How long can IOER go on?…and why the Fed Balance Sheet matters

So, the Federal Reserve just raised the federal funds target rate again to 0.75%. I wouldn’t consider this particularly noteworthy, except for the way that the Fed is doing it.

It used to be that commercial banks tended to expand their loans on their balance sheet up to (or even slightly past) the point where they had just enough reserve funds (whether through opening checking and savings accounts for depositors and holding their money, or by soliciting short-term loans from other banks) to cover the fractional backing requirement for those loans. After all, “excess” reserves that were not backing loans was just money that was sitting there doing nothing for the bank, earning 0% interest, as opposed to a much better risk-adjusted rate of return that they could get by pyramiding those reserves into a 20x greater loan (assuming that the reserve requirement stays fixed at 5%).

It used to be that, when the Fed wanted interest rates to increase, they would sell Fed assets (usually govt. treasuries) in exchange for bank reserves (money), thus vacuuming up some reserves from the banking system. That made it harder overall for banks to get emergency loans to shore up their reserve requirements after a busy day of making new loans, and those desperate banks would bid up the interest rates on those loans until such a point that it became pointless to extend new loans at a certain going interest rate because the banks would have to pay just as much interest for the reserves to back it. After an evening of musical chairs, some banks would sometimes fall short of securing short-term loans to meet their reserve requirements, and they would have to come crawling to the Federal Reserve for a loan from the “discount window,” which was another way that the Federal Reserve could influence what the competitive going interest rates were.

All of that is out the window now thanks to the several rounds of Quantitative Easing (QE), which were basically just open market operations on steroids.  In isolation, the QEs would have allowed for an explosion in the amount of commercial bank loans thanks to the extent to which they increased the monetary base of reserves held by those commercial banks.

However, at the same time that the Federal Reserve was doing its QEs, it also started a new policy meant to counter-act the effect of its own QEs, interest on reserves.  (Why the Fed would want to do a huge QE, and then shoot its previous QE in the foot with IOR, instead of just doing a smaller QE in the first place, has to do with the Fed’s idea of “Operation Twist,” in which they wanted to specifically bring down long-term interest rates without unleashing inflation).

Paying interest on reserves has disincentivized commercial banks from using those reserves to reach for riskier gains when they could just sit back and reap risk-free returns from the Fed, especially if borrowers were not willing to take on debt at interest rates much higher than the interest on reserves.  The slight added margin wouldn’t be worth the risk.  So, commercial banks have sat on these reserves.

However, as the business cycle improves, borrowers are becoming more eager for loans and feel more confident about being able to pay them back, even at slightly higher interest rates.  This would ordinarily tempt banks to starting writing more loans (at those slightly higher interest rates), threatening to explode the broad money supply.  Therefore, as the business cycle improves, unless the Federal Reserve wants to undo its QEs, or unless it wants to tolerate an explosion of inflation above its declared 2% target, the Fed must increase the interest on reserves that it pays to commercial banks to make that money stay put rather than chase greener pastures.

Some economists seem to see nothing wrong with interest on reserves and assume that it will become the new normal, but I see reasons for why interest on reserves is unsustainable, and it has to do with the Fed’s balance sheet.

Why the Fed Balance Sheet Matters

For my understanding of why the Fed balance sheet matters, I must thank Mike Sproul for explaining it in his many comments on blogs such as those of David Glasner (uneasymoney), Nick Rowe (, Scott Sumner (themoneyillusion), and JPKoning (moneyness).

Here’s the thing:  people assume that the Fed plays by entirely different rules because it has access to the printing presses.  It cannot go out of business if it makes bad deals.  It does not need to make a profit to continue to exist.  All of that is true.  However, if the Fed cares about the integrity of the dollar as a currency, it would behoove the Fed to act as though it was a normal bank.  In other words, if it cares about the dollar, the Fed ought to not make a habit of giving things away for free.  For every dollar it issues, it ought to try to have a dollar’s worth of assets in its possession.  Why?

It is true that the Fed’s dollar “liabilities” are unlike typical liabilities in that the Fed can never be put under the legal obligation to redeem outstanding dollars for Fed assets.  That’s true.  But the Fed has a practical obligation to offer such redemption if it wants to protect the value of the dollar and hit its inflation targets.

Dollar velocity and the demand for dollars are contentious topics.  For the moment, I won’t delve into what determines these.  However, I think it should suffice to say for our present purposes that these two things are not stable.  As much as we would like to assume that velocity stays constant, we have empirical evidence that it doesn’t.  Likewise, demand for dollars can suddenly increase or decrease for reasons that are difficult to understand.  Regardless, there may come times when the velocity of money surprisingly increases or the demand for dollars suddenly decreases.

When these things happen, if the Fed wants to hit its inflation target, it must be ready to sell its assets on its balance sheet in exchange for vacuuming up as much base money as it needs to in order to bring the supply of dollars in line with the new demand for, and velocity of, dollars.

