Interest On Reserves, Part II

banking theory, excess reserves, financial crisis, interest on reserves
Pound Layer Cake, by Scheinwerfermann. Available on WikiCommons.

banking theory, excess reserves, financial crisis, interest on reservesOf 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.  Thus 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.

  • therooster57

    Reserve funds and any interest applicable is "dark side" economics in the face of trying to add debt-free liquidity into circulation. What's emerging , birth pains aside, is a yin-yang of liquidity where gold based currency can support real economy and also allow for debt based liquidity (fiat) to be purged and retired.

    It's not that complicated. We simply need some Yang with our existing Yin. The market can do this on its own.

    Just add assets and stir !

  • Banks do not lend out reserves, excess or otherwise, but the increase in deposits generated by direct monetisation of publicly held (vs bank held) debt securities certainly did increase lending capacity of the banks who did receive the deposits. By paying IOER the Fed in no direct way has diminished that increased capacity to lend. The Fed has, however, indirectly reduced the “need” or “desire” for banks to lend by increasing income to the bank through IOER (in essence the Fed swapped one income paying debt security in the form of treasuries for another in the form of interest bearing Federal Reserve Notes – for lack of a better term). Income that would theoretically reduce to zero if sufficient lending occurred to the point of wiping out excess reserves for a single banking institution or system wide. The results are pretty clear that given a choice of investing substantial time, effort and resources in to developing a portfolio of commercial and consumer loans has been deemed an inadequate replacement for the IOER they are already receiving. Coppola in one sense is correct, but in the larger and more important sense is incorrect.

    • George Selgin

      Milton, I can only say that, no matter how many times people repeat that banks do not lend reserves, I shall stand ready to deny it, for reasons I explain to the best of my ability in this blog. And to say that positive IOR did not diminish banks "capacity to lend," but merely their desire to do so, you do not contradict my position on the matter, which is precisely that positive IOR increased the reward for holding reserves relative to that for lending the same.

      Moreover, in speaking of the Fed's having increased banks' capacity to lend, you beg the question: how did it do so, other than by supplying them with increased reserves for the purpose? Treasuries cannot serve for interbank settlements. Only reserves have the capacity to do so. That is why QE is normally expansionary. That it was abnormally non-expansionary after October 2008 is because banks could earn more on their excess reserves than they could earn by swapping the reserves for interest-earning assets.

      • George, OK, got it. I was not intending to contradict what you were saying just trying to work it out in my head. Coppola, after reading some other things she had written, had me convinced of her position – you have convinced me otherwise. Thank you for the clarification. With regards to capacity, yes, I was only stating that their inventory of rubber ducks was greater, but that in no way would lead to additional sales in and of itself – especially when they are being paid to hold the rubber ducks in inventory.

        BTW, I just got started on your book, The Theory of Free Banking: Money Supply Under Competitive Note Issue. Have read Lombard Street, several other articles and papers by you and your colleagues, finishing up Vera Smith after reading Hayek's Denationalisation and have viewed your talks, what is available, on YouTube. I'm not sure there would be a more important development than a truly free market banking system as you, and your colleagues, have laid out.

  • Jaime Narbon

    Very good article George. It seems amazing that such easy concepts from Money and Banking Class can be forgotten (whether on purpose or by mistake or both!). I remember seeing an interview to a Chicago Economist not too long ago where he expressed that Excess Reserves held at the Fed as a result of QEwould not be a problem since it cancels out once Treasuries mature. This was troubling because the freezing of bank lending still occurs, in my opinion. Do you agree or have an opinion about this idea of excess reserves being a wash?

    • George Selgin

      I'm not sure what your Chicago Economist has in mind in claiming that excess reserves would "cancel out" once Treasuries mature, so I can't really address the question. When Treasuries mature on the Fed's books, reserve balances will decline only if the Fed doesn't choose to reinvest the income. But there is nothing necessary about it. In effect, the Fed remains in that instance, no less than in any other, in command of whether bank reserves decline or not.

  • Walker F Todd

    Best thing I have read on excess reserves so far. And I think competent academic research will back up what George says here. I was at a conference in Europe recently with a group of current and former Swiss National Bank representatives. They kept asking me, "Why is the Fed paying above market interest on excess reserves?" Their analysis essentially was the same as George Selgin's. Interest at market rate or lower might be justified for required reserves (but it is still a subsidy of the banks). Interest above market rate on excess reserves cannot avoid diminishing banks' willingness to lend at rates below that artificially higher rate decreed by the Fed. This is the fatal flaw of QE: drastically diminished returns (in the form of increased bank lending) as quantities of excess reserves increased. If so, then why continue doing it (expanding QE)? The Swiss decided, after expanding the National Bank's balance sheet to 80 pct. of GDP through purchases of euros in a vain attempt to hold the Swiss franc at 1.20 per euro last year, that enough was enough and that they would try negative interest rates instead. Fed Vice Chairman Stanley Fischer, in a speech at the American Economic Assn. meetings this past weekend, devoted extensive time to negative interest rates and the Europeans' experience with them. He knows the same Swiss central bankers that I do. I have no reason to assume that they tell him anything different from what they told me about this subject. Negative rates are a bad idea except when the alternative is further and pointless expansion of excess reserves and the central bank's balance sheet. By the way, the Fed now stands at 25 pct, of GDP, up from a range of 6 to 8 pct. before the crisis. Enough is enough when it comes to monetary (or potential monetary) expansion. And for asset bubbles, margin requirements, the truly forgotten policy instrument in recent decades, go further than interest rate increases and with less widespread harm to the general economy if policy makers decide that some sector-specific anti-bubble measure is needed. — Walker Todd, Chagrin Falls, Ohio, 7 above this morning

  • So, I think that the Fed did tighten by IOR. But they tightened before that, a year before that, in ignoring the explosion of LIBOR as it went higher. They should have cut to zero then, back in 2007. But here is the problem I see with the market monetarists, the Fed won't bail you out when the NGDP bubble bursts again. They won't be there for you. Why won't they be there for you? Because protecting the banks is more important than protecting society.

