Sterilization, Fed Style

Ben Bernanke, Courage to Act, financial crisis, Great Recession, NGDP sterilization
"Various Scalpels" by Spekta, Wikicommons,

Ben Bernanke, Courage to Act, NGDP, Great Recession, sterilization, financial crisisAt the risk of belaboring the obvious, I feel compelled to begin this second installment of my response to Ben Bernanke’s memoirs with an observation — a platitude, if you like — concerning the proper role of emergency central-bank lending in a generally free economy.

The observation is simply that emergency lending, far from being an end in itself, is but one of many possible means by which a central bank might achieve the ultimate end of avoiding general reductions in lending and spending that might otherwise result in more general business failures — that is, in a recession or depression.  For so long as the overall flow of spending remains stable, it must be the case, as a matter of simple logic, that aggregate business receipts do not fall remarkably short of aggregate outlays, and that the flagging incomes of particular firms are matched by the net revenues of others.

From this banal observation two others follow.  The first is that central bank emergency lending can be justified only to the extent that it succeeds in keeping overall spending stable.  The second is that a central bank that allows the overall volume of spending to collapse has blown it, no matter how much emergency lending it undertakes.  Indeed, to the extent that a central bank engages in emergency lending while failing to preserve aggregate spending, it may be guilty of compounding the damage attributable to the collapse of spending itself with that attributable to a misallocation of scarce resources in favor of irresponsibly-managed firms.  Thanks to moral hazard, the extent of such misallocation, instead of being proportionate to the actual volume of emergency lending, is augmented by the expectation that such lending will continue to be resorted to in the future.

In a previous post, I took Ben Bernanke's Fed to task for contributing to the moral hazard problem during the recent crisis.  It did this by repeatedly violating Walter Bagehot's "dictum" ("lend freely at a high interest rate, against good collateral"), especially by  extending credit to troubled institutions on collateral that was neither "commonly pledged" nor "easily convertible."  Although Bagehot himself never spoke in such terms, it seems to me that his emergency lending principles are broadly consistent with the overarching goal of preserving overall spending while limiting risk subsidies.

I now turn to consider the bearing of the Fed’s actions on the course of spending.  As I have plenty to say on the topic, I plan to divide my observations into two posts, with this one dealing with the period prior to October 2008, and the next addressing developments after that.  Still, I don’t want to keep anyone in suspense, so allow me to come right out and state my conclusion:  Far from seeing to it that its emergency lending and subsequent large-scale asset purchases served to preserve the flow of aggregate spending, or to revive that flow following its collapse, Bernanke’s Fed went out of its way to make sure that the programs in question did no such thing.

Note that I am choosing my words quite deliberately:  the Fed did not merely fail in its efforts to revive the flow of spending.  It deliberately prevented such a revival, and by so doing prolonged the Great Recession.

Of course Bernanke and other Fed officials did not see things this way.  They viewed the steps they took as ones essential to maintaining control of monetary policy.  But what they imagined they were doing, and what they actually did, were two very different things.

What steps?  Until the AIG bailout, the Fed made a point of "sterilizing" its emergency lending.   Afterwards, finding that it lacked the resources it needed to continue to sterilize its loans and asset purchases, it sought to achieve similar results by alternative means.  On September 17, 2008, the Treasury, at the Fed's request, inaugurated its "Supplementary Financing Program," whereby it issued additional Treasury bills, the proceeds of which were deposited in a new Fed account created for the purpose.  Then, on October 1st, the Board of Governors announced that it would soon begin paying interest on depository institutions' required and excess reserve balances.  The Fed took these steps, which served either to drain reserves from the banking system, or to immobilize excess reserves that remained outstanding, for one reason only, to wit: to make sure that its crisis-related lending and asset purchases did not sponsor any corresponding increase in bank lending.

You need not take my word for it.  Here is Bernanke's own explanation of the Fed's decision to sterilize its emergency loans:

We were facing what might prove to be a critical question:  Could we continue our emergency lending to financial institutions and markets, while at the same time setting short-term interest rates at levels that kept a lid on inflation?  Two key elements of our policy framework — lending to ease financial conditions, and setting short-term interest rates — could come into conflict.

When the Fed makes a loan, taking securities or bank loans as collateral, the recipient of the loan deposits the funds in a commercial bank.  The bank in turn adds the funds to its reserve account at the Fed.  When banks hold substantial reserves, they have little need to borrow from other banks, and so [sic] the interest rate that banks charge each other for short-term loans — the federal funds rate — tends to fall  (p. 236).