To be perfectly prudential, the Fed ought to have enough assets so that it can vacuum up ALL of its outstanding dollars, if need be.  That way, no matter how low the demand for dollars temporarily dips, or how high the velocity gets, the Fed can always decrease the supply of dollars to make the dollar hit its inflation target.  That would give the dollar supreme credibility, and would dissuade people from even testing the Fed with a temporary run on (away from) the dollar.

Another thing that would be prudent for the Fed to do is keep some assets on its balance sheet whose values are not denominated in dollars.  The reason is, if the value of the dollar ever starts to slip, that is precisely when the Fed would need to rely on selling its assets to vacuum up enough dollars to re-establish the desired target.  Yet, as the dollar loses value, so will, to the same degree, any assets that the Fed has that are denominated in those same dollars.  A government bond or an MBS promising payment in dollars will lose value precisely proportional to the loss in the value of the dollar.  The Fed could find itself chasing its own tail.  However, a large gold hoard that the Fed would be willing to partially sell off would be a stabilizing influence because, as the dollar lost value, a given ounce of gold would buy (vacuum up) more and more dollars, thus making the problem actually easier to correct as it became worse.

How the Fed has harmed its balance sheet since 2008

The Fed has done two things to impair its balance sheet since 2008:  buying toxic MBS assets during its rounds of QE, and paying interest on reserves.

Banks have only been too happy to get a lot of their MBS assets off their balance sheets and onto the Fed’s balance sheet since 2008.  I imagine that the Fed was betting that those assets only seemed toxic at the time due to an abnormally distressed situation on the financial markets.  However, what if those assets really are toxic in a fundamental way?  What if too many of those MBS tranches have home loans that will never be fully paid back, not during a recession, not during a boom, never?  If so, then the Fed overpaid for those assets.  If the markets correctly perceive this, then when the Fed eventually goes to unwind its QEs and sell those assets back to the market, the market will only accept those MBS assets at a discount compared to what the Fed originally paid for them (let us disregard for the moment changes in price due to partial maturity of the assets in the intervening time).  What that means is that, even after all of the MBS assets are once again off the Fed’s books, some dollars that were originally injected into the monetary base from the original QE will remain permanently stranded out there, permanently swelling the monetary base (unless the Fed wants to deplete some of its other assets to compensate).  In any case, the Fed’s ammo for vacuuming up dollars in the future, should it need it, will have been permanently depleted.

As for interest on reserves, there the Fed is giving commercial banks value without getting anything for the Fed’s own balance sheet in return.  Some commentators talk as if this is to compensate for the fact that the Fed is getting a constant revenue stream from its financial assets bought in the QEs, and the banks are not.  This is a red herring, though.  Those revenue streams were already factored into the open-market prices of those financial assets when the Fed originally bought them.  The banks have already been paid for them.  The banks freely chose to trade a lump-sum of reserves for an ongoing (and uncertain) revenue stream, and the banks were able to freely hold out as long as they wanted until the Fed was offering enough of a price to allow the Fed to buy all of these revenue streams to hit its QE targets.  The Fed never “forced” banks to part with these revenue streams.  That’s what “open-market operations” means.  The Fed merely had to increase the offer price until the banks were willing to sell them however much the Fed wanted to buy.

The Fed’s paying commercial banks 0.75% interest on its reserves each year is a bit like the Fed having overpaid originally for those financial assets by 0.75%, multiplied by however many years this is allowed to continue and adjusted according to whatever the average interest on reserves payment happens to have been when integrated over the whole time from the start of the QEs until the unwinding of the QEs.

Interest on reserves is a permanent increase in the monetary base that the Fed has no way of vacuuming up if the Fed should ever need to do so.  The Fed has nothing to offer for that money.

There is a way out, however:  the fiscal authority could compensate by doing either of two things that amount to the same thing:  bestow non-monetary assets to the Fed’s balance sheet (taking them from somewhere else on the fiscal authority’s balance sheet, of course, such as social security) so that the Fed gets more ammo that it can use to vacuum up dollars, or run a tax surplus that is then destroyed (rather than recycled back into the economy via debt repayment and/or program spending).  These would alternative methods of vacuuming up dollars if the Fed’s balance sheet should ever become exhausted.

However, I find these alternatives politically unrealistic.  The fiscal authority is well-known to have an inflationary bias.  Would the public really tolerate their incomes being taxed, only to hear that that tax money would then be shredded (rather than going towards paying down the debt or some social program)?  This is why we have an independent monetary authority in the first place—to do the tough jobs that the popularly-elected fiscal authority won’t do.   If the “independent” monetary authority can’t do the job, why would we presume that the fiscal authority could?

In short:  the Fed’s balance sheet matters.  Let’s imagine that interest on reserves goes on for long enough and reaches a high enough level that fully one half of the monetary base was dispensed via interest on reserves, with the Fed having no assets on its balance sheet to show for it.  At that point, if the demand for dollars should ever suddenly drop in half, or the velocity of dollars should ever double (both plainly imaginable scenarios), the Fed would be out of ammo on its balance sheet for vacuuming up unwanted dollars, and inflation would be off and running.