    • George Selgin

      Gary, I agree that Fed policy was tight before IOR–see my post "Sterilization–Fed Style." As for "the Austrians" going for deregulation, well, this is just too sweeping a statement to pass muster. Which Austrians? What deregulation? Although I myself (a fellow traveler) have often argued the merits of free banking, to me that doesn't mean deregulatng willy-nilly, e.g., by letting banks do anything they wish to while also guaranteeing their creditors!

      But I also question your suggestion that "deregulation" played an important part in the subprime boom. What deregulation? The partial roll-back of Glass-Steagall is the one most often referred to by those who blame deregulation (what other candidates are there?). But I have yet to hear a coherent account of how that measure can have been to blame, given the players most heavily involved in both the manufacturing and the acquisition of the toxic assets you refer to.

      • Thanks for the response, George. I think Austrian deregulation had its roots in Thatcherism. So, the Garn-St Germain Act of 1982, which was signed by Reagan, allowed liar loans. So then when you could insure liar loans by the repeal of Glass-Steagall, the party of evil was on! Most of the libertarian arguments came from the UK on why Thatcherism was good. And remember, the UK never had a Glass-Steagall. They were polluted from the start, and self certified loans from the UK were imported to Spain, and the US, where they were called liar loans. Just FYI, but you probably already know this. Yeah, sorry libertarian Austrians, deregulation helped make it happen, along with mispricing of risk by the Federal Reserve through a bogus Gaussian Copula that included an assumption that all mortgages could not go bad at the same time. Lol.

        • George Selgin

          Well, I have heard Thatcherites say that Thatcherism had its routes in Austrian economics! In any event, it is unwise to confuse the beliefs of an economic school with the agendas of politicians, as the last inevitably involve considerations in which economics play at most a secondary part.

          As for the rest, the connection of Garn-St Germain to the subprime boom can at best be a very remote one, given the timing! As for Glass-Steagall, well, Canada also never had it, yet Canada didn't take part in the subprime nonsense. So I don't suspect you will see many Austrian economists or libertarians hanging their heads on account of the points you make. (This fellow-traveling non-libertarian non-Austrian free banker continues in any event to be quite untroubled by them!)

          • I want the Austrians to hang their heads. 🙂 On the other hand, I also know they are in agreement with me that the Fed mispriced risk and caused the housing bubble. So they aren't all bad. :)They just are fooled by banksters a lot.

          • George Selgin

            Well, I hope you won't catch those banksters fooling me!

          • Lol, I don't know who is funnier, Market Monetarists or Austrians!

  • Max

    The bottom line is that there's an inconsistency between saying "we're making these investments to stabilize the messed up [in 2008/2009] markets" and "we need IOR to prevent our investments from having a stimulative effect". Unless the investments were not intended to be investments, but rather gifts. Because there's no inconsistency in wanting to give away money without stimulating the economy.

    In any case, I'm all in favor of getting rid of IOR, with the possible exception of IOR on *required* reserves. It's a failed experiment.

    • George Selgin

      A failed experiment, indeed! And I agree that IOR on required reserves is not so dangerous an idea as IOR on excess reserves..

      • Michael Byrnes

        The law does not specifically authorize interest on excess reserves, does it? Interest is paid on all reserves, whether required or excess, correct?

        But the stated rationale for the policy (not making reserve requirements punitive for banks) is only a justification for IORR. (If banks are choosing to hold excess reserves, then they are obviously not being penalized by reserve requirements).

        Of course, pre-2008 there were virtually no excess reserves in the system, so it is not too surprising that our wonderful legislators overlooked this.

  • Thomas M. Humphrey

    Excellent analysis, George, and confirmation of the correct "old school" account of how, in the absence of interest payments on excess reserves, the banking system would exhaust those excess reserves in expanding loans and hence deposits. In an article in the Richmond Fed's Economic Focus (4th Quarter 2014) I noted that the Classical formulators of lender-of-last-resort theory would, during financial crises, "have opposed the Fed's payment of positive interest on excess reserves . . . . Such payments, which boost demand for idle reserves and keep them immobilized in reserve accounts rather than getting them lent out into active circulation in the form of bank deposit money, would be inconsistent with the classicals' goal of expanding or maintaining the stock of broad money as required to keep economic activity at its pre-panic level.

    • George Selgin

      Thanks for your comment, Tom. find it reassuring to be on the same side as the likes of those great classics–Bagehot and Thornton (and Humphrey!).

