Banking and Excess Reserves

After yesterday's post, I received a question about cash.  More specifically, what does it mean to "sit on cash?"  The complete answer is more complex than you may realize.  One of the aspects of our economy that I intentionally excluded from yesterday's post is the role of banking.  Because the parable of the broken window does not consider a bank loan as an option, I too excluded banking in my analysis for simplicity sake.  The question I received, "what does it mean to sit on cash?" cannot ignore the role of banks in our economy.  Moreover, introducing banks into the parable of the broken window helps explain in greater detail what "hoarding cash" really means.

In yesterday's post, I said:

Because our economy is still emerging from a recession, some people and corporations are hoarding money.  This is what happens in a recession.  The demand for money increases while the demand for productive assets decreases.  For evidence, consider that Apple was sitting on $76.2 billion in cash as recently as July.

Is Apple sitting on giant mountains of $20 and $100 bills?  No.  To do so would mean that Apple is sitting on $76.2 billion in currency.  The term "cash" has several uses, but in a business setting we typically mean currency and extremely liquid assets such as money in a checking account.  It's important to make a distinction between currency and bank deposits because banks will take the deposit and then make a subsequent loan.  When the bank makes a loan, they are injecting money back into the economy.  Therefore, if a corporation hoards cash, it doesn't automatically mean that they are pulling money out of economic distribution. 

Banks, however, do not actually lend out 100% of the money they hold as deposits.  Banks are required to retain a specific percentage of deposits in reserve which are simply called "required reserves." Required reserves help ensure that the bank will be able to pay depositors when they withdraw funds from the bank.  In a normally functioning economy, the bank will lend out virtually all the deposits in excess of the required reserves in order to maximize their profit. 

Banks are not required to lend out all the money they hold above the required reserve level.  Additional reserves over the required reserve threshold are called excess reserves, and they are a strong indicator of a bank's demand for cash.  If a bank is concerned that withdrawals are going to be exceedingly high (meaning depositors want currency over deposits), they will keep a higher level of reserves than is required.  Additionally, if interest rates fall too low, then banks lose the incentive to lend as it is not profitable.  With no incentive to lend, banks accumulate excess reserves as well.

The Federal Reserve provides information on banks' excess reserves, and currently they are extremely high.  Our banks are holding almost $1.6 trillion dollars in excess reserves right now.  Compare this to pre-crisis levels that typical remained below $10 billion!  Are the banks hoarding cash?  Yes, but only to a point.  The large amounts of excess reserves are primarily a result of expansionary monetary policy by the Federal Reserve coupled with extremely low interest rates.  This means that the Federal Reserve is effectively pushing cash into the banking system, but the individual lenders have no reason to lend the money out.  The banks' demand for cash is greater than their demand for loans, and so the money is not reaching the general economy. 

What does this mean in terms of the parable of the broken window and our current economy?  Well, for starters, parables about broken windows probably shouldn't be used to explain banking.  However, we can still conclude that cash is being hoarded in our economy.  Businesses are hoarding cash primarily in the form of deposit instruments, which does not directly take money out of the economy.  Banks are hoarding cash in the form of excess reserves, though, which limits the amount of money moving throughout the economy. What isn't so obvious in this equation is that banks are primarily hoarding cash coming from the Federal Reserve, not from depositors.   Fiscal policy does not have the same limitations as monetary policy in low interest rate environments, but that topic will have to wait for another post.

Krugman and the Parable of the Broken Window

Paul Krugman sure does seem to piss off a lot of conservatives.  Krugman's ability to set America's right on their ear was on full display recently when a fraudulent Google+ account under his name posted this: 
People on Twitter might be joking, but in all seriousness, we would see a bigger boost in spending and hence economic growth if the earthquake had done more damage.

