Friday, 6 June 2014

Sacred cows and the demand for loans



Scott Sumner, on a recent post, asked me to explain what I meant by "loan demand". This got me thinking. Exactly what DO we mean by "loan demand"? Who is demanding, and what do they really want?

By "loan demand", we usually mean the demand from households and corporations for the credit provided by banks. But actually this makes no sense. What households and corporations actually want is not loans. It is money.

Households that have money generally do not borrow. They buy their houses, cars, yachts, holidays to Bermuda with money they already have. It is households that DON'T have money that borrow. They do so in order to buy the houses, cars, holidays to Ibiza (perhaps not yachts so much) that they don't have the money to afford. They would really like to buy these things from money they already have, but there isn't enough of it right now, and in the case of houses there won't be for at least 25 years even if they save assiduously. They do not "want" loans. They want money. If someone gave them the money to buy their house, car, holiday, they would gratefully accept it - and that would be one potential borrower lost to the banking system. If everyone had enough money for everything they needed, we wouldn't need banks.

Clearly, therefore, in an economy in which people don't have enough money to buy all the things they want, there is no such thing as lack of demand for credit money. People still want these things. Only if everyone had unlimited money would there be no demand for credit money.

So it is actually meaningless to talk about changes in demand for (credit) money. What we should be talking about is the supply of loan assets. But it is not banks that supply loan assets. What we usually call "demand for loans" is actually the supply of loan assets by households, corporations and governments to banks and investors. What we usually call the "supply of loans" is actually the supply of money by banks and investors in return for loan assets from households, corporations and governments.

This is more obvious when loan assets are supplied in the form of bonds. A lender to the UK government receives a pretty piece of paper which in days gone by used to have a golden edge (that's why UK government bonds are known as "gilt-edged securities"). This piece of paper IS the loan asset.*

Loan assets are claims on the future income of households, corporations and governments. Lending is always a bit of a gamble: future income is by definition uncertain. Default happens when income in reality does not match the expectations against which the loan was advanced. The interest payments on a loan are both compensation for the opportunity cost to the lender of not using the money (although in the case of banks which create money when they lend, the existence of this opportunity cost is debateable) and, more importantly, a consideration or surety against possible future default. The higher the likelihood of future default, the higher the interest payments. Payday lenders such as Wonga operate a model in which very high interest payments more than compensate for the losses due to default: they make money not by ensuring that loans are repaid, but by rolling them over and continuing to charge interest, often at ever-higher rates, when they AREN'T repaid.

Traditionally, we model demand for money as if money itself is interest-bearing - so demand for money reduces as the interest rate rises. But fiat money in the form of currency does not bear interest, and it is exchangeable at par with credit money: credit money therefore cannot bear interest either. It is the loan assets associated with credit money that bear interest. The amount of money borrowed is discounted by the interest rate over the period of the loan: we can regard this as a "haircut". The longer the duration of the loan, and the less creditworthy the borrower, the deeper the haircut. In practice, of course, the amount of money borrowed is fixed, and the amount paid to the lender varies (at least for long-term loans such as mortgages). The haircut can be reduced by guarantees or collateral that reduce the risk to the lender.

Clearly, a lender that wants a high return will lend to less creditworthy borrowers and for longer periods of time. The ability to recall money lent out reduces the risk to the lender and therefore the price of the loan. We see this most obviously in the case of call deposits at banks, where the ability to withdraw money on demand means that depositors earn practically nothing: those who are prepared to tie up their money for longer periods of time earn more. But it equally applies to longer-term lending by banks and investors. We call the higher rate paid for longer-term loans the "illiquidity premium".

So when we talk about "falling demand for loans", what we are actually saying is that banks and investors are demanding a deeper haircut on money lent out than households, corporations and governments are prepared to accept. When banks and investors won't lend at all, the haircut is 100%. And the reason for this is that banks and investors perceive the risks to have increased. Whether this perception is accurate is not the point: it may be because banks are damaged and investors fearful, rather than any real change in the circumstances of the borrowers. Or it may be because the value of borrowers' collateral has fallen (house price collapse, for example), or borrowers have suffered falls in their real income that make the price of loans unaffordable. Whatever the reason, the effect is that borrowers - whose demand for money, remember, is still the same - decide to go without their houses, cars, holidays rather than accept what they consider a disproportionately large claim on their future income. They postpone their purchases and may save up for them instead of borrowing. This reduces the supply of loan assets. And since what banks and investors provide in return for loan assets is MONEY - and banks create money when they lend -  it therefore reduces the supply of money in circulation.