  • JKH

    It is a decent point you make about the popular sloppiness of failing to distinguish clearly between excess reserves and required reserves. But it is a relatively minor point in the full context of the explanation of things when properly understood – which itself explains (but does not excuse) the tendency to sloppiness on the point itself. As to the rest of the argument within your two posts, there is a serious misunderstanding about the economics of reserves versus the economics of bank capital, and how these two things relate to the commercial bank lending function. The grand monetarist error in these things is the entrenched mistake of confusing the functional role of reserves with the functional role of bank capital. This manifests in popular discussion such as here with the confusion of essential characteristics as between the fed funds lending function and the commercial credit lending function, which are two very different outlets for bank lending that have fundamentally different causes in terms of the respective motivations for excess reserve management and (excess) capital management. And they have fundamentally different mechanisms with respect to lending or not lending reserves respectively. Taking these issues into account, the heterodox story about reserves is infinitely closer to the truth than your story. The inconvenient fact is that the economics profession for the very most part has virtually no understanding of how banks actually work – particularly about how the machineries of reserve management and capital management work in different modalities, but with effective balance sheet management co-ordination. Understanding the essential elements of bank capital management is key to understanding reserve management in all its aspects, because the distinction between the two is essential to the comprehension of how these functions each work in their own respective ways.

    • George Selgin

      JKH, I don't see how I'm guilty of confusing the parts that capital and reserves play in bank lending. In my post previous to this one, I explicitly consider the question whether bank lending was capital-constrained. And I certainly don't claim that the influence of IOR on lending of all sorts was the same as its effects on interbank lending. Finally, if as you suggest "the heterodox view about reserves" that I criticize–that is, the view that banks are collectively unable to reduce their excess reserve holdings by lending more–is "infinitely closer to the truth" than my opposite claim, I should like to see that claim, not merely asserted, but coherently demonstrated.

      • JKH

        Fair enough. Forget the idea of a “heterodox” view, whatever it is (and it’s amorphous at best). This is just my view here.

        In the most general sense, the issue about capital and the connection between capital and excess reserves is not really about whether banks are capital constrained – although that can be a concern at times. The issue is about how banks manage capital from first principles – under any conditions.
        As a simplification, suppose the banking system is running smoothly sometime before a financial crisis. That means among other things that individual banks are managing their capital positions economically. The purpose of equity capital is to insure against losses. Banks allocate equity capital across a range of risks – credit risk, interest rate risk, foreign exchange risk, operational risk, etc. Shareholders expect a return on equity and banks respond by setting standards for return on equity and for the amount of capital allocated to the degree of risk taken. Functioning banks generate capital internally through profits. In managing their capital positions, banks will pay dividends and do share buybacks to the degree they don’t require internally generated capital to expand their business. And there is also a concept of “excess capital” in which banks may choose to retain a portion of their capital in unutilized form (invested in risk free assets requiring no or little capital allocation), as a buffer to take advantage of potential or scheduled opportunities to deploy it.
        Very little of that capital management process has anything to do directly with the effective management of reserve balances held at the Fed. There is a relatively minor pricing effect, in that banks will factor the equivalent interest margin cost of required reserves on deposits into the pricing of loans that require deposit funding. That becomes part of the equation that ends up satisfying a return on equity hurdle rate. It is a relatively small pricing tweak.

        The core purpose of reserve balances is to allow for effective clearing of transactions with bilateral effects on banks – all types of transactions that result in customer deposit transfers through various means. The direct trading of reserve positions through the fed funds market is one aspect of the entire process of managing the net clearing effect for a bank balance sheet. There are many others that include pricing/volume strategies for other assets and liabilities.

        There seems to be some indirect semantic play in your argument that banks lend reserves even to non-customers. That is unconvincing when one considers that most loans are made by crediting a deposit account at the same bank, and many if not most loans are repaid by debiting a deposit account at the same bank. Neither of these transactions have a reserve impact. The fact that subsequent or prior deposit transfers in those respective situations may well involve an interbank flow is neither here nor there in assessing the operational effect of loans on reserve positions. It is happenstance relative to the lending function, since most of the volume of such interbank clearing occurs for reasons of ongoing day to day commercial activity that have nothing to do with new bank loans. That said, the semantics of “loans create deposits”, while factually true, is a minor aspect in the context of banking economics. James Tobin recognized all this in his superb 1963 essay “Banks as Creators of Money”. But he certainly conceded that “loans create deposits”, an idea which is sometimes popularized in modern day interpretation as “endogenous money”.

        Commercial lending at the aggregate banking system level is not constrained by reserve availability per se – not in the case of a normally functioning banking institution. This is an observable fact, not theory. As such, it is picked up frequently by “heterodox” voices such as MMT. I am not an MMTer or a heterodox anything. But this particular point is correct, and it is fundamental to how banks work.
        (I’ll just note that I’ve managed the reserve position of a major bank at an executive level of responsibility. While I realize that may not necessarily be convincing evidence of my understanding of these things in the case of somebody of your academic orientation and profile, it should at least reduce the probability that I have no absolutely idea of what I’m talking about.)

        If you look back over the last 50 years or so to the statistics on the excess reserve position for the US banking system as a whole, pre-crisis, the excess amount is miniscule compared to the nominal size of the system balance sheet. It was around $ 2 billion on average as I recall. The reason it was so small is that the Fed managed a quantity of non-interest bearing reserve balances so as to direct the effective fed funds rate toward the target rate, according to the ongoing interbank competition for sufficient clearing balances required to clear positions. It was a simple matter of supply and demand affecting the price. But there is an incredibly high degree of effective fed funds pricing leverage involved when the Fed controls that scarce non-interest bearing required resource as the monopoly supplier of it.

