Of the many bemusing chapters of the whole interest-on-reserves tragicomedy, none is more jaw-droppingly so than that in which the strategies' apologists endeavored to show that paying interest on reserves did not, after all, discourage banks from lending, or contribute to the vast accumulation of excess reserves.
Apart from resting on logic that's bound to bring a smile to the face of anyone reasonably conversant with the rudiments of Money and Banking 101, these demonstrations fly in the face, both of the original justification for IOR, as offered by Federal Reserve officials themselves, and of the Fed's recent decision to double IOR (and, with it, the upper-bound of the Fed's federal funds rate target range) so as to prevent inflation from rising above the Fed's 2 percent target.
Now, unless general understanding of basic monetary economics has deteriorated even more than I suspect it has over the course of the crisis and recovery, that understanding still sees inflation as a consequence of "too much money chasing too few goods." But money can either chase after goods, or rest in bank vaults (or in the virtual vaults consisting of deposits at the Fed). It can't do both. Hence the logic (and for once it is logical logic) behind the Fed's decision, both in October 2008 and last month, to check inflation by raising the interest return on bank reserves.
Now on to the exhibits. I start with another passage from the Richmond Fed article by Walter and Courtois referred to in my earlier post. There I noted how these authors shared Bernanke's own understanding of the Fed's decision to introduce IOR in October 2008. "Once banks began earning interest on the excess reserves they held," Walter and Courtois write, "they would be more willing to hold on to excess reserves instead of attempting to purge them from their balance sheets via loans made in the fed funds market."
Perfectly correct. Nor do Walter and Courtois suggest that there was anything wrong with the Fed's understanding of what it was up to. Yet, some paragraphs later, the same authors declare that banks' subsequent accumulation of excess reserves
has mistakenly been viewed by some as a sign that the Fed's lending facilities — the goal of which has been to maintain the flow of credit between banks, and therefore from the banking sector to firms and households — have not worked.
Now, this is already rather confusing, for as we've seen, according to these authors themselves, the whole point of IOR was, not to "maintain the flow of credit" in the sense of keeping it from shrinking — for shrink it most certainly did — but to make sure that the Fed's additions to the total stock of reserves did not increase that flow, which is to say, did not serve to arrest the flow's decline.
But let us set our befuddlement aside, in order to allow our authors to dispute the view that the vast post-IOR accumulation of excess reserves was evidence that the Fed's emergency loans and asset purchases weren't serving to "maintain" an adequate flow of credit:
To the contrary, the level of reserves in the banking system is almost entirely unaffected by bank lending. By virtue of simple accounting, transactions by one bank that reduce the amount of reserves it holds will necessarily be met with an equal increase in reserves held at other banks, and vice versa. As described in detail in a 2009 paper by New York Fed economists Todd Keister and James McAndrews, nearly all of the total quantity of reserves in the banking system is determined solely by the amount provided by Federal Reserve. Thus, the level of total reserves in the banking system is not an appropriate metric for the success of the Fed's lending programs.
A gold star to all who spot the fallacy here. For those who can't, it's simple: "reserves" and "excess reserves" aren't the same thing. Banks can't collectively get rid of "reserves" by lending them — the reserves just get shifted around, exactly as Walter and Courtois suggest. But banks most certainly can get rid of excess reserves by lending them, because as banks acquire new assets, they also create new liabilities, including deposits. As the nominal quantity of deposits increases, so do banks' required reserves. As required reserves increase, excess reserves decline correspondingly. It follows that an extraordinarily large quantity of excess reserves is proof, not only of a large supply of reserves, but of a heightened real demand for such, and of an equivalently reduced flow of credit.
And what about Keister and McAndrew's 2009 paper, which Walter and Courtois refer to as the locus classicus of their argument? As Jamie McAndrews has generously contributed, in the course of several recent email exchanges and also in his published works, to my own understanding of the whole IOR business, I'm pleased to report that a careful reading of that paper does not support the conclusion that Walter and Courtois draw from it. On the contrary: Keister and McAndrews understand that, unlike the total quantity of reserves, the quantity of excess reserves is a function of banks' willingness to lend. Moreover, they remind their readers that the Fed began paying interest on reserves "to prevent the increase in reserves from driving market interest rates below the level it deemed appropriate given macroeconomic conditions," and that it was only owing to IOR that banks willingly held on to so many excess reserves instead of lending them away.
But while the 2009 paper by Keister and McAndrews cannot be said to confuse the determinants of banks' excess reserve holdings with those of banks' total reserve holdings, the same cannot be said of an August 27, 2012 Liberty Street Economics post by Keister and Gaetano Antinolfi. Antinolfi and Keister explicitly deny that the Fed, by lowering the interest return on excess reserves, might encourage banks to "lend out some of these 'idle' balances." Why not? Because, according to their reasoning, "lowering the interest rate paid on reserves wouldn't change the quantity of assets held by the Fed." Since lowering the rate of IOR is also unlikely to increase the share of the monetary base consisting of currency rather than bank reserves, it follows that it "will not have any meaningful effect on the quantity of balances banks hold on deposit at the Fed."
Here is that silly fallacy again: for the question isn't whether a lower rate of IOR can reduce banks' total reserve balances. It is whether it can reduce their excess ("idle") balances by inducing them to lend more. For while such lending wouldn't serve to reduce the aggregate stock of reserves, it would lead to an increase in the nominal quantity of bank deposits, and a proportional increase in banks' required reserves. So, even as they caution their readers that "Language Matters," Antinolfi and Keister blunder badly by neglecting to heed the crucial distinction between the total quantity of bank reserves, which no amount of bank lending can alter, and the quantity of excess reserves, which, by means of sufficient bank lending, might always be reduced to zero.
