Interest on Reserves and the Fed's Balance Sheet

Cato Staff

SelginTestimony(Recently I was invited to testify on the title subject, along with Robert  EisenbeisTodd Keister, and John Taylor, before the House Committee on Financial Services Subcommittee on Monetary Policy and Trade.  The topic is, as loyal Alt-M readers know, one that I have plenty to say about. Here's my written testimony.)

May 17, 2016

Chairman Huizenga, Ranking Member Gwen Moore, and distinguished members of the Committee on Financial Services Monetary Policy and Trade Subcommittee, my name is George Selgin, and I am the Director of the Cato Institute’s Center for Monetary and Financial Alternatives.  I am also an adjunct professor of economics at George Mason University, and Professor Emeritus of Economics at the University of Georgia.  I am grateful to all of you for having granted me this opportunity to testify before you on the subject of “Interest on Reserves and the Fed’s Balance Sheet.”

The Federal Reserve was originally given the authority to pay interest on bank reserves effective October 1, 2011 by the Financial Services Regulatory Relief Act of 2006.  The intent of that step was to increase commercial banks’ efficiency by reducing the opportunity cost they incurred in being required to hold reserves that bore no interest.

The Emergency Economic Stabilization Act of 2008 subsequently accelerated the effective date upon which the Fed might begin paying interest on reserves to October 1, 2008.  The Fed in turn actually began paying banks interest on both required reserves and excess reserves on October 9, 2008.

The rationale behind the early deployment of the Fed’s authority to pay interest on reserves was entirely different from that behind the original, 2006 measure. Interest on reserves was to be relied upon, not as a means for improving banks’ efficiency, but as a new Federal Reserve instrument of monetary control.  Specifically, it was resorted to as a contractionary monetary measure, meant to prevent monetary expansion that would otherwise have taken place as a consequence of the Fed’s post-Lehman emergency lending operations.  As Chairman Ben Bernanke explained at the time:

our liquidity provision had begun to run ahead of our ability to absorb excess reserves held by the banking system, leading the effective funds rate, on many days, to fall below the target set by the Federal Open Market Committee.  … Paying interest on reserves should allow us to better control the federal funds rate, as banks are unlikely to lend overnight balances at a rate lower than they can receive from the Fed; thus, the payment of interest on reserves should set a floor for the funds rate over the day. With this step, our lending facilities may be more easily expanded as necessary.[1]

In his memoir Chairman Bernanke says that “by setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much [emergency] lending we did."[2]

According to Richmond Fed economists John R. Walter and Renee Courtois, Fed officials were concerned at the time that, in pushing the fed funds rate below its target, the Fed's emergency credit injections might end up “increasing the overall supply of credit to the economy beyond a level consistent with the Fed’s macroeconomic policy goals, particularly concerning price stability…. Once banks began earning interest on the excess reserves they held, 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, which would drive the fed funds rate below the Fed’s target for that rate.”[3]

The Fed’s decision had reflected the FOMC’s belief in the days immediately following Lehman’s failure that the inflation outlook was highly uncertain, and that, in the absence of interest payments on reserves, continued emergency lending could well push inflation above the Fed’s 2% target.  In retrospect, the Fed’s fears were tragically misplaced. Instead of assisting it in achieving either its federal funds rate or its inflation target, the Fed’s decision to begin paying interest on bank reserves contributed to a collapse in nominal spending that was already in progress, helping thereby to turn the subprime crisis into a more general macroeconomic downturn.  That the Fed realized that the macroeconomic situation was rapidly worsening even before it actually began paying interest on reserves was reflected in its decision to further reduce its federal funds target, from 2% to 1.5%, on October 8, 2008.  The Fed chose not to reconsider its decision to commence paying banks to hold reserves a day later.

The rapid decline in the growth rate of nominal GDP, from about 3.5% at the start of 2007 to minus 3.3% by the second quarter of 2009, is shown in Figure 1, which also shows the progress of adjustments to the fed funds target and the “effective” federal funds rate, which is the average rate of interest paid on actual overnight loans.  The collapse in spending is ipso-facto evidence that the Fed’s stand was overly tight.  The figure shows that the Fed’s rate target had become more-or-less irrelevant by the third quarter of 2008, and that this continued to be the case after it began paying interest on bank reserves.  The latter policy did, however, reduce the volume of interbank lending and overall credit expansion, contributing thereby to the collapse of nominal GDP.

Figure 1

SelginIORTestimonyFigure1

The Fed’s policy of paying interest on excess reserves, combined with the substantial scale of its post-Lehman emergency lending and the even greater scale of later rounds of Quantitative Easing, led to a massive accumulation of banking system excess reserves.  As Figure 2 shows, excess reserves, which between 2002 and 2008 had seldom exceeded $1.8 billion, had risen to almost $2.7 trillion in August 2014, and as of this April still exceeded $2.33 trillion.