        The salient point is that the Fed provided the necessary excess reserve quantities needed to steer the funds rate to target, according to supply and demand conditions for reserves that paid zero interest. Given that reserves paid no interest, but that the fed funds rate was bounded above by the discount rate, this always amounted to keeping the supply of reserves tight enough, but not too tight. Occasionally, when the Fed misjudged demand, this might involve the funds rate temporarily slipping excessively below target, but such conditions were soon reversed by marginal tightening. Deposit growth increased the aggregate system requirement for “required reserves” reserves over time. Incremental changes in requirements were calculated with a time lag, after the fact of the creation of deposits that generated them. The Fed then supplied any incremental reserves to meet the demand for a new incremental requirement on a timely basis each time the aggregate reserve requirement
        quantity increased. This was done seamlessly in matching supply to demand
        (demand according to the change in required reserves) so as not to disturb the parallel process of effective fed funds rate targeting, which required corresponding
        excess reserve targeting in fine tuning fashion. The role of excess reserves
        in fed funds rate targeting was thus managed seamlessly with respect to lagged,
        step-wise increases in required system reserves due to banking system balance
        sheet expansion. And with all this going on in the machinery that handled the daily
        clearing of funds between individual banks, reserves had no direct impact on the
        economics of capital allocation and risk taking, with the minor exception of
        the interest margin cost of required reserves, as noted above. Excess reserves
        were not an issue for commercial bank lending expansion.

        And the critical observation for a realistic monetary economics is that this final fact has not changed with the crisis. Excess reserves are not a direct issue for commercial lending – even with a system saturated by $ 2 trillion of excess reserves. The fact that the Fed has dumped these reserves into the system has no direct effect on return on equity criteria simply due to the quantity of reserves alone. It may well have had an effect in terms of expectations for the risk free rate over the longer term, and risk premia may have been affected at the margin, and therefore the required return on equity levels may have been affected at the margin. But the role of excess reserves
        has had little material effect on whether a given bank’s target return on equity capital is 10 per cent, or 12 per cent, or 14 per cent. Moreover, required capital quantities have generally increased due to the hangover of the financial crisis risk effect, acting as a drag on bank appetite for credit risk even in the case of any marginal downshift in the target return on equity. But there is no material quantity effect on credit risk appetite whereby the banking system feels compelled to “use up” excess reserves by lending, thereby converting excess reserves to required reserves. And on the aspect of excess capital, to the degree that it exists banks will dividend it out or do share
        buybacks before considering risk taking in the form of commercial lending that
        is uneconomic from a hurdle/required return on equity standpoint.

        QE for the most part consisted of the Fed’s purchase of assets not directly from banks but rather from the customers of banks. Therefore, typically both customer deposits and bank reserves were newly created when for example the Fed bought Treasury bonds from customers such as pension funds. That balance sheet result for the banking system and individual banks then prodded a net income consequence for the juxtaposition of newly created reserves with newly created deposits. That included a core interest margin effect along with peripheral non-interest revenue and expense effects. E.g. additional fee revenues in the face of narrow spreads might enter the
        equation. The important point here is that the capital allocation required for this activity – for this slice of banking system balance sheet expansion induced by QE, comprising both reserves and deposits – is negligible, when compared with the usual relevant case of commercial credit lending. That means that provided there is no net income loss resulting from this system balance sheet QE “slice”, there is little damage done to return on equity, because of the negligible capital requirement. The mass of QE reserves and associated deposits just sits on the face of the banking system, largely useless for purposes of the business of banking. And the banks ensure that it is not a net cost through their natural efforts to recover the cost of narrowing margins at and around the zero bound. Individual banks will do this through pricing competition, prepared to shed deposits and reserves to other banks if the economics are not yet correct. It should be noted that even with negative rates, banks would have taken steps to avoid a net cost due to QE, including charging negative rates on
        deposits. QE excess reserves become a cost management exercise at and around the zero bound. But there is no inducement to compromise prudent return on
        equity capital targets by suddenly adopting a substitution strategy where banks attempt to get rid of their excess reserve shares by materially weakening their required return on equity capital targets. Forces on the deposit pricing side will act force to create the required economics for the QE margin effect. Accordingly, there is no motivation due to QE alone for banks to change their return on equity criteria or to allocate capital to assets they would not have otherwise acquired.

        Therefore, the notion that QE excess reserves must somehow cause banks to go
        out and lend in the form of commercial credit risk in a way they hadn’t previously considered is just wrong-headed. Moreover, the fact that there may well be a marginal effect on required return on equity capital levels is very different from the idea that mass quantities of excess reserves somehow induce a substitution effect in the form of risky credit lending.

        There is another dimension to this erroneous theme of a significant substitution effect arising from QE excess reserves. Considering the size of required banking system reserves in the current situation, and using that as a proxy for an overall balance sheet ratio, a banking system expansion of nominal size in the order of magnitude of 20 times or more would be required to “use up” these excess reserves (ballpark calculation but reasonable in order of magnitude) in the sense of the academic theorizing on this idea of excess/required reserve conversion. If you trend this out at a 5 per cent nominal GDP, it would take 60 years to accomplish this feat of consuming excess reserves by lending. Surely the absurdity of such a calculation should point to a fundamental flaw in linking excess reserves to the expansion of bank lending in the form of commercial credit risk. The idea that the Fed would pump in $ 2 trillion to get
        a process rolling that envisaged a correlated quantity effect in excess reserve
        utilization though lending is ludicrous. Something is going on with QE, but it’s not that.