Bernanke's account calls for some further elaboration.  It is, of course, not lending on the federal funds market per se, but a more general increase in lending, that has the capacity to "raise the lid" on inflation.  Bernanke's concern must, in other words, have been that the Fed's emergency lending would result, not merely in a reduced federal funds rate, but in a general loosening of credit.  Such a loosening was,  evidently, not what Bernanke had in mind in claiming that the Fed's emergency lending was supposed to "ease financial conditions."

Sterilization, Bernanke goes on to explain, involved

selling a dollar's worth of Treasury securities from our portfolios for each dollar of our emergency lending.  The sales of Treasuries drained reserves from the banking system, offsetting the increase in reserves created by our lending (p. 237).

The sterilization shows up in the chart below (reproduced from James Hamilton's Econbrowser) as a decline in the light-gray field representing the Fed's holdings of (mostly Treasury) securities, which served to more-or-less perfectly offset its pre-AIG emergency lending.


To understand just how misguided the Fed's sterilized lending program was, it helps to go back to the event that marked the beginning of the crisis:  BNP Paribas' August 9, 2007 decision to suspend withdrawals from three of its subprime mortgage funds.  The French bank's announcement had banks everywhere scrambling for liquidity.  Bernanke's description of the Fed's response to that event makes for a revealing comparison with his subsequent defense of sterilized lending:

That morning, I emailed Brian Madigan…to instruct the New York Fed to buy large quantities of Treasury securities on the open market.  The cash that the sellers of the securities received  from us would end up in banks, meeting the banks' increased demand for cash.  If banks had less need to borrow, the federal funds rate should move back to target and the pressure in short-term funding markets should ease.  If all went well, we would withdraw the cash from the system in a day or two.

Walter Bagehot's lender-of-last-resort concept argues that central banks should stand ready during a panic to lend as needed, which in turn would help stabilize financial institutions and markets.  Later that morning, consistent with Bagehot's advice and my instructions to Brian, the New York Fed injected $24 billion in cash into the financial system (pp. 143-4).

Although Dan Thornton is probably correct in calling the Fed's response to the BNP Paribas event "anemic," the point remains that at the time Bernanke understood the Fed's responsibility as being that of avoiding a general contraction of bank lending by seeing to it that the U.S. banking system as a  whole remained well-stocked with reserves, which the Fed made available by means of net open-market asset purchases.  A plot of excess reserves during 2007 and the first quarters of 2008 makes the point better than words can:


Notice that the increase in banks' excess reserves in August 2007 was due to the Fed's having expanded the monetary base, so as to loosen credit, and not to its having rewarded banks for holding reserves, as it was to begin doing in October 2008.  Although paying banks to hold reserves led to very substantial growth in banks' excess reserve holdings, that policy served not to loosen credit but to  tighten it.

In contrast to the Fed's actions in August 2007, its subsequent turn to sterilized lending had it, not buying, but selling Treasury securities, with the aim of preventing its emergency lending from resulting in any overall increase in the supply of bank reserves.  Financial conditions were thus "eased," not generally, but for particular institutions and their creditors.  For the rest, credit was actually tightened.  Because it serves to redistribute credit rather than to alter its overall availability, sterilized lending is properly regarded, as Marvin Goodfriend insists, as an exercise in fiscal policy rather than one in monetary policy in the strict sense of the term.  The principal beneficiaries of this fiscal policy were the creditors of the aided institutions, while the losers were those prospective borrowers who were denied credit because the Fed had directed the reserves that might have supported lending to them elsewhere.

Between December 2007 and September 2008, the Fed sold over $300 billion in Treasury securities, withdrawing a like amount of reserves from the banking system, or just enough to make up for reserves it created through its emergency lending, chiefly through its Term Auction Facility.   Bank lending suffered, because available reserves, instead of being augmented to accommodate the  increased demand for liquidity that normally accompanied worsening economic conditions, were instead withdrawn from relatively well-capitalized institutions while being supplied to ones that were more likely to be capital-constrained.

After mid 2008, commercial and industrial bank loans, having peaked as borrowers drew on existing lines of credit, went into sharp decline:*

Commercial and Industrial Loans

The reduced lending contributed to an equally precipitous decline in overall spending, as measured by nominal GDP:


What was the FOMC thinking?  It isn't the case that it was blind to what was happening to bank lending, or to the fact that the economy was contracting.  "In a particularly worrisome development," Bernanke writes concerning the situation as of August, 2008,

our quarterly survey of bank loan officers had revealed that banks were tightening the terms of their loans, especially loans to households, very sharply.  The staff maintained its view, first laid out in April, that the economy was either in or would soon enter recession (p. 238).