This creates a considerable problem for economic theories involving the demand for money versus the demand for credit. If we look at the standard IS-LM model, for example, it shows the demand for money increasing at the expense of the demand for riskier & less liquid loans (and other assets) when output and interest rates fall. But this isn't right. The demand for money does not change. What changes is the willingness or capacity of banks and investors to meet that demand by lending. This remains the case whatever action is taken by central banks to increase the actual supply of monetary base. If banks and investors remain risk-averse, and households, corporations and governments remain unwilling or unable to improve the quality of the loan assets they offer, the increased monetary base goes nowhere: it sits on bank balance sheets as reserves and in investor portfolios as safe assets.

And this raises serious questions about the conduct of monetary and fiscal policy when the supply of quality loan assets by households, corporations and governments falls - whether that is caused by declining creditworthiness on the part of loan asset suppliers, or risk aversion on the part of banks and investors. If we wish to improve activity in the economy, we need to find ways of enabling households, corporations and governments to spend.

One approach is of course to encourage those who have money to spend it rather than lend it: this is the principal objective of QE, but it founders on the problem that people who are rich enough to have large holdings of financial assets tend already to have bought their houses, cars, yachts etc. We say that they have a low "marginal propensity to consume", but we could just as easily say that they have a low demand for money. If we exchange some of their assets for money, all they do is reinvest that money in other financial assets: admittedly, if these are corporate loan assets there might be some benefit to the economy, but the evidence seems to be that far too much of the QE money went to blow up unproductive asset bubbles, not into productive lending to the real economy.

Another approach might be to make it easier and cheaper for people to borrow money, perhaps by offering guarantees for certain types of loan asset: Help to Buy is an example of this, as are the extensive systems of loan guarantees that most governments offer to small businesses and exporters. A third would be to reduce the real demand for money by simply giving people more of it: this is the famous "helicopter drop", or if the money is specifically used to redeem loan assets, debt jubilee or "monetization"**. And a fourth would be to encourage corporations to pay higher wages and governments to pay higher benefits, though this could be viewed as "robbing Peter to pay Paul", since governments must recover this from taxes and corporations from profits: it would only be beneficial if multiplier effects meant profits and tax incomes rose more than the cost of higher wages and benefits***.

Whatever approach is taken, the objective is clear. Lack of spending in an economy (shortage of aggregate demand) is caused by distributional scarcity of money, not by lack of loans. It is not necessary to restore lending in order to encourage spending. It is necessary to replace the money that is not being created by banks - this is the job of central banks. And it is necessary to ensure that the new money created by central banks goes to where it is needed. We are doing pretty well on the first of these, but are failing abysmally on the second. A whole herd of sacred cows, with names like "debt monetization causes hyperinflation", "higher wages cause inflation" and "no-one should get something for nothing", are getting in the way. We need to shoot them.

Related reading:

Rediscovering IS-LM - Pieria



* Well, ok, in these days of electronic settlement and custodian banks the lender probably wouldn't receive the actual security - it would be held in custody somewhere. But it would physically exist.

** Debt jubilee in this context means central bank monetization of private sector debts.

*** Yes, I know I haven't considered inflation. As direct stimulus of this kind would be a response to low aggregate demand, inflationary effects may be a sign that it is working. I find it very disturbing that inflation is always regarded as a bad thing: out of control inflation is extremely damaging, but mild inflation can be a necessary consequence of recovery from a slump and in my view should not routinely be squashed.


30 comments:

  1. Well put. This seems to be a clear exposition of the secular stagnation point: households, with stagnant wages and too much debt, demand money/credit that is very cheap - offering loan assets where the "haircut" is zero, or even negative (I think this is a better way to put it than lenders demanding a 100% haircut). Lenders, pushed into more risk with low rates and QE, still aren't ready to pay to lend money; to give it away, essentially (through risk at zero rates, or just negative rates). So there's the ZLB etc. That's why Summers et al argue for government spending (or, relatedly, German rebalancing to higher wages/investment) - the point is essentially that more wages (increased employment or rising real wages) are the only way to meet the money demand without negative or at least zero lending rates. The demand for money is fixed - but the capacity to afford it (the offered loan assets) are especially depressed at the moment.

