Tuesday, 31 December 2013

Banks, bubbles and Bitcoin

"I don’t think that the -coins we are seeing now are the last word in digital currency. They are experiments. And I do think there is a bubble in the making, which will burst noisily at some point. But unlike others, I don’t regard this as a bad thing. Just as the dot-com bubble and bust was an essential part of the evolution of the Internet, so the bursting of the -coin bubble, when it comes, will enable a new digitized financial architecture to emerge.
"So bring on the -coin bubble and bust. I want to see what grows in its place."

Me, at Forbes.

Friday, 20 December 2013

The death of John Galt

I've been meaning to write this post for ages. It's about the democracy of ideas. We can only profit from our ideas when we share them with others, freely and without expectation of reward. By depriving the world of his ideas, John Galt chose his own death.

Oh, and there are guest appearances by Old Holborn, Bitcoin and Robert Louis Stevenson.

Read on here.



Thursday, 19 December 2013

Forward non-guidance

My new Forbes post is on the limitations of central bank forward guidance, in the light of the US's taper decision and the UK's rising gilt yields. Markets will only be guided in the direction in which they were going anyway.....

Read on here.

Wednesday, 18 December 2013

Interest rates, growth and the primary balance

Nick Edmonds objects to my assertion that real interest rates should be at or below the real growth rate of the economy (my emphasis):
"Interest payments are just transfer payments, so their impact on stability has to be seen in the context of other transfer payments (principally taxes and benefits). Depending on the structure of these other transfers, there is no reason per se why the interest rate on safe assets has to be below the growth rate. (See for example http://www.levyinstitute.org/pubs/wp_494.pdf ) There is no public sector in Samuelson, so you don't get these transfer flows, but by the same token his assets aren't actually claims on anybody, so they can't really be thought of as safe assets. 
"Of course, it may be that excessive interest rates entail tax and transfer rates that are unpalatable, but that's a different issue."

I don't think it's a different issue at all. It's the whole point. Not just "unpalatable", but unsustainable tax and transfer rates are inevitable if real interest rates on safe assets are too high. And this has serious implications not only for the welfare of future generations, but also for economic stability and long-run growth. As Left Outside points out, real interest rates persistently above the long-term expected real growth rate are effectively a subsidy of current generations by future generations.  
The paper Nick quotes in support of his argument that real interest rates above the growth rate is this one by Wynne GodleyGodley's paper does indeed demonstrate that government debt dynamics can be stable with real interest rates far above the real growth rate. But that doesn't mean that the economy as a whole is stable. 
What Godley is saying is that in conditions of full employment, for the government deficit to stabilise after an interest rate shock, government spending adjusted for the new real interest rate must grow at the same rate as the economy. That is eminently sensible - though it is not the situation we have. 