And if the Fed should ever try to get away from Interest on Reserves, it would also need to unwind all of its QE or else risk an explosion of loan creation (and even if QE is unwound fully, I fear that there will be some permanently stranded dollars that the Fed will not be able to buy back with the toxic assets on its balance sheet).  Unwinding either QE or IOR will be painful.

Interest on reserves is a poisoned chalice.  Everything is treating it like a cure-all, but it will slowly poison the Fed’s balance sheet and tarnish the dollar’s long-term value prospects.

Money, or, How to measure whether you are making a profit

What is the point of investing?  What exactly are we trying to do here?

A child could probably tell you that the purpose of investing is to “make more money.”  And if you asked most economists, they would be hard-pressed to offer you a much more substantive answer.

You might think that this is a simple question that doesn’t require a very complicated answer in the first place, but you would be wrong.  It’s not that the children and economists are wrong in a literal sense.  The point of investing, as I see it, is indeed to “make more money.”  The tricky part, however, is to figure out what “money” is and how to tell how much more of it (or less of it) you have of it after a certain period of time.

But surely any child knows what money is.  “It’s what you buy stuff with,” a child might say.  When mainstream economists define money as a “medium of exchange,” they are hardly improving upon the commonsense grade-school understanding of money.

If money is “what you buy stuff with,” then having more money lets you buy “more” stuff.  And the reason why you are probably interested in investing is that you would certainly like to be able to buy “more” stuff at some point.

However, how do you define “more stuff”?  Do you define it by weight?  If yesterday you could buy a gold ring, but today you can buy a sack of flour, are you able to “buy more stuff” today?  Most people would say, no.

How do you know if you have “bought more stuff” on one day as compared to on a previous day?  Common sense tells us that we should simply determine how much money we spent on each two occasions.  If we spent more money, then we bought “more” stuff.

But I hope you see now that we are dealing with a circular definition of “money” and “stuff.”  How much money do you have?  Perhaps enough money (of some number of dollars M”) to buy some “X assortment” of stuff.  How “much” stuff is this “X assortment” of stuff?  Enough to cost M dollars.  We can only go back and forth without getting any closer to the question of how to measure money.

If yesterday you had one dollar and could barely buy a pound of fluor with it, and today you have two dollars and can barely buy a pound of flour with it,  have you made money?  Why yes, of course!  Today we are buying more stuff, aren’t we?  The stuff that we are buying with our total savings today costs two dollars, whereas the stuff we bought yesterday with our total savings cost only one dollar.

But, you might object, “Any child can see that you have only broken even!  Yesterday, your money could only buy 1 pound of flour, and today it is the same!”

Ahem, didn’t we agree just a second ago that we were going to measure our quantity of “stuff” by how much it cost us rather than any physical property of that stuff, such as weight?

To be continued….

A little Voynich puzzle I contrived….

I figure it might be a neat little exercise for Voynich cryptographers to calibrate their attacks on the Voynich Manuscript by tackling a different encipherment that uses the same script—one that I devised myself!  See if you can decipher it.

If the correct answer has not been found in a year’s time, I will post the correct answer exactly a year from now:  July 18th, 2017.  The only hint that I will give is that the intended message is clear and unambiguous, and there are clear rules for constructing and deconstructing the message that I could convey to a trusted confidant on the other end in less space than it took to write this post.




Why I’m glad I occasionally pay attention to mainstream economists

Recently J. P. Koning at his Moneyness blog noticed that so-called “Fedwire” transaction volume is down this past year and a half.

The “Fedwire” is a mechanism that enables banks with Federal Reserve accounts to calculate their net obligations at the end of each day and settle that net difference.  So, for example, rather than having Bank A pay Bank B $9 billion from one set of transactions, only to have Bank B pay Bank A back $10 billion owing to a different set of transactions, the obligations would be mutually settled through Fedwire and the only net transaction that would have to take place would be for Bank B to pay Bank A $1 billion at the end of the day.

This might seem like a trivial accounting difference, but it actually has critical implications.  In order to settle obligations in the first scenario, the banks need $10 billion in currency, or they would need to resort to short-term overnight credit.  In order to settle obligations in the second scenario, only $1 billion in currency is needed.

But who cares how much currency is actually needed?  Can’t the Federal Reserve just print more currency if it is needed to circulate the desired amount of value that parties wish to transact?

Well, the Federal Reserve could do this, but increasing the dollar tokens with respect to gold would devaluate the dollar versus gold, and at some gut level the Federal Reserve understands this.  After all, if the Federal Reserve had absolute freedom to expand and contract the monetary base as the “demands of commerce” apparently demanded, then there would be no need for settlement mechanisms or short-term credit in the first place. No bank would want to take out an overnight loan if it could just as easily ensure that it got paid in hard cash by calling up the Federal Reserve and letting them know that the “needs of commerce” demanded more liquidity.

