Helping the Fed Solve the Problem of Excess Reserves

The key to the game is your capital reserves. You don't have enough, you can't pee in the tall weeds with the big dogs. - Gordon Gekko

Ben Bernanke and the brain trust at the Federal Reserve have been working overtime trying to solve the problem of excess reserves in the US banking system. "How," they wonder, "can we drain these reserves from the system without destabilizing the markets?" Their fears of destabilizing markets are, I believe, justified, which seems odd given that the Fed, in the past, has been able to drain reserves, although the quantity drained was admittedly much smaller.

To the extent there is no way to drain these reserves without upsetting the markets the solution to the problem might not be one of action, but of thought. As Norman Vincent Peale said, "Change your thoughts and you change your world." Instead of trying to drain the excess reserves let's admit that they are not, in fact, "excess", but rather, "prudent", or even, as I suspect, "insufficient."

How do we determine if reserve levels are prudent, excess or insufficient? The determination is a process of thought. If financial assumptions about the future are perfectly accurate, there is no need of reserves- correctly valued assets will, under that head, always generate income sufficient to pay liabilities.

Reserves, then, are a safety measure in the event assumptions about the future are inaccurate- if assets are, in fact, not correctly valued. The more inaccurate prior assumptions of future events prove to be the wiser it would have been to increase reserves before the inaccuracies come to light.

The apparently resolved crisis in Greece seems a case in point (as, it seems to me, was the US crisis of 2008). The Greeks didn't simply decide, out of the blue, to borrow an additional 50 or 100 billion Euros, they, at certain levels of government, knew their fiscal position. Why then the crisis?

Simple. They made poor assumptions about either the value of their assets relative to liabilities (what economists call the primary fiscal balance) or the duration of the deceit which, in part, allowed them to borrow in sufficient quantities at favorable rates. In their case the latter seems more of an issue, as tends to be the case when crises "suddenly" manifest.

Like the homeowner who lied about his income to get a home or the Ponzi schemer who claims to own more than he does, the Greeks had been living on borrowed time. The question in that case about a crisis is not if but when.

Deceit, of course, is a loaded term as it connotes intent. Bernie Madoff is in jail because he admitted to such. In other instances a more appropriate phrase would be willfully ignorant. Those in charge hope for an outcome more objective, but equally educated persons deem unlikely, or impossible. Traders call this, talking your book.

Regardless of intent, the effects are the same. Reserves bridge the gap between projected and actual income relative to liabilities whether the gap is a function of deceit or ignorance (willful or otherwise). Sufficiently higher levels of reserves (other things equal) would have kept Mr. Madoff out of jail and obviated the Greek crisis.

Gordon Gekko had it right.

Returning to the issue du jour- the proper level of reserves in the US banking system- the difficulty of imagining a plausible future scenario with the reserves drained strongly suggests to me that current levels are minimally prudent. That is, if draining reserves would cause rates to rise, decrease real sector activity, or some combination thereof such that bank incomes wouldn't cover required payments then they shouldn't be drained.

Why then does the Fed seem so intent on draining? Perhaps they aren't as intent on draining them as some might think. Perhaps their intent is simply to maintain the illusion that the reserves are considered excess. If they told the world the level of reserves was considered prudent this would likely send a message that the financial state of US banks is not as healthy as otherwise advertised. This, in turn, might exacerbate future gaps between bank income and outflow, requiring even higher levels of reserves than currently exist, or, as was the case in Greece and with Mr. Madoff, precipitate a crisis.

Perhaps the only way to keep the real sector operating such that bank assets perform is to increasingly dilute the currency (since any increase in reserves would most likely be "borrowed" from the Fed as happened during the last crisis). Perhaps Mr. Kinsley's nightmare scenario of impending substantial inflation and even hyper-inflation is much nearer that truth than the Fed or Mr. Krugman would have us believe.  Perhaps the classification of reserves as excess has more to do with what the Fed wishes others (i.e. those who lend money to the US) to assume than what they assume, which edges ever closer to Greek deceit.

The Fed could, of course, prove me wrong by draining the reserves deemed to be in excess without precipitating a crisis.

I won't, however, be holding my breath.

The Kins(l)ey Report (on Inflation)

One could, in a debate of US inflation prospects, discuss the virtues of issuing the currency in which your debt is denominated, and the ability of US political leadership to enact tough change counter-balanced, I think, by the magnitude of the debt in question relative to world GDP, and the actual history of US political leadership to enact tough change. But my aim is not (in this essay) a reasoned debate but a notice of the lack thereof.


If, like me, you're an official member of the pajama wearing blogger corps, you might be familiar with the recent debate over US inflation prospects between Michael Kinsley and Paul Krugman, et. al. If not, here's Kinsley's initial article, Krugman's rebuttal, Kinsley's retort, and Krugman's rebuttal of the retort.

Krugman's second rebuttal dripped with condescension, or so it seemed to me, recalling memories of school yard bullies. Those memories tempted me to begin this article with a quip about Krugman needing to pick on someone his own size......, but I'll use a different metaphor.

