Pragmatic Capitalism

Practical Views on Money, Finance & Life

Q&A…The Answers

Thanks for another round of good questions.  I’ll do my best to answer them all….

Stephen:  Can’t excess reserves held at banks incentivize new loans due to the spread between IOER (.25%) and effective FFR (.15%)?

In other words, a bank with excess reserves has a 5bp advantage over a bank without excess reserves if both increase loans/deposits equally.

Consider 2 banks: Bank A has $20 billion in excess reserves, Bank B has $0 in excess reserves.

If Bank B increases loans/deposits, it must pay .15% on borrowed funds in the overnight market to bring its required reserves level up to requirement.

But if Bank A increases loans/deposits, it’s effectively only paying .10% (by converting excess reserves to required reserves, it forgoes the .25% IOER but does not have to pay .15% to borrow funds overnight as Bank B does).

Am I missing something here?

CR:  There are a few moving parts in this spread.  Beowulf’s answer on the FDIC fee is good as is LVG’s answer on the GSE’s.  The GSE’s are ineligible to earn IOER so they lend to the banks at a rate below the IOER rate.  The banks are mostly borrowing from the GSE’s and pocketing the spread.  So that explains the spread.

Ijustgotup: You’ve often said that the US doesn’t have a debt or a deficit problem and I understand your logic behind these (inflation constraint not liquidity constraint and so on). Yet I’d be interested to hear, if – in your mind – there’s a scenario in which the debt and deficit could become a problem, because interest on the debt got to high and so on. Analogies can be drawn to Japan’s situation of course, which has much higher debt/GDP, but can it ever become too high? Or in other words: Is it possible to run up debt so high in a low interest rate environment that you’d not be able to control it anymore once inflation starts to finally pick up and interest rates rise?

CR: I don’t say the US doesn’t have a debt or deficit problem.  I say the USA can’t run out of money so it doesn’t have a solvency constraint.  So when politicians go on TV and tell you the USA is bankrupt or at risk of becoming Greece they’re misleading or misunderstanding.

The make-up and efficiency of the deficit and the government’s spending is a totally different matter.  It’s entirely possible that the government could spend in ways that hurts our society.  Remember, our living standards increase primarily by the quality of our production and the things we provide that improve living standards (depends on your definition there to some extent).

If we use a human body analogy, spending is the flow (government spending can be an enormous flow).  The body needs the flow to live.  Just like an economy does.  It needs a flow of spending.  But a healthy economy needs the right kind of flow to prosper.  Inefficient or misguided spending is like a body that gets the wrong blood type infused.  A body that gets the wrong blood type gets a bad flow.  Just like a society that makes nothing of utility has a bad flow.  But a bad flow which can cause inflation and lower living standards is totally differnent from running out of the flow (which the USA can’t).

V:  Haven’t seen an update in a while, whats the algo saying these days.

CR: There was a window there when I wasn’t running a RIA so my compliance side was relaxed.  Unfortunately for readers here, I can’t just go around giving buys and sells because of the regulations that go along with the formation of my new company, Orcam Financial Group.  I’d love to be able to really spill the beans on everything I am seeing in the markets, but with Orcam and being a government regulated RIA I have to keep Pragcap strictly informational and educational.  Sorry.

George H added:  Does your venture Orcam use the algo to provide client trading advice if they so choose?

CR:  Orcam’s Research product issues updates on all of my indicators and offers much more detailed thoughts and specifics than I can offer to readers here.  As I mentioned before, I wish I could issue more detailed insights at Pragcap, but it’s a big regulatory no-no so I have to keep Pragcap strictly informational.  Again, sorry, but it’s kind of out of my hands here and in the hands of the lawyers.

Larry:  Cullen, have you decided yet who you will be supporting for president?

CR:  I am biased towards thinking about the economic issues so here’s my concern.  If we re-elect Obama there’s a very good chance he’ll get nothing done in his second term because the Republicans will stonewall any major spending program.  And if we elect Romney there’s a chance he will actually stay true to his budget cutting initiatives and drive us back into a deep recession just when it looks like we’re coming out of the Balance Sheet Recession.  So, flip a coin and let’s see which guy is worse for us all….I am so torn about who to vote for because it seems like a lose lose to me.  And my endorsement of either of these candidates is an endorsement of economic policies I don’t agree with.  So, I honestly don’t know what I am going to do….

Rich:  Years ago, when I was being miseducated in the field of economics at a major US university, I recall the term GNP was often used in place of GDP (today). In fact, I recall:

GNP = C + I + G + (X-M)

Where GDP was defined as: GDP = C + I + G, thus GNP = GDP + (X-M).

The GNP definition actually makes more sense to me…when and why did this change take place ? Do you agree the previous distinction was actually more technically accurate ?