So, the settlement mechanism is actually quite important.  It allows commercial activity to expand to many multiples of what the dollar monetary base, and the world gold market standing behind that, would allow by themselves.  The J. P. Koning article linked to above has some exact figures that will astound you—for example, that the Fedwire in 2015 handled $834 trillion in transactions, even after using the settlement mechanism.  (How much more money would have had to have changed hands without the settlement mechanism!)  To be sure, most of that trading was probably speculation in financial assets of various sorts, but still….

If you will recall from my previous post on money capital vs. commodity capital, I found to my surprise that, over the last 50 years, annual world GDP as measured in ounces of gold has averaged about 1000 times the annual production of gold bullion on the world market, with unsustainable boom periods marked by world GDP outstripping this average, and periods of crisis marked by world GDP lagging behind this average.

In a hypothetical world where a given ounce of gold, or its dollar-token equivalent, could only be exchanged once per year, where there was no credit offered by anyone, and where settlement mechanisms such as Fedwire did not exist, world gold production would need to have been about 1000 times greater in volume over the last 50 years in order to accommodate the circulation of the value of the commodities being circulated.  Capitalism overcomes this “metallic barrier” by:
1.  Increasing the velocity of money, so that a given ounce of gold or its dollar-equivalent can be exchanged multiple times over a given year.  This is aided by technologies such as, for example, having paper tokens represent gold in circulation rather than circulating gold directly and risking wear-and-tear.
2.  Extending credit.
3.  Introducing settlement mechanisms to cut down on the actual amount of money that needs to be exchanged (which, in a way, is sort of an intra-day credit that temporarily exists on paper before it is paid back at the end of the day without interest, leaving behind a small net settlement balance that then must be paid with either cash or actual short-term, interest-yielding credit).

Although I have not done the math, it makes sense to me that these three factors could account for the large, but consistent discrepancy between world GDP as measured in gold ounces and the actual number of ounces of gold production in any given year.

But is it not strange that this ratio has not re-adjusted to some new order of magnitude over the last 50 years?  Yes, there have been fluctuations, but it appears that the 1000:1 ratio has had a very strong pull.

One would think that new technology, such as debit cards and Fedwire, would allow this ratio to increase even more.  Perhaps these new technologies have been counter-balanced by the fact that the U.S. left the Bretton-Woods gold peg in 1971, which (counter-productively from the Federal Reserve’s standpoint) made capitalists more insistent on holding, say, 2-3% of their portfolio wealth in gold on average as opposed to, say, 1-2%, due to the greater risk that the dollar could be at any time depreciated versus gold.  These larger immobile gold hoards would cause more gold to be needed to circulate a given value of commodities on the world market.  Again, I have not run the numbers on this, but it seems plausible that these factors could have partially canceled each other out.

Does the Fedwire data in J.P. Koning’s post say anything about the current state of the business cycle?  Yes.  I think it shows, once again, that the boom phase of the current cycle has not even really begun yet and still has plenty of room to grow.  If the Fedwire settlement mechanism were being stressed to its max (in addition to the credit markets undergoing the same), then I would say that a crisis would be right around the corner.  But as J.P. Koning’s post shows, there is still plenty of slack in the Fedwire system, and we know that interest rates on the credit markets are still rock-bottom.  There is still plenty of gold, and dollar-token-equivalent representing that gold, to circulate commodities at their present values on the world market.  There is still plenty of room for more credit creation (whether of the intra-day Fedwire kind or the longer-term interest-yielding kind) to inflate the appearance of expansion of the world market for commodities.

As Sam Williams says, paraphrasing Marx, an ounce of gold or its dollar-token equivalent can only be in one place at a time.  Velocity can increase, but only up to a certain point with our given level of technology.  Sooner or later, the world market runs into a situation where the tower of credit and the chain of payments becomes shakier and shakier, until the same ounce of gold or dollar-equivalent is called upon to settle two different credit obligations at the same time, and as this becomes more widespread, a credit crisis erupts and then a general crisis of overproduction that was building latently (while being papered over by the expansion of credit) finally makes itself apparent.

But we are not there yet.  We are nowhere close to that part of the business cycle.  There is still plenty of slack in the system, plenty of room for credit to expand.  That is why I bought into VT (Vanguard Global Equity ETF) this past week right after the Brexit debacle.  I anticipate the share price going up quite a bit over the next three years or so.  Only when world GDP as measured in gold ounces begins to appear to be solidly outrunning world gold production (after adjusting for the 1000:1 ratio measured earlier), and only when interest rates have climbed again and Fedwire has started accommodating a greatly-expanded volume—that will be when I sell off my stocks and buy gold (or more likely, gold-related financial assets such as SPDR shares).  Shortly thereafter we will see stocks plunge and gold soar, as we did in the 2008 recession.