    The problem with stagnation is that the biggest costs are hidden, in a sense. You see unemployment and low or no growth - but of course you can't see the total damage relative to the higher-spending counterfactual. And, interestingly, economics doesn't really seem to have a theory of this. Summers proposed the "Inverse Say's Law" - that lack of aggregate demand creates a lack of aggregate supply. But really economics has tended to ignore the long term effect of aggregate demand on potential. That might turn out to be a huge mistake. What do you think?

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    1. You can look at it from both directions, actually. Households strapped for cash only want to offer low-haircut loans, but moneylenders will only accept high-haircut loan assets, often with additional collateral that is potentially very costly to the household.

      I think economics has no answer in a world where supply persistently exceeds demand. Our whole economic paradigm is based on scarcity. We are busy creating artificial scarcity, mostly of money, because otherwise our whole economic and political belief system collapses. The result is completely unnecessary poverty and distress. It's an outrage.

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    2. gastro george8 June 2014 12:39

      Excellent and clear post, Frances.

      Your point here about scarcity also relates to your last note about inflation. A lot of people obsess about the dangers of inflation when the supply of money goes up - "printing money" in their terms. But of course, inflation only occurs when there is a scarcity of goods. When the economy is under-producing, the dangers of inflation are over-stated.

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  2. You have a talent for explaining banking to the non-specialist while challenging received wisdom at the same time. Will you collect your banking blogs into a book? Could become required reading!

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    1. Thanks Fiona! I have certainly been thinking about doing that.

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    2. looking forward for it !!

      I'd love it if you could also add some of your valuable insights on the consequences at the social front, it will be far more interesting than just a "banking" book :)

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  3. "no-one should get something for nothing"

    When the central bank conducts monetary policy through OMO's or QE existing asset holders experience a wealth effect. This wealth effect is free wealth. Therefore directly expanding money to citizens through monetary policy would be just another wealth effect and all monetary policy is free wealth and giving something for nothing. Directly expanding wealth of all citizens is creating a equitable wealth effect and more efficient too because the average MPC is higher.

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    1. I'm afraid this confuses stocks and flows. Wealth effects can only lead to more spending if there is also an income effect. The income effect may be because rising asset values mean people feel less urge to save from their disposable income. Or it may be because moneylenders are more willing to lend against the rising value of assets. The second of these is what got us into this mess in the first place. We should not go there again. Be careful what you ask for.

      It is completely wrong to conflate wealth effects with giving money directly to citizens. Wealth effects only benefit those who have wealth. A large proportion of the population do not have significant wealth and therefore do not experience wealth effects. One of the unfortunate consequences of QE was the fact that it disproportionately benefited those with wealth, and particularly the very wealthy. It is grossly regressive and I am unconvinced that its benefits outweigh the distributional costs.

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    2. Money is wealth. If you received more money your wealth went up. This could also be termed a wealth effect. This was my main point.

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  4. In my experience there are many people who borrow money - even though they have sufficient money/assets to meet their needs. Some of these people simply are poor money managers. Some are just greedy. I have seen a lot of people who have many debts - some who are at their wits end on how best to pay their debts off. And yet many of these people have savings and assets. They simply cannot prioritise their financial affairs. Am I wrong to assume that commercial organisations are very much different to this?
    If you accept there is some truth in my assertions, could you review your blog again and explain a little further. Thanks

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    1. You are making considerable value judgments about others. How do you define "sufficient money/assets to meet their needs"? Indeed, how do you define "needs"? How do you know what their needs are? What do you mean by "greedy"? What is a "poor money manager"? What is "prioritising their financial affairs"?

      You assume people with assets/savings can easily realise them to pay off debts. But that's not the case. Many people's assets are highly illiquid, which means they cannot easily obtain money with them. We say they are asset-rich but income-poor. And people whose main asset is their house still need somewhere to live, and would still pay rent, even if they sold their house. It is not as easy as you suggest.

