Monthly Archives: January 2013

Where is the money coming from?

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PalmTreeIt has been quite some time since I wrote about the mechanics of money, but today I am at it again. The catalyst is not, as some might expect, the recent discussions about the possibility of the US Treasury minting a trillion dollar coin, but rather a recent discussion I had with a banker about deposits on a small tropical island.

While deposit levels at banks in Australia are below upcoming regulatory minimums, leading to intense competition in the pricing of term deposits, the banker I spoke to was facing the opposite problem in the small nation of Paradise Island (not its real name).

As he told the story, despite offering rather unattractive interest rates on deposits, deposit balances had continued to grow. Worse, demand for loans was weak and so the bank was forced to keep growing balances on deposit with the island nation’s central bank. Since banks like to diversify their investments, this situation was not ideal. Ordinarily, he said, deposits would build up as exporters took in payments for their goods, but periodically these balances would be swept out again as they remitted their profits to offshore parent companies. This did not seem to be happening any more. Exactly why these deposits were growing was a mystery and, short of closing the doors of all their branches, he did not really know how to stop these balances from growing.

With years of reading Bill Mitchell under my belt, I knew that the way to think about this question was to take a macro perspective rather than thinking from the perspective of one bank.

The first thing I focused on was the balances with the central bank. A popular misconception is that banks can choose between holding deposits with the central bank or lending the money to their customers. In fact they cannot. The central bank itself only has two types of “customer”: banks and the government. You and I cannot walk into the central bank and open up an account. This means that the only thing that can happen with central bank balances is that they move around from one bank to another or to and fro between the government and banks.

Imagine for a moment that the bank arranges a $100,000 loan for me to buy a nice little shack on one of Paradise Island’s beaches. If the shack vendor banks with my bank, then our bank will see both its loans and its deposits increase by $100,000. On the other hand, if the  vendor banks elsewhere, my bank will have to transfer $100,000 to the vendor’s bank. This is done by moving money between the banks’ respective  accounts with the central bank. So, in this case, my bank has an increase in its loans of $100,000 and a decrease of $100,000 in its deposits with the central bank. But that central bank deposit has not left the system (and it has not gone to me). Rather, it has moved from one bank to another.

While there will be movements in central bank balances in this fashion from one bank to another in the normal course of business transactions, balances will tend to average out to reflect each bank’s market share. So, my banker friend is unlikely to be alone in seeing deposits with the central bank growing. Indeed, looking at the aggregate bank balances with the Paradise Island central bank, it becomes evident that there is a systematic trend.

Deposit BalancesAggregate Balances with the Central Bank

So how does this happen? The most likely explanation is that the balances are coming from the government. As the government spends money, behind the scenes there will be money moving from the government’s account at the central bank to the accounts of commercial banks. This can happen if the government is running a deficit, spending more money than it is receiving. But that is not the case here. In fact, Paradise Island has been running a surplus of late.

A bit more digging through the national accounts reveals the answer. Paradise Island receives aid from larger developed nations and the  government has been spending most, but not all of this aid. The twist is that this aid has come in the form of foreign currency, which the government then deposits with the central bank in return for local currency balances which it is then able to spend. As a result, the central bank’s foreign asset balances have also been steadily growing. The similarity of these two charts is no coincidence: the two sides of a balance sheets must balance and the growth in the central bank’s assets directly mirrors the growth in their liabilities, in the form of commercial bank deposits. This is an example of what is known as “grossing up the balance sheet”.

Foreign Assets

 Foreign Assets of the Central Bank

So the growth in bank deposit balances with the central bank has nothing to do with Paradise Islanders hoarding money or choosing not to remit their profits offshore. Instead it is the direct result of the government spending its aid money. If the local banks want to have less of their money tied up in deposits with the central bank, rather than pointlessly trying to incentivise their customers to borrow or place their deposits elsewhere, they should consider encouraging the central bank to sell some of their foreign assets, reversing the grossing up of the balance sheet.

For me the most interesting aspect of this discussion is the fact that even if you can see exactly what is going on inside your own institution, it can be difficult to understand the workings of the system as a whole.

Echo Alpha Romeo

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The Mule is travelling and, while he contemplates possible posts by the sea, regular guest contributor James Glover has stepped in with an analysis of applause.

It may seem indulgent (and possibly non productive) but Friday Afternoon Physics (FAP) like Friday Afternoon Maths is one of my favourite activities. It is also the holiday season and as the owner of this blog is busy counting echidnas down south I wanted to share what is so far my favourite FAP for 2013.

The question is: why isn’t it the case that the more people are clapping in an auditorium that the volume actually decreases?

Now this may seem like a dumb question. Surely the more people clapping = more noise = louder. Right? Well except that it isn’t true. Noise cancelling headphones work by detecting the incoming noise signal and producing a signal of exactly the opposite shape. Detected sound (by our auditory system – ears + brain) is a variation in the ambient pressure. So noise cancelling headphones actually produce, on average, a slightly higher pressure as they carry energy from both the original signal and the noise cancelling signal. Your ear drums don’t care what the overall pressure is though (up to a point) just the differences. An electrical device can’t easily produce an exactly cancelling sound but it can produce a sound with the opposite signal at the same average pressure. So if a lot of people are clapping randomly then while this increases the overall pressure the differential contributions tend, on average, to cancel each other out.

This just doesn’t just seem counterintuitive but experience suggests that the clapping in a room with more people is louder than a room with less people. But it would appear mathematically to be correct. Just as the average of a sequence of random variables has a smaller average amplitude from the mean (the standard deviation) so it must be the case that the more people in a room clapping will have a higher average pressure (not detectable by our auditory system) but also a lower variation (which is what we detect as volume).

Our solution: people nearby are less likely to average out than people far away. If we divided the room into people nearby (say under 25m) and those further out it would appear that the smaller contribution from those further out is not just because they are further way but because there contribution actually evens out. It raises the overall pressure but not so much the apparent volume. In fact in the simplest models it would actually decrease the more people there were present!

My insight is this: next time you are in a concert hall with say 1000 people compare the apparent volume with say a hall with 10,000 people. It would be deafening if it scaled up with distance alone. I am not sure about this but it appears to be true.

My final piece of evidence for this is the following: modern concert halls try to reduce unnecessary echoes, but total reduction of echo is bad. They used to do this by adding partial noise absorbing materials to the roof and walls. That is a disaster. A concert hall without echoes is a soulless place. Modern concert halls add random topographical features (usually in the ceiling at eg. random heights) that produce decoherence. Decoherence means the sound waves reflected back have different phases and hence quickly (but not too quickly) are undetectable as they tend to cancel each other out. The refurbishment of Hamer Hall in Melbourne did exactly this. So the solo horn in Brahms First Piano Concerto reflects but doesn’t reverb. Something similar happens with those noise “reduction” walls you see along freeways. They don’t absorb noise but all those cockatoos and gum leaves act to randomise the noise signal from the highway and even it out – the ear doesn’t notice the increase in average pressure but enjoys the decrease in variation.

Friday Afternoon Physics is good. It doesn’t lead to Nobel (or IgNobel) prizes but occasionally leads to Back of the Beer Coaster Calculations. Just prior to our discussion of this question we also worked out that 2-3 tankers a day could supply Melbourne with fresh water from Antarctica. But that’s another post.

Editors note: the echidna count so far has been zero.