December 17, 2013
- Why a highly touted chart does not spell the end of the world
- Chris Mayer on a “neat little trick” that will change everything you know about credit creation
- Traders wait on the Fed: The 5’s “taper” call for tomorrow
- That didn’t take long: Asia-Pacific arms race underway in earnest
- A total waste of China’s gold stash… sussing out who are the “fools”… Google’s real plans for its robot acquisition… and more!
Poke around the seamier corners of the financial blogosphere and it won’t be long before you stumble on what’s often touted as The Scariest Chart of All Time™.
Maybe you’re already familiar with it…
These are the “excess reserves” held by banks at the Federal Reserve. The chart started going vertical during the Panic of 2008. To keep the system afloat, the Fed began paying banks interest on those excess reserves of a quarter-percent. The line on the chart has climbed steadily since, pausing only when the Fed paused its “quantitative easing.”
Four weeks ago, Fed leadership let it drop that they’ve been talking among themselves about cutting that rate “at some stage” — nudging the banks to start “lending out” those excess reserves to goose the economy, or so the thinking goes.
The usual suspects pimping The Scariest Chart of All Time™ will tell you whenever “some stage” arrives, the result will indeed goose the economy temporarily… and then it’s sure to backfire and set off a HYPERINFLATIONARY TSUNAMI. Gold will zoom to $10,000, store shelves will be stripped bare, humanity will turn feral.
Moreover, the usual suspects are on high alert today; the Fed’s Open Market Committee (FOMC) has begun one of its regular two-day meetings. White smoke will emerge from the Marriner Eccles building tomorrow at 2:00 p.m. EST, the FOMC will issue a “policy statement” and Ben Bernanke will hold his final press conference as Fed chairman. Tsunami alert!
“Many people don’t understand what excess reserves are,” says our Chris Mayer, “even people who ought to know.”
Fair warning, dear reader: Chris is taking us into the weeds today. But we promise you’ll come out the other side with more knowledge than the usual suspects and, for that matter, many central bankers. “I’m going to show you a neat trick the banking system performs,” our resident former banker promises.
“Let’s start with a fact,” says Chris, “the key to the whole thing. If you remember this, you can’t go too far astray: Banks do not lend out deposits. Loans create deposits.”
Most people have been taught that banks get deposits first and then lend out a portion of them. “This view is a complete fiction,” he declares. “It is not how banks actually work.
“As banks make a loan, they simultaneously create both the loan and the deposit. Say the banking system makes $1 billion in mortgage loans. It also simultaneously creates $1 billion in deposits as it credits the borrowers’ accounts. There is no need to have the deposits ahead of time. This is why lending is called ‘credit creation.’ The deposits come from nowhere. With a few keystrokes, the banking system creates money.
“Neat trick, right?”
But that’s not where the story ends. “The banking system then creates reserves,” Chris explains — “an amount they have to set aside against those deposits. These reserves are held at the Federal Reserve Bank.
“So just remember: Loans create deposits. Not the other way around. Banks do not lend out deposits. And they do not lend out reserves.”
Alas, even a former vice chairman of the Fed doesn’t get it. Alan Blinder got some buzz last week with an Op-Ed in The Wall Street Journal: “Excess reserves sitting idle in banks’ account at the Fed do nothing to boost the economy. We want banks to use the money.”
“But now you understand,” says Chris, “that banks cannot ‘use the money.’ The reserves are a residual, set aside against deposits. And banks don’t lend deposits. They create deposits when they make loans. On a systemwide basis, there is nothing the banks can do to lower reserves. The central bank (almost entirely) determines the level of reserves through its actions.”
So if banks don’t lend reserves, you ask, what’s the point of “QE”?
“Because QE drives down interest rates,” says Chris.
“The lower rates may, at the margin, bring in borrowers who might not have otherwise borrowed. They may induce lenders to make loans they otherwise wouldn’t have made. But the connection is far weaker than most people think. And it has nothing to do with reserves.” If banks don’t see a way to make a profit by lending, they won’t lend. “I can tell you when I was in banking, we never made a loan decision based on what our reserve position was.
“What the Fed’s manipulating of interest does is set off a boom in so-called risk assets — like stocks. Lower rates tend to put upward pressure on asset prices.
“You can criticize QE for inflating asset prices by keeping rates lower than they otherwise might be. (And it clearly helps borrowers and punishes savers.) But now you know how banks really create money. And QE is not part of the credit creation process.”
[Ed. Note: The Fed’s incessant inflation of asset prices has frustrated Chris to no end; it makes bargains extremely hard to find. But deep within the market’s hidden crevices, he’s dug up a rare find: It can outperform traditional stocks by 300-500%, but you can buy it just as easily as traditional stocks through your online brokerage account. For the skinny on this unique “make money while you sleep” play… look here.]
Major U.S. stock indexes are in suspended animation this morning, as they often are when the FOMC is in session. Everything is in the red, but not by much: As we write, the S&P’s at 1,779.
The Bureau of Labor Statistics is out with its latest read on consumer prices — flat in November. The year-over-year increase works out to 1.2% — still well below the Fed’s 2% sweet spot.