In fact, as the NBER subsequently determined, the Great Recession began back in December 2007. Yet even with the benefit of hindsight Bernanke insists that sterilization was called for, because it alone allowed the Fed "to make loans as needed while keeping short-term interest rates where we wanted them" (ibid.). In particular, the Fed wanted to keep the federal funds rate at 2 percent, where it had been since April.

But why 2 percent, rather than 1 percent, or (for that matter) zero percent?  According to Bernanke, the Fed determined to keep its rate target unchanged owing to concerns about inflation.  In early August the Fed's economists were predicting a core CPI inflation rate of 2.5 percent (which was also the rate over the course of the proceeding year) —  high enough to cause one FOMC hawk, Richard Fisher, to actually favor raising the federal funds target rate.  According to Bernanke, the FOMC

could not completely dismiss inflation concerns.  Oil prices had fallen to $120 per barrel from their record high of $145 in July.  However, staff economists still saw inflation running at an uncomfortable 3-1/2 percent in the second half of the year.  Even excluding volatile food and energy prices, the staff expected inflation to pick up around 2-1/2 percent, more than most FOMC members thought was acceptable (p. 238).

In retrospect it is all too clear that the hawks were mistaken, and that the FOMC ought to have paid  less attention to inflation (and to headline inflation especially), and more attention to NGDP and other measures of total spending. Scott Sumner and other Market Monetarists have harped on this for some time, so I won't bother to repeat their arguments.

But there's a more fundamental point I think worth emphasizing, which is that conceiving of monetary stability as a matter of stability of total spending, or aggregate demand, or NGDP — call it whatever you like  — makes nonsense of any supposed "conflict" between maintaining an appropriate monetary policy stance ("setting short-term interest rates") and keeping the financial system liquid ("eas[ing] financial conditions"), for the connection between a sufficiently liquid financial system and a stable flow of spending is (or ought to be) obvious in a way that the connection between a sufficiently liquid financial system and, say, a stable rate of inflation, is not.  Had the Fed acted to preserve overall liquidity in the financial system, instead of letting would-be borrowers go begging for the sake of bailing-out troubled firms, overall spending might never have collapsed.

Please do not misunderstand me:  I am not claiming that the Great Recession was entirely due to the Fed's failure to maintain a steady flow of overall spending during 2008.  I am not pretending that by doing so it could somehow have erased all the losses and prevented all the failures connected to the subprime bust, let alone prevented the bust itself.  Nor do I mean to deny that easy money contributed to the  boom that led to the bust.  I am saying that, whatever part the Fed played in the boom, it also deepened the bust by keeping money excessively tight throughout much of 2008.  There is no economic law that says that central banks must err only on the side of loose money, or only on the side of tight money.  They can, and do, err both ways.

Just as a rising tide lifts all boats, a collapse in aggregate spending depresses all markets, including the market for overnight funds.  The collapse was therefore bound eventually to undermine the Fed's 2 percent funds target, and (as the chart below suggests) would have done so even if the Fed had continued to sterilize its emergency lending.  The irony of this is that, by attempting, by hook and by crook, to hold the federal funds rate at 2 percent, the FOMC, far from succeeding in keeping interest rates a safe distance from their zero lower bound, propelled them in that direction.  As any fan of Knut Wicksell will tell you, this outcome was, according to that great economist, inevitable once the "natural" funds rate fell below the Fed's target.


With its September 2008 rescue of AIG, the Fed exhausted its capacity to sterilize its emergency loans.  Yet instead of giving up its goal of keeping the fed funds rate pegged at 2 percent, and allowing its emergency asset acquisitions to assist a revival of bank lending in what was by then a downward-spiraling economy, the Fed remained determined to keep a lid on credit.  It found a new means for doing so in the permission Congress had given it two years earlier, for reasons quite unrelated to the crisis, to pay banks interest on their excess reserves. I plan to discuss the consequences of that fateful discovery in another post.


P.S.: In a post he published yesterday, David Beckworth offers some further evidence of the Fed's having engaged in what he calls "passive tightening."


*I have corrected the graph after having originally published an erroneous one.

