Innovation in Monetary Policy in Sweden Works: Negative Interest Rates

The Sveriges  Riksbank (a.k.a.  Riksbanken), the Swedish central bank, tried an innovation in monetary policy two years ago in July 2009 when it set the official deposit rate at a negative interest rate of -.25%.  The objective was to stimulate and motivate banks to lend their “excess” reserves to businesses and households and to therefore stimulate the economy.  The Riksbanken was the first central bank to try a negative interest rate and as far as I know, it’s the only one that has tried it.

The results of the experiment look pretty good.  The Financial Times has reported that Sweden’s economy has come roaring back from the depths of the global recession.  It recorded a 7.3% growth in real GDP for 4th quarter 2010 (year-over-year). Fast enough growth that the bank has long since found it necessary to raise interest rates back into positive territory.

So what happened here? And how does a “negative interest rate” work?  Monetary policy is primarily handled by changes in interest rates. In particular, central banks change interest rates on their dealings with commercial banks in their country.  Remember a central bank is a “banker’s bank” – it’s where your average ordinary bank, be it JP Morgan Chase or Podunk Community Bank, has both deposit accounts and loan accounts.  The average commercial bank keeps a certain amount of money on deposit at the central bank. This is what are called “bank reserves” (technically currency in the vault also counts as “reserves” but it’s minor statistically).  Reserves are used to handle transactions with other banks (customer checks to be cleared) and, sometimes, as a cushion for safety. In normal times when the economy is growing and there are plenty of credit-worthy people to lend money to, a bank wants to hold only minimal reserves.  In fact they want to hold only enough to handle any withdrawals such as clearing checks to other banks.  Historically banks would be required to keep a certain % of their deposits as “reserves”.  However, in many nations that’s no longer true (Canada, Japan, Australia).  It’s partly true in the U.S. where demand deposits (checking accounts) have a minimum reserve requirement, but not true for savings deposits.  The reason banks don’t normally want to hold reserves is because they can make more profit by lending the money out.  But lending is only attractive (read highly profitable) in normal times.  In times of crisis, recession, and panic credit-worthy customers are harder to find.  Banks raise their lending standards and become more focused on security/safety instead of making more loans.  So the amount of reserves tends to rise as the banks are reluctant to lend the money.

So banks have deposit accounts called “reserves” at the central bank.  But banks also can borrow from the central bank when they want or need more reserves.  The central bank can arbitrarily set the interest rate for both of these, the deposit (reserve) accounts and the loan accounts (discount loans).  Historically, the Federal Reserve Bank in the U.S. has only set an interest rate on the loans to banks – this is the “discount rate” and it’s set by the Fed Board.  (it’s closely related to the “fed funds rate”, but that’s a whole other story).  Again, historically the Federal Reserve Bank never paid interest on the reserve accounts.  They required banks to keep them, but wouldn’t pay interest on the deposits.  That changed in October 2008 when The Fed finally did what others have long done and took the new step of paying interest to banks on the reserves they keep on deposit at The Fed.  I believe the current rate is 0.25%.  Not much, but when figured on hundreds of billions of dollars that are just sitting there securely at The Fed, it’s a nice source of profits to banks.

Therein lies a problem.  In the crisis banks accumulated very large reserves. Reserves are now much greater than what the need for transactions suggests.  In effect, banks are simply sitting on the money.  They have the funds to make loans but choose not to. Instead, they choose to let the reserves sit idle rather than loan them out.  It’s a nice deal for the banks.  Nice safe profits with no risk. But it’s a problem for the rest of us.  We need a growing economy. And a growing economy needs consumers and businesses to spend more.  Consumers need to buy more and businesses in particular need to spend more on investment and expansion if we are to create jobs and grow the economy.  Problem is, businesses and consumers aren’t getting the loans they need.  Why?  In part because banks want to sit on the reserves.

The solution?  Obviously we need to lower the interest rate paid on the reserves so that banks would choose to make loans (at least constructive loans, not just loans to buy derivatives) in larger volume again.  Well with an interest rate as low as 0.25%, one-quarter of one percent, it’s hard to go much lower.  Or at least that’s what economists and central bankers have long thought.  We thought there was a “zero lower bound” which fancy talk for “interest rates can’t be negative”.