However, from the table of endogenously-determined variables on page 10 and Godley's subsequent mathematical analysis it is clear that maintaining an interest rate persistently higher than the growth rate requires a primary surplus: 
Note that this does not mean the debt/gdp level falls, as it would if government ran a primary surplus with real interest rates at or below the real growth rate. Indeed the debt/gdp level becomes very high, although it does eventually stabilise:
No, it means that a primary surplus is required purely in order to service the interest on the debt.  
National income accounting requires that (assuming external trade is balanced) a persistent primary surplus reduces private sector saving.
Y = C + I + (G-T) + (X-M)
where Y = private sector income net of taxes, C = private sector consumption, I = private sector investment,  G = government spending, T = taxes, (X-M) = net exports/(imports). 
If X-M = 0 (trade is balanced),
Y = C + I + (G-T)      
Clearly if G < T, i.e. the government is running a surplus, C + I must increase if Y remains constant. In other words, the private sector has to work harder to maintain its income. (UPDATE: I have corrected this. Originally said C + I must reduce). 
Private sector saving is the residue of income left after taxes and consumption, and for the purposes of this analysis we assume it is entirely invested in some way (UPDATE. See comments. I have implicitly assumed that trade is not balanced. If S=I, for there to be a government surplus G<T there must also be a trade surplus X>M. However, the next paragraph doesn't really require S = I anyway. The statement that higher T requires either C or S to fall is correct even if S and I are not equal). 
S = Y - T - C = I
So it should be obvious that if T is higher than strictly needed for government spending, then unless C reduces, S must fall. Persistently running a primary surplus means that the private sector must either reduce consumption or dis-save. We assume that labour is taxed more highly than wealth - this is generally the case in Western societies. So to maintain above-growth returns to holders of safe assets, income earners must be taxed more highly than required to meet government spending commitments. 
Godley demonstrates that the required primary surplus becomes stable if interest-adjusted government spending is allowed to grow at the same rate as the economy. But it is still extracting more money from the private sector than it returns as government spending. Admittedly, the difference goes to the holders of government debt, some of whom will spend that money into the economy. If all of them did, it would be a wash. But not all of them will. Many (probably most) will save that interest rather than spending it, either by buying more assets or increasing funds in insured deposit accounts.  It is therefore a wealth transfer from income earners (who are taxed on their labour) to asset holders (who are given a tax credit), most of which does not recycle back to the benefit of income earners but goes to increase the wealth of asset holders. This impedes the desire of income earners to save and causes widening inequality. As income earners tend to be young and asset holders old, it also impoverishes the young and enriches the old. If the asset holders lend their wealth to the young to enable them to buy consumption goods and/or assets, it creates a growing private sector debt burden which is ultimately unsustainable. 
Note also that since S = I, deliberately maintaining interest rates at too high a level reduces productive investment in the economy, since it limits the saving of income earners. The desire of asset holders to have positive risk-free real returns even in a recession therefore impedes recovery and limits the growth potential of the economy. Which is unfortunate, because risk-free real returns above the real growth rate are an open punt on the future growth rate of the economy. In effect, they are saying that although we aren't generating enough at the moment to pay those returns, we will manage to do so in the future even though we are making it damned hard for anyone to invest in order to generate growth in the future.

But Godley's baseline model (pages 9-10) actually has a real interest rate below the growth rate of the economy (inflation 2%, nominal interest rate 3%, growth 2.5%). And under these conditions, the government needs to run a primary deficit in order to maintain a stable supply of safe assets. This is is because with a balanced budget and positive real growth matched by an equally positive real interest rate, debt/gdp naturally falls over time. The maths to prove this is on pages 11-12 and Godley explains it thus:
".....it is rather obvious that an increase in the real rate of growth of the economy, accompanied by an equal increase in the real rate of interest net of tax, will lead to a decrease in the public debt to GDP ratio, as long as the propensity to spend out of disposable income is higher than that out of wealth. Only when the growth rate of the economy gets down to nil—the stationary state—should the real deficit become zero and the real budget be balanced."
Godley further shows that under all scenarios, debt/gdp stabilises at some combination of interest rate, growth rate and primary deficit/surplus - provided there is full employment. So debt/gdp does not "spiral out of control" if government produces as much of it as people need in order to save. On the contrary, in my view government creating a plentiful supply of safe assets is essential for financial and economic stability. Deliberately restricting the supply of safe assets by, for example, running a primary surplus in combination with low interest rates (so debt/gdp falls) causes instability: when government doesn't create enough safe assets, the private sector creates faux safe assets, which give the impression of being safe when they are not and are consequently mispriced. When the inadequacy of private sector "safe assets" is exposed, there is a violent crash and a flight to real safe assets, creating bubbles. The 2008 crash was not caused by investors seeking too much risk: it was caused by investors looking for safety, and the private sector attempting, and disastrously failing, to provide it.


But of course we don't have full employment, so our ability to support even the safe assets we already have is curtailed, and lots of people are struggling to maintain essential consumption because their incomes aren't high enough. For these people, saving is a distant dream. Maybe that's what we should be concentrating on, really. 

UPDATE. Ramanan points out (see comments) that in Godley's model the increase in debt/gdp is due to fiscal policy designed to create full employment, and that the fiscal surpluses are a consequence of higher fiscal activity arising from full employment. I don't disagree. But I was looking at the steady-state after full employment is achieved. 

It is distinctly possible that the high interest rates in scenario three are a consequence of the very high debt/gdp level (over 90%) required to achieve full employment. But if that is the case, then government debt in that scenario  can't be considered risk-free: the high interest rate represents the increased default risk associated with such a high debt/gdp level. This is entirely different from Nick's argument that risk-free interest rates can be sustainably above the long-run growth rate. 