CR:  GNP is just expanded to include all the citizens of a nation outside of its borders.  Gross DOMESTIC product is just a calculation of domestic citizens.  So it depends on you perspective.  Personally, since we’re generally trying to gauge domestic product I think GDP is a more accurate calculation.  Otherwise, you have to start taking all sorts of other factors into account for GNP.  So I think there’s a fair bit of logic behind the use of GNP as the economy becomes increasingly global in nature.

D:  Hi Cullen, I know your long-standing view that quantitative easing is not inflationary since it’s just a equal swap of different financial assets. However, my question is what do primary dealers do with the reserves once they have sold treasuries/what have you to the Fed? I understand the increase in reserves do not translate to increase in lending, but what do investment banks like GS and MS do with the reserves? Do they turn around and just buy more treasuries, thus lowering the yield? Is this the gist of how QE works? Also, are they forced to buy treasuries? What’s stopping them from buying stocks/commodities or whatever they want?

CR:  Banks use reserves to meet reserve requirements and to settle payments.  What a bank decides to do with its balance sheet following the sale of assets to the Fed is entirely up to the bank though these actions don’t reduce or increase the amount of reserve held in the banking system.  Remember, the Fed decides the amount of excess reserves held in the banking system.  Banks cannot eliminate reserves.  So, if JP Morgan sells $1MM of bonds to the Fed and obtains reserves then its net financial asset position hasn’t changed.  But it’s conceivable that JPM could feel the need to go out and replace the lost interest in its revenue stream due to the sale of the bonds.  This is the hope from the Fed – that banks and other private actors will invest further up the risk curve in what they call a portfolio rebalancing effect.  This is why we often see asset prices rise during QE.

D: Also, if I am allowed to ask two questions, would I be on the right track if I were to explain the current economic climate this way: the Fed’s policy of lowering interest rates is not wholly effective by itself because the lack of lending is not only due to the rate of interest in the first place, but also the lack of qualified borrowers. Thus it would be more effective to address the other side of the equation as well–mending the balance sheet of consumers, not decreasing the price of credit.

Please have more Q&A sessions. I have more questions, but I think three is too many from one person.

Thanks for all you do Cullen!

CR:  Here’s my explanation from the other day:

Let’s step back and review the last 5 years in 180 seconds.   We had a huge housing bubble which resulted in very high levels of private sector debt.  This was sustainable as long as the economy remained strong and incomes could support these higher debt levels.  When house prices started to fall (for varying reasons) the economy weakened, incomes declined and a falling rock had triggered an avalanche.  Our monetary system is one which is built mainly on two things – inside money (bank deposits created by loans) and the flow of this bank credit throughout the system (all in the pursuit of creating goods and services and hopefully higher living standards).  So when this crucial piece of the puzzle cratered the economy collapsed and capitalists stopped acting like capitalists because their revenues collapsed.  And their revenues collapsed because their customers had stopped spending as much money in an effort to focus on repairing their busted balance sheets.  The result was this great big mess we’ve been in for years.

Monetary policy primarily works through lending channels.  So, if lending is broken then monetary policy is largely broken.  That’s the environment we’re in.  Hence, the weakness of monetary policy.

Steve W:  When it comes to the Federal Govt. increasing deficit spending (as you recommend due to the BSR), you say that you would prefer tax cuts over increased spending. I understand that both methods increase the deficit. Given the political challenges of implementing significant tax cuts, can you provide some of your opinions on the best things that the government can spend money on? I know the goal of MR is to be descriptive rather than prescriptive, but I hope you’ll share some personal views. Seems to me that infrastructure might be better than more job training programs, or more student loan guarantees or more Pell grants. Loan guarantees for green energy firms have not been that successful (and I don’t just mean Solyndra). Old fashioned bridge and road work, the national power grid, and defense/military spending all seem like better bangs-for-the-buck, with more immediate impacts on employment.

CR:  MR focuses a great deal on Investment because this is the core way in which we build a wealthier and more prosperous society.  That’s why we focus so much on the equation S = I + (S -I).  This is the most accurate reflection of our nation’s wealth since most of our wealth is the result of private investment.  Government is generally a less efficient investor because there is no profit motive.  Ironically for MR, there’s a certain blase sense of “oh, we can’t run out of money” (even though they obviously don’t think that).  So the government I envision is a more efficient one.  I am definitely a big fan of infrastructure spending.  I’ve also proposed an Innovation Initiative to try to jump start and promote govt spending around entrepreneurship and investment projects.  This doesn’t mean I am against all forms of social spending, but I think we need to be very specific there.

Naa Laa:  Hi Cullen -I asked in another post of yours but didn’t get an answer so I am asking here again :)How can the Fed target the unemployment rate directly the way they target short-term interest rates? What tools do they have for their second mandate?Thanks again!