Vast numbers of right-wing writers immediately attacked the post as evidence of Krugman's heartlessness and lack of understanding of basic economics.  The stock response to the faux-claim has been to cite "The Parable of the Broken Window."  If you're not familiar with the parable, it goes like this:

A shopkeeper's son breaks a window.  The shopkeeper must replace the window, which costs $50.  Lamenting his loss of $50 to a friend, the shopkeeper's naive friend tells him that the $50 spent on the window went to the glazier, who now has $50 more to spend in his shop!  The money will come back to the shopkeeper and everything will work out in the end.  The shopkeeper, though, realizes the fallacy of his friend's logic and says, "What you forget is that I was going to spend that $50 on a new coat!  The clothier now will no longer have the $50 to spend in my store!  While I may be able to replace the window, I'm still out the coat!"

Thus, the parable of the broken window concludes that destruction is not beneficial to the economy.  Even though the impostor who posted the statement attributed to Krugman  has since revealed himself, it seems that he has managed to bring forth the parable as an argument against Keynsian economics.  It's not an original argument, and I have no doubt it will be trotted out again many times in the future.

There's are multiple problems with using the parable of the broken window, though, when viewing our current economy.  Before describing those problems, I have to lay down some basic ground rules.

1) Economics is an amoral scientific analysis of human behavior and wealth.  Note that I do not say immoral, just amoral.  There are no basic moral assumptions in economics.  For example, the drug trade, prostitution, and murder-for- hire are all examples of activities commonly (not universally) viewed as immoral.  However, economics does not consider the moral weight of any of these actions.  An economist can draw many conclusions about these activities without making any moral judgment on them.  Black markets exist, and an economist can study these markets without condoning them. 

2) An amoral economic conclusion, even if it is economically beneficial, is not necessarily an endorsement of a specific economic activity.  For example, most people attribute a highly expansionary effect on the economy due to World War II.  Few people, though, believe that World War II was beneficial to mankind.  Moreover, no one of conscience advocates simply going to war as an good economic solution. 

With these ground rules in place, I will affirmatively state that I do not condone or advocate property destruction, whether caused by man or nature, as an appropriate economic tool in any circumstances.  The conclusions that I draw are merely an amoral economic analysis and predictions of outcomes based on theoretical scenarios.

Now, back to the parable of the broken window.  Why doesn't the parable provide us proper insight into the economic effect of natural disasters?  Also, why is it an inappropriate comparison to Keynsian economics?

To begin to answer these questions, we have to look at the assumptions of the parable.  The "naive" friend assumes that the $50 spent on a new window is $50 injected into the economy.  Therefore, he believes that the money will ultimately "come back" to the shopkeeper when the glazier uses the money to make purchases in the shopkeeper's store.  In the parable, this assumption is false because the shopkeeper was planning on purchasing the a new coat.  Therefore, the total purchases in the economy in dollar amounts has not changed at all, and the shopkeeper no longer can afford his new coat.  The important assumption is that the shopkeeper was going to spend the money elsewhere, and this is why the shopkeeper is correct in the parable.

If the parable of the broken window is to have any truth when applied to a natural disaster, we must consider the basic assumption that the money used to replace the window was going to be used for other purposes.  Perhaps this seems like common sense to you.  It shouldn't be.  The shopkeeper always has the option of simply hoarding the $50.  What if the shopkeeper intended to bury the $50 in a jar?  If this is our new assumption, the "naive" friend begins to seem a little less crazy.  Instead of burying the $50, now the shopkeeper must spend it.  With this new assumption, total purchases do increase.  The economy has effectively grown, though the shopkeeper is still without his $50 in a jar.

What if the shopkeeper didn't have $50 to spend at all?  Unless someone is willing to give the shopkeeper $50, nothing happens.  The shopkeeper loses his window, the economy doesn't grow, and no one is better off, least of all the shopkeeper.  If someone is willing to give the shopkeeper $50, then we have to consider what the generous benefactor was going to do with that money.  If they had planned on spending the money, then the shopkeeper's logic holds.  Total purchases do not grow.  However, if the benefactor was simply hoarding the money, then total purchases do increase, and the "naive" friend's logic is not so flawed.

Given these different assumptions, it becomes clear that the original use of the $50 is paramount to any conclusion we may draw about the effect of the broken window.  If the $50 would be hoarded absent the broken window, then the parable's conclusion is incorrect.  If the $50 is earmarked for a different purchase, then the shopkeeper's logic is sound. 