Monday, 16 December 2013

Weird is Normal

My latest post at Pieria:

"Three years ago, Nick Rowe produced this post describing a “weird world” – a world in which the equilibrium interest rate is at or below the long-term growth rate of the economy, rather than above it as we are used to. In such a world, bubbles are inevitably created as investors search for positive yield. This is also the world recently described by Larry Summers.
"But I don’t think this world is weird. I think it is actually normal, and we have been living in a weird world of unstable Ponzi schemes that eventually crash and reset." 

Read on here.

Sunday, 15 December 2013

Germany and interest rates

This comment from Mysjkin on my previous post about Germany has made me think about the effect of free movement of capital and harmonised interest rates in a currency union:
"Imagine a German company going to a German bank, asking for a loan. The German bank answers: no we are not going to lend money to you because we can lend it for a higher interest rate to a company in Spain, but we will lend the money to you if you will also pay this higher rate. If the investment, at that interest rate, is still profitable for the company, it will borrow the money at the higher rate, problem solved. If the company (read: German corporations) does not want to borrow at this higher interest rate, it seems to me that monetary policy is not too loose, but too tight for German domestic conditions."
The argument is that ECB interest rate policy prior to the Eurozone crisis resulted in interest rates that were too high for Germany and too low for the periphery. And indeed, a look at Germany's economic performance during that time suggests that this is indeed the case. Germany was "bumping along the bottom" from 2000-2005. Even its pre-crisis boom barely reached 5% and was very short-lived:

FRED Graph

This is certainly not a shining economic performance. And it suggests that ECB interest rate policy has been persistently too tight for Germany.

What would be the effects of policy that is persistently too tight, remembering that Germany is part of a currency union? As Mysjkin points out, bank credit would be too expensive. Banks might of course reduce margins in order to maintain lending volumes as funding costs rose. And there is some evidence that they did exactly that:

Graph of Bank's Net Interest Margin for Germany

But in a currency union with free movement of capital, banks can simply lend to households, firms and governments in other countries where the returns are better. Indeed they were encouraged to do so. And the result was a horrible collapse in domestic bank lending to the private sector - a collapse which it seems is still continuing:

FRED Graph

Of course, this chart is in relation to GDP. But a quick look at the GDP growth chart above doesn't suggest that the reason is a massive rise in the denominator. No, it genuinely seems to be a fall in domestic bank credit.

So interest rates prior to the crisis were too high for Germany. Banks were not able to earn enough by lending to the domestic private sector, so they looked elsewhere. And in a currency union, they didn't have far to look. Commercial property lending in Ireland, Spain and Portugal. Greek and Italian sovereign debt. Not that they stayed within the currency union, though - they also invested heavily in US subprime mortgage assets. The result was a series of frightful crashes, as one after another these more lucrative lending markets collapsed and cross-border deposits fled back to Germany. But that doesn't mean that banks are lending any more domestically. The charts above show that they are not.

So if German banks still aren't lending domestically, and investment is continuing to fall, what on earth is the justification for arguing, as this paper does, that ECB interest rates are now too low for Germany? How exactly would raising interest rates encourage cash-rich NFCs to borrow? Raising interest rates to borrowers discourages demand for loans, and raising funding costs for banks discourages their supply. Even if Germany were not in a currency union, raising interest rates at present would be idiotic. Fortunately it is in the Euro area, and the ECB is not going to raise rates simply because German savers would like it to.

Solving Germany's investment problem requires both low interest rates and increased government investment. The ECB is at least attempting to address the first of these. But when is the German government going to accept its responsibility for the second?


Related reading
Germany's investment problem
Cross-border banking transactions in the Euro area - BIS (pdf)
Cross-border banking and financial stability - vox (pdf)
Financial crises and cross-border banking - Cass business school (pdf)
Banking across borders - NY Fed (pdf)
Why Germany's exports are so strong - World Review
Germany's recovery is faltering - Michael Burke

Saturday, 14 December 2013

Germany's investment problem

We all know that Euro membership has been of doubtful benefit to periphery countries such as Greece and Portugal. But Germany has been a net beneficiary of the Euro, hasn't it?