CR:  As I explained above, monetary policy mainly works through lending channels.  One thing we learn from MR is that most of the money in our economy exists as a result of private banks creating what MR calls “inside money” or bank money.  Inside money usually expands when demand for credit is strong and the private sector is healthy enough to ramp up investment and spending.  The problem with a balance sheet recession is that inside money demand is impaired so the private sector is impaired.  So the problem with Fed policy is that they can’t really target a reduction in unemployment if they can’t spark the credit markets.  That’s because changing the overnight rate changes the spread at which banks lend.  So their second mandate is really an indirect target from their control over the overnight rate.

Darren:  I was at an event at Brookings the other day with Jeremy Stein with the Federal Reserve. He said the Fed believes that the effect of an incremental $500 bn in asset purchases would be to reduce the unemployment rate by 0.2%. That same day, I read this by Jan Hatzius

“We are surprised that neither party has seriously challenged the case for near-term fiscal retrenchment. In particular, the expiration of the $126bn payroll tax cut (1% of disposable income) is almost universally accepted. This expiration alone is likely to shave 0.6 percentage point from 2012 growth on a Q4/Q4 basis”

So wouldn’t it be more effective to just print $126bn and give it to Congress? Am I missing anything here, other than the obvious political uproar it would cause?

CR: From a budget perspective, a tax cut and a spending increase have the same impact.  So, cut taxes by $126B or spend $126B more is the same from the budget perspective though they have obvious distributional differences.  Govt spending has a bad reputation because govt is notoriously inefficient at picking who gets the funds and why.  That’s why I say just cut taxes.  It’s more politically acceptable and it lets the people decide how to spend more of their money.

jt26:  How is quality incorporated (if at all) in growing GDP?

Everyone says we need more growth (esp. nominal growth from the NGDPers!). But do we really need growth? Does 0 growth mean the quality of life is going down? Personal technology is a good example where spending has been very constant, but quality has gone up dramatically. Does it matter if GDP in real or nominal $’s increases, if we have more free time or higher quality time?

CR:  Time, as you know, is my ultimate form of real wealth.  Improvements in technology naturally increase GDP because they give us more time.  So, instead of waiting 3 weeks to get a telegram from NYC the Chicago businessman makes a phone call and spends his time producing and consuming in much more efficient ways.  There’s an interesting battle at work here though.  I theorize that humans can’t stop making progress.  We are inherently designed to applaud progress and superior achievements.  So the question really becomes “when is enough enough”?    I don’t know.  And most likely, the answer is “enough will never be enough”.  So growth  and expansion will continue to be synonymous with our definition of “increased living standards”.

Whatisgoingon:  Is there a good primer on investing in debt securities?

CR:  Try these:

Yourejammingmeup:  In your opinion, what place has the best chance at returning ~10% on your investment over the next few years?

CR:  As I said above, now that I am running Orcam I can’t really give specific advice like this on the site.  It would be totally irresponsible for me to make sweeping comments like this without knowing more specifics behind your potential goals, risk attitude, etc.

Nils:  What is your favorite curse word?

Just kidding, you mentioned you used to trade earnings reports, why did you quit?

CR:  I grew up with three brothers and 4 sisters in a pretty competitive Irish household.  I managed to embed the F word into my vocabulary at a pretty young age.  I’ve cleaned up my act quite a bit, but it stills slips out every once in a while.  :-)

Trading these reports was extremely stressful and time consuming.  It required a HUGE effort and I just got burned out.  My other strategies were more than making up for the lack of implementing this event driven approach so I got out of it as time went on.

Darial:  A couple policy-related type of questions from a MR perspective:

What the top strategies a government can use to tackle the following scenarios, assuming a government is managing their currency value to achieve a steady inflation rate:

1. Over a period of 5 constant years, the US experiences an agricultural boom combined with significant increases in efficiency and production. The average cost of food decreases because of greater supply.

2. Over a period of 5 constant years, the US experiences an agricultural bust and significant decrease in efficiency and productivity. The average cost of food increases because of lesser supply.

CR:  I’m not really an agricultural expert so you’d need to contact someone who really understands the ins and outs of government policy and its impacts on the economy.  Sorry.

Darial:  In a previous article, you state that the money multiplier is a myth. Assuming you are discussing monetary realism with someone who is hesitant to adopt this paradigm, and this same person starts citing the importance of the money multiplier, what thoughful question would you ask this person so that they would have to truly reflect on their beliefs about the money multiplier?

CR:  I think the explanation is rather simple.  Just explain to them that when a bank makes a new loan it doesn’t check its reserve account first.  Banks makes loans first and find reserves later.  Bankers know this.  It’s economists and policy makers who don’t.  See this article from the Fed for more.