Communist Economics Part 4: Updated Production for Use Spreadsheet

I have recently updated my “Production for Use” spreadsheet to be (hopefully) a little easier to follow.

I also fixed some errors in some of the equations where I was not distinguishing between the “Production Cost” for items and the “Consumption Cost” for those same items.  These are two different things.

The equation for the “Production Cost” of an item is:

(Labor hours of input materials * subjectively-reported unpleasantness weighting factor of those labor hours spent making the input materials * the factor utilization of those input materials) / the factor utilization of the outputted product.

And the units would be in “modified labor hours.”

Whereas the equation for the “Consumption Cost” of an item is:

((Labor hours of input materials * subjectively-reported unpleasantness weighting factor of those labor hours spent making the input materials * the factor utilization of those input materials) + (Labor hours spent assembling the input materials * subjectively-reported unpleasantness weighting factor of those labor hours spent assembling the input materials)) * the factor utilization of the outputted product.

And the units would once again be in “modified labor hours.”

When to use Production Cost vs. Consumption Cost?

Production cost would be calculated when items are produced, and consumption cost would be calculated when items are consumed.  It’s that simple.  In either case, the relevant participants involved with each would want to make each measure of cost as low as possible, although how they can achieve this varied between the two situations.  (Such as:  if you are producing an item, you want to produce an item with a high factor utilization using inputs with low factor utilizations.  Whereas, if you are consuming an item, you want to consume an item with a low factor utilization that itself was also made from inputs with low factor utilization).

Anyways, here’s the updated Production-for-use-calculator-v2

The current minor slowdown: an “Inventory Cycle”?

Michael Roberts once again has a post up foretelling another recession brewing within the next 1 to 3 years.  I don’t necessarily disagree that much on the timing.  I think 1 year is a bit too soon.  Three years sounds about right, though.

The main difference between Michael Roberts’s forecast and mine, however, is that Roberts sees the economy’s trajectory gradually rounding the top and worsening in these next three years, starting from right now.  I, however, think that we have yet to really enter the boom phase proper.  I think we will see quite a bit of improvement in the meantime before the next full-blown crisis hits in about 3 years.

In other words, whereas Roberts sees the economy as gradually stalling towards recession starting now, I predict that the economy will begin to accelerate.  I still think that a recession is about 3 years away, but I think the period immediately before the recession is more likely to look like a prosperous boom than the current sluggish stall.

Why do I think the economy still has a lot of potential left in it to accelerate before hitting another recession?

I agree with Sam Williams’s crisis theory that the main reason why there have to be crises under capitalism from time to time is that production inevitably gets expanded beyond the  monetarily-effective demand needed to buy up that production.

What, ultimately, determines long-run monetarily-effective demand?  World production rates of the money commodity (which currently is gold).

Why does the production of all other commodities inevitably race ahead of the production of the money commodity?  Because the expansion of credit in a cycle artificially inflates the prices of all non-money commodities above their values and artificially inflates the profits on paper of producing them (while simultaneously deflating the price of the money commodity below its value and artificially reducing the incentive to produce the money commodity just when the world needs it the most).

According to this theory, leading up to a full-blown crisis of overproduction (of all non-money commodities relative to the money commodity), one should see:

  • A.  Declining world money-commodity production (relative to world GDP growth, but even more so if there is even an absolute decline in the rate of money-commodity production). Our money commodity in the present world is gold.  So, look at gold production.  If it is lagging behind reported world GDP growth, and especially if it starts declining in absolute terms for several years in a row, a crisis cannot be far off.
  • B.  The expansion of credit to unsustainably create the appearance of increasing demand for non-money commodities in the absence of enough commodity-money (or token money representing commodity-money) to really purchase all those non-money commodities.
  • C.  Increasing interest rates as hard money and credit become more scarce.  How high can interest rates go before triggering a crisis?  As interest rates approach the average rate of profit, then you know that the profit of enterprise is getting squeezed out of existence, and factory shutdowns, layoffs, and consumer debt/mortgage defaults cannot be far off.
  • D.  A stall and decline in housing starts (as high mortgage interest rates become unsustainable).  This, not investment in fixed capital, is the leading indicator to watch out for.  Investment in fixed capital is a lagging indicator of crisis, contrary to what Michael Roberts argues.
  • E.  A high and increasing velocity of money.
  • F.  A build-up of excess inventories.

What do we see currently?

A.  World Gold Production 

B.  Bank Loans

C.  Prime interest rate

D.  Housing Starts

E.  Velocity of money

F.  Excess inventories

Of all those indicators, only B and F point to the possibility of an imminent crisis of overproduction.  (And I still think B can go way higher before hitting a limit based on how much capital there is still sitting idle as excess reserves).

In his recent column linked to above, Michael Roberts alleges that there is currently a problem of profitability, and that sluggish or falling profitability will lead us into a new crisis.

