Topic: Finance, Banking & Monetary Policy

Everything You Need to Know About Net or Gross Saving Rates

Writing in Project Syndicate, Stephen Roach, former chief economist for Morgan Stanley, declares the U.S. economy’s foundations fundamentally unsound:

“America’s net national savings rate – the sum of saving by businesses, households and the government sector – stood at just 2.1% of [gross] national income in the third quarter of 2017.  That is only one third of the 6.3% of the average that prevailed in the final three decades of the twentieth century… America… is saving next to nothing.  Alas, the story doesn’t end there. To finance consumption and growth, the U.S. borrows surplus saving from abroad to compensate for the domestic shortfall.  All that borrowing implies a large balance of payments deficit with the rest of the world which spawns an equally large trade deficit.”   

This alleged “savings crisis” has popped up periodically since the 1980s when there’s a Republican in White House, such as 2006 when I wrote about it.

Roach believes it “important to think about saving in ‘net’ terms, which excludes the depreciation of obsolete or worn-out capacity in order to assess how much the economy is putting aside to fund the expansion of productive capacity.”  

Dividing net savings by gross national income subtracts a semi-arbitrary estimate of depreciation from the numerator but not from the denominator. Dividing net by gross shrinks the resulting savings/income ratio. For Roach to suggest that more net savings could in any sense pay for more “consumption and growth” is misleading at best.  Don’t expect a discount on a new car because you hope to pay with net savings, after subtracting estimated depreciation.

The amount of money needed for new plants and equipment is gross, not net. And it is the dollar gap between gross investment and gross saving that needs to be financed by attracting foreign investment.  Mr. Roach calls foreign investment in U.S. equity (stocks) or real property “borrowing,” but that’s not how we describe the same investments if made by a U.S. resident.

Gross and Net Saving and Investment Rates

The blue line in the first graph shows gross savings as a percentage of gross national income (GNI). The red line shows gross private domestic investment as a percentage of GDP, which is quite similar to GNI (GDP excludes income of foreigners spent in the U.S. and remitted income of Americans living abroad).  

The dotted green line is net savings divided by gross income – the extraneous ratio that worries Mr. Roach.  The green line appears to fall much more than the blue line simply because estimated depreciation rose from 12.3% of national income in 1969 to 15.9% in 2017 – as the capital stock shifted from structures to rapidly-depreciating high-tech. Because rising depreciation estimates are subtracted from saving yet added to income, the downward tilt of the green line is exaggerated by the oddity of dividing net savings by gross income. 

A declining net savings rate since the mid-1960s did not thwart fixed investment, though recessions always do.  Real net domestic fixed investment nearly tripled from $379.9 billion in 1983 (in 2009 dollars) to over $1 trillion by 2005-2006, and has again been heading up since the 2008-09 recession.

In the second graph, the ups and downs in the net savings rate (green line) do not track or explain the movements in net exports (exports minus imports). The U.S. runs a capital surplus and current account deficit when the economy is growing briskly.  Trade deficits shrink just before, during and right after recessions.  

Net Saving does not explain net exports

When previous “net savings” anxieties appeared, they were used as a rationale for raising taxes.  In accounting, unlike economics, it sounds simple to raise national savings by reducing the government’s negative savings (budget deficits).  If we carelessly assume that higher taxes have no bad effects on the economy or private savings, budget deficits would then fall with higher taxes and national saving (the sum of public and private saving) would rise.  In this simplistic bookkeeping, more taxes are defined as being identical to more savings.     

There are big problems with assuming a $100 million tax-financed cut in the deficit equals a $100 million increase in national savings.  One is that politicians’ favorite targets for new taxes are savers and savings – retained corporate profits, dividends, interest, capital gains and high incomes in general.  If successful firms and families pay more in taxes, they’ll have less to save.

Trump’s Criticisms Shouldn’t be the Most Important Headlines about the Fed

On Tuesday, the president renewed his earlier criticisms of the Federal Reserve’s interest rates hike—saying he was not happy with the fast pace of the Fed’s “normalization” plan.  This pattern has been reported as “breaking” with tradition and questioning the “independence” of the Fed.  Then yesterday afternoon, after a plunge in financial markets, Trump sharpened his critique saying “the Fed has gone crazy.”