Darial:  In part 3 of your Understanding the Modern Monetary System, under the section entitled Understanding the Machine, where does “access to natural resources” fit in to your car metaphor?

CR:  I guess we can imagine the car we are in is inherited.  Natural resources would be the quality of the car before we add anything to the car (like turbo boosters or a suped up engined that would come from domestic investment).  So, the USA has a BMW right from the start.  A nation with no natural resources starts with a Pinto.

Jacob:  Hypothetically, what would happen if the US paid China back? More specifically, what effect would it have on their economy? Wouldn’t it just trade one dollar-denominated asset (dollars) for another (Treasuries) and not have much immediate effect? I feel like that’s too simple…

CR:  I think it’s important to understand the dynamics here because so many people have a tendency to just jump to the end of the story with this sort of stuff.  China accumulates dollars as a result of their trade surplus with the USA.  So company XYZ gets dollars for trade business, exchanges them with the central bank in local currency and the Chinese government ends up with oodles of dollars.  What do they do with all these dollars?  They can either let them sit around or they can do what China does which is buy interest bearing assets and control the RMB/USD exchange rate to keep those dollars flowing in (and the many domestic benefits that follow).  So, China doesn’t want us to “pay them back”.  They want those dollars to keep flowing in and they want to keep investing them in ways that are better than the equivalent of having stacks of paper around that do nothing for them.

On the same note, there’s really no such thing as “paying off the national debt”.  The national debt represent a large stock of domestic saving.  To pay it back means to change all those t-bond accounts into cash accounts earning nothing.  This is why it’s so funny when people complain about how the Fed is hurting savers by reducing their interest rate on saving when at the same time these same people usually complain about the size of the national debt.  They don’t even realize that paying back the national debt means no risk free interest bearing saving!

JK:  Can/do foreign governments (e.g. China) obtain Treasuries at auction, or only afterward “from” the Primary Dealers?

CR:  If you look at the results of tsy auctions you’ll see a section listed as “indirect bidders”.  These are institutions that bid on behalf of other insitutions.  Included in this is foreign central banks and governments.

Chas:  fm David Brooks column –

“According to the Urban Institute, the average couple in 2010 had paid $109,000 in Medicare taxes during their working years but would be able to receive about $343,000 in benefits. A chunk of that $234,000 gap will be paid for by their grandkids. That should weigh on the conscience of every American over 55. You’re supposed to help your grandkids, not take from them.”

How do I explain that this debt is not the “grandkids” problem?

CR:  People aren’t born with a bill attached to their foot.  Americans, in fact, are born into an extremely fortunate situation where they have natural wealth that far surpasses the average situation human beings are born into.  Would you rather be born in Somalia where David Brooks would say your natural bill is zero dollars?  This is the mistake people make.  We don’t leave our kids with a bill that they need to pay off.  We leave them with a certain living standard.  And yes, govt spending can have a huge impact on that future living standard (either positive or negative), but this whole idea that our kids have to pay off a bill from previous generations is wrong.  The previous generations in the USA didn’t leave us with a bill to be paid.  They left us with a certain living standard.  A pretty fantastic one.  We should seek to better understand our monetary system and the ways govt influences it so we can do the same.

George H:  Why does Jan Hatzius think QE has a measurable (and positive) economic impact?

CR:  Hatzius seems to buy into the Market Monetarist thinking that expectations can have a huge impact on the economy.  I don’t entirely disagree, but I think this impact has diminishing returns as an economy normalizes.  For instance, in 2008 when everyone thought the world was ending, the Fed came in and added a huge amount of stability to the markets and the economy by changing expectations in QE1.  They basically said “look, we’re not going to allow this economy to go down in flames just because people are scared to act on anything”.  All those govt guarantees and policies helped bring some semblance of normalcy back to the markets.  But what about any economy like this one where we’ve normalized to a huge degree.  What is the impact?  I say far less than some presume….At this point, the disequilibrium between fundamentals and market prices has normalized (perhaps even exceeded in disequilibrium now to the UPSIDE) so I think the impact is far more muted and perhaps even destructive in the wrong direction.

LVG:  Cullen, I noticed that Orcam’s services do not involve money management. Will you ever get back into money management again?

CR:  I have no idea if I’ll get back into managing money directly again.  It’s extremely stressful even if it’s extremely rewarding in many ways.  For now, I’ll see where Orcam takes me and if it makes sense for me to manage money in some capacity again then I’ll do it. I really like the consulting set-up because I think my interests are better aligned with clients.  Not that money management can’t achieve the same thing, but for now, it’s mostly consulting and research.

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC.Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services.He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.
Cullen Roche

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