  • Walker Todd

    Excellent posts by George Selgin so far on the Fed's handling of the crisis after early August 2007. For those who would excuse Bernanke, Geithner, and even Paulson for their decisions during the crisis, many people (mostly former Fed types who had been through earlier rounds of banking crises in the 1970s and 1980s) were still around and willing to provide the historical and institutional structural insights that apparently escaped those three (and Neil Kashkari, the appointed head of the Minneapolis Fed, who ran TARP starting in the fall of 2008). We weren't asked. Officialdom was so hellbent on inventing its own version of the credit wheel (a version that, incidentally, favored credit for Establishment financial institutions while giving the back of the hand to households and the general line of business firms) that it did not want to hear about "old" (e.g., 1930s) initiatives covering exactly the same ground. Bernanke in particular was wedded to a "data is everything, structure is nothing" view of the 1930s initiatives (Home Owners' Loan Act, Reconstruction Finance Corporation (RFC) instead of TARP or Section 13(3)(which uses monetary policy tools to accomplish redistribution of credit ends and which George properly notes is fiscal policy in a thin disguise, etc.). Bernanke was said to have spread the word within the Fed that he was interested in learning more about how Sweden (1993) and Japan (1997-1999) restructured their banking systems, but he apparently said that he was uninterested in learning about the RFC, which did the same thing for banks in the USA in the 1930s. Ironically, in both Sweden and Japan, officials were using Jesse Jones's autobiographical history of the RFC as their guide. Give 'em hell, George. — Walker Todd, Chagrin Falls, Ohio

    • George Selgin

      Thanks, Walker. It always gives me a boost to know that something I've written passes muster with you.

  • Cytotoxic

    This article is good except for the nonsense infused in it regarding the role of central banks. Central banks do not have a role in maintaining spending, and spending shouldn't be maintained. It is a good thing that markets and credit were subjected to a sharp contraction in the Great Recession. It is the only way to fix those markets poisoned by easy money.

    • George Selgin

      Cytotoxic, Ludwig von Mises had a nice reply to your way of thinking. He likened it to someone's thinking that, by backing over his neighbor's cat, he might make up for having run over it in the first place.

      • Keith Weiner

        Suppose the Fed pushes down interest and pushes up the money supply. This fuels the speculators, who expect inflation. The combination of dirt cheap credit and high oil prices encourages the shale oil explorers to raise capital and go on a spending orgy to increase production.

        The price of oil collapses inevitably, of course. Then the shale oil players cut spending.

        Is it "backing over the cat" to say that spending on oil rigs and production equipment have to cease? If it doesn't, there's just more capital destruction.

        • George Selgin

          No, Keith: you misunderstand the point. If spending grows too rapidly, causing capital mis-allocation, the bust will come without any need for spending to be made to grow too _slowly_, as if that would assist recovery. The slow-down in spending just becomes an additional source of distortions and grief. What is needed is to return to the long-run stable spending equilibrium as quickly is possible, letting spending bygones be bygones.

    • Mike Sproul

      You are correct that the central bank does not have a role in maintaining spending, and George should lose his Free Banking badge for spouting such Keynesian nonsense.

      But it is a mistake to suppose tight money will undo the trouble caused by easy money. As long as a bank issues its money only in exchange for good quality short term bills of adequate value, it cannot go wrong in issuing as much money as the public will receive from it.

      • George Selgin

        The first statement is nonsense, Mike. It is just plain bad history of thought to assume that anyone who claims that stability of spending is desirable must be a "Keynesian." A well-functioning banking and monetary system is, according to writers of many schools of thought over the course of many generations, one that offsets increased demand for real money balances (bank-intermediated savings) with an increased supply (banks-sponsored lending and investment). Keynes didn't invent this way of thinking; and even if he had, merely referring to his name doesn't amount to a serious argument of any sort.

        • Mike Sproul

          Whether we call it Keynesian or something else, the claim that maintaining spending is among the proper duties of a central bank is incorrect. It's also a surprising claim to come from you, an advocate of free banking. I consider myself an advocate of free banking, and I believe that a free market in banking allows banks to automatically provide the right amount of money to accommodate the needs of business, just as free markets allow farmers to automatically provide the right amount of apples. There is no more reason for a central bank to provide money than there is for the government to produce apples.

          I presume you also disagree with my second statement, but are exercising your prerogative to close your mind to the real bills doctrine.