While it is—at least among recent presidents—unusual for the president to opine on monetary policy, this has been a most unusual presidency from the start.  And while Trump’s criticisms of the Fed are good for generating headlines, they risk drawing attention away from more important matters at the central bank. To that end, I want to share two points to help put the president’s remarks in proper contexts—followed by two additional points to reorient the Fed discussion around what’s actually important.

One worry people have about Trump’s comments is that they call into question the Fed’s “independence.” But it is critical to remember that central bank independence is a somewhat amorphous term—with different speakers relying on different definitions. It is, however, a useful concept when independence refers to the Fed conducting monetary policy without regard to political considerations.  That is to say, the Fed is an independent institution insofar as it sets policy in reaction to changing macroeconomic conditions—not in reaction to changes in the legislative agenda or electoral prospects. What is not, or should not, be meant by central bank independence is that the Fed is fully divorced from all other public institutions.  Chair Powell often, and rightly, stresses that the Fed pursues goals given to it by Congress; in that respect, the Fed is certainly not independent from accountability to the public.

To the extent anyone is worrying that the Powell Fed will change policy based on Trump’s remarks, such concerns are unfounded.  

On the policy front, the president seemed to suggest the Fed should wait on raising interest rates until “inflation [comes] back.” What threshold Trump has in mind when he says “back” is anyone’s guess, but inflation has been increasing. While this morning’s CPI release had month-over-month inflation below expectations, the Fed’s preferred inflation metric has moved up to their 2% target in recent months. And the ten-year forecast, put out by the Cleveland Fed, shows long-run inflation expectations have also increased of late and are now slightly above the Fed’s 2% inflation target.

These inflation data have been moving up as the Fed has been increasing their policy rates, suggesting that monetary policy has not become overly restrictive. Scott Sumner, in a post reacting to yesterday’s stock market developments, points out that while monetary policy was too tight it has recently moved towards a more neutral and appropriate stance. Remember, looking at just interest rates is insufficient to judge the actual stance of monetary policy. Therefore, at least for now, the Fed is likely to continue the normalization plan it has been talking about for years.

Of course, the Fed should not stick to this plan irrespective of any and all changes in the macroeconomy; indeed, I have been critical of their defense of rates increases in the past. But daily stock market volatility and the president’s response to it are not developments that should immediately change the Fed’s longer-term strategy. 

For the astute people monitoring the Fed, the president’s comments ought to be largely ignored.  It is far more important to pay attention to two conversations occurring within the Fed. 

One conversation is about changing the Fed’s 2% inflation target. Several Fed officials have already endorsed their preferred strategies. Eric Rosengren, President of the Boston Fed, believes an inflation range, perhaps 1.5-3%, is best, while New York Fed President John Williams and Atlanta Fed President Raphael Bostic, want to adopt a new target altogether: a price level target. Ex-Fed officials have also joined the conversation, with former Fed Chair Ben Bernanke proposing a hybrid system that would move from an inflation target to a price level target when the policy interest rate got close to zero.  There are very good reasons for the Fed to begin reconsidering its monetary policy target, but for this conversation to be truly beneficial the Fed should include an NGDP level target on the list of alternatives. 

The second conversation, and one of more immediate concern, is about the Fed’s operating framework for executing monetary policy. The current framework—which pays banks an above market interest rate on their deposits held at the Federal Reserve in order to keep the effective federal funds rate within the Fed’s target range—was created during the financial crisis.  The Fed is still learning about this new framework for setting interest rate policy and has already needed to tweak the framework once. Chair Powell has signaled that the FOMC will be exploring it further throughout the fall.  For those interested in learning more about the potential issues embedded in the Fed’s new operating framework and why it is in need of reform, I would point you toward my colleague George Selgin’s summary of his forthcoming book Floored!.

There are important challenges facing the Fed and its conduct of monetary policy, and they deserve more attention than do the president’s rants.