Back to our natural disaster.  Which of the above assumptions most closely resembles our current economy?  In truth, a combination of all the assumptions is closest to our economy.  Consider the city of New York.  New York consists of poor people and rich people as well as many businesses.  Because our economy is still emerging from a recession, some people and corporations are hoarding money.  This is what happens in a recession.  The demand for money increases while the demand for productive assets decreases.  For evidence, consider that Apple was sitting on $76.2 billion in cash as recently as July.  However, not everyone is sitting on mountains of cash.  Poor people, in particular, would have no ability to replace lost assets without private or public assistance.  Would a generous benefactor sweep in to replace the lost assets?  Don't hold your breath.  If the relief efforts after Hurricane Katrina are any indication, some public and private assistance would be given, but not enough to replace the total lost assets of those without wealth.  So some of the citizens of New York resemble the shopkeeper with the jar in the backyard, some resemble the shopkeeper who wanted the new coat, and others resemble the shopkeeper without $50 at all.

With this new framework, what happens to New York after a theoretical natural disaster?  Let's start with the wealthy who are hoarding cash.  In order to replace their lost assets, they dip into their cash reserves.  This will grow the current economy.  The individuals with money that would be spent on other goods redirect their funds towards replacing their lost assets.  This is a wash for the size of the economy, but a loss of assets for the individuals.  The poor, however, must rely on assistance to replace lost assets which typically is not enough to cover their losses.  They lose assets, and any economic effect complete relies on the intentions of their benefactors.

To our final economic conclusion:  what is the effect of a natural disaster on the total economy?  Because some people have cash reserves that are redirected into the economy, the size of the current economy grows.  However, these individuals still lose assets.  Moreover, the economic stimulus of the event is only in proportion to the amount of cash reserves redirected into the economy, not in proportion to the total economic activity needed to replace all lost assets.  Finally, the damaged assets of the event may be replaced, but the total value of the assets is completely lost.  Thus, natural disasters may increase the current size of the economy at the expense of valuable assets.

Having concluded that amoral analysis, should we wish for natural disasters to save us?  The obvious answer is no.  Even though the current size of the economy may grow, we lose valuable assets.  Furthermore, the lost assets will hinder long-term economic growth.  Simply put, cash hoarders will not always want to sit on their money.  Eventually they will want to place their money in productive assets or use the money for consumption which will grow the economy more in the future.  So the immediate benefits of an expanding economy are offset by the long-term loss of assets.  Furthermore, the greatest effects of the disaster will be disproportinately felt by the poor who do not have the means to replace their assets.

If you are wondering why the "Parable of the Broken Window" is used as a counter-argument to Keynesian economics, you have to go back to the shopkeeper's assumption.  The shopkeeper realizes the additional spending on the broken window isn't an economic gain because he was going to buy that new coat.  Therefore, increasing spending on the window doesn't help the economy.  The flawed logic therefore concludes that Keynes' assertions about government spending are wrong.  What Keynes realized, and we see through empirical evidence, is that cash is hoarded in a recession.  Therefore, mechanisms that inject additional cash into the economy such as deficit spending and* expansionary monetary policy do* can have a stimulating effect by allowing the demand for cash to be met without a corresponding reduction in productive assets. The parable is simply a false counter-argument based on improper assumptions applied to a recessionary economy. 

If you are curious about Krugman's personal response to his impostor, you can find it here.

*edit:  in my attempt to keep this post from running too long, I originally condensed some of Keynes main points too much.  I've made these changes to better reflect a recessionary economy that does not enter into the Keynesian "liquidity trap."  However, our current economy might likely best be defined by the liquidity trap in a Keynesian model.

New Ideas to Combat Poverty

While the Federal Reserve System's primary role may be to control our nation's monetary policy, one of the lesser known functions of our central bank is as an economic research center.  To keep the public informed of current work in the field, a number of publications are made available covering a wide variety of topics, as well as specialized publications for educators* and students*.  If you have never seen the Federal Reserve's offerings, I highly encourage you to take a look*. If you are reading this blog, there is something there for you.