          • George Selgin

            Mike, I have written a volume and more showing how a free banking system itself tends to maintain a steady flow of spending, and also explaining why that is a desirable feature of such a system. I can hardly then do other than to suggest that any alternative system ought to be judged according to whether or not it achieves a similar outcome. It is ridiculous to suggest that, because I have argued for free banking, I must refrain from criticizing the performance of a central-bank based arrangement because to do so is to implicitly endorse such an arrangement! Are those who suggest that Venezuelan central bank has been pursuing an excessively easy policy also guilty of impicitly endorsing central banking?

          • Mike Sproul

            It's not that you refrained from criticizing central banks, it's that you claimed that central banks have a duty to maintain spending. Here's the offending passage:

            "a central bank might achieve the ultimate end of avoiding general
            reductions in lending and spending that might otherwise result in more
            general business failures — that is, in a recession or depression. For
            so long as the overall flow of spending remains stable, it must be the
            case, as a matter of simple logic, that aggregate business receipts do
            not fall remarkably short of aggregate outlays"

            It's as if you think that by maintaining C+I+G, the central bank can maintain Y. That is a misleading view. A better way to think of it is that merchants who have a certain amount of trade to conduct will require a certain amount of money. A free banking system will automatically provide that amount of money. A central bank can potentially do the same, but not automatically. If it should fail to issue enough money, then trade will be hampered and a recession will result.

          • George Selgin

            "A central bank can potentially do the same, but not automatically. If it
            should fail to issue enough money, then trade will be hampered and a
            recession will result."

            Since it is precisely such a failure that my article seeks to point out, I can't imagine how you can read me as suggesting that central banks can be counted upon to supply "automatically" the quantity of money required to maintain the flow of spending! It's as if, in the passage you quote from me, you imagine that the letters "m-i-g-h-t" spell "will"!

  • Justin Merrill

    Great post, George. It is very similar to a post I did covering Fed policy during this period (Dec, 2007-Dec, 2008) and their decisions to sterilize lending and start paying IOR. It amazes me that while financial markets were blowing up they were concerned with inflation and the Fed Funds rate being below their target.

    • George Selgin

      Thanks, Justin. My next post will cover IOR, but your earlier one makes the essential observations on that topic. Like you, I am flabbergasted that the Fed acted as it did, and especially so in light of Bernanke's determination and promise to not do "it" again.

  • Postkey

    "What was the FOMC thinking?"

    This is what Mervyn King was 'thinking' in September 2008.

    "In the UK we face a difficult but, temporary, period during which inflation will remain high for a while and output growth at best weak. But provided we do not impede the required adjustment we will come through this temporary period and resume a path of normal economic growth with inflation close to target."

  • I suggest there’s a flaw in the basic justification given near the start of the above article for emergency lending by central banks. George Selin says, “..emergency lending, far from being an end in itself, is but one of many possible means by which a central bank might achieve the ultimate end of avoiding general reductions in lending and spending that might otherwise result in more general business failures…”. The flaw there is as follows.

    It is widely accepted that in a free market, and given incompetence by a firm or firms, those firm/s should go to the wall, unless some business angle decides to rescue one or more of those firms.
    Thus given incompetence and hence insolvency among banks (or widget makers), that may well have a deflationary effect, and it is certainly the job of the state and government (not just the central bank) to maintain aggregate demand as far as possible. (Continued)

    • Continuation of comment above….But it is not the job of the state to make any special effort to rescue widget makers when widget makers have problems. Same goes for banks.

      • George Selgin

        Ralph, we are not necessarily in disagreement. My claim is simply that IF central-bank emergency lending can be justified at all, it must be justified on the grounds that resorting to it is necessary to maintain aggregate demand. I do not claim that emergency lending serves this end in actual practice–in fact I tend to doubt it.

  • Very interesting analysis! Thanks! I think it confirms the old saying that the banks initiate the boom but the real economy ends it. Evidence that the Fed has become impotent exists in the fact that corps have been sitting on mountains of cash or buying back shares. They refuse to invest the cash in business expansions, so why would they borrow for such. Some are borrowing to buy back shares. Profits have been high, but the business environment, from high taxes to crushing regulation, makes expansion not worthwhile.

    We may be in a situation like the 1970s when New Deal regulations strangled the real economy. We don't have high inflation because the state isn't spending as it did then on new welfare programs and the Vietnam war. But that could change with a new president.

    Of course, it's possible that the expansion would have gone differently if the Fed had not started paying interest on reserves. But it seems that most of the time the Fed is impotent, especially during a recession. Once in a recession the Fed is ineffective. It seems the only time it is effective is when an expansion has gone on long enough to cause price inflation and the Fed could dampen the boom.