As such, we’ll be shocked if the Fed decides to “taper” its QE program tomorrow. “I don’t think Bernanke’s really going to do anything [before] he leaves,” Currency Wars author Jim Rickards told us last summer. He’s sticking to that call: “No December taper,” he tweeted yesterday.
In the real world, by the way, consumer prices have risen 8.8% in the last year, according to the latest calculations by the intrepid John Williams at Shadow Government Statistics.
Japan’s cabinet has fulfilled a forecast made in our virtual pages barely two weeks ago — planning for increased military spending.
“Over the next five years,” the BBC reports, “Japan will buy hardware including drones, stealth aircraft and amphibious vehicles. The military will also build a new marine unit, an amphibious force capable of retaking islands.”
As you may know, Japan and China are locking diplomatic horns over the Senkaku Islands — controlled by Japan, claimed by China. China asserted control of the airspace over the islands last month.
“I foresee increased defense budgets for aircraft, ships and systems intended for East Asia among Japan, South Korea and the U.S,” our Byron King said here on Dec. 2. “Money will flow like Niagara into Asian rearmament.”
And that’s just in the East China Sea.
Meanwhile, in the South China Sea, U.S. and Chinese forces came dangerously close to the sort of “accident” we warned about last Thursday.
Turns out on Dec. 5, the guided-missile destroyer USS Cowpens had to take evasive measures to avoid colliding with a Chinese naval vessel. The Pentagon says the Cowpens was “lawfully operating in international waters.”
This morning, the Chinese Communist Party newspaper Global Times said the Cowpens was “tailing after and harassing” a formation of Chinese warships — including the Liaoning, the nation’s first aircraft carrier.
Get used to hearing a lot about this sort of thing…
Staying with China: Do you get the sense its present-day leaders feel conflicted about the legacy of the mass murderer Mao Zedong?
That’s $16 million in gold and jade — all tied up in this 32-inch high statue unveiled last Friday in Shenzen. “The city was little more than a fishing village a few decades ago,” the AFP newswire informs us, “and its booming prosperity epitomizes China’s transformation since the days of Mao’s command economy.”
One week from Thursday is the 120th anniversary of Mao’s birth. Chinese media reports are mum about who commissioned or paid for the statue… but regardless, it seems to run counter to president Xi Jinping’s request that any commemorations be “solemn, simple and pragmatic.”
Still, other people seem to be taking Xi’s cue: According to the aforementioned Global Times, an event on the anniversary date scheduled at Beijing’s Great Hall of the People was originally called “Reddest is the Sun and Dearest is Chairman Mao.”
It has since been renamed. “New Year’s Gala.”
Pragmatic, indeed.
“I don’t know which group of people are being referred to as fools,” a reader writes after yesterday’s episode, “the recipients of the entitlement payments or the economists who believe Keynesianism is the proper path to follow.
“What I do believe is that human psychology is fairly predictable, and the vast majority of people will always choose what benefits them the most. Today, we have almost half the population receiving some type of payment from the government each month, and understanding this makes it easy to predict how they will vote when it comes time. Even if we made radical changes today, I believe it is too late, we are still destined for much upheaval.
“But what is apparent is the government has no intention of making any changes. Their lust for power and office will not allow them to make such changes, so we are practically guaranteed a very turbulent future in this country.
“So would I call the people fools? Probably not: They are just doing what others before them have been doing for almost 100 years.
“The average person on the street has no concept of economics, and the politicians have been able to deceive them for so long, they believe everything is normal. But I do believe the majority of politicians are hypocrites and have no intention of telling the truth, that throughout history continued deficit spending has never ended well.”
The 5: What? You’re not overjoyed at the bipartisan kumbaya that will cut the deficit by $23 billion over 10 years? Cynical cat you are…
“If something costs $1,000 and the customer does not have the money,” a reader weighs in on the higher-education bubble, “the product in unaffordable.
“HOWEVER, if a person BORROWS the money to purchase the product, it is now ‘affordable.’
“I never did figure out how putting more money into the student loan program made college ‘affordable.’
“It is my belief,” a reader writes after yesterday’s episode, “that Google intends on leasing their newly acquired four-legged robot, named Big Dog, to Amazon for local deliveries.
“Hopefully, the Starship Troopers will not blast the buglike creatures to dust thinking they have saved the FEDeration.”
The 5: Maybe they team up to hunt down feral hogs…
Cheers,
Dave Gonigam
The 5 Min. Forecast
P.S. Yesterday, a federal judge declared that NSA’s vacuuming up of “metadata” likely violates the Constitution. He called it “almost Orwellian.” He said James Madison would be “aghast.”
Alas, nothing will change as a practical matter for now; the judge ordered the feds to stop collecting the data on two plaintiffs in the case… and then he stayed the order so the feds could appeal.
Now there’s an object lesson in how you can’t count on government to restrain its own power. That’s up to you. For access to scads of practical tips to cover up your digital tracks from the prying eyes of the NSA, take a look at this.