Scottish Banks and the Bank Restriction, 1797-1821, Part 1

From the beginning, there is one embarrassing and evident fact that Professor White has to cope with: that “free” Scottish banks suspended specie payment when England did, in 1797, and, like England, maintained that suspension until 1821. Free banks are not supposed to be able to, or want to, suspend specie payment, thereby violating the property rights of their depositors and noteholders, while they themselves are permitted to continue in business and force payment upon their debtors. …White correctly notes that the suspension was illegal under Scottish law, adding that it was ‘curious’ that their actions were not challenged in court. Not so curious, if we realize that the suspension obviously had the British government’s tacit consent.
–Murray Rothbard, “The Myth of Free Banking in Scotland

Back in April, while Bob Murphy and I were debating whether fractional reserve banking poses a threat to market stability, Bob asked whether it was the case that, despite not having had Parliament’s permission to do so, the Scottish banks joined the Bank of England in restricting specie payments between 1797 and 1821. The answer, I said, was that they had indeed done so. I also pointed out that, although the Scottish banks’ decision was presumably illegal, the Scottish public appeared to go along with it.

In this and a subsequent post, I plan to delve more deeply into the story of the Scottish bank suspension, so as to offer more complete and accurate answers to Bob’s questions, and to answer as well other important questions that the restriction episode raises. If the British government didn’t authorize a Scottish suspension of payments, did it otherwise alter the rights of holders of claims against the Scottish banks? If those banks refused to pay their notes in specie despite being obliged to do so, why was no Scottish bank ever taken to court? To what extent, and in what fashion, were Scottish bank creditors harmed by the Scottish bankers’ actions? Should those actions prevent us from regarding the pre-1845 Scottish banking system as an informative case study of free banking? Does the Scottish suspension suggest that fractional reserve banking is, inconsistent with genuine freedom in banking, including the consistent honoring of bank customers’ property rights?

In this post, I’ll first review the events leading to the passage of the Bank Restriction Act. Then I’ll discuss how that act altered the legal rights of Scottish bank creditors. Finally I’ll propose an explanation for the fact that no Scottish banks were sued for suspending payment. In Part 2 I’ll consider the adverse effects of the Scottish suspension on the Scottish public. The restriction’s main victims, I plan to argue, were tradespeople and others whose livelihood depended upon ready access to small change. But their plight, far from enduring throughout the full period of the restriction, was confined to its opening months. Finally, in Part 3, I’ll argue that the Scottish restriction does not, after all, warrant any major revision of claims that Larry White and I and other members of the “modern free banking school” have made regarding the implications of  unrestricted freedom in banking. On the contrary: to the extent that Scottish bankers were guilty of “violating the property rights of their depositors and note holders,” the fault lay mainly, not with freedom banking, but with provisions of the 1765 Scottish Bank Notes Act that placed unwise and unwarranted limits upon that freedom.

Phillip Cagan’s 1984 Reflections on a Gold-Convertible Currency

Milton Friedman published Studies in the Quantity Theory of Money in 1956, a seminal anthology of papers from five economists, leading with “The Monetary Dynamics of Hyperinflation” –the recent PhD dissertation of Phillip Cagan (1927-2012), which became an instant classic.  So, Cagan was thought to be a “Monetarist” a dozen years before that phrase was even coined by my UCLA teacher, Karl Brunner.

Soon after August 15, 1971 when President Nixon opted to renege on the Bretton Woods pledge to convert foreign official dollar reserves into gold on demand (rather than simply devalue the dollar/gold ratio), we entered a long and painful period of extremely high worldwide inflation.

Even as measured by the gentler “core” CPI (less food and energy), U.S. inflation averaged 9% from 1974 through 1981, reaching 12.2% in 1980.   When President Reagan took office in January 1981, the Fed had pushed the fed funds rate above 19% – up from 9% six months earlier.

We can’t always fix such big problems by thinking small, so the prolonged stagflation of 1968 to 1982 led several economists to propose fundamental, even radical monetary reform, preferably on a global scale.  Such ambitious reform plans commonly involved making dollars convertible in tangible assets, such as gold or a group of commodities.

