Several readers have ask me to comment on a King World interview of
Before I offer my comments on Pento's thoughts, let
me say upfront that Eric King is a world-class interviewer. King lets his
interviewees have their say, no matter what it is.
It is up to listeners to decide whether the message makes any sense or not.
King merely wants the position to be well stated.
Email Request From US
Have you listened to Mike Pento's scenario where
the FED will cease to pay interest on reserves held at the FED, as a result,
forcing banks to loan out the money to seek some return. He believes that
they will be encourage to purchase US treasuries:
Is this viable and/or probable?
Thanks for providing us with such a great blog.
All the best,
Email From Down Under
I follow your work from Australia with great interest. I was impressed with
your argument that the creation of new money will not lead to price increases
because it is deposited with the Fed, and does not make it into the real
You will no doubt be aware of recent comments by Michael Pento
on King World News that the Fed is about to eliminate the incentives for the
banks to deposit excess reserves with the Fed, and that this will force the
banks to lend in the economy and cause significant inflation, and presumably
a drop in the USD.
I would be greatly interested in your views on this, as a deflationist,
because if Pento is right then the reason for
deflation over inflation might be eliminated. Furthermore, the worsening in
key stats such as auto sales and official unemployment might just be the
trigger that forces the Fed to squeeze the money out into the economy.
Primer on Bank
With that background out of the way, my first thought is "Here we go
again. How many times does such silliness have to be rebutted before it
Banks lend if and only if both of the following are true.
are not capital impaired
They have credit-worthy borrowers willing to borrow.
That is not an opinion. Rather, that is a statement of fact. I discussed this
at length many times.
Excess Reserves Yet Again
Here is a discussion from BIS Working Papers No 292, Unconventional monetary
policies: an appraisal.
Note: The above link is a lengthy and complex read, recommended only for
those with a good understanding of monetary issues. It is not light reading.
The article addresses two fallacies
Proposition #1: an expansion of bank reserves endows banks with
additional resources to extend loans
Proposition #2: There is something uniquely inflationary about bank
From the article....
premise of the first proposition is that bank reserves are needed for banks
to make loans. An extreme version of this view is the text-book notion of a
stable money multiplier.
In fact, the level of reserves hardly figures in
banks’ lending decisions. The amount of credit outstanding is
determined by banks’ willingness to supply loans, based on perceived risk-return
trade-offs, and by the demand for those loans.
The main exogenous constraint on the expansion of
credit is minimum capital requirements.
A striking recent illustration of the tenuous link between excess reserves
and bank lending is the experience during the Bank of Japan’s
“quantitative easing” policy in 2001-2006.
Japan's Quantitative Easing Experiment
Despite significant expansions in excess reserve balances, and the associated
increase in base money, during the zero-interest rate policy, lending in the
Japanese banking system did not increase robustly (Figure 4).
Is financing with bank reserves uniquely inflationary?
If bank reserves do not contribute to additional lending and are close
substitutes for short-term government debt, it is hard to see what the origin
of the additional inflationary effects could be.
There is much additional discussion in the article, but it is clear that
money lending theory as espoused by many did not happen in Japan, nor is
there any evidence of it happening in the US, nor is there a sound
theoretical basis for it.
In fiat credit-based economies, lending comes
first, reserves come second.
Fed's Next Move
Pento was preaching the same thing on IB Times
FX in The Fed's Next Move
As I predicted as far
back as June of 2010, the Fed will soon follow the strategy of ceasing to pay
interest on excess reserves.
Since October 2008, the Fed has been paying interest (25 bps) on commercial
bank deposits held with the central bank. But because of Bernanke's fears of
deflation, he will eventually opt to do whatever it takes to get the money
supply to increase. With rates already at zero percent and the Fed's balance
sheet already at an unprecedented and intractable level, the next logical
step in Bernanke's mind is to remove the impetus on the part of banks to keep
their excess reserves laying fallow at the Fed. Heck, he may even charge
interest on these deposits in order to guarantee that banks will find a way
to get that money out the door.
Commercial banks currently hold $1.42 trillion worth of excess reserves with
the central bank. If that money were to be suddenly released, it could
through the fractional reserve system, have the potential to increase the
money supply by north of $15 trillion! As silly as that sounds, I still hear
prominent economists like Jeremy Siegel call for just such action. If they
get their wish, watch for the gold market to explode higher in price, as the
U.S. dollar sinks into the abyss.
Facts of the Matter
Money supply has already soared by any number of
Credit expansion has been anemic except for student
loans and FHA (both with government guarantees)
The Fed did not cease paying interest on excess
reserves as predicted in 2010.
It would not matter from a lending perspective if
the Fed did.
The idea that excess reserves will come pouring into
the economy, multiplied 10 times over is widely believed nonsense. In
practice, lending comes first, reserves second. (see
“The Roving Cavaliers
of Credit”by Steve Keen for further excellent
The simple fact of the matter is Pento has no idea
how bank lending works in the real world.
There is no other way to state it. If banks thought they had good credit
risks, they would lend (provided of course they were not capital impaired).
Moreover, by paying interest on reserves, Bernanke is slowly recapitalizing
banks over time. Would Bernanke easily give that up? Well he hasn't so far.
Nor has he even dropped a hint of it.
Even if Bernanke did cease paying interest on excess reserves, it would not
impact bank lending for reasons stated.
For the sake of argument let's play "What If"?
What if the Fed were to reduce interest rates on excess reserves to -3%.
Would that do it? Well, it sure would get banks to do something, but
that something might not necessarily be lending!
For example, banks might bet against the US dollar, bet on gold, plow into
the stock market, etc., etc., etc., but there is no reason to assume banks
would extend credit to unworthy borrowers.
Moreover, Bernanke (as foolish as he is), is at least bright enough to figure
Thus, the idea that Bernanke can get banks to lend by reducing interest rates
on excess reserves is 100% without a doubt, fatally flawed nonsense from both
theoretical and practical standpoints.
ECB Cuts Reserve Rate to Zero
As a practical matter, the ECB just cut interest on reserves to zero. The
result is reduced liquidity as banks shut down money market funds rather than
Please consider How Money Market Funds Were
Wounded by European Interest-Rate Cuts
The cut in the
interest rate was meant to convince banks to stop parking money, to lend
more, to get more money into the system and make it more stable - in Wall
Street parlance, to add "liquidity."
But the backlash from banks shows that they're willing to close money market
funds rather than lose profits. The effect, ironically, is to reduce
liquidity in the financial system.
JP Morgan alone pulled $29 billion in
It's supposed to be different here?
Additional Discussion of Excess Reserves and Constraints on Bernanke
Monopoly Money vs. Bernanke
Money, is there a Difference?
Bernanke's Deflation Prevention Scorecard
Fictional Reserve Lending And
The Myth Of Excess Reserves