"Ouch!," you might be thinking, "that's a bit cruel."

True.

So's this line from Krugman to Kinsley: "I’m tempted to get into an argument about whether it’s “bullying” to suggest that if you’re going to write about an economic issue, you might want to study it first. But what I really want to do is..."

Don't you love the artful use of the non-statement statement?

Aside from my belief that future events are more likely to follow some variation of Kinsley's nightmare scenario than Krugman's Japan model (about which, more here), the element of the exchange that inspired this post was Krugman's nasty dismissal of an apparently serious inquiry from one who apparently admires his views.

Kinsley's initial article contains statements like: "am I crazy?", "Every economist I admire, from Paul Krugman and Larry Summers on down, is convinced that inflation will remain low for as long as we can predict", "I can’t help feeling that the gold bugs are right", and "My fear is not the result of economic analysis. It’s more from the realm of psychology."

These are the words of a humble student searching for wisdom to quell his fears.

The wise Professor Krugman begins his rebuttal with: "Mike Kinsley has an odd piece in the Atlantic in which he confesses himself terrified about future inflation, even though there’s no hint of that problem in the real world."

You can almost see the sneering Professor holding up the student's paper in front of the class as you read the words (at least I could).

Using the tried and true nasty Professor trick of tossing about a bit of relevant jargon and a counter-example, Krugman expects Kinsley to slink back into his seat.

To his credit, Kinsley doesn't flinch.... much. He almost falls for the Professorial misdirection (debating whether a sudden 100% inflation shock is better than a Weimar hyper-inflation is like debating whether losing both legs is better than getting killed- I see your point, but I'll take none of the above) but then gets back on point, telling the Prof (in effect), "you didn't answer my question."

Why not inflation?

As Kinsley argued, the 70s demonstrated the US is not immune to inflation and Gold has risen from $275 to over $1000 during the past decade. Perhaps Kinsley's main confusion lies in his focus on the future tense, instead of seeing it as an ongoing issue.

Kinsley's search for the truth on inflation reminds me of Alfred Kinsey's search for truth on human sexual habits, which led to the publication of two books on human sexuality known collectively as the Kinsey Reports. Like Kinsley (or so it seems to me) Kinsey's search for truth battled with popular conceptions of what should (in some views) be, but wasn't.

In a sense Kinsey reported on what everyone (collectively) knew, but was afraid to say. The fear (perhaps, with the benefit of hindsight, somewhat justified) among then current opinion shapers was, in part, that open discussion would release the genie from the bottle. Hugh Hefner, of Playboy fame, credits Kinsey with opening his eyes to human sexual experience.

Krugman, in my view, is too smart an economist to dismiss outright the possibility of another significant inflation episode in the US, which may or may not be followed by hyper-inflation.

To use his phrasing, for those dismissing prediction of substantial US inflation, what is it about the US now that looks different to you from Thailand, Korea and Indonesia in say, 1997 (or Russia in 1998, or Iceland just recently)? Substantial public and private sector debt? Check. Huge expansion in the monetary base? Check. Large external debts and ongoing external deficits? Check. Increasing difficulties rolling over ever shorter term debt? Check. And yet each of those countries suffered, not multi-year hyperinflation, admittedly, but a sudden substantial (50-100% or more) inflation shock.

There are, admittedly, differences. As I wrote, I was using his phrasing and argument form. One could debate the virtues of issuing the currency in which your debt is denominated, and the ability of US political leadership to enact tough change counter-balanced, I think, by the magnitude of the debt in question relative to world GDP, and the actual history of US political leadership to enact tough change. But my aim is not a reasoned debate but a notice of the lack thereof.

Mr. Krugman might snidely respond to my snidely put question that the issue was hyper-inflation. I lived in Asia during their crisis and such shocks are worth worrying about even if hyper-inflation is avoided (besides, his use of Japan- a nation which self-finances, which seems to me a critical distinction- as counter-point suggests even moderate inflation is unlikely). Moreover, as Kinsley notes, who knows what policy makers will opt to do when the next crisis erupts. The history of the Bernanke Fed is not one of monetary restraint in a time of crisis.

I suspect that Krugman, not the economist, but the opinion shaper is, like those Kinsey battled, trying to keep the genie in the bottle- thus the Professorial dismissal instead of reasoned discussion of the issue. Inflation has both psychological and real world causes- when the two unite, the fireworks begin.

Perhaps, in a limited fashion, the Kinsley Report on Inflation will have a similar effect as Kinsey's, (then again maybe both should be seen as catalyst instead of cause) by bringing the debate into the open.

I wonder who the Hugh Hefner of Inflation will prove to be- perhaps Bill Murphy of GATA?

My advice to Kinsley is to have the courage of his convictions and buy some Gold, the price of which may have been as suppressed as reasoned open debate on US inflation prospects appears to be- both actions aim at the same effect.  I did (at $275 for Krugman's information) and I'm still holding.