I was invited to testify before the 1982 Gold Commission, perhaps because of a decade of published and personal connections to Milton Friedman and Karl Brunner.  I had echoed conventional objections to a gold standard before, and was probably expected to do so again.  But that would have been too facile. I instead took the occasion to review periods of long and impressive prosperity when currencies were linked (or re-linked) to gold, invariably followed by instability and crises when they weren’t.

Other economists attempted to replicate some key advantages of being able to convert dollars to gold and vice-versa at a predictable guaranteed rate, yet do so without using gold. In 1983, Greenfield and Yeager proposed the “Black-Fama-Hall” system (melding similar analyses of Fischer Black, Gene Fama and Robert Hall) in which the unit of account would be defined by convertibility into a basket of commodities, rather than just gold and/or silver.

Chicago School monetarists were generally quite critical of any of these ideas, except, as we later learned, Phil Cagan.  

After Brunner moved to the University of Rochester and his star pupil Alan Meltzer to Carnegie-Melon, they held legendary Carnegie-Rochester conferences which I attended.   

After the conference on April 15-16, 1984 I kept the paper by Phillip Cagan of Columbia University, “The Report of the Gold Commission (1982)” later  reprinted in Carnegie-Rochester Conference Series on Public Policy 20 (1984) 247-268.  In it, Cagan flirted with hopeful thoughts about hypothetical hybrid standards, such as Black-Fama-Hall, but not before he said this about gold:

The appeal of the gold standard… is that it solves to problems.  First, if control over the quantity of transactions balances becomes more difficult and discretionary policy is unable to achieve reasonable stability of the price level, convertibility can provide the needed control of the relevant monetary quantities for stabilizing the price level.  Second, even if monetary policy continues to be capable of achieving stability of the price level, discretionary control may still fail to do so, as in the past, because of inadequate determination or inability to pursue polices that are successful (for political or other reasons). Convertibility provides a mechanism for making a commitment to price stability.

I see no escape from the conclusion, inherent in the position of the advocates of gold, that only a convertible monetary system is sufficiently free of discretion to guarantee that it will achieve price stability… If one is looking for some kind of long-last commitment of a constitutional nature, a convertible monetary system seems to be the only practical possibility.

Affordable Housing: Hard Way and Easy Way

A new GAO study examines the Low-Income Housing Tax Credit, which is a complex government program aimed at increasing the supply of affordable housing.

How complex is it? Vanessa Brown Calder and I noted that one LIHTC guidebook is 1,400 pages long.  

The LIHTC is a classic government solution to a problem. It is complicated, raises costs, and is not very effective. Nonetheless, some people favor such approaches. Adam Smith called them “men of system.” 

An easier way to solve problems is to let markets work. This approach leans toward simplicity and low cost. Some efforts may not be effective at first, but through innovation and feedback entrepreneurs eventually nail it. Adam Smith called it the “obvious and simple system of natural liberty.”

Below, a diagram from the GAO study shows part of the LIHTC process. Little tax credit boxes float around and dollar signs flow to LIHTC investors, which are usually major banks. This is the hard way to increase affordable housing supply.

Below that, I’ve diagrammed the easy way, which is to deregulate, remove the subsidies, and let banks and developers compete in the marketplace.

Affordable Housing: The Hard Way

 

Affordable Housing: The Easy Way

The Narrow Bank: A Follow-Up

In my last post I wrote about the lawsuit TNB USA Inc has filed against the New York Fed, which has refused to grant the would-be bank a Master Account. I argued that, despite its name (TNB stands for “The Narrow Bank”), and despite what some commentators (now including, alas, The Wall Street Journal’s editorial staff) seem to think, TNB isn’t meant to supply ordinary persons with a safer alternative to deposits at ordinary banks. Instead, TNB’s purpose is to receive deposits from non-bank financial institutions only, to allow them to take advantage, indirectly, of the Fed’s policy of paying interest on bank reserves — thereby potentially earning more than they might either by investing directly in securities or by taking advantage of the Fed’s reverse repo program, which is open to them but which presently offers a rate 20 basis points lower than the Fed’s IOER rate.

A Hollow Victory?