In the winter edition of Bridges, a quarterly publication distributed by the St. Louis branch of the Federal Reserve, Ray Boshara discusses new innovations in savings for America's impoverished.  Through exploration of the American Dream Demonstration and Individual Development Accounts, Boshara highlights how many commonly held beliefs about the plight of those in poverty turn out to be quite wrong.  People in poverty can save money, given some basic education and appropriate financial tools.  Additionally, some findings were quite shocking.  Households earning 200% of the poverty line saved about 1% of their income, while families only making 50% of the poverty line saved about 3%.  Furthermore, controlling for factors such as age, gender, race, employment status, or welfare receipt showed that savings occurred across the spectra of these categories.  In the American Dream Demonstration, "every hour of financial education was correlated with greater saving, but only up to 10 hours."

The results of the American Dream Demonstration are important on many fronts.  For the politically minded, it is refreshing to see conservative ideas used for social benefit.  Boshara takes a minor swipe at "left-leaning academics" who doubted the viability of the ideas, but it is a swipe the left should gladly take.  The mechanisms described by the article promote asset growth among our poorest citizens.  This growth in net worth correlates to greater financial stability, greater ability to survive financial distress, and of particular importance, improved outcomes for children raised in poverty.  The mechanisms are cost effective and do not require billions in federal funding.  The American Dream Demonstration may not solve all the problems of those in poverty, but it's a tremendous step in the right direction.

*I have linked to the St. Louis Federal Reserve publications, as this is the bank in my home region.

More political support for ABC theory

Though Ron Paul may lay claim to being the godfather of ABC theory in the GOP, it appears that at least one of his opponents is brushing up on the ideas as well.  Expect to hear much more about credit cycles, monetary policy, and the gold standard as we head deeper into the primary season.  I will be surprised if we hear anything about praxeology, though.  I imagine that the methodology of ABC theory plays against media narratives entirely too much for sufficient press coverage.

Warren Buffett, Socialist? Really?

The Daily Show has a nice segment on the reaction to Warren Buffett's editorial.

Ron Paul, the Gold Standard, and ABC Theory

Ron Paul seems to have made headlines recently for not making headlines.  The attention (or lack thereof, depending on viewpoint) has brought Paul back into the media's eye for another moment, and along with stories about Ron Paul come stories about the gold standard.    For advocates of the gold standard, there is no greater ideal than a return to gold-backed currency.  They believe this will solve the problem of economic "bubbles" and the subsequent "busts" that create recessions and economic turmoil. 

If it sounds fishy, that's because it is.  The theory behind Ron Paul's view of money is a school of economic thought called "Austrian Business Cycle theory,"  or more simply, ABC theory.   In order to understand why Paul thinks we should return to the gold standard, we're going to have to visit the strange and unusual world of the ABC theorist.  Be warned:  this is a world of crazy.

The first thing you need to know about ABC theory is that it denies empirical evidence can be used in economics.  Von Mises, one of the founding fathers of ABC theory, establishes this principle in his work, Human Action.  Von Mises surmises that man has free will, and therefore we can never make predictive judgments on the actions of man based on observation.  Each individual man choses for himself what his goals and actions will be, and observing one man or action tells us nothing about future actions or the actions of other men.  Therefore, the study of economics must only be the study of human behavior using pure theory and logic.  This specific methodology used by the ABC theorist is called praxeology.

What does this mean in practice?  It means that ABC theory will reject any use of historical data, scientific studies, or statisical analysis. This aspect of Von Mises work caused the economic historian, Mark Blaug, to quip, "his writings on the foundations of economic science are so cranky and idiosyncratic that one can only wonder that they have been taken seriously by anyone."  It is a fair criticism.  Without any ability to "prove" conclusions empirically, ABC theory borders on a faith-based approach to economics.  Additionally, it's virtually impossible to "disprove" ABC theory to a supporter, as evidence does not matter in their framework. 