        The point is that if massively outsized excess reserves due to QE have any effect on bank lending, it is due to the marginal effect on the required return on equity capital and not because of the quantity of excess reserves per se. A return on equity target is a pricing criterion, not a quantity criterion. Moreover, the risk that can be assumed with commercial lending depends on a quantity criterion for the requisite capital allocation that must earn the hurdle rate return, not a quantity criterion for the
        utilization of excess reserves.

        Here is a final point regarding the payment of interest on reserves. The pre-crisis mode of Fed management ensured that the necessary supply of excess reserves was like a drop of water in the ocean of banking system stocks and flows. This was because of the enormous leverage that the Fed exerted on the fed funds rate using a reserve stock that paid no interest, in tandem with an effective ceiling on the fed funds rate in the form of the discount rate. As I said earlier, the quantity of excess reserves necessary to achieve the desired target rate effect was around $ 2 billion, in a banking system of $ trillions in assets and liabilities, and that excess reserve amount
        didn’t even change much over the course of 50 years. The implication of this very tight operational leveraging mechanism in the case of zero interest reserves meant that the introduction of “super-excess” QE reserves was problematic for the control of the Fed funds rate on the downside (apart from an initial increased demand for clearing purposes because of heightened banking uncertainties at the start of the crisis). That’s in effect why the Fed had to start paying interest on reserves (that being apart from Treasury’s co-ordinated involvement at the very beginning of the crisis in assisting with reserve draining though non-standard balance sheet operations).

        The point is that interest on reserves is a necessary feature in order to enforce a positive fed funds rate target when excess reserves soar to the massively outsized levels associated with QE. Banks simply don’t need those reserves for operational purposes, so the short rate would plummet to its natural competitive rate of around zero when supplied in such super-abundant excess, absent a positive rate of interest to be paid on reserves.

        Thus, the issue has always been what the Fed’s strategy is for targeting the fed funds rate or its trading range. It has never been interest on reserves. Interest on reserves is a constraint induced by QE outsized excess reserves, when the fed funds rate target itself is non-zero. Zero is an interest rate. And so the rate on QE excess reserves must match up coherently in strategy with the interest rate or interest rate range that is the effective target for fed funds.

        Therefore, the payment of interest on reserves is never the strategy issue for monetary policy. The strategy issue has always been and will always be the target rate or the target trading range for the fed funds rate. I know this focus on the interest rate aspect is anathema to monetarists, but that is the way it works.

        It is one thing to opine that the funds rate should be targeted at zero, or targeted positive, or targeted negative. That is front and center in monetary policy at all times, QE or no QE, notwithstanding the eternal monetarist push back to avoid talking about monetary policy in terms of interest rates. But once that strategy is set, the payment of interest on reserves is a mere operational feature of the way in which reserve quantities are managed. The pre-crisis Fed did not need to pay interest on reserves because it restricted the quantity of reserves. The post-crisis Fed must pay interest on reserves in order to enforce its fed funds targeting strategy, unless and until outsized excess reserve balances are drained in a QE exit strategy that eventually returns the excess reserve regime to its former operational mode of tight quantity management and an IOR of zero. That will be up to the Fed. It sounds like that’s what they want to do eventually, notwithstanding cries from some corners of academia for a permanently saturated sponge of system excess reserves and reverse repos (e.g. Cochrane).

        It’s been a while since I looked at the Keister and McAndrew 2009 paper, which was very good. According to my recollection, I doubt anything there will contradict in effect what I’ve saying here. I haven’t read the other papers you cite.

        • JKH

          At least one point I neglected to add. The issue of capital allocation applies to short term liquid assets such as fed funds loans, treasury bills, commercial paper, and bankers' acceptances in the same way as it applies to excess reserve balances that earn interest – i.e. the requirement for capital is negligible compared to the case for the main commercial lending book which consists of longer duration riskier loans. The point is that bank liquidity management is quite distinct for the most part from bank capital management. The main business of banking is making profitable loans that are risky and require capital. Liquidity management that doesn't use much capital is a necessary side show to that core credit risk function. The short term reserve management manipulations of the pre-crisis Fed were designed to control the fed funds interest rate level. Yes, that would have consequences at times for turbulent activity in the money markets (treasury bills, commercial paper, bankers' acceptances, etc.), and that would include distinct reactions from commercial banks in the form of either new money market lending or the calling in or maturing of short term loans, depending on short term Fed easing and tightening actions respectively. But all of this short term activity is about liquidity management and has little to do with the main banking business of more durable capital allocation to risky commercial lending. And once again, the presence of $ 2 trillion in excess reserves has no effect on the distinction between these two bank strategy modes – liquidity management and capital management. So in that context, the graph on commercial lending that you included in your first post is really not relevant in the context of the issues of short term bank liquidity management that you implicitly focus on in your general discussion. That graph is correctly about capital allocation instead.

          • George Selgin

            Sorry I've fallen behind n replying, JKH.