Yet for all the controversy TNB’s lawsuit has generated, its outcome may no longer matter as much as it might once have. For one thing, TNB’s success can no longer undermine the Fed’s ON-RRP program, which is designed to implement the Fed’s target interest rate lower bound, for the simple reason that that program is already moribund. Commenting on my post, J.P. Koning observed that, while the Fed’s ON-RRP facility, first established in December 2013, once supplied non-bank financial institutions with an attractive investment alternative, it ceased being so this year. As the chart below, reproduced from J.P.’s comment, shows, the facility — which once accommodated hundreds of billions of dollars in bids — is now completely inactive:

The decline on ON-RRP activity since the beginning of this year is a byproduct of the general increase in market rates of interest, both absolutely and relative to the Fed’s ON-RRP offer rate, that has made the program both less attractive to potential participants and unnecessary as a means for establishing a lower-bound for the effective fed funds rate. But that decline is but one symptom of a more general development, to wit: the tendency of the Fed’s policy rate settings to lag further and further behind increases in market-determined interest rates, thanks in no small part to the Trump administration’s fiscal profligacy. Here, for example, is a FRED chart comparing the Fed’s policy rate settings to the yield on 1-month Treasury bills:

In the figure the “Lower Limit” of the Fed’s federal funds target range is also the Fed’s ON-RRP facility offer rate, while the “Upper Limit” is the same as the Fed’s IOER rate until mid-June 2018, and 5 basis points above the IOER rate afterwards.

Although an overnight repurchase agreement is a more liquid investment than a one-month Treasury bill, its easy to appreciate how that difference ceased, in the last year or so, to compensate for the gap between the ON-RRP rate and other money market rates. But those rates have also increased relative to the IOER rate, with the Fed’s June decision to reduce the IOER – ON-RRP rate spread from 25 to 20 basis points, reducing the attractiveness of IOER relative to money market rates by another 5 bps. Consequently, bank reserves are also much less attractive relative to money market instruments, and especially to shorter-term Treasury bills, than they were a year ago.

All of which means that TNB’s efforts could end up being in vain even if the Fed ends up granting it an account. As J.P. Koning points out in his own post concerning the TNB case, “even if TNB succeeds in its lawsuit, there is a larger threat. The gap the bank is trying to exploit is shrinking.” In contrast, when the TNB plan was originally developed in 2016, that gap was about 25 basis points.

The Skinny on The Narrow Bank

Dedicated readers may recall my having reported here several years ago the suit filed by Colorado’s Four Corner’s Credit Union against the Kansas City Fed — after the Fed refused it a Master Account on the grounds that it planned to cater to Colorado’s marijuana-related businesses. Until then the episode was almost unique, for the Fed had scarcely ever refused a Master Account to any properly licensed depository institution. Eventually the Fed and Four Corners reached a compromise, of sorts, with the Fed agreeing to grant the credit union an account so long as it promised not to do business with the very firms it was originally intended to serve!

Well, as The Wall Street Journal’s Michael Derby reported last week, the Fed once again finds itself being sued for failing to grant a Master Account to a duly chartered depository institution. Only the circumstances couldn’t be more different. The plaintiff this time, TNB USA Inc, is a Connecticut-chartered bank; and its intended clients, far from being small businesses that cater to herbalistas, include some of Wall Street’s most venerable establishments. Also, although TNB is suing the New York Fed for not granting it a Master Account, opposition to its request comes mainly, not from the New York Fed itself, but from the Federal Reserve System’s head honchos in Washington. Finally, those honchos are opposed to TNB’s plan, not because they worry that TNB’s clients might be breaking Federal laws, but because of unspecified “policy concerns.”

Just what are those concerns? The rest of this post explains. But I’ll drop a hint or two by observing that the whole affair (1) has nothing to do with either promoting or opposing safe banking and (2) has everything to do with (you guessed it) the Fed’s post-2008 “floor” system of monetary control and the interest it pays on bank reserves to support that system.

What’s In a Name?

To understand the Fed’s concerns, one has first to consider TNB’s business plan. Doing that in turn means demolishing a myth that has already taken root concerning that enterprise — one based entirely on it’s name.

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