Not according to these charts from Albert Edwards (h/t Edward Harrison).



(larger image here)

Note the point on both charts where the trend changed sharply. Yes, it's 2000 - when the Euro was introduced. Admittedly, Germany's gross fixed investment was already declining, but after 2000 it fell off a cliff. And the current account decomposition chart shows us why. Note the collapse in borrowing by non-financial corporations from 2000 onwards. That is disappearing domestic private sector investment. In fact in 2009-10 NFCs were net saving. This is distinctly unhelpful in an economy which has seen gross fixed investment falling for the last twenty years.

To start with, it appears that government borrowing replaced private sector net borrowing. But even that declined from 2004 onwards, replaced by income from a growing current account surplus. Good news for German households, apparently. They increased their saving. But contrary to popular belief, their hard-earned savings have not been productively invested in the local economy. They have unproductively blown up sovereign and private debt bubbles in other countries. The German banking system - including the marvellous Sparkassen, whose equivalent some people would like to see in Britain - has not been doing its job.

Admittedly these charts only go as far as 2010. But they do not tell a story of a booming Germany benefiting from the single currency. They tell a story of a country from which productive investment is being drained by a banking system that sees greater returns elsewhere.

If the German banking system were genuinely a private, free-enterprise system, this would be understandable. But it is not. The majority of it is either state-owned or state-controlled, and even the parts of it that are not state-owned benefit from implicit sovereign guarantee. No way is Germany going to allow its bigger banks to fail: to do so would put at risk the prized Sparkassen, Volksbanken and Raffeisenbanken. It would surely be reasonable to expect that a state-backed banking system would principally invest domestically. But clearly, it doesn't. German domestic businesses can rightly feel that they have been let down by their banks.

But this is not entirely a story of banking. After all, savers expect banks to generate good returns on their savings, and if that can best be done by investing that money outside the country, then can we really blame banks for doing so? This is a story of the ECB's one-size-fits-all monetary policy and its insane insistence, prior to 2009, that all sovereign debt was of equal quality.

And it is also a story of too-tight fiscal policy. Instead of increasing its own borrowing to compensate for the fall in NFC borrowing, the German government gradually reduced its fiscal deficit - indeed in 2007 and 2008, it was net saving (running a surplus). On the face of it, this looks sensible: after all, we are led to believe that governments should net save during booms. But not, emphatically not, when there is a growing current account surplus. A persistent current account surplus is contractionary over the medium-term, because it by definition means that productive investment is leaving the country. Note how the domestic deficit (private and public sector) exactly parallels the current account surplus: as I've noted before, the larger the current account surplus, the greater the capital deficit, and that translates into reduced domestic investment. If Germany were not in a currency union, then the correct course of action would be to raise interest rates to encourage domestic investment. But Germany does not have that option. Its government should therefore have been borrowing to invest even during the boom, which would have had the effect of raising real interest rates. I know it seems counter-intuitive to suggest looser fiscal policy as a counter to too-loose monetary policy, but remember that the problem is lack of investment: if the private sector won't invest domestically (because real returns are higher elsewhere), then government must. When countries have no control of monetary policy, fiscal policy cannot be counter-cyclical.

So it seems that Germany has suffered from poor investment since the start of the Euro as a direct consequence not only of the ECB's interest rate policy but also of its own government's tight fiscal stance. And this story continues. The German government is intent on fiscal consolidation, even as the current account surplus grows ever larger in relation to GDP:

Graph of Total Current Account Balance for Germany


Increasing government investment in Germany would not necessarily mean the current account surplus fell, at least at first. It could be done on a balanced-budget basis, in which case it would mean reduced domestic consumption spending instead (government spending cuts and/or higher taxes, forcing the private sector to cut spending). Given that German GDP is stagnating at present, this is perhaps not the best course of action. Borrowing to finance increased government investment strikes me as a much better approach. This might mean that the German government would face higher borrowing costs - although savvy investors should regard an increase in German government debt for investment as a good thing. But it would stop the bleeding of capital investment from the domestic economy without squashing domestic demand.