Figure 2

SelginIORTestimonyFigure2

Although some authorities[4] have claimed that the scale of the Fed’s reserve creation alone made a corresponding increase in bank holdings of excess reserves inevitable, that is not correct.  Although the total quantity of bank reserves is largely determined by the Fed’s rather than commercial bankers’ decisions, banks are always capable in principle of reducing their holdings of excess reserves by swapping them for other assets.  Although the swapping does not destroy reserves, it does result in overall growth in the quantity of bank deposits, together with a corresponding increase in required reserves and a like reduction in excess reserves.  Until the third quarter of 2008 this process kept bank excess reserves roughly constant despite steady growth in total Federal Reserve Bank assets and the monetary base; and it might have done the same afterwards had circumstances not been such as to encourage banks to accumulate excess reserves.  Nor did the tremendous scale of the Fed’s asset purchases itself matter: During the notorious Weimar hyperinflation, for example, the growth in total bank reserves far exceeded that witnessed in the U.S. since Lehman’s bankruptcy.  Yet Germany’s banks, instead of accumulating excess reserve, increased their lending and deposit creation proportionately, and eventually more than proportionately, with terrible consequences.

Nor is U.S. banks’ decision to accumulate excess reserves attributable to the panic that followed the Fed’s decision to allow Lehman Brothers to go bankrupt.[5]  Although banks’ fear that their counterparties might be allowed to go bankrupt would make them reluctant to lend to other banks, it alone would not necessarily cause them to decisively favor reserves over low-risk Treasury securities.  Furthermore, as Figure 3 shows, although the TED spread — a widely-used measure of the perceived risk of bank failures, equal the difference between the interest rate on short-term interbank lending and the interest rate on Treasury securities — spiked not long after Lehman's failure, the spread returned to normal levels afterwards, mainly in response to the Fed’s decision to rescue AIG, while banks’ excess reserve holdings did not.  The persistent increase in bank holdings of excess reserves suggest that the payment of interest on such reserves, rather than banks’ reassessment of the risk of counterparty failures, is behind the increase.

Figure 3

SelginIORTestimonyFigure3

Finally, the timing of the substantial rise in banks’ excess reserve holdings, as shown in the next chart, is also consistent with the view that the Fed’s policy of paying interest on excess reserves contributed more to the increase than Lehman’s failure did.  As Figure 4 shows, although banks accumulated excess reserves immediately following Lehman’s failure, most of the increase in excess reserves occurred after the Fed began paying interest on reserves.

Figure 4

SelginIORTestimonyFigure4

Some experts doubt that the very modest return on excess reserves — for most of the period between October 2008 and December 2015 the rate of interest on excess reserves was fixed at just 25 basis points — can have sufficed to induce banks to hoard reserves.  However, banks’ willingness to hold excess reserves depends, not on the absolute return on such reserves, but on how that return compares to the return on alternative liquid and risk-free assets, such as Treasury bills.  As Figure 5 shows, the interest rate on excess reserves has generally exceeded the yield on Treasury bills.  The same figure shows how the volume of interbank loans has tended to vary according to the difference between the rate of interest on excess reserves and the yield on Treasury securities, which can be regarded here as a proxy for market rates more generally.

Figure 5

SelginIORTestimonyFigure5

Because reserves began to bear a higher return than safe governments securities, the demand for those securities did not increase substantially after Lehman’s failure (Figure 6).

Figure 6

SelginIORTestimonyFigure6

As I’ve noted, a desire to prevent its emergency lending from contributing to the availability of federal funds supplied the original inspiration for the Fed’s decision to begin paying interest on bank reserves, so it is no surprise that the policy should have been responsible for the actual decline in interbank lending that took place after Lehman’s failure.  Once they were able to earn interest on their excess reserves exceeding the effective federal funds rate, banks (mainly smaller ones) that until the crisis had generally been net interbank lenders, withdrew from that market, while those (mainly larger ones) that had previously tended to participate as borrowers found it both necessary and no longer onerous to hold substantial quantities of excess reserves instead.

Besides contributing to the collapse in interbank lending, the Fed’s decision to reward banks for holding excess reserves prevented the creation of additional reserves from giving rise to corresponding growth in other kinds of bank credit by short-circuiting of the base-money “multiplier” that normally connects growth in bank reserves to more substantial growth in bank deposits.  As the Figure 7 shows, the M1 multiplier, the ratio of M1 (currency in circulation plus demand deposits) to the monetary base (currency in circulation plus total bank reserves) fell from 1.617 on September 10th to half that value by the beginning of 2010.

Figure 7

SelginIORTestimonyFigure7

The collapse of the money multiplier was in turn responsible for the failure of the Fed’s large-scale asset purchases to give rise to any corresponding increase in bank deposits, bank credit, and nominal GDP.  Instead, banks’ holdings of excess reserves grew almost in lock-step with the Fed’s creation of new base money.  Had banks not been rewarded for holding excess reserves, a much smaller program of Quantitative Easing might have given rise to a much more substantial increase in bank deposits, bank lending, and nominal GDP.

Partly owing to the repressive effect of interest on reserves on bank deposit creation, most forms of bank lending, instead of being revived by the Fed’s creation of fresh bank reserves, remained stagnant or (in the case of Commercial and Industrial Loans) continued to decline long after Lehman’s failure.  Commercial and Financial Lending declined until the third quarter of 2010, as seen in Figure 8.  And although it has made up for lost ground since, it remains well below the level consistent with its pre-boom trend.  Moreover, because the crisis resulted in a large and lasting decline in net “shadow” bank lending to non-financial firms,[6] especially by Money Market Mutual Funds, much of the revival in commercial bank lending has  consisted of lending to corporate borrowers that had previously relied upon funding from shadow banks.  Lending to small businesses has suffered correspondingly.