Beyond the basic framework of praxeology, though, ABC theory has come to many conclusions about how the economy works.  Remember, real world evidence is not needed for these conclusions.  The first conclusion is that increases in the money supply create economic "bubbles."  The logic is simple (though erroneous):  given more money, individuals will invest in new things.  Given enough money, individuals will run out of "good" investments and start investing in "bad" investments.  This is the description of an economic bubble, and ABC theorists believe that the root cause of such a bubble is an increase in the supply of money. After a time, all bubbles "pop" and a recession occurs as the "bad" investments go away, the capital is reallocated to good investments, and workers adjust to the new economy with new labor demands. 

The current appeal of ABC theory should be apparent.  The recent sub-prime mortgage debacle appears to closely resemble the the "bubble" and "bust" paradigm.  Our monetary policy, primarily controlled by the Federal Reserve System, did provide for an increasing money supply leading up to the financial crash.  The heavy investment in sub-prime loans did resemble "bad" investment.  These simple correlations have lead many to believe that ABC theory might be onto something.  Finally, the solution to the problem of recessions in this framework is to contain the money supply.  That's where the gold standard comes in.

Ron Paul and his disciples believe that by pegging the value of the dollar to the value of gold, the money supply will therefore be fixed.  With the return to a tightly controlled money supply, bubbles will no longer be able to form.  Without bubbles, there won't be any busts.  Our economic woes will be over.  Aren't most of the world's problem this easy to fix?

The oversights of this logic become apparent once any sort of scientific analysis is introduced.  Let's start with the historical record.  America experienced recessions beginning in: 1796, 1802, 1807, 1812, 1815, 1822, 1825, 1833, 1836, 1839, 1845, 1847, 1853, 1857, 1860, 1865, 1869, 1873, 1882, 1887, 1890, 1893, 1895, 1899, 1902, 1907, 1910, 1913, 1918, 1920, 1923, 1926, 1929 (the Great Depression), 1937, 1945, 1949, 1953, 1958, 1960, 1969, 1973, 1980, 1981, 1990, 2001, 2007.   It's a long list, and I include it in it's entirety to demonstrate how often recessions have historically  occurred.  It's particularly notable that the United States has only experienced six recessions of varying intensity in the forty years since abandoning the gold standard.  Forty recessions, including the Great Depression, all occurred before this abandonment (with notable exceptions during war time).

What about more scientific studies and historical analysis?  Ben Bernanke delivered an illuminating speech in 2004 that discusses the effects of the gold standard during the Great Depression.  Relying on the work of the economists Milton Friedman and Anna Schwartz, Bernanke discusses how a constrained money supply slowed America's ability to emerge from the Depression.  Bernanke's speech expands on this idea by addressing the international community's use of the gold standard during the Depression.  As Bernanke states:

Perhaps the most fascinating discovery arising from researchers' broader international focus is that the extent to which a country adhered to the gold standard and the severity of its depression were closely linked. In particular, the longer that a country remained committed to gold, the deeper its depression and the later its recovery (Choudhri and Kochin, 1980; Eichengreen and Sachs, 1985).

In light of such evidence that debunks ABC theory, many are not deterred. Of course, for the pure ABC theorist, evidence does not matter.  For them, evidence only tells you what happened one time and has no application to what will happen in the future.  This is why Ron Paul and his gold standard rhetoric is so frightening.  It has no basis in history.  It has no basis in scientific observation.  It is only how the world should work inside his own head.  Such reasoning should not be involved in our economic problem solving.

Beyond Marginal Tax Rates: LIFO

While much of the nation's tax debate centers on marginal income tax rates, a slew of deductions, incentives, loopholes, and accounting tricks escapes the attention of media and the electorate at large.  These lesser known tax issues can amount to huge tax breaks for their recipients--sometimes by design, but sometimes not.  In an effort to further understanding of the tax system in place, I will periodically be posting on these lesser known issues and what they mean for American tax policy.

