"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Wednesday, February 24, 2010

Loan officer theory of helicopter drop monetary policy

Nick Rowe added a comment to his must-read post about money supply multiplier and keynesian multiplier models:
"I'm going to make just one last point before leaving this topic. It may help clarify a source of disagreement, or (more likely) it may fail totally. But I'm going to make it anyway.

Banks (either individually, or in total) need a lot of different things if they want to expand. Reserves, capital, yes. But also loan officers, computers, tellers, etc. Not to mention people and firms who want to lend or borrow from banks. Why should I "privilege" just one of those many things (reserves)? Why should others "privilege" capital? Aren't the others on the list equally important?

Here's my answer: I privilege reserves because I am interested in the public policy question. The Bank of Canada controls one aspect of public policy (monetary policy), and the Bank of Canada controls the supply of reserves to the banking system. (Again, you can read "the supply of reserves" as either an interest rate (price) or a quantity, but better yet as a functional relationship.) The Bank of Canada does not (except when it bails out banks) directly control the supply of capital, reserve officers, tellers, or anything else."

His comment inspired me to write about the loan officer theory of helicopter drop monetary policy. A good central bank needs two tools - supply of reserves to the banking system and supply of cash to general public using fleet of helicopters.

When commercial banking system is solvent, by controlling the supply of reserves to the banking system, if needed the central bank can cause the expansion of all the things needed for monetary stimulus - solvent banks are ready to hire new loan officers, purchase new computers, increase the number of bank tellers, they can even expand their capital base without any big problems.

The iron law of banking says that it is better to fail conventionally than to succeed unconventionally. This unwritten law was codified in various regulations (Basel, etc.). This means that when banks make mistakes, they repeat them on a system-wide basis. A crisis comes, and the market value of aggregate bank capital falls below the replacement cost. Capital constraint becomes binding. All the bank tellers, loan officers and computers effectively disappear from the monetary transmission mechanism, as stock market is shouting to the banks that they should have hoarded more reserves before the crisis. The only way to break the deadlock is to dispatch the helicopter drops. The helicopter drop policy should be continued until the private sector slowly rebuilds the capital base of the banking system by establishing new good banks.

What is the best way to drop money from helicopters? Nick Rowe once suggested that central banks should buy antique furniture from non-bank public (a must-read link). For me the most important thing that loan officers are incapacitated when banks are insolvent. This means that central bank should soften the blow that is caused by all missing loan officers - i.e. central bank should buy commercial bonds from non-bank public when performing the quantitative easing.

COMING NEXT: How central banks have hijacked the meaning of word "reserves".


  1. So you were impressed with Nick's arguments. He "priveledges" reserves because that's what the institution, built on some theory, requires him to "priveledge" if he wants it to have impact?

    Don't you think it is more important to "priveledge" reality because, well, it is reality?

    Nick is on the record as saying he has no interesting in understanding reality, only in explaining it, and he believes that one need to understand reality in order to make explanations. He is correct in this, but vastly over-privildges the value of explanations that have nothing to do with reality.

  2. No, central banks have a serious impact on prices of all important liquid assets, so I am inclined to attribute the overemphasis of reserves to intellectual inertia.

  3. are you likewise inclined to attribute belief in flatness of earth to intellectual inertia as well?? how about whether man evolved from ape or was created on day 6???

  4. Intellectual inertia explains beliefs that have no practical consequences pretty well. One doesn't need to now the theory of internal combustion in order to be a good driver...


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