Figure 8

SelginIORTestimonyFigure8

Banks’ unprecedented accumulation of excess reserves has as its counterpart a very large Fed balance sheet relative to both overall economic activity and private lending.  As Figure 9 shows, the increase relative to GDP is the largest since the World War II era, when the Fed was committed to setting a floor on the governments’ wartime borrowing costs by serving as a “last resort” purchaser of its bonds.[7]  That commitment finally ended with the so-called “Treasury Accord” of 1951.[8]  Although the Fed’s balance sheet reached its highest historical level relative to GDP during the Great Depression, that record mainly reflected that era’s extreme drop in GDP, as opposed to growth in the absolute size of the Fed’s balance sheet.

Figure 9

SelginIORTestimonyFigure9

Substantial growth in the Fed’s balance sheet, combined with the incomplete revival of bank lending since the crisis, has caused the Fed’s overall share of bank-based financial intermediation to triple, as seen in Figure 10:

Figure 10

SelginIORTestimonyFigure10

Such a large increase in the Fed’s role in the allocation of scarce savings is much to be regretted, as it almost certainly means that those savings are not being devoted to their most productive or welfare-enhancing uses.  At best central banks are inefficient financial intermediaries, not the least because efficient intermediation forms no part of their official responsibilities. Instead, their acquisition of interest-earning assets is supposed to be incidental to their tasks of regulating overall monetary conditions and serving as lenders of last resort.  They are, furthermore, generally supposed to avoid exposing themselves — and, indirectly, taxpayers — to loss, and are for that reason expected to fully secure their last-resort loans and to limit their outright asset purchases to safe government securities.  Commercial banks, in contrast, are not similarly constrained, and cannot be if they are to take full advantage of opportunities for productive lending.

Until the recent crisis, the Fed was no exception to the general rules governing central banks.  Before early 2008 Fed assets consisted overwhelmingly of U.S. Treasury bills, notes, and bonds. Since the crisis, however, the Fed’s asset holdings have changed considerably, in ways that generally involve still greater departures from any efficient use of scarce funds, including a substantial increase in MBS holdings and long-term Treasury securities acquired during several rounds of Quantitative Easing (Figure 11):

Figure 11

SelginIORTestimonyFigure11

Although the Fed’s crisis-related asset purchases may have been instrumental in combating the panic and subsequent recession, its continued holding of non-traditional assets long afterwards constitutes a serious distortion in the allocation of scarce capital, including a perpetuation of the very misallocations of which irresponsible private lenders (encouraged in many cases by government policies[9]) were guilty in the years leading to the crisis.

Despite the counterproductive consequences of the Fed’s original decision to employ interest payments on bank reserves as an instrument of monetary control, and the inefficient allocation of savings to which banks’ hoarding of excess reserves contributes, the Fed continues, seven and a half years since the crisis, not only to rely on that new instrument, but to rely on it and changes in the interest rate it offers in its overnight reverse repurchase agreements (ON RRPs) exclusively for monetary control purposes, while dispensing entirely with traditional open market operations.  Its decision to do so, and more specifically, to maintain a positive rate of interest on excess reserves, and even to increase that rate (as it did in mid-December 2015), is to be regretted.

The December rate hike itself appears in retrospect to replicate the Fed’s error of October 2008, when it employed interest on reserves to avoid an unwanted loosening of credit, on the grounds that such a loosening might prevent it from achieving its policy targets.  In electing last December to raise the interest rate paid on excess reserves from 25 to 50 basis points, the FOMC pointed to a “considerable improvement in labor market conditions,” while declaring that it was “reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.”[10]  As of this writing, both core and headline PCE inflation remain below the Fed’s 2% target, while the unemployment rate is again at 5%, its level in October 2015. Many observers have since concluded that the December rate hike was a mistake.

However, it would be more accurate to claim that, while the December doubling of the rate of interest paid on excess reserves was a mistake, the decision to pay 25 basis points on those reserves was a mistake as well.  As David Beckworth has put it in a blogpost on the topic, “The Fed…got ahead of the recovery well before December.”[11]  According to the Fed’s own estimates, as seen in Figure 12 below, the “natural” fed funds rate, which is the rate consistent with a stable level of spending growth and inflation, has been persistently negative since Lehman went bankrupt.  Consequently, in setting a positive funds rate target band, the upper bound of which was determined by the interest rate on excess reserves, the Fed maintained an excessively tight policy.

Figure 12

SelginIORTestimonyFigure12

It is owing to the perception that natural rates in their own struggling economies are also negative that several foreign central banks, including the ECB and the central banks of Denmark, Sweden, Switzerland, and, starting in January this year, Japan, have turned to charging rather than paying interest on bank excess reserve holdings.  The step has been controversial, and its consequences have not clearly fulfilled the hopes of those central bankers that have resorted to it.  However, regardless of its merits the policy turn raises obvious questions concerning the Fed’s decision to continue pursuing its opposite strategy.