I agree that profitability is important.  But I think that, so long as profitability is still substantially above the rate of interest that industrial capitalists must pay for capital, then there is still plenty of incentive to invest.  Consider:  the risk-free interest rate on excess reserves (charitably being paid by the Federal Reserve to banks on their excess reserves) is currently 0.5%.  Assuming that the “prime rate” that banks will charge capitalists has to be a little bit above that (in order to make it worth their while to process the loans, pay overhead, etc.)  Let’s say the prime rate is 3%.

The rate of profit needs to be substantially above that to justify the risk of risking money in the uncertain industrial capitalist circuit of M-C-P-C’-M’.  Let’s say, 5% above the prime rate, or 8%.  Are you telling me that the average rate of profit is currently below 8%?  If so, then capitalism is truly screwed.  Because that means that, even with interest rates at the lowest that they will ever go, industrial capitalists will not see a reason to risk their capital (or borrow capital) to go into production of most commodities.

If the rate of profit truly is sliding below 8% or so, then there’s what I predict you would see:  negative interest rates as far as the eye could see.  Which would logically lead to the taxing of depositors with negative interest rates—in effect, subsidizing banks’ appropriation of surplus value on the front end to make up for the fact that they will not be able to appropriate as much surplus value “on the back end” with their interest rates to industrial capitalists being limited to something like 1% or 2%.  (Limited, that is, by the industrial capitalists’ willingness to pay higher rates of interest for that loan money).

Of course, banks might still go out of business in this situation if depositors withdrew all of their money and tried to hold it as (unpenalized) cash or gold.  There are a number of things that could happen at that point:

  1. The government could try to outlaw physical cash and/or gold ownership (such as with FDR’s Executive Order 6102 in 1933).
  2. Perhaps we would evolve to a system where savers loaned money to industrial capitalists directly rather than go through the middle-men of banks who would shave off their traditional 3%.
  3. Perhaps the government would step in and perform the banks’ traditional financial intermediary services at a loss, with tax revenue making up the shortfall.

Anyways, determining the average rate of profit is above my pay-grade, but unless someone can show me that the average rate of profit has plunged below about 8%, then I’ll regard this permanent negative interest rate scenario as unlikely for the near future.

Michael Roberts has pointed out that one reason that profit rates are low currently is that fixed investment is low, and thus the Department I industries (heavy industries that produce means of production) are doing badly.  However, this is not a sign of a coming recession.  This is to be expected at the bottom of a business cycle, not on the approach to the top.  On the approach to the top, you would expect to see Department I industries booming as businesses expand production on the (mistaken) assumption that the boom will keep going forever.  Rates of profit in Department I industries are a lagging indicator of the business cycle, not a leading indicator.  Once the boom phase of our current cycle and credit inflation gets some momentum, we will see the Department I industries taking off.

As I have said in recent posts, the Federal Reserve could retard the coming boom a bit by increasing the Federal Funds rate, which it can only do now by increasing its rate of interest on excess reserves, and thus discouraging banks from making loans on those reserves…or by unwinding QE, which it will not do any time soon.  In that case, if the Federal Reserve hikes too quickly, we could see a bit of a prolonged malaise before the boom period proper picks up again.  But we are not primed for another full-blown crisis of overproduction just yet in any case.

A crisis of over-production of non-money commodities relative to the money commodity requires over-reliance on credit and a resulting credit crunch.  There can’t be a credit crunch if credit is not already over-extended, and right now credit is not especially over-extended.

When those 2.3 trillion dollars currently in excess reserves become required reserves serving as the base for $23 trillion in new loans on top of them, THEN you will know that we are primed for another crisis of overproduction and credit crunch.  (And in the meantime, we will be riding one hell of an inflationary roller-coaster with all that new loan money flooding into the economy…unless the Federal Reserve unwinds its QEs).

Instead, in addition to the Fed being aggressive in tightening, what might be going on right now is an “Inventory Cycle” or “Kitchin Cycle.”   This could explain the recent rise in the inventory to sales ratio.

The basic idea is, now that the economy is starting to exit the depression phase and is getting set for the boom phase, money capitalists anticipate an increasing level of demand for credit. So these money capitalists start to anticipate being able to get industrial capitalists and consumers to sign onto higher-interest loans in the near future.  So the money capitalists start to, in a sense, get ahead of themselves in demanding higher interest rates before the economy is really ready to support those higher rates.  And so, especially at a point when demand for Department I goods has not really taken off yet to help the expansion along, you get a temporary hiccup in the expansion, a temporary apparent dearth of available credit at reasonable rates, a temporary lack of apparent demand, and a temporary accumulation of unsold inventories.

However, as soon as money capitalists re-adjust their expectations downwards and begin to offer credit again at more reasonable rates that the (slowly expanding) economy can support, credit and demand should pick back up again, inventories should drop, and the boom phase proper of the industrial cycle should commence.

That’s my forecast, and I’m sticking to it.

More evidence that we are NOT near the start of a new recession

The job market.

Housing starts.