The ghosts of Weimar need to be laid to rest. An increase in government borrowing to fund medium-term investment is not going to result in out-of-control inflation. But failure of capital investment due to an out-of-control capital account deficit will in the end impoverish Germany.

UPDATE. Via @wonkmonk_ on twitter, this special report by Natixis into the German current account surplus reaches the same conclusion as me. The fundamental problem is failure of private sector investment in Germany throughout the period of the euro - and it is very bad for Germany.

Thursday, 12 December 2013

A simply appalling scheme

Lloyds Banking Group has been fined £28m by the Financial Conduct Authority for simply awful management of staff. From the FCA's press release:
"The Financial Conduct Authority (FCA) has fined Lloyds TSB Bank plc and Bank of Scotland plc, both part of Lloyds Banking Group (LBG), £28,038,800 for serious failings in their controls over sales incentive schemes. The failings affected branches of Lloyds TSB, Bank of Scotland and Halifax (which is part of Bank of Scotland). 
This is the largest ever fine imposed by the FCA, or its predecessor the Financial Services Authority (FSA), for retail conduct failings.
The incentive schemes led to a serious risk that sales staff were put under pressure to hit targets to get a bonus or avoid being demoted, rather than focus on what consumers may need or want".
And according to the FCA's Tracy McDermott, the FCA's findings "make unpleasant reading". Indeed they do. I've read them, and I have to say that they describe one of the worst employee compensation schemes I have ever seen.

The people affected were retail branch sales staff. So we are not talking about traders or top managers with telephone-digit salaries and bonuses resembling the GDP of a small country. We are talking about ordinary people with ordinary salaries. At Lloyds TSB, base salaries ranged from £18,200 to £72,600, with most people in the range £33,706 - £46,621, while at HBOS, base salaries ranged from £22,000 to £73,000. So the base salary in most cases was sufficient to ensure a reasonably comfortable lifestyle.

Except that it wasn't. Usually, in sales teams, the base is fixed and performance-related pay takes the form of bonuses which are additional to the base pay. And indeed, LBG sales staff did have bonuses - sometimes very large ones (more on that shortly). But their BASE salaries also depended on performance. A poorly-performing branch sales adviser could lose up to 35% of their base pay. At those salary levels, these were extremely severe penalties. When your base pay is £40,000, a cut of 35% probably means losing your house. It is hardly surprising therefore that sales advisers would sell customers products that they didn't need or were unsuitable for them. If the choice is between mistreating customers and losing your house, what would you choose?

The bonus schemes also created considerable incentive for mis-selling. There were both individual and team bonus schemes, and additional one-off incentive payments. This graphic from the FCA Final Notice report shows how the addition of individual and other bonuses inflated pay:

And there is a similar inflation in pay for HBOS, too:

Note that these are MONTHLY figures. For a mid-tier sales advisor, this would be a very substantial addition to his salary.

There was collusion between managers and staff over mis-selling. The FCA notes that managers' bonus schemes depended on the performance of their staff, so they had an incentive to encourage mis-selling that inflated the bonuses of their staff or prevented their demotion. But there is a human angle to this, too. The severe financial penalties for under-performance would have presented a considerable management challenge. It is difficult enough to give someone a bad performance rating when you know this will cost them a pay rise and possibly blight their future career with the company: performance management schemes are often skewed to the upside  for exactly this reason. But when you know that giving someone a bad rating will result in a pay cut that could mean they lose their home, you might be understandably reluctant to do this. Any half decent manager would massage the figures to prevent the penalty being applied, in the interests of team morale if nothing else. Financial penalties of such severity are no way to manage people.

The sales incentives and penalties structure in effect set up a competition between employees and customers. Good customer service may include not selling products, if they are unsuitable or not needed. But at LBG, this would have resulted in financial penalties. So meeting customers' needs could come at a considerable cost for staff. This created perverse incentives: employees were rewarded for bad service and penalised for good. That is bad design in any performance management scheme and appalling in one where there were severe financial penalties for bad performance.

In short, this was a simply terrible scheme for staff, managers and customers alike.