Now we return to Sweden.  The Swedes at the Riksbanken thought “outside the box”, or at least outside the “lower bound”.   They lowered the interest paid on bank reserves deposited at the Riksbanken to a negative number: -0.25%.  In effect, Swedish banks now had to pay the Riksbanken for the privilege of keeping the reserves at the central bank.  As their chair explained, it was, in effect, like having a penalty tax on holding extra reserves.  The idea was to motivate banks to reduce the level of reserves to what they really needed for transactions and take the rest and lend it.  By lending it, it would lower interest rates charged to business and consumers (‘banks compete, you win!’). Businesses and consumers take their new loans and spend the proceeds.  Spending makes sales at businesses. GDP grows. People get hired.  The economy recovers.

It worked. Dramatically.

And it worked.  Sweden’s growing now at over 7%.  They’re now concerned about how to keep the economy from overheating.  We in the U.S. should be so lucky.  Instead we’re still stuck with anemic growth of around 3% despite unemployment of near 9% or more.  Both the government and Federal Reserve continue to be concerned with the health of the banks – whether they are profitable enough and have enough reserves.  We’re worried about helping banks, but nobody is willing to make the banks help the economy through the right incentives.

The challenge getting an economy to recover and grow again after

Excess Bank Reserves: Theory vs. Reality

In the macro econ textbooks, the mainstream explanation for money creation is the story of fractional reserve banking where reserves limit the amount of loans made.  In the traditional theory, the central bank (The Fed in U.S.) controls the amount of reserves banks have through either reserve reqmts or open-market operations.  Commercial banks are supposedly limited in their ability to make loans until they have sufficient excess reserves to “loan out”.  These new loans are what creates new money (at least the M1 variety of bank-credit money).  A lot rides on this theory.  For example, the theory implies that the Central bank has the power to control the supply of money and loans to the economy as opposed to only controlling short-term interest rates.  The theory doesn’t really fit reality very well.  There’s lots of problems with it.  (follow the posts at Bill Mitchell’s blog  Among the problems are that, in many countries (and in the US for savings accounts) there is no reserve requirement.  Another is that operationally, banks aren’t limited by reserves.  They make loans, then find out how much reserves they have to borrow.  Not the other way ’round.

But a critical piece of the mainstream theory that underpins monetarist theory is that banks, being profit-maximizers, will always lend out their excess reserves.  Wrong.  Check this out:

More on Modern Banking – end of fractional reserves

More on MMT & end of fractional reserve banking:  From Naked Capitalism and Washington’s Blog. There’s more in the entire post to see, but this is a critical part (bold is mine):

From Fractional to Fictional Reserves

But whatever you think about fractional reserve banking, whether or not you agree with its critics, the truth is that we no longer have it.

As the above-linked NY Fed article notes:

In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels.

And as Steve Keen notes – citing Table 10 in Yueh-Yun C. OBrien, 2007. “Reserve Requirement Systems in OECD Countries”, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, 2007-54, Washington, D.C:

The US Federal Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.

So huge swaths of loans deposits are not subject to any reserve requirements.

With the repeal of Glass-Steagall, deposits have been used to speculate in every type of investment under the sun, using insane amounts of leverage. Instead of the traditional 10-to-1 ratio…

Banks Create Credit Out of Thin Air

From Washington’s Blog:

More Evidence that Banks Create Credit Out of Thin Air

I recently provided evidence that banks create credit out of thin air.

I’ve just found two more pieces of evidence:

(1) William C. Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, said in a speech last July:

Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don’t need a pile of “dry tinder” in the form of excess reserves to do so. That is because the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference.

(2) On February 10th, Ben Bernanke proposed the elimination of all reserve requirements:

The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

Of course, Bernanke’s proposal is the exact opposite of the 100% reserve system proposed by Nobel prize winning economist Milton Friedman and Laurence Kotlikoff, former Senior Economist for the President’s Council of Economic Advisers.

More importantly, if banks don’t make loans based on available reserves, but can enter into loan agreements first and then borrow any reserves needed, that means:

(1) This was never a liquidity crisis, but rather a solvency crisis, as I and many others have repeatedly tried to explain. In other words, it was not a lack of available liquid funds which got the banks in trouble, it was the fact that they speculated and committed fraud, so that their liabilities far exceeded their assets. If you don’t understand what I’m saying, please read this.