            The idea that the Fed's ordinary pre-crisis management of the FFR had little bearing on overall bank lending, though it has a certain appeal, misconstrues the fact that, appearances notwithstanding, the overall scale of the banking system, and hence the scale of nominal lending (as that of all nominal money magnitudes in the economy), depends crucially in normal times on the nominal stock of reserves (or base money): that is the essential premise of FFR targeting as a means for monetary control–and it explains why, despite massive growthh in the nominal base over many decades, excess reserves normally remained very small, while required reserves grew pari passu with actual. That could only be the case because bank lending (and interest-earning asset acquisition more generally) , and with these, reservable deposits, tended to expand in step with nominal reserve creation. Economists' understanding than bank lending is "constrained" by reserves is a shorthand way of capturing these essential truths. And though the banking business supplies a rather different perspective, the facts remain consistent with that view, with post-2008 developments constituting a striking exception to the usual case, hence one warranting special attention.

            I have another post on this subject coming out tomorrow. We can perhaps pick up the discussion there.

        • JKH

          One more minor point (further to my comment just below this):

          "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."

          The KM quote itself is a correct interpretation. The purpose of IOR is to set a floor for the fed funds trading rate in the presence of outsized QE reserves (ex the consequences of certain unfortunate operational complications such as the fact that the agencies earn no interest on their balances at the Fed). That prevented the fed funds rate from dropping to zero (ex those complications), as I noted in my earlier comment. And that was a direct function of the fed funds target rate strategy, given the presence of those outsized excess reserves.

          That's the issue – not the aspect of "lending them away". Lending activity in the money markets (including the Fed funds market) continues on to some degree regardless of the level of rates and without significant capital allocation, as I described. And lending activity for longer duration credit risk that requires capital allocation is fundamentally distinct from the issue of liquidity management, as I noted earlier.

          Again, I would expect the KM interpretation to reflect what I've said here, rather than the point you make in the above quote.

        • JKH

          (In sequence from my two comments just below this and the longer previous one above)

          I watched the part of the Greenspan interview above that refers to interest on reserves.

          Alan Greenspan may be a brilliant person at whatever he’s brilliant at, but the fact that he ended up as Chairman of the Fed doesn’t necessarily mean he correctly understands how commercial banks respond to the Fed’s reserve strategies (Volcker is a similar example, with his botched strategy of quantity targeting). Greenspan’s explanation is totally wrong.

          Greenspan argues that an interest rate of 25 basis points instead of an interest rate of 0 basis points somehow “neutralizes” bank lending propensities and stops the “multiplier” in its tracks (pretty much). His logic is completely wrong. There’s no reason to suggest that there is a point of discontinuity at an interest rate of 0 basis points, where banks at that rate pursue lending opportunities and super-charge the “multiplier” with great abandon, but are stopped in their tracks or “neutralized” if the rate is moved to a positive level of a mere 25 basis points. The effect of a policy interest rate of zero (Fed funds target rate with a supporting IOR) would be only to move comparable market rates such as very short term treasury bills and high quality money market paper to approximately that same 0 basis point rate level (liquidity and minor credit considerations being additional complicating factors in that general zone of rates). This occurs through market arbitrage every time there is a change in the target funds level – QE or no QE. And as I noted above, the IOR has to move consistently with the change in the funds target in order to support it from below when excess reserves are in super-abundant supply due to QE. Moreover, it is generally acknowledged now that central banks who choose to move to a negative rate policy as has been done in some European cases can gain at least some traction in their desired monetary policy in doing so. Accordingly, it makes absolutely no sense to view a rate of 0 basis points as some black hole where banks will start lending like crazy just because they are earning “no interest”. They are earning an interest rate of zero, which is one point in a continuum of possible positive, negative, or 0 rates. The argument that 25 basis points was some especially dark thundercloud hanging over and preventing the potential stimulative effect of a monetary policy that had a choice of 0 basis points is just absurd. The impact of the interest rate on activity is a continuous function. And to repeat a point I made earlier, it is the fed funds rate target that is the overarching policy question, to which IOR in a QE excess reserve environment must adhere and with which it must be consistent.

        • George Selgin

          I've only time now for a quick response to one claim you make, to wit, that "most loans are made by crediting a deposit account at the same bank, and
          many if not most loans are repaid by debiting a deposit account at the
          same bank. Neither of these transactions have a reserve impact." But what generates the reserve impact isn't the granting of credit balances, but the tendency of creditors to draw on those balances, that is, to spend them. You argue here as if borrowers just left their balances untouched until their loans come due.

          • JKH

            I think the memes “loans create deposits” and “banks don’t lend reserves” are overemphasized in the “heterodox” blogging space to the point of being counterproductive, so I really don’t want to overemphasize them here as bones of contention. They are arguably the least important points and the most mundane observations among the issues I have raised. So I take your point and your interpretation by way of example. However, it is a fact that banks lend reserve balances to other banks in the fed funds markets but do not lend reserve balances to bank customers. Non-bank customers are under no obligation themselves to deliver reserve balances in repayment of their loans. It is the customer’s bank – not the customer per se – that has the obligation to make payment in reserve balances in settling a loan repayment that requires an interbank flow of funds. And it is also the case that loans are frequently repaid by bookkeeping entries within the same bank without any involvement of interbank reserve transfers. And it is the case as well that exactly the same type of reserve payment is made in the example of an interbank deposit flow where there is no loan settlement involved, which is an example that points more directly to the functional role of reserves in serving as the medium of exchange used by banks in dealing with each other, rather than by banks in dealing with their customers. And in considering these various permutations I am not arguing that “borrowers just left their balances untouched until their loans come due.” I’m merely stating the facts of how the reserve system operates and who its direct users are, including usage in the case of a loan transaction. Finally, a loan transaction is distinct from the spending of balances from a deposit that may be created by a loan transaction. It is even distinct from the spending that can arise directly from a cheque that is issued by a bank lender where that cheque is settled so as to create a deposit in another bank. But if you prefer to extend the semantics of these various cases to define indirect usage in the case of customers who move their balances around following the actual transaction that constitutes a loan, that is not going to be something that will require a dispute settlement mechanism here. There are far more important ideas swimming around within the subject. And as I say, I’m fundamentally sympathetic to the view that the referenced memes while technically correct are far overdone as themes in certain places in the blogosphere where they are excessively popular.