The FCA says that LBG should have had procedures in place to monitor the sales of sales advisers at risk of financial penalty or close to financial reward (promotion or extra bonuses), because those people were most likely to mis-sell. And it criticises LBG management for their blindness to the risks of such a scheme:

"The root cause of these deficiencies was the collective failure of the Firms’ senior management to identify remuneration and incentives for advisers as a key area of risk requiring specific and robust oversight..."

But there is a wider issue, too. The abuses described in the FCA's report happened after LBG was bailed out in the financial crisis.  Massively expanding insurance product sales was a deliberate strategy on the part of LBG's Board because of poor returns on investment products. From the FCA's report:
From 2010, the Group had a target for its combined retail bancassurance
business to approximately double its customer base by 2015. In seeking to meet
this growth target the Group’s strategy was to focus on sales of protection
products over investment products. There were a number of reasons for this
strategic focus on protection: 
(1) the Group wanted to increase the profitability of its bancassurance
business, and protection products were more profitable; 
(2) the Group’s analysis showed that there was a ‘protection gap’ in the UK
market and wanted to meet the protection needs of customers;
(3) the financial crisis had resulted in a fall in customer demand for
investment products; and 
(4) the Group had reduced its appetite for sale of investment products, which
it saw as higher risk from a regulatory perspective, including anticipated
regulatory developments. 
4.7. During the Relevant Period, as a result of the various factors described in
paragraph 4.6 above, LTSB’s sales of protection products increased by 65% while
its sales of investment products decreased by 54%. During the same period
Halifax’s sales of protection products increased by 94% while its sales of
investment products decreased by 68% and BOS’s sales of protection products
increased by 67% while its sales of investment products decreased by 67%. 
The FCA report shows that sales advisers were incentivised to sell insurance products in preference to investment products, even when this did not match with customer needs. The extent to which the over-selling of insurance products (especially life insurance) and under-selling of investment products will adversely affect customers in the future remains to be seen. It's worth remembering at this point that LBG has been forced to make greater compensation payments for PPI and other mis-selling than any other bank, and the full extent of its exposure is not yet known, although it has substantial provisions. 
.
Regulatory fines and compensation for customers are inadequate. LBG has bought its return to profitability at the cost of ripping off its customers and abusing its staff.  The Board should resign.



Tuesday, 10 December 2013

Big banks versus small banks: size doesn't matter

In my very first Forbes post I've sidestepped the argument about whether big banks or small banks are best. Both can behave badly and cause systemic crises. It's not about size of banks, though how they behave does matter. It's about the fact that the entire banking system is "too big to fail", and by restricting public support and applying regulation inconsistently we place the entire financial system at risk.

You can read the whole post here.


Sunday, 8 December 2013

Making the Desert of Plenty bloom

My latest post at Pieria delves back into the history of the Long Depression in the 19th Century to find lessons for today's "secular stagnation". Persistent excess of supply over demand is anything but benign and surprisingly difficult to deal with.

"In my post “The desert of plenty”, I describe a world in which goods and services are so cheap to produce that less and less capital is required for investment , and so easy to produce that less and less labour is required to produce them. Prices therefore go into freefall and there is a glut of both capital and labour. This is deflation.
There are two kinds of deflation. There is the “bad” kind, where asset prices go into a tailspin and banks and businesses fail in droves, bankrupting households and governments and resulting in massive unemployment, poverty and social collapse. We have seen this in the past, in the Great Depression; we narrowly avoided it in the Great Recession; and there are currently places in Europe that are skirting dangerously around the edge of this catastrophe.
But there is also another kind. This is where falling costs and increasing efficiency of production create a glut of consumer goods and services. In other words, supply persistently exceeds demand."
Read on here.
 

Monday, 2 December 2013

Zombie alert!

What evidence is there for the "plague of zombie companies" that is supposedly strangling the life out of the UK economy? My latest at Pieria:
There is a prevalent view that part of the reason for the UK’s slow recovery and poor productivity is the existence of large numbers of companies that should have died in the recession. “Zombie firms in danger of strangling the economy”, screams one newspaper headline. And another warns of the “Zombie businesses spreading like a virus”.
It’s not always clear what people mean by a “zombie company”. The usual definition of “zombie” is one that generates enough cash flow to service its debt but not enough to repay principal, or alternatively one that generates enough cash flow to survive but not enough to grow. But lots of businesses don’t grow. Indeed, the majority of microbusinesses – sole traders and firms with fewer than 9 employees – not only don’t grow but have no desire to do so. Are they zombies? No. They are active economic agents contributing to the economy. We really can’t use the absence of growth as an indication that a company is not viable. Many of these companies happily bump along the bottom for decades.
Indebtedness does seem to be characteristic of zombies.....
Read on here.

