. This is the neutralizing component of a fully accommodating policy, and it is one reason why it is difficult in practice to relate change in bank reserves to open market operations …

What is so nice about the quote above is that Eichner knew exactly what factors affect reserve balances. At the time, “float” may have been more important than it is today. Eichner not only knew that the Treasury’s account at the Fed affects reserve balances but also holdings of other institutions such as foreign central banks – i.e., as a result of “flows of funds into or out of the Federal Reserve System” in his own words. (In the same paragraph from which the quote is taken).

Further the article goes:

An increase in the demand for credit will, to the extent it is satisfied, lead to an increase in bank deposits (especially demand deposits). This is because banks make loans by simply crediting the borrower’s account at the bank with the funds advanced. The increase in deposits will, however, require that banks maintain larger reserves at the Fed. Thus required reserves, ResR, will increase and, unless the Fed acts through the purchase of government securities in the open market to provide banks with the necessary additional reserves, banks will find themselves with insufficient reserves to meet their legal requirements… the Fed is forced to accommodate, at least in part,  whatever demand for credit may manifest itself.

The terminology “accommodating” was later made clear later by Eichner in his book Macrodynamics as operations aimed at pegging the short term interest rate whatever the economic or credit conditions. So when the Fed is not accommodating – in this terminology – it means it is pursuing a policy of raising rates at frequent intervals with an aim to impact credit and aggregate demand.

The Google Books link is embedded below.

click to view on Google Books

Endnote

*Chief Economist and Economic Analyst, respectively at The New York Times at the time of writing.