          • George Selgin

            But I made clear already in the very passage I referred to before that although ordinary bank borrowers aren't after reserves per se, in making loans to them, banks are in effect lending away reserves. This was the whole point of the passage. And it is a standard and perfectly reasonable assumption, common to all the classic treatments of the bank lending process (e.g. C.A. Phillips _Bank Credit_ or Alec Macleod's _Theory of Financial Intermediation_) that bank's borrowers apart from other banks secure loans for the sake of spending the proceeds. Note that in fact most banks charge interest only on drawn balances, and not on lines of credit. It is in that case clearly not the credits per se but the spending of them that defines the extent to which a bank has aqcuired an interest-earning asset, and therefore the extent that it is actually engaged in lending in the strict economic sense.

          • JKH

            I understand your explanation. But a bank loan is not the same as spending from the proceeds of a bank loan. A bank loan establishes a new stock position on balance sheets – a bank asset and a customer liability. Spending is a separate flow event as recorded on accounting income statements. These are different and not necessarily simultaneous events. It is often the case that the timing of spending from deposit created by a loan is different than the timing of the loan creation and the corresponding deposit credit. Also, a line of credit is not a bank loan. A line of credit is an off balance sheet contingency. A bank loan is a balance sheet position representing a follow-on action relative to that line of credit where applicable. Bank charges for loans are different from charges for lines of credit that accommodate those loans, a point you make yourself. These are all facts of distinction.

            Also, there is really no law of banking that asserts that the payee must not have his account at the bank of the payer/borrower. No reserves are involved when that is that case. If the second or third or nth payee down the road banks somewhere else, then reserves get transferred. But that’s disconnected from the loan itself. Similarly on the incoming side when the loan is repaid. Again, this points to the purpose of reserves, which is to make interbank payment for all manner of customer transactions that involve two different banks – not just spending from the proceeds of loans or the repayment of loans.

            Again, this area is not the most important point. I do understand your usage. I also think it helps to make the distinction, but it’s the discussion regarding the difference between bank liquidity management and bank capital management that is more material to the interpretation of QE excess reserves and IOR in my view.

          • JKH

            Further to above:

            I suppose it’s possible to think of the banking system as if loans were always made in central bank currency held in commercial bank reserves. In that case, currency is transported in physical form from borrower/payer to payee. Payees would then use the currency for another commercial transaction or deposit the currency in either the same bank or another bank. If another bank, both banks would take steps to restore their currency reserves to desired levels through various types of asset and liability management. And so on.

            So that works. But it’s not actually what happens, of course. The way it actually happens is that most of the transaction volume in all types does not include the use of physical currency. It involves electronic activity. And even where that electronic activity involves transactions in reserve balances held at the Fed, those reserve balances are not touched by non-bank customers. And other electronic activity involving payments made across the balance sheet of a single bank does not touch electronic balances held at the Fed at all. So there’s a different way of describing what actually happens. There has to be.

            So these are two quite different ways of thinking about it, and that’s the source of the split in the interpretation as far as this minor point is concerned. I’m open to the possibility that the first way of thinking about it is better in some sense. I’ve just never seriously test driven that possibility, since I’ve worked in the industry at a rather intensive level with regard to these issues, which leads me to think of it in the second way. And that works for me.

  • Michael Byrnes

    Thank you for this excellent (though depressing) series of posts.

    One thing I have trouble with as a non-expert is understanding the relative impact of different policies.

    A massive increase in the monetary base is, by itself, clearly expansionary. IOR is, by itself, clearly contractionary.

    How is one to judge the extent to which one offsets the other?

    • George Selgin

      Michael, one gauge is the extent to which QE results in expansion of bank deposits and (on the other side of the balance sheet) bank loans and investments. The hard part is untangling the effects of positive IOR from other factors that might contribute to an unusually high demand for excess reserves. The matter calls for more careful research. I plan to say a bit ore on the topic in my next port.

      • Michael Byrnes

        Looking forward to it!

  • joebhed

    I agree with the many in congratulating you on this article, being really a new high mark for attempts to advance our monetary system central banker understandings..
    But I admit to being just as hung up as the commentor Churchill about banks lending out reserves.'to customers as opposed to other banks'.

    Seeing your reply said you have best laid out your position in this article, I read all the relevant sections I could find again. Then I re-read your reply to Mr. Churchill again.
    But I'm still right here.My thinking is like this .

    Reserves are central bank created and issued inter-bank settlement media, needed to make the payments system work..
    Customers of banks have no account which can recognize or use reserves to buy, spend, or lend, as customers do with money.
    So, while I totally agree with your description of the mis-informing postulations of modern money system commentors, notably a la Ms Coppola, I am at a loss to comprehend the fact that you are attempting to establish by your comment ….. unless it is totally encompassed through use of the term, "in effect", which still leaves me wondering about bank customers activity in the overnight market.
    Thanks again for this excellent posting on the IOR riddle.

