August 29, 2011 12:21PM

Lagarde Confused, Again

Christine Lagarde, the new managing director of the International Monetary Fund and former French finance minister, is confused, again. In her speech before the central bankers assembled in Jackson Hole, Wyoming this weekend, Ms. Lagarde asserted that the way forward for Europe was to recapitalize Europe’s “weak” banks. This, she claimed, would cut the “chains of contagion” and promote growth.

Nothing could be further from the truth. Even the IMF, in its July 2011 Article IV consultations with Mexico, realized that mandating higher capital‐​asset ratios (recapitalization) for banks, would take some steam out of Mexico’s money supply growth and jeopardize Mexico’s economic recovery.

It is rather easy to see why higher capital‐​asset ratios are “deflationary.” If we hold the level of a bank’s capital constant, an increase in its capital‐​asset ratio requires that the level of its assets must fall. This, in turn, implies that the banking system’s liabilities – demand deposits – must contract. Since the money supply consists of demand deposits, among other things, the money supply must, therefore, contract.

Alternatively, if we hold assets constant, an increase in the capital‐​asset ratio requires an increase in capital. This destroys money. When an investor purchases newly‐​issued bank shares, for example, the investor exchanges funds from a bank deposit for the new shares. This reduces deposit liabilities in the banking system and wipes out money.

Given Euroland’s anemic broad money growth rate (M3), the struggling state of Europe’s economies, and the IMF’s recent counsel to Mexico, Ms. Lagarde’s Jackson Hole assertions signal confusion, at best.