Speaking of language, one of the peculiarities of how it evolves, according to my own (admittedly inexpert) observations, is the particular tendency of bad language memes to go viral. Once upon a time, some moron imagined that "incentivise" was a word, and the next thing you knew every other moron couldn't wait to slip it into a sentence. Before long, Webster's scouts cottoned-on to the new coinage, and, voila!: English done got itself a brand-new — and perfectly superfluous — verb.
In the same way, bad monetary analysis has a way of spreading like a wildfire. So I suppose it was only to be expected that Antinolfi and Keister's "proof" that lowering IOR wouldn't promote bank lending would be cited approvingly (or at least not disapprovingly) by numerous other commentators. Jon Hilsenrath reported favorably on Antinolfi and Keister's argument for the Wall Street Journal's Real Time Economics blog, as did Jonathan Spicer for Reuters, while Mark Thoma included a large chunk of their post in a post of his own, without expressly endorsing it, but also without suggesting that there was anything wrong with it.
The mistaken understanding of Keister and McAndrews (or, as now seems more likely, the correct understanding of Keister's own contribution to that work) likewise became, in some quarters at least, the popular understanding. Thus, according to Frances Coppola, writing for Forbes,
The volume of excess reserves in the system is what it is, and banks cannot reduce it by lending. They could reduce excess reserves by converting them to physical cash, but that would simply exchange one safe asset (reserves) for another (cash). It would make no difference whatsoever to their ability to lend. Only the Fed can reduce the amount of base money (cash + reserves) in circulation. While it continues to buy assets from private sector investors, excess reserves will continue to increase and the gap between loans and deposits will continue to widen.
Nor, according to Ms. Coppola (writing in another Forbes column), has IOR anything to do with it:
Banks are not being paid not to make loans. They don't lend out reserves to customers. They only lend reserves to each other. By competing with banks in the market for reserves, the Fed controls the price at which they lend reserves to each other. It has nothing whatsoever to do with customer lending.
There you have it: banks can hold on to reserves, and yet lend all they wish to (though not, for some reason, overnight). Such a marvelous business! Whoever said that one can't have one's cake and eat it, too?
Well, banking would indeed be a marvelous business if it worked as our expert at Forbes assumes. Alas, it is not so marvelous as that. For despite what Ms. Coppola claims, banks do, in effect, lend "reserves" to customers no less than to other banks. The lending of "reserves" is more apparent in the overnight market simply because it is reserves per se that borrowers in the market are after, for they need extra reserves to avoid shortfalls that would otherwise subject them to penalties, or to what amounts to the same thing: a visit to the Fed's discount window.
If, on the other hand, a businessman borrows $500,000 from a bank, it isn't cash itself that the businessman wants, but other things that can be got for the cash. But as soon as the proceeds of the loan, originally received as a deposit balance, are drawn upon for the sake of acquiring these other things, the withdrawals, whether by check or draft, lead quickly to redeposits in other banks, and thence to a $500,000 adjustment to the pattern of interbank clearings and settlements at the expense of the lending bank and in favor of rival institutions compared to what would have been the case had the loan not been made.
All this is entirely elementary. Yet it is not just the folks at Forbes that don't get it. Here is what The Economist had to say back in December 2009 about the piling-up of excess reserves:
The point is that the Fed is not trying to increase lending by increasing reserves; it is trying to increase lending by lowering long-term rates and directly supplying credit to borrowers who can't get it elsewhere. Higher reserves are the unintended byproduct. Well, unintended or not, couldn't all those excess reserves spur credit growth and inflation? No. Reserves have not been a relevant constraint on bank lending for decades, if ever. Bank lending is constrained by customer demand and by capital. Right now, loan demand is moribund (in spite of a zero federal funds rate) and capital is in short supply.
Although it is certainly true that the Fed wasn't trying to get banks to lend more, it did not itself believe that reserves were not a "relevant constraint on bank lending." If it had thought so, it would not have bothered sterilizing its pre-Lehman lending, and it would not have resorted post-Lehman to paying interest on excess reserves. Jose Berrospide has it right when he says that, once that policy was in place,
banks sold assets worth selling, such as treasuries and [other] government securities, because the return on those assets was almost zero. Banks accumulated cash and excess reserves at the central bank because of the interest earned on reserves balances.
The Fed's creation of vast quantities of fresh reserves did not result in a like increase in bank lending, not because reserves had ceased to be a relevant constraint on lending "decades before," but because, thanks to IOR, "the marginal return on loans [was] smaller than the opportunity cost of making a loan" (ibid.).
Nor, as I pointed out in my previous post, was bank lending capital constrained except for a brief time during 2009. After that, many banks held both excess reserves and excess capital. As for lending being "constrained by customer demand," oh puh-lease! The quantity of loans demanded, which is what the writer ought to be talking about, depends on the rate charged. The problem is that no bank was willing to lend for, or to buy assets yielding, less than the rate paid on reserves themselves.
Economists seem lately to have built a little cottage industry around the notion that those old-fashioned accounts of bank lending, what with their reserve multipliers and clearing losses and all that, are passé. To subscribe to them is to be hopelessly out of fashion. Well, call me an old fogey if you must, but I say, show me some au courant writings on the matter, and I will show you some fashionable nonsense.