(2) The giant banks are not needed, as the federal, state or local governments or small local banks and credit unions can create the credit instead, if the near-monopoly power the too big to fails are enjoying is taken away, and others are allowed to fill the vacuum.

Loans Create Reserves, not Vice Versa

From Washington’s Blog – 7 Questions About Public Banking

This is an open letter to the economics, finance and banking communities.

I don’t have any dog in the fight, other than to figure out and then publicize what is best for the greatest number of people. People I greatly respect advocate for federal-level public banking, state public banks or a return to the gold standard. I am simply attempting to start a high-level debate about what the best option is.

Please see responses posted by economists and others below. I will update the responses as I receive them.

How Is Credit Created?

I pointed out in September:

As PhD economist Steve Keen pointed out recently, 2 Nobel-prize winning economists have shown that the assumption that reserves are created from excess deposits is not true:

The model of money creation that Obama’s economic advisers have sold him was shown to be empirically false over three decades ago.

The first economist to establish this was the American Post Keynesian economist Basil Moore, but similar results were found by two of the staunchest neoclassical economists, Nobel Prize winners Kydland and Prescott in a 1990 paper Real Facts and a Monetary Myth.

Looking at the timing of economic variables, they found that credit money was created about 4 periods before government money. However, the “money multiplier” model argues that government money is created first to bolster bank reserves, and then credit money is created afterwards by the process of banks lending out their increased reserves.

Kydland and Prescott observed at the end of their paper that:

Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

In other words, if the conventional view that excess reserves (stemming either from customer deposits or government infusions of money) lead to increased lending were correct, then Kydland and Prescott would have found that credit is extended by the banks (i.e. loaned out to customers) after the banks received infusions of money from the government. Instead, they found that the extension of credit preceded the receipt of government monies.
Keen explained in an interview Friday that 25 years of research shows that creation of debt by banks precedes creation of government money, and that debt money is created first and precedes creation of credit money.

As Mish has previously noted:

Conventional wisdom regarding the money multiplier is wrong. Australian economist Steve Keen notes that in a debt based society, expansion of credit comes first and reserves come later.

This angle of the banking system has actually been discussed for many years by leading experts:

“[Banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers’ transaction accounts.”
– 1960s Chicago Federal Reserve Bank booklet entitled “Modern Money Mechanics”

“The process by which banks create money is so simple that the mind is repelled.”
– Economist John Kenneth Galbraith
“[W]hen a bank makes a loan, it simply adds to the borrower’s deposit account in the bank by the amount of the loan. The money is not taken from anyone else’s deposit; it was not previously paid in to the bank by anyone. It’s new money, created by the bank for the use of the borrower.
– Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report

“Do private banks issue money today? Yes. Although banks no longer have the right to issue bank notes, they can create money in the form of bank deposits when they lend money to businesses, or buy securities. . . . The important thing to remember is that when banks lend money they don’t necessarily take it from anyone else to lend. Thus they ‘create’ it.”
-Congressman Wright Patman, Money Facts (House Committee on Banking and Currency, 1964)

The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented.”
– Sir Josiah Stamp, president of the Bank of England and the second richest man in Britain in the 1920s.

“Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . . Each and every time a Bank makes a loan . . . new Bank credit is created — brand new money.”
– Graham Towers, Governor of the Bank of Canada from 1935 to 1955.

I’ve also noted:

In First National Bank v. Daly (often referred to as the “Credit River” case) the court found that the bank created money “out of thin air”:

[The president of the First National Bank of Montgomery] admitted that all of the money or credit which was used as a consideration [for the mortgage loan given to the defendant] was created upon their books, that this was standard banking practice exercised by their bank in combination with the Federal Reserve Bank of Minneaopolis, another private bank, further that he knew of no United States statute or law that gave the Plaintiff [bank] the authority to do this.

The court also held:

The money and credit first came into existence when they [the bank] created it.

(Here’s the case file).
Justice courts are just local courts, and not as powerful or prestigious as state supreme courts, for example. And it was not a judge, but a justice of the peace who made the decision.

But what is important is that the president of the First National Bank of Montgomery apparently admitted that his bank created money by simply making an entry in its book …

William C. Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, said in a speech last July:

Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don’t need a pile of “dry tinder” in the form of excess reserves to do so. That is because the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not.

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