Besides contributing to what may have been an excessively tight policy stance, the continuation of interest payments on excess reserves also serves to perpetuate the Fed’s unusually heavy involvement in the allocation of savings, and the consequent mal-investment of those savings.

The alternative to continuing the present policy is, of course, to dispense with interest payments on excess reserves while restoring conventional open market operations as the Fed’s primary instrument of monetary control.  Restoring efficient credit allocation in turn means reducing the size of the Federal Reserve’s balance sheet both absolutely and relative to that of private intermediaries.

For the Fed to do all of these things while maintaining a proper monetary policy will be challenging.  But for it to avoid taking these steps is for it to continue to contribute to the economic malaise that has made for a slow and still unsatisfactory recovery from the 2008 crisis.  And although the task of normalizing monetary policy may be difficult, it is hardly impossible.  The phasing-out of interest on excess reserves, together with the lowering of interest payments on ON RPPs, will help to revive the money multiplier, thereby not just allowing but necessitating a compensating unwinding of the Fed’s post-crisis balance sheet.  If it isn’t to disrupt markets the unwinding must be both gradual and anticipated: one proposal would have the Fed begin by committing to sell $4-$5 billion in short-term Treasuries each week.[12]  Such a sale would, incidentally, more than make up for the reduction in Fed interest payments to Money Market Funds, by returning to the marketplace securities that such funds have long been craving.

Having the Fed return to its pre-crisis policy of zero interest on excess reserves does not mean forgetting the arguments that supported the 2006 legislation that originally granted the Fed the right to pay interest on reserves.  However, meeting the spirit of those arguments requires only that the Fed be able to pay interest on banks’ required, as opposed to their excess, reserves.  So long as excess reserves bear no interest, banks have little reason to accumulate them, and would therefore suffer little from the inefficiency connected to their slight holdings.  Economic efficiency is in any case better enhanced by encouraging banks to put excess reserves to use, than by paying them to hoard such reserves.

___________________

[1] (http://www.federalreserve.gov/newsevents/speech/bernanke20081007a.htm)

[2] (Courage to Act, pp. 325-6).

[3]https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_brief/2009/pdf/eb_09-12.pdf

[4] See, for example, Todd Keister and Gaetano Antinolfi, http://libertystreeteconomics.newyorkfed.org/2012/08/interest-on-excess-reserves-and-cash-parked-at-the-fed.html#.Vzog6ORGR2A

[5] This claim has been put forward by Alex Cukierman, among others.  See “U.S. Banks’ Behavior since Lehman’s Collapse, Bailout Uncertainly and the Timing of Exit Strategies.” Working paper, August 30, 2014.

[6] See Joshua Gallin, “Shadow Banking and the Funding of the Nonfinancial Sector.” Working paper 2013:50, Federal Reserve Board.

[7] The chart comes from Lowell R. Ricketts and Christopher J. Waller, “The Rise and (Eventual) Fall in the Fed’s Balance Sheet.” The Regional Economist, January 2014, Federal Reserve Bank of St. Louis.

[8] A still larger ratio during the Great Depression mainly reflected the tremendous GDP collapse of that episode rather than of absolute growth in the Fed’s size.

[9] See Peter Wallison, Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again. New York: Encounter Books, 2015.

[10] https://www.federalreserve.gov/newsevents/press/monetary/20151216a.htm

[11] http://macromarketmusings.blogspot.com/2016/02/the-fed-did-not-make-mistake-in-december.html

[12] http://www.ft.com/cms/s/0/520377e8-037e-11e5-b55e-00144feabdc0.html#axzz48p3YArDG.  See also Norbert Michel (http://www.heritage.org/research/reports/2014/08/quantitative-easing-the-feds-balance-sheet-and-central-bank-insolvency), who proposes that the Fed take until 2020 to sell 75% of its long-term securities and MBS, at a rate of $45 billion each month, while holding the other 25% until they mature.

  • Michael Byrnes

    Think any of them listened to you?

    • George Selgin

      I'm pretty sure that some actually did! I'm equally certain that others didn't: it's politics, after all. Still the turnout was good as such things go, and it gave me an excuse to write-up my thoughts.

  • As long as 95 million working age Americans being completely out of the workforce = full employment and S&P 500 > 2,000 is the primarily policy objective Gosbank ministers maintain current policy for glory of mother US of A.

  • Dan Thornton

    George has done a nice job of
    reviewing the FOMC’s motivation for IOER, but his analysis doesn't explain why
    banks are holding such a massive amount of excess reserves. I argue elsewhere,
    (http://dlthornton.com/images/services/The%20Feds%20Monetary%20Policy%20Excess%20Reserves%20and%20Excessive%20Risk%20Taking.pdf)
    that banks have an incentive to make loans and investments whenever the
    risk-adjusted rate of return on such investments is higher than the IOER. While
    the IOER has frequently been above the 3-month T-bill rate, it has been below
    longer-term Treasury rates and well below banks’ prime lending rate, so why
    haven’t banks run their holding of excess reserves to the tertiary level prior
    to Lehman (about $2 billion)? The main reason they haven’t is that they find it
    difficult, essentially impossible, to make that many loans or investments. The
    bank lending multiplier is approximately 10, which means that banks would have
    to increase their lending and investments by about $23.2 trillion to reduce
    excess reserves to their pre-Lehman level. As I point out in the essay cited
    above, banks have increased their required reserves by nearly $44 billion since
    September 2008, which supported a $1.7 trillion increase in lending, which is
    nearly 40% of the total lending during the 14-year period from 1994 through
    2007; a period when economic growth was more than twice as strong. Banks have
    also massively increased their investments by historical standards.
    Nevertheless, as George has pointed out, they still holding $2.3 trillion in
    excess reserves. Conclusion: Banks are holding massive amounts of excess
    reserves, in spite of aggressive efforts to reduced them, because they simply
    cannot make enough loans and investments—they are holding them because,
    effectively, they have to.