More data.

Sorry folks!  But our job as Marxists is not to be perpetual pessimists preaching that doom and gloom are always right around the corner.  I calls it like I sees it.  And right now, it looks like we are entering the boom phase of the industrial cycle.

Only if the Federal Reserve quickly raises the payment of interest on excess reserves to higher rates will this boom get snuffed out before it gets going.

The deflationary signals that we are seeing right now stem from the Fed’s increase of the IOER from 0.25% to 0.50% recently.  That is keeping money cooped up in bank vaults on the Federal Reserve’s account rather than having that money serve as the fractional basis for new loans.  The Fed might have some difficulty finding its desired balance between deflation and inflation with this new (and absurd) “tool,” so no guarantees that it won’t overshoot and push things temporarily into deflation.

But I cannot see how even a deflationary blip engineered by the Fed’s IOER would permanently put an early end to this business cycle before we really get to experience a “boom” phase that uses up all of that excess capital and leverages a lot of new credit money on top of that excess capital.

Excess Reserves: The Fed’s ticking timebomb

The Federal Reserve has backed itself into quite a corner with its three rounds of “quantitative easing.”  In order to make sure that the resulting increase in bank reserves did not cause hyperinflation, the Federal Reserve has had to keep those reserves quarantined in bank vaults, away from bidding on the prices of commodities in the real economy.  To persuade banks to keep their money sitting idle in vaults, the Federal Reserve has had to pay interest on the excess reserves that resulted from those quantitative easings.

The Federal Reserve’s quantitative easings (creating electronic money out of thin air and using that money to buy various financial assets on the open market) brought about an expansion of the monetary base that was unprecedented.


Normally, this would have produced Weimar-like hyperinflation.  I’m not exaggerating. Just look.  We went from $0.8 trillion in the monetary base to $4 trillion in monetary base in about 5 years.  That’s about a 100% annual rate of inflation.  The problem is, when you get that level of inflation, people start to react to it by dramatically increasing the velocity of money (trying to get the increasingly-worthless hot-potato money off their hands before it loses more value), which would have started to increase the rate of inflation exponentially as the same dollar bills got to bid on more and more commodities in a period of time.

So, why hasn’t there been hyperinflation?  Because, as I’ve said, the extra monetary base has been mostly quarantined in bank vaults in the form of excess reserves.  How did the Federal Reserve accomplish that?  By paying interest on excess reserves (IOER) to make holding that money in bank vaults more attractive than making new loans on the basis of that money to the real economy.

At first, the Federal Reserve did not have to pay much interest to coax that money to stay in bank vaults—only 0.25%.  The reason was, banks saw few prospects for making good (credit-worthy) loans to companies at any interest rate higher than 0.25%.  That’s how bad the economy was during the bottom of the Great Recession.

But as the economy (haltingly) improves, banks will become more and more tempted to make loans on those excess reserves.

Technically, as many people have rightly pointed out, banks do not “loan out excess reserves.”  No, it is far worse.  They make loans using excess reserves as their required “fractional reserve,” which currently by law is mandated to be 10% of the loan amount.

What this means is that, although banks have $2.3 trillion in excess reserves, they could actually loan out $23 trillion in new money.  Yeah….

And when those loans are made, the reserves (no longer “excess,” but now “required”) stay in the banking system.  In fact, although banks might shuffle some of those reserves between themselves, there is really no way for those reserves (and thus the fractional base for loans) to be drawn down except by the Federal Reserve REVERSING quantitative easing and selling the financial assets on the Federal Reserve’s balance sheet in exchange for bank money (which the Federal Reserve would then electronically delete from existence once it collects that money).

Commentators often focus on the Federal Reserve’s balance sheet and explain that the balance sheet can be gradually decreased without reversing QE, but instead simply by holding the financial assets to maturity.  While this would indeed decrease the Federal Reserve’s balance sheet, it would do nothing to reverse the expansion of the monetary base.  It is the expansion of the monetary base that is the real problem, of which the Federal Reserve’s ballooned balance sheet is only a symptom.  The only thing that having the Federal Reserve hold those assets to maturity will do is remove those assets as something the Federal Reserve can sell back to the market in exchange for clawing back some of the monetary base it injected.  The more those things are held to maturity, the more permanent the expansion of the monetary base will be.

Thought-Experiment – If the Federal Reserve Ended IOER

As a thought-experiment, what would happen if banks this next year suddenly decided to make new loans off of all of their $2.3 trillion in excess reserves (perhaps in response to an improving business climate promising that most of those loans would be paid back, and/or the Federal Reserve ceasing the payment of interest on those reserves, thus no longer giving that money a reason to stay cooped up in banks without loans on top of them)?  Well, the M2 money supply would increase by not $2.3 trillion, but $23 trillion (due to the 10x multiplier of only needing a 10% fraction as a base for the loans).  Here’s where M2 money is right now:


It’s at about, let’s say, $13 trillion right now.  It would be expanded to $36 trillion in one year, which would be an annual increase of 175%.  That gives us a lower-bound for our rate of inflation that year….