    • George Selgin

      Jobhead, in answering Churchill as i did, I was referring to my two paragraphs above beginning with "Well, banking would indeed be a marvelous business," which are specifically intended to explain why lending to bank customers can be understood as lending "reserves," no less than lending on the interbank market can. It isn't a matter of "in effect": the lending bank must have reserves sufficient to cover its marginal lending, whatever form that lending takes.

      • joebhed

        Thanks a lot for the reply. You do an outstanding job of responsiveness on your blog.

        George, with all due (very considerable) respect , sorry but I see nothing that explains the basis of your statement that – banks do … lend "reserves" to customers no less than to other banks.-

        I did not put that in quotes only because I left out the qualifying phrase, “in effect”, after “banks do”.

        The second para of the two you mentioned above merely describes a customer-based banking transaction, and anything that comes close to involving CB reserves comes after ‘pattern of interbank’, so, no longer involving a bank-customer relationship. .

        Within that first para, I still see ‘in effect’ as the saving grace of your explanation, just as your reply comment is only so convincing as the new qualifier “can be understood as”.

        Sorry, George. When postulating adjustments to money system understandings, ‘in effect’, and ‘can be understood as’ do not carry the weight of persuasiveness from my perspective.

        Either banks DO, or they DO NOT lend reserves " to customers no less than to other banks”. And to me the day that banks can trans-substantiate their reserve account balances into customer bank-credit balances will be a scary day indeed.
        I do not believe we are there yet.

        OTOH, I do very much appreciate this excellent post on the lunatic ( we MUST do something ) central bank policy of expanding our taxpayers’ support of the banks at this critical time. More should be said about this inane policy’s effect, being an increase in public debt in order to pay MORE to the banks.

        joe bongiovanni
        The Kettle Pond Institute

  • Rob

    Professor Selgin, this recent discussion with Dr Greenspan will be of interest to you. He discusses Interest on Reserves from the 29 minute mark onwards, refers to their intention as "neutralising the system" i.e. intention was to do exactly as you have described above.

    • George Selgin

      Hi Rob. Have you a URL for the Greenspan talk?

      • Rob

        Hi George, the above link should take you to the video.

        It is an interview at The Council on Foreign Relations and was recently posted to their YouTube Channel. If it still doesn't work please let me know.


  • John Walter and Renee Haltom

    George – Thanks for the discussion of our 2009 Economic Brief. We think a couple of our statements – the primary ones you take issue with – may have been misunderstood:

    (1) We state that the goal of the Fed’s lending facilities was to maintain the flow of credit between banks, and therefore to firms and households. You say this statement is confusing because we had already argued that “the whole point of IOR was… to make sure that the Fed’s additions to the total stock of reserves did not increase that flow” (emphasis in original). We wonder if you are mistakenly reading the phrase “lending programs / lending facilities” – by which we mean to refer to emergency lending during the crisis – as a reference to IOR. Positive IOR would indeed have opposing effects on overall credit than would lending facilities, as described in our piece.

    (2) We note that some observers incorrectly point to large reserves as a sign that the Fed’s lending programs (again referring to emergency crisis facilities) have failed. We argue that this is not true because banks have no control over the total quantity of reserves in the banking system – that is, we are pointing out that it is not the case that total reserves would decrease if banks were to increase lending. We see how our language might have caused confusion, though, in that we note that these mistaken observers often focus on large excess reserves. But our argument was intended to be that banks have no control over total reserves. It might have been helpful for us to have included an additional statement noting that bank lending will, however, affect the mix of excess and required reserves. But in the piece we were not equating reserves with excess reserves as you suggested.

    John Walter and Renee Haltom (née Courtois), Richmond Fed

    • George Selgin

      Thank you for this helpful clarification, John and Renee. My own view is that, had the Fed really been determined to keep credit flowing both among banks and from banks to non-banks, it ought to have stuck to supplying more reserves to the system, whether through emergency lending or by other means, without implementing positive IOR (especially IOER), which only caused banks' demand for excess reserves to increase in step with the increase in total reserves. It is indeed the accumulation of excess reserves, not reserves per se, that points to a failure in the Fed's policies, taking those as a whole. But I am also pretty certain that those who pointed to the piling up of "reserves" as evidence of a problem had "excess reserves" in mind in so doing.

  • Andrew_FL

    George I realize it's been quite a while since this post went up but I only just actually looked into it: what do you mean the word incentivize is superfluous, exactly? Every source I've looked at claims "incent" is a back formation from incentivize-though it is itself a newish word. Every use of "incent" before the 80s appears to be as a name. I'm assuming I'm missing some obvious word that came before both that made coining incentivize unnecessary since I was born well after incentivize came into general use.

    • George Selgin

      Andrew, "incent" is itself a semi-literate formation. Originally we had the noun "incentive" and the verb "incite." "Incentivize" cropped up much later as an unnecessary innovation (unnecessary because it means nothing that isn't meant by other words, including incite, motivate, and encourage, among others.) Incent is therefore doubly damned, as a back-formation meaning the same thing as incentivize, which means the same thing as the other words I've mentioned.

      Language innovations that fill gaps have a purpose; those that merely compensate for the innovators' ignorance are otiose.