    • George Selgin

      If desire not to part with reserves isn't keeping banks from buying other assets, even when other assets earn more interest, as you say many do, what is? It can't simply be the fact that they would have to buy a very large amount of such assets in order to turn the excess reserves into required ones: every hyperinflation shows that banks usually are able to handle in this way any amount of nominal reserves sent their way. (In the Weimar case, the Reichsbank's increase in B was about the same magnitudes as the Fed's this time as of August 1922; after that it was many times greater. Yet the banks weren't seen hoarding excess reserves–they lent them all away, with notorious consequences.

      • Dan Thornton

        Yes, but this was a cash economy. Loans were made, money was created, and inflation accelerated reducing the indebtedness. We are not in a cash economy. Loans were made the M1 more than doubled since Sept. 2008, but inflation remains subdued. It's a different world. My point is $22 trillion is a really big number. Yes, if the IOER was zero or worse yet negative, banks would work even harder to make loans and investments, many of which would undoubtedly be more risky than the ones they have made thus far, but they will find it virtually impossible to make $22 trillion worth.

        • Though they may have been running around Germany just prior to the event saying something similar, that $22 trillion was alot of money, when in short order it was not enough to buy a bagel.

          • Dan Thornton

            Yes, and if we get high inflation, the same will be true here. But that hasn't happened yet. While I inclined to believe that the inflation may be heading up over the next year, we'll still be able to purchase a whole lot of bagels with $22 trillion.

      • Vich

        George, to answer your question "If desire not to part with reserves isn't keeping banks from buying other assets, even when other assets earn more interest, as you say many do, what is?" The answer is credit risk. Banks aren't going to make loans and give away their reserves to just anybody without evaluating the likelihood of getting their money back. Bank profit margins are already low, if a bank starts making risky, bad loans they will not survive long.

        This shouldn't be a surprise after a financial crash. Banks always restrict credit after they've been burned. Banks would love to earn more than 25 or 50 basis pts on their assets; they're just not willing to risk it on sub-660 FICO score borrower. And, again this shouldn't be a surprise, but after a financial crash, many potential borrowers have impaired credit. Banks don't make loans based on how many reserves they have; they make loans based on their risk appetite and the credit quality of the borrowers.

        And I'd also like to hear your response as to why Japan (and others) had such an increase in excess reserves even without paying IOER.

        • George Selgin

          I think we are perhaps talking past one another, Vich. I agree with all you say about risk etc. My point is not that other interest rates cannot be so low as to cause banks to accumulate excess reserves even when they bear no interest (though this is a very rare thing). It is, rather that the lower other (risk adjusted) rates are, the greater will be the effect on banks demand for excess reserves of any given absolute increase in the rate paid on excess reserves. How many profitable loans might be made, given generally low margins, were the alternative that of earning 0 basis points of net profit per dollar of cash assets rather than 50? My priors tell me that that could be quite a big number, when we are talking about net interest margins of just a few percentage points, from which all the costs of lending apart from the interest paid for lent funds must then be deducted. (I only wish that someone would look into it.)

          I hear all the time, by the way, that "banks don't make loans based on how many reserves they have." The claim is a mere exercise in semantics. Banks don't look at reserves when lending; they are not conscious of lending reserves. Yet lending $X necessarily adds approximately $X to a bank's net clearing losses, ceteris paribus. Of course banks are anticipating inflows to cover those losses. But in the end it simply isn't true that banks can lend whenever they see a good prospect without arranging to fund the loans. A banker will say that banks "lend" deposits, not reserves. But this is just different language expressing the same underlying ideas. Acquiring deposits is the same as acquiring reserves, even if the bank never sees the reserves because other actions put them to use before they can actually accumulate beyond desired levels.

          • Vich

            OK… I think I agree with most of your response, except our priors are different. While I do think a net positive number of profitable loans would have been made had the FFR been 25 or 50 basis pts lower, I just don't think it would have put too much of a dent in the amount of excess reserves out there. The growth rate of M1 since 2008 has already been far steeper than the previous 30 years, and we're still left with $2.3 trillion of excess reserves. A lower IOER would have helped a little, but I concur with Dan Thornton above on this point.

            I agree with much of your semantics point too. I suppose where I stray from your logic is that I don't believe the massive increase in the monetary base gave banks any more room to lend than they otherwise had. The Fed has always supplied the amount of reserves demanded by banks for clearing purposes. The important variable for bank lending is always the PRICE of reserves, and we agree that the Fed set this price too high given the circumstances.