      Many people also have both savings and debt. Debt counsellors usually advise that people use savings to pay off unsecured debt. But if the unsecured debt is short-term, and the savings are long-term (perhaps for retirement), it can be psychologically difficult to use savings in this way. People often prefer to struggle in the present rather than compromise their old age. We call this "negative time preference" and it is a controversial subject - economics assumes that people's time preference is always positive, but that's not necessarily the case. But my perspective is that people should not have to struggle in the present in order to build up savings for old age. Making difficult choices like that is a consequence of their general shortage of money - which is the point of this post. .

      Please sign your post. I accept Anonymous comments because the sign-in protocol is difficult for some people, but it is discourteous of you not to tell me your name.

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  6. " so in any model .... the demand curve should be a vertical line "
    assuming volume of [ credit ] money is on the horizontal axis ,
    what exactly is on the vertical axis ?
    it cant be the price of [ credit ] money .
    that would imply fixed demand at any price . ??????
    if so , have you succeeded here in explaining this ?

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    1. This comment has been removed by the author.

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    2. I've amended the post slightly to clarify what I mean. Traditional money demand models have the price on the y axis, so money demand reduces as the price rises. But in a fiat money economy where money is created almost entirely through bank lending, this is not an accurate way of modelling money. The "price of money" is actually the discount rate on the associated loan assets. As the discount rate rises, suppliers of loan assets become less willing to supply them. Does that make sense?

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    3. This comment has been removed by the author.

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    4. didn't realize you had amended main post .
      for people to accept the new theory posted ,
      they would have to be told the specifics ,
      vis a vis fiat money .
      for example , when the central bank issues currency on demand to commercial banks ,
      what goes back in the opposite direction ?
      when one bank issues credit , other banks must validate it .
      if netting takes place , is interest paid / received on net amounts at the central bank ?
      without knowing how exactly banking works ,
      it is impossible to accept the statement
      " fiat money in the form of currency does not bear interest "
      or " credit money cannot bear interest either "
      an economically illiterate reader might assume that money to a bank is free .
      to someone with a bit of economic understanding , this seems unlikely .

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    5. I do assume that people who read this post are familiar with my work. All of the issues you mention have been covered in previous posts.

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  7. First, the demand for capital goods is a derived demand, derived from primary consumer demands. Even in a capitalistic system, the end and objective of all production, is human consumption. The demand for inventory or plant and equipment, however far removed from the ultimate consumer, is derived from final consumer outlays in the marketplace.

    Demand is always paramount in successful business planning and commitment decisions. If sufficient demand is not expected to exist, it matters not what the expected costs will be. "Sufficient" demand, of course, is an income stream that covers all costs, plus the expected after tax profit margin.

    And only in the frictionless world created by the mathematical model builders are the asked prices in equilibrium with consumer spendable income. In the real world, there is always a purchasing power deficiency gap of varying proportions. This is just another way of saying that to have high levels of production and employment, we need not only a vastly more competitive price structure, we also need a steady but slightly inflationary monetary policy (prices increase c. 2-3 percent annually), and a tax policy that contains some elements of compulsory income redistribution - downward.

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  8. Leland Pritchard (Ph.D., economics, Chicago, 1933): "The demand for money should not be confused with the demand for loan-funds. The demand for loan-funds is not a demand for money, per se, but a demand which reflects the advantages of spending borrowed money. Insofar as there is a relationship it may be said that an increase in the demand for loan-funds tends to be associated with a decrease in the demand for money"

    I.e., Keynes's “liquidity preference” curve (demand for money), is a false doctrine. A liquidity preference curve is presumed to exist which represents the supply of money. In this system, interest is the cost which must be paid, if lenders are to forgo the advantages of liquidity. All of this has little or nothing to do with the real world, a world in which interest is paid on demand deposits.

    As Alfred Marshall said - Money is a paradox - by wanting more, the public ends up with less, and by wanting less, it ends up with more. All motives which induce the holding of a larger volume of money will tend to increase the demand for money - and reduce its velocity.

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    1. All good, except that by and large interest is NOT paid on demand deposits. Time deposits, yes.

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  9. Changing the rates on IBDDs is not going to change business's & consumer's balance sheets (& their demand for loan-funds). However, the federal gov't is the largest credit worthy borrower (with the biggest borrowing requirements). Transactions between the Reserve Bank & the commercial banks don't create new money (they're asset swaps). But the purchase of securities in the secondary market by the commercial banks from the non-bank public always creates new money (i.e., the CBs always bought short-term securities between 1942 & 2008 in order to minimize their non-earning assets & increase their liquidity reserves during recessions). Now with a remuneration rate that exceeds all money market rates, the CBs now hold more, idle, & unused IBDDs (as IBDDs are higher yielding & less risky). Thus the Fed (via the introduction of the payment of interest on reserve balances), has emasculated its "open market power". It has severely circumscribed its ability to increase aggregate monetary purchasing power in order to stimulate gDp.