Sunday, 1 December 2013

Malinvestment and the endogeneity of money

So much has been written about the endogeneity of money that I thought it was now widely accepted. But recent exchanges have shown me that people STILL aren't getting it. Most recently, there have been two themes doing the rounds that bother me:

- malinvestment is caused by a growing money supply
- the presence of excess reserves in the system indicates a growing money supply (and therefore malinvestment)

Both are wrong. They are wrong for slightly different reasons, but they both boil down to the same thing - that money exists independently of the actions of banks. It does not. If there is malinvestment in the system, it is caused by an excess of bank lending, not by a growth in the money supply: very fast broad money growth is a consequence (or better, an indicator) of excessive bank lending. And if there are excess reserves in the system, they are caused by the desperate attempts of central banks to stop the money supply falling as banks deleverage. You could say they are caused by LACK of bank lending. 

Firstly, let me run through how bank lending works. The example I shall give is simple unsecured bank lending, but it applies equally to all forms of bank lending, including retail and wholesale secured lending (mortgages, repo).

Banks do not "lend out" existing money. They agree a loan, then obtain the funds to enable the borrower to pay the money. Let's use a car loan as an example. The bank lends say £5,000 as an advance against a car that the borrower intends to purchase. The accounting entries are DR loan account (asset)*, CR customer current account (liability). At that point the bank's balance sheet has expanded by £5,000 and sterling M2 has also increased by £5,000. But because the entries are balanced, there is no need for additional reserves at this point.

At this point also, no payment has been made. All the bank has done is put money in the borrower's account. And it has not "moved" this money from anywhere. The bank's cash balance does not change, and neither do the balances on any other customer deposit accounts. Banks DO NOT LEND OUT DEPOSITS.

The customer may leave that money in his account for several days or even weeks after the accounting entries have been made for the loan. The money supply therefore increases as an inevitable consequence of loan approval, not the consequent payment. Unfortunately traditional "money multiplier" explanations of lending fail to separate loan approval from its subsequent drawdown. Consequently we get absurdities such as "banks need reserves in order to lend". No they don't. They need reserves in order to make payments. And it doesn't matter whether the money they are paying out is money they have lent to the customer, or money that the customer himself has deposited. The same reserves are used to make payments in both cases.

When the customer actually pays for the car, he withdraws £5,000 from his current account. The entries are DR customer current account (liability), CR reserve account (asset). At the central bank, the entries are DR reserve account (liability), CR receiving bank's reserve account (liability). Note there is no impact on the asset side of the central bank's balance sheet. The amount of reserves in the system does not change as a consequence of payments being made: only the distribution of those reserves changes. Or, putting it another way, banks don't lend out reserves.

The sending bank has to obtain funds if funding that payment would take its central bank reserve account below the required reserve limit. It does so by borrowing from other banks, or as a last resort by borrowing from the central bank. In these days of instantaneous funds transfer, you could even say that the bank funds the payment by borrowing back the £5,000 it has created from the bank it has just paid it to, since it can run a daylight overdraft in its reserve account and clear it at the end of the day. Making payments has no effect on broad money, but if a bank has to obtain additional reserves from the central bank then it can result in the monetary base increasing. Monetary base expansion therefore tends to lag broad money expansion.

When the loan is repaid (let's assume bullet repayment to keep it simple) the entries are DR customer current account (liability), CR loan account (asset), reducing the loan account to zero. The bank's balance sheet has shrunk by £5,000 and so has M2 by the same amount. Repaying a loan actually destroys money. Yes, the bank may make another loan of £5,000 to someone else, in which case the money supply will be restored, but it doesn't have to. It will only do so if the risk versus return profile at that point in time is in its favour. And that is not a constant factor.