            Why don't you think the Fed selling $4-$5B of short-term Treasuries each week would be as contractionary as IOER? The sell off would raise other market rates wouldn't it?

          • George Selgin

            The thing to look at is growth in bank deposits, rather than M1, which includes currency. So: between September 2008 and April 2013, total deposits increased 40%–much slower than the rate before the crisis. Excess reserves, on the other hand, went up about 1000%! And Dan is wrong to suggest that, because proportionate expansion would have involved a huge increase in deposits, it couldn't happen! He's wrong for two reasons: first, he neglects that, had the multiplier been working, the Fed would not have dared acquire all those assets, and wouldn't have had any reason to do so to achieve its target. Second, if the Fed had done so, despite a lack of IOER to suppress the money multiplier, there's no reason to assume that the banks would not have responded as banks have tended to do in every episode of hyperinflation.

            Indeed, as the Fed why they need IOER now, and they will say that they need to be able to raise it still further in an increase in other rates should lead to a revival of the multiplier and consequent inflation, their position being that the alternative of asset sales would be too disruptive. Well, if raising IOER can keep the multiplier down, then surely having it at all does the same!

          • Vich

            Good point about M1 and bank deposits, but where are you getting that 40% growth figure? According to FRED, total demand deposits have skyrocketed since 2008 [https://research.stlouisfed.org/fred2/series/DEMDEPSL].

            In your testimony you say "Until the third quarter of 2008 this process [banks swapping excess reserves for other assets] kept bank excess reserves roughly constant despite steady growth in total Federal Reserve Bank assets and the monetary base." But it wasn't bank lending that kept excess reserves roughly constant, it was the Fed's open market operations. Banks would make loans to satisfy their risk appetite, and the Fed's trading desk would respond through daily asset purchases or sales in order to provide enough reserves to clear all payments and meet reserve requirements. If the Fed provided too many reserves, the FFR would drop below target; if it provided too few, the rate would rise above target. The Fed would respond accordingly to provide the amount demanded by banks to keep the FFR on target. Over time, bank lending grew, requiring an ever increasing base to stay on target, always with a small cushion of excess reserves. Once the crisis hit, the Fed began emergency measures pumping in liquidity and providing way more reserves than banks demanded, pushing the FFR towards zero. The drastic rise in excess reserves began in Aug of 2008 and then picked up pace in Sept 2008, BEFORE the Fed began paying IOER on Oct 9, 2008 [https://research.stlouisfed.org/fred2/series/EXCSRESNS].

            I think we differ in our view of the money multiplier. Do you view it as a causal mechanism (i.e. an increase in reserve balances causes an increase in bank lending, ceteris paribus)? That's how I'm reading you, so correct me if I've misinterpreted. I see it, at best, as merely an ex post accounting truism. At worst, it's a highly misleading account of how the central bank influences bank lending. Viewed as an ex post accounting identity, it's no surprise at all the multiplier dropped along with the massive asset purchases and increase in reserves, with or without IOER.

            Could you explain, in detail, what you think banks would have done if the Fed had not paid IOER? Would banks have dropped their lending standards in order convert their excess reserves into required reserves? Why? Would depositors have flocked to their banks demanding cash? Why? I think rates across the board would have been slightly lower (<.25%) than they have been, which would have expanded lending a bit, but nothing close to hyperinflation. And we have a perfect empirical example of just this…Japan! The BOJ conducted huge asset purchases and did not pay IOER and no hyperinflation… not even close! The classic cases of hyperinflation involve breakdowns of political authority, collapse of economic production, and debts owed in foreign currencies, before the money printing begins. None of these characteristics were present in the US.

          • George Selgin

            Vich, quickly as I have a full plate today, (1) my 40% figure refers to total deposits, not just demand deposits. You will see that it is correct; (2) I address the timing of IOER and excess reserve growth above; see especially figure 2; (3) you are entirely wrong that Fed open marker operations are what kept banks from holding excess reserves before 2008. The decision to accumulate or not accumulate such reserves is entirely up to the banks; the Fed only controls total reserves, not excess reserves. I also specifically point out that, where this not the case, instead of causing corresponding (or even more-than-corresponding) hyperinflation, massive base-money expansions in Weimer Germany, present Venezuela, and elsewhere, would have led to corresponding build-up of excess reserves.

          • George Selgin

            I will add that the references you make to the 'special conditions" in hyperinflations only refer to the very last, break-up phases of such. My point applies to earlier stages as well. In Weimar Germany the factor increase in B up to August 1922, well before the break-up phase, was about the same as in the U.S. since 2008. Yet there was no build up of excess reserves.

            Japan's case proves, not that IOER doesn't encourage banks to hoard reserves, but that it is on rare occasions possible that banks will hoard reserves even in the absence of IOER. Once AD is allowed to collapse, as it did in the US in part thanks to IOER, then demand for loans collapses as well, causing equilibrium rates to decline. IOER has been responsible, directly for an increase in the return on reserves, and indirectly for a decline in the return on all other assets. Those who would attribute high excess reserve demand to the latter factor only neglect that it and IOER are not independent.