    But we are not through. Bankrupt U Bernanke's remuneration rate induces dis-intermediation among just the non-banks (82 percent of the lending market prior to the Great-Recession). I.e., Bankrupt U Bernanke destroyed non-bank lending/investing. The commercial banking system would have to grow at twice the old rates for some time in order to compensate for this mistake.

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  10. Don't consider whether the resumption of CB lending/investing is an important factor. Dropping the remuneration rate would reinvigorate non-inflationary NB lending/investing (where savings are matched with investment). I.e., it would restore the wholesale funding market for the NBs that Bankrupt U Bernanke destroyed (bolstering NIM in the borrow short - to lend long savings-investment paradigm).

    -----
    For an explanation of non-bank (non-inflationary), vs. commercial bank (inflationary), lending/investing (traditional vs. shadow) see:

    "Should Commercial Banks Accept Savings Deposits?” by Leland J. Pritchard, Edward E. Edwards, and Lester V. Chandler at the 1961 Conference on Savings and Residential Financing in Chicago, Illinois

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  11. Frances! Welcome to the club!

    All we are haggling over now is minor details, and terminology.

    What you call "loan assets" I call "non-monetary IOUs". (Yep, mine is an ugly mouthful). If I want a loan from the bank, and the bank wants to give me a loan, I supply a non-monetary IOU to the bank, and the bank demands a non-monetary IOU from me. And in a monetary exchange economy, we buy and sell everything else (including little bits of paper called "non-monetary IOUs") in exchange for money.

    When a bank, or central bank, buys a loan asset/"non-monetary IOU" (or when it buys *anything*) it supplies money in exchange.

    "Traditionally, we model demand for money as if money itself is interest-bearing - so demand for money reduces as the interest rate rises. But fiat money in the form of currency does not bear interest, and it is exchangeable at par with credit money: credit money therefore cannot bear interest either."

    A slight overstatement there. The balance in my checking account might sometimes pay interest. But i will sometimes hold currency too, even though it pays no interest, because currency is sometimes more convenient. But yes, the demand for money (the quantity of money we wish to hold) is a negative function of the difference between the rate of interest paid on loan assets (non-monetary IOUs) and the rate of interest (if any) paid on money.

    "A third would be to reduce the real demand for money by simply giving people more of it: this is the famous "helicopter drop",..."

    OK, but couldn't we call this "increasing the supply of money"? But either way, it reduces the *excess demand* (demand minus supply) for money, which is what causes recessions.

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    1. Hehe. The idea of "loan demand" being demand for money actually came from you, sort of!

      Yes, of course a helicopter drop increases the supply of money. My point is really that increasing the money supply is by itself insufficient. The way in which you increase it matters too. Because of previous bad experiences we unnecessarily restrict use of things like helicopter drops, and thereby make relating after a debt-deflationary crisis far more difficult. Hence the reference to sacred cows.


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    2. Gah, iPad autocorrect strikes again! I mean "reflating", of course.

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    3. Hmmm. In that regard, I think that banks are even more sacred cows for the ECB?

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    4. Everything's a sacred cow for the ECB.

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    5. Frances, I too like the demand for money instead of demand for loans way of looking at it. I think Nick Rowe did say that a while back, but I'm not sure he approved of everything I tried to do with that (I'm still not sure why). In fact you commented on my post commenting on Nick's post months ago on this subject:

      http://banking-discussion.blogspot.com/2014/03/nick-rowes-example-from-sense-in-which.html

      The way I put it was that the borrowers were supplying the dollars of loan equity, and lenders were providing the demand for those dollars. Alternatively replace "loans" with "bonds" or "personal bonds" and the English language makes sense again: borrowers supply personal bonds to banks who demand them, and the banks pay money for them. Supply and demand curves crossing and it all makes sense again. That's why "supply" (green curves) are in quotes in my top plot: those are really demand curves, but Nick used "supply" in his post, so I wanted to match.

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