If you've never heard the term LIFO, you are not alone.  LIFO is the acronym for "Last In, First Out," which is simply an accounting method for valuing inventory, and the term is typically reserved for some of the most technical accounting discussions that can take place in a business environment.  However, LIFO means big money for some of America's largest corporations.  Here's how it works:

Imagine that you are a large oil company.  Every year, you must prepare financial statements and file a tax return like any other company.  One of the largest expenses your company will incur is "cost of goods sold."  Calculating the cost of goods sold can be complicated though.  As a large oil company, you maintain a large reserve of oil as a course of business.  Additionally, you continue to purchase oil throughout the year.  You encounter a problem when you must calculate the cost of goods sold because your reserves and the oil you purchased throughout the year were purchased at varying prices.  It is impossible to determine exactly  the cost of the specific oil that was sold throughout the year, as the oil mixes together in the reserves tanks and is completely homogenous.  In order to solve this problem, accountants developed a number of ways to account for the cost of goods sold.  The two most important methods are LIFO and FIFO.

As earlier stated, LIFO stands for "Last In, First Out."  This means that the latest purchase of goods is treated as the first item sold when calculating the cost of goods sold.  FIFO stands for "First In, First Out," and it means that the earliest purchase of goods is treated as the first item sold when calculating the cost of goods sold.  You must chose one of these methods.  Is there an advantage to either method?

The answer is a resounding "yes."  Because a normal economy experiences incremental inflation, LIFO presents a clearly superior option for companies with large inventory reserves.  Consider an oil company that has been around for 40 years.  The price of oil in 1971 was around $18/barrel.  Because your company has maintained a large supply of oil over the course of its existence, LIFO allows you to continue valuing your reserve inventory at much older prices, perhaps as low as $18/barrel!  The additional ramification of this decision is that your "cost of goods sold" is shown on your tax return at much larger current purchase prices, currently around $87/barrel.  This means that your "cost of goods sold" is higher than reality so long as inflation keeps prices above your historic purchase levels.  The increase in the COGS reducing your net taxable income.  The lower net taxable income means you pay less in taxes.  Thus, in a normal inflationary economy, the choice of LIFO will lower your total tax bill.

For some of you, this may seem grossly unfair.  Remember, though, that either accounting method has been legal since the 1930s.  Additionally, should the economy experience severe deflation, FIFO becomes the preferable accounting method to reduce taxation.  Because we normally see modest inflation, companies with very large inventories do tend to elect LIFO accounting methods.  While it's understandable why a corporation would make this election, is it in the best interest of society to allow for either option to exist?

The debate over the appropriateness of LIFO has been quietly going on for years.  Most recently, Democrats proposed the elimination of the LIFO accounting method during the debt ceiling negotiations.  The anticipated result of such a decision is projected to generate $72 billion in additional taxes from these companies which would reduce the federal deficit.  Republicans balked at this proposal claiming that it is a tax increase on business that would hurt jobs, and that LIFO is actually a more appropriate method as it better reflects economic gains over inflationary gains.  For the time being, Republicans have won out, and LIFO is still a legal accounting method.

The assertion that LIFO is more appropriate than FIFO due to economic gains is dubious.  Companies are charged with maximizing shareholder value, and LIFO is simply a better method for doing so in a normal economy.  Should America enter a long and severe deflationary cycle, many companies would switch to the FIFO method when possible to continue maximizing shareholder value.  This is their job.  When have large corporations ever advocated for legislation on the grounds of appropriateness over profitability?  Because of this, the arguments for keeping LIFO don't pass the smell test.

There is still a problem, though, in that companies can chose an accounting method to lower their tax bill.  To maintain parity between businesses, one standard accounting method should be adopted.  Standardizing the accounting method is not a tax on all business, as not all businesses chose the LIFO method.  Moreover, FIFO more closely resembles reality.  Older inventory does get sold--it doesn't simply sit on a shelf while newer inventory cycles in and out of the business.  Truly, the use of LIFO is simply a tax loophole created by accountants and should be eliminated in America. 

The elimination of LIFO would not be an innovation or place us at a disadvantage.  LIFO is already illegal in Europe and other westernized countries like Australia.  The arguments supporting LIFO accounting are flimsy and transparent.  Most important, though, the elimination of LIFO will make taxation across businesses inherently more fair.