          • Vich

            I really appreciate you taking the time to respond, especially given your busy schedule. Nonetheless, you're missing the point about (3). You're right that an individual bank could decide to accumulate excess reserves, but if enough banks did this, then one of three scenarios would occur: 1) if banks reduced lending and excess reserves increased, then the FFR would drop below target. The Fed would respond by conducting open market sales, sucking out the excess reserves to maintain their target rate, or 2) the Fed would lower their target rate in order to stimulate lending and deposit growth, thereby, turning the excess reserves into required reserves. Or 3) if banks just started hoarding excess reserves and refusing to lend them at the target rate, then the FFR would rise since some banks would be left short, and the Fed would respond by conducting open market purchases providing the demanded reserves to maintain their target rate. So in this latter case, the private banks would force the Fed's hand to supply more excess reserves, but outside of a liquidity panic, why would a bank ever do this if they're not remunerated for holding the reserves? Prior to 2008 banks were devising creative ways (sweep accounts) to hold fewer reserves.

            If you don't take my word for it, try the Keister paper you link to above. He says "Prior to 2008, when the interest rate on excess reserves in the U.S. was zero, the Fed needed to create a scarcity of reserves to keep market interest rates positive. The Fed did this by supplying just enough reserves for banks to meet their minimum reserve requirements. Because reserves were scarce and individual banks constantly faced the possibility of falling below their reserve requirement, banks were willing to pay a positive interest rate to borrow reserves from one another. By controlling precisely how scarce reserves were, the Fed could effectively control the interest rate in this federal funds market (p4)."

            I would argue that, prior to 2008, the Fed controlled excess reserves directly (with OMOs), but only controlled total reserves and required reserves indirectly (by influencing bank lending through interest rate adjustments). Since 2008, the Fed directly controls total reserves and excess reserves with OMOs, and indirectly controls required reserves with IOR.

          • George Selgin

            Vich, I know the Keister paper you refer to all too well: I criticize it in an earlier post. (http://www.alt-m.org/2016/01/05/interest-reserves-part-ii/) Moreover, in subsequent exchanges with Todd, I was left in no doubt that my criticisms were sound when Todd claimed that while my logic was right it would not apply if the growth in B was sufficiently large. That's when I first had occasion to bring up hyperinflations, all of which offer evidence contradicting that claim.

            I don't get your scenario in which banks deciding to accumulate excess reserves _lowers_ the FFR. That seems the opposite of what would happen. Certainly the Fed believes that encouraging banks to hold reserves (increased IOER) serves to raise, not lower, the FFR.

          • Vich

            Are you confused about my scenario #1) above? Remember, I was describing the pre-2008 world. As Keister says, the Fed would keep reserves scarce, providing just enough required reserves, with a slight cushion of excess reserves. If excess reserves increased, then banks holding the excess would bid the FFR down because lending them overnight for anything above zero, that which they would earn by holding them, would be a net gain. So it was simple supply and demand: the increased supply of excess reserves would lower their price on the overnight market. But because the Fed targeted the FFR, the Trading Desk would intervene on a daily basis, in this case reducing the excess reserves, to ensure there was an equilibrium amount, which usually meant just slightly above zero.

            In the post-2008 world, the Trading Desk does not need to intervene in the supply of excess reserves to maintain the FFR target because reserves are no longer scarce. The Fed now sets the floor of the FFR at the rate of IOER (except for the problem posed by the GSEs, but I'm simplifying for now). Banks will not lend reserves to other banks overnight at less than the rate they will earn by just holding them. It isn't so much that the Fed is encouraging banks to hold reserves, which then raises the FFR, as you say. That gets thing backwards. The Fed now directly raises the FFR by raising the rate of IOER, which then raises other interest rates, which reduces commercial bank lending, which slows the conversion of excess reserves into required reserves.

            You're right that if the rate of IOER was lower, excess reserves would convert into required reserves more rapidly (because lower rates would make more borrowers credit worthy), but it would not lead to anything close to hyperinflation. You seem to think that the closest examples (Japan and current European countries not paying a positive rate on IOER) are outliers, but I think your cases of hyperinflation are really comparing apples to oranges. I'm not sure why you think my 'special conditions' only refer to the very late, break-up phases. All of my conditions were present in Weimar Germany prior to 1922: breakdown of political authority – the Weimar Republic, established in 1919 by revolution never had widespread public support in Germany, especially in the early years; collapse of economic production – the war had decimated German industrial and farm production, trade was curtailed by the Treaty of Versailles in 1919, and its most productive sector in the Rhineland was occupied by the French during the inflation years; debts owed in foreign currencies – all German debts had to be paid in gold or foreign currencies; the Reichsbank had to purchase foreign currency to buy back German govt' debt. I don't see these as special conditions; these are necessary conditions for hyperinflation. Not a single one of these applies to the US.

          • George Selgin

            Vich, I never said that without IOER we would have had hyperinflation. I used the hyperinflation examples to make the point that the mere scale of reserve expansion alone cannot account for the extent to which _excess_ reserves have accumulated.

          • George Selgin

            My proposal, Vich, is to have the Fed sell Treasuries while simultaneously lowering IOER. So I am counting on a revival of the multiplier to offset the Treasury sales. As I say above, keeping IOER at a level consistent with the fed's policy objectives while also selling of securities will be challenging. But then again, keeping the IOER rate right is already a challenge.

        • George Selgin

          Here, Vich, to further support my position, is a paragraph I have just added to an extended version of my testimony that I'm preparing for late, separate publication:

          "A look at the distribution of excess reserves holdings supplies further
          evidence that what appears to be a very modest return on such holdings can have a very big influence upon banks’ willingness to add to them. As Robert Eisenbeis notes in his testimony on interest on reserves before the House Subcommittee on Monetary and Trade Policy, U.S. subsidiaries and affiliates of foreign (and mainly European) banks presently hold 40% of all U.S. excess reserves (the figure was once as high as 50%), despite accounting for only 10% of total deposits. According to Eisenbeis, the reason for this is that, while larger U.S. banks are subject to an FDIC assessment of over 15 basis points based upon their total assets (up from 10 basis points before December 2015), foreign banks are not. Consequently, while the U.S. affiliates and subsidiaries of foreign banks now realize a return on their excess reserves equal to the full 50 basis points paid by the Fed, and can (thanks to negative policy rates in some countries) earn as many as 90 basis points by depositing funds borrowed from their central banks at the Fed, U.S. banks earn a net return of only 35 points. Obviously, if a cost difference of just 15 basis points can inspire such a large discrepancy between foreign and domestic banks’ demand for excess reserves, the difference under the same circumstances between the quantity of excess reserves demanded when those reserves pay a gross return of 50 basis points, or just 25 basis points, and the quantity that would be demanded if they paid nothing at all, must also be substantial."

    • George Selgin

      It is, by the way, not the gross rate on loans that should be compared to IOER, but banks net interest margin on them, which is much lower. Remember IOER is costless income: no loan supervision, no paperwork, no capital, no muss, no fuss. Just a "check' from the Fed.

    • The Fed does not want the banks to lend the excess reserves and the rate they have set on excess reserves ensures this. Otherwise, if banks could earn more after netting all costs, banks would lend it, all of it. What you are saying is banks are passing up opportunities to make money, against their own self interest. For what reason? It's a clever strategy really keep rates low, drive up asset prices and hold down lending and ultimately inflation.

      • Dan Thornton

        I'm not saying that at all. Banks have made massive amounts of loans but $22 trillion is a large number. Indeed, it seems likely that they in their desire to ride themselves of excess reserves, they have likely made more risky loans than is wise. Remember too that they are somewhat limited by regulations.

        • Your point is well taken that $22 trillion is a big number. Whether due to lack of profitable ideas or simply not enough good ideas period, the reality is that there never was any intention for the asset purchases to generate anywhere near that much in new credit. To your point I think, the Fed may not even need to pay IOER, though it appears not a chance they are willing to take.

          • Dan Thornton

            Yes, my point is that banks would be holding large amounts of excess reserves even if the IOER was zero.

    • George Selgin

      Remember that, IF the deposit multiplier would have been even twice what it became as a result of IOER, that would have meant a much larger impact of any given value of Fed asset purchases on D, M, MV, and Py, that is, aggregate demand. As aggregate demand rises, so does the demand for credit of all kinds. Although it is true that, for a given overall level of credit demand, good loans would probably have been exhausted well before loans rose by $10 trillion, let alone twice as much. But the more demand rises, the greater the expansion of loans possible without running out of good ones. So everything hinges, in short, how how much more effective QE stimulus would have been in the absence of IOER. If it had been sufficiently so, the a relatively small scale of asset purchases might have been sufficient to restore AD, with the full multiplier again coming into play.

  • Vernon L. Smith

    George: Suppose you just told the Committee that the Fed policy on excess reserves boiled down to paying the banks not to lend money.

    • George Selgin

      I'm pretty sure I said something very close — I believe my words were "paying banks to hoard reserves instead of lending — in my spoken testimony. There I particularly emphasized the fact that IOER is a contractionary measure. Others spoke of IOER as a "subsidy." That's not exactly wrong; yet people find it hard to see why the subsidy was also a contractionary measure.

  • Representative Agent

    I don't understand. Surely you're not claiming that interest on reserves prevented the money multiplier from operating? We have lots of evidence that excess reserves pile up without positive IOR: look at Japan during the 2000s, or the various central banks that now have *negative* interest on reserves.

    The theory behind this is simple. The "money multiplier" relation holds with near-equality as long as excess reserves are costly, i.e. as long as the interest paid on excess reserves is below the interest rate that prevails in money markets. Once excess reserves are injected into the system, equilibrium is obtained when the money market interest rate falls to (roughly) the IOER rate, which is what has happened with every central bank that has tried it.

    That's it. The central bank has no ability to force a "money multiplier" to hold otherwise, and IOR certainly didn't stop anything.

    [By the way, I remember being frustrated in arguments like these several years ago, when the only empirical counterexample against the "but the money multiplier would hold, if only not for the pesky IOR" argument was Japan during a portion of the 2000s, and most people didn't even remember that. But now there are a lot of empirical counterexamples – surely you must see the writing on the wall for this position now, right?]

    • George Selgin

      Representative Agent, I am confused