But wait, there’s more.  Remember when I said that the velocity of money really picks up when people expect inflation?  That’s true, in which case a “modest” amount of inflation can serve as a seed for hyperinflation, as people increasingly react to inflation by changing their expectations and spending money as quickly as possible.  But it’s also true that the velocity of money typically increases during the boom phase of any business cycle.  We don’t even need to postulate huge changes in psychological expectations to see how changes in the velocity of money would further increase the inflation.

So let’s be conservative in our thought-experiment and imagine only that the velocity of M2 money returned to where it was during the boom of the late 1990s.  (As I’ve said, it could go much worse!)


Going from 1.5 to 2.2 would be another roughly 50% increase.  So add that to the inflation rate.

We’d be looking at a yearly inflation rate of about 225%.  By the end of 2016, the price of gold would be about…$3900 under this scenario.

The Lesser of Two Evils

Of course, the Federal Reserve will not allow this sort of inflation to happen (we assume…).  Instead, the Federal Reserve will continue to raise the interest on excess reserves (IOER) so that keeping those reserves as idle excess reserves will be competitive with using those reserves as the base for 10x the amount of new loans.  Making new loans will become more and more attractive as the economy improves (and borrowers will be willing and able to pay higher and higher rates of interest), which means the Federal Reserve will have to keep raising the IOER to keep pace.

Some commentators have been incredibly glib about this reliance on the IOER as the Federal Reserve’s new primary tool for keeping inflation in check.

(From the link above)—”Basically, the payment of interest on reserves allows the Fed to maintain control of the Fed Funds Rate even when the balance sheet is expanded.  So the Fed can raise interest rates no matter what the size of the balance sheet is because it can simply increase the rate of IOER.”

“Basically”?  “Simply”?  Oh yeah, this IOER thing will be a piece of cake!  Why didn’t the Fed think of this earlier?!  Okay, everybody go home, everything’s fine, nothing to see here….

Needless to say, there are other bourgeois commentators who are less enthusiastic about relying on IOER…

There are four major problems with IOER that I see:

  1. It is basically a taxpayer subsidy to the banks.  Right now it is “only” $6.5 billion per year, but if the IOER rate were to go up to something like 4%, it would be closer to $100 billion per year.
  2. It is baking-in more inflation in the long term because IOER is directly increasing bank reserves without investing to expand production in the real economy.  So if IOER is ever unwound, it will have more and more of a severe aftermath the longer it has been in place.
  3. It could cause “supply-side inflation” if the IOER rate were to go above the traditional target inflation rate of 2%.  Imagine that the IOER is 3%.  That means that banks could then reap a real, inflation-adjusted return on their money of 1% by just letting their cash sit idle.  A riskless 1% return that is perfectly liquid (not tied up in bonds or other long-term instruments)?  Not only would existing reserves stay cooped up in bank vaults to get this great interest rate, but even new money that is currently tied up in the real economy would abandon the real economy and flock into bank vaults.  Hey, instead of risking your money running an enterprise like some old-fashioned dweeb, how about you get in on this riskless 1% action?  Of course, if money exits real production in order to chase this 1% real return in bank vaults, the actual amount of goods produced will fall.  With supply reduced, prices will rise.
  4. IOER is a blunt and leveraged instrument.  For example, right now the IOER is at 0.50%.  If it were at, say, 0.10%, it is possible that ALL of that $2.3 trillion in reserves would be establishing new loan money at higher rates instead (and thus, hyperinflation).  If it were at, say, 1.0%, it is possible that a lot of existing productive capital would exit the real economy and flood into bank vaults to obtain that comparatively high interest rate on idle reserves, thus depressing prices (this may already be happening with the 0.50% rate, to some extent—hence the current fear of deflation).  The Federal Reserve now has $2.3 trillion (or possibly more) that it is implicitly responsible for direction—money that could swing wildly in either direction (real economy vs. idle excess reserves) based on small changes in the real economy (the rates borrowers are willing to pay for loans) or the IOER.  Really, the Federal Reserve should be raising in 0.10% increments at more frequent intervals if it wants to use this blunt, leveraged instrument with more finesse.

These problems will only get worse the longer IOER is in effect.  The only way to unwind IOER, though, will be to unwind QE, or tolerate hyperinflation…and the Federal Reserve has implied that it will not be doing the latter two any time soon….

Communist Economics Part 3: Production for Use Calculator

I have finally made an excel spreadsheet demonstrating some of my ideas for calculating who would get to use scarce goods first under a “production for use” framework.

Here is the spreadsheet:


Here is a youtube video series where I walk through how one would use this spreadsheet.

There has always been a question among communists of “Who will clean the sewers?”  In other words, how can we incentivize socially-useful behavior without money or production for exchange?  Well, I think this spreadsheet explains one viable option.  Check it out!