Prior to 2008, banks were lending exorbitantly, and borrowers were lapping it up. Money supply consequently grew very fast. Then came the subprime crisis, followed by the collapse of Lehman and the financial crisis. The swathe of mortgage and other loan defaults at that time not only caused bank failures, it caused a sudden catastrophic fall in the rate of growth of the broad money supply. As an example, this chart from the ECB clearly shows the overheating growth of M3 followed by sudden fall back when the crisis hit:

Click here to see the full series

Post-2008, banks are more risk-averse than they were, partly because of regulatory changes that force them to include more equity in their funding mix, and partly because - as the Large report noted - bank staff responsible for lending decisions have had their fingers very badly burned and are terrified of getting it wrong again. (Sometimes I think we forget that lending decisions are made by people.) And banks are still cleaning up their balance sheets. Therefore they are not lending as much as they were prior to 2008. They discourage demand in two ways - firstly by charging higher interest rates on loans, particularly to poorer risks (that's why interest rates to SMEs have gone up considerably since 2008), and secondly by refusing to lend at all. Furthermore, households and corporates are not borrowing to the extent that they were before the crisis. They are paying off debt and not taking out new loans.

The problem prior to 2008 was that banks mispriced risk and therefore lent far more than they should have done at too low a price. The result was malinvestment (sub-prime loans and their derivatives, dodgy corporate lending and so forth). And the result was also a sharply rising money supply AS A CONSEQUENCE of that malinvestment. In Austrian economics, this is inflation - but it showed itself as rising prices in certain asset classes, not a general rise in the price level. I'm not going to discuss the reasons for this here: inflation-targeting central banks claim credit for it, but in my view it might also have something to do with the imbalances in international trade and the general stagnation in wage levels in developed countries.

We now have the opposite problem: banks don't want to lend, and households and corporates don't want to borrow. The result is a broad money supply that stubbornly refuses to grow. Central banks are attempting to counter that by increasing the monetary base - with some success, though mainly through portfolio effects as bank lending, particularly in Europe, is still very low. Except for the ECB, that is, which has been happily allowing broad money supply to stagnate for the whole of 2013, mainly due to banks paying off the LTROs early and not lending to periphery businesses.

This is not to say, however, that there is no malinvestment at the moment. There is, and it comes in two forms: residual malinvestments from prior to the crisis that banks, households and businesses are still trying to unload, and new malinvestments. But the new malinvestments are not caused by central banks increasing the supply of the monetary base. They are caused, just like the older malinvestments, by the mispricing of risk.

Good investment requires accurate pricing of risk. Too cautious a view is as damaging as too reckless a view. So when banks and investors take too cautious a view, they stuff their balance sheets with safe assets while denying viable businesses the investment they need. When businesses take too cautious a view, instead of investing in risky projects for the future they hoard cash on their balance sheets and buy back their own stock. When households take too cautious a view, the result is a stagnant housing market and depressed consumer demand. And when governments take too cautious a view, the result is lack of public sector investment.

Prior to the crisis, malinvestment was caused by too optimistic a view of risk: post-crisis, it is caused by too pessimistic a view. Malinvestment doesn't end when there is a crash: a crisis does not necessarily clear out all malinvestment. Denying finance to viable businesses because of too-tight credit criteria, or killing off developing businesses by raising interest rates to "clear out zombies", is just as much malinvestment as providing credit to businesses whose business plans have serious weaknesses or whose market is in terminal decline.

We can reasonably ask what is being done with all the money that central banks are producing. I have no doubt that there are all manner of stupid investments being made. But I am not convinced that investment would be any better directed without central bank support. Unless we become much, much better at pricing risk, malinvestment is an inevitable consequence of doing business.


Related reading:
Understanding the Modern Monetary System - Cullen Roche
Malinvestment, not overinvestment, causes booms - Ludwig von Mises (excerpt)
The Trading Dead - Tom Papworth, Adam Smith Institute
Reply to Pedro al Sombrero Negro - Smiling Dave's Blog

* Footnote for non-accountants. DR to an asset increases it, CR decreases it. DR to a liability decreases it, CR increases it. So a DR to an asset is balanced by a CR to a liability, and together they increase the size of the balance sheet. Conversely, a CR to an asset is balanced by a DR to a liability, and together they decrease the size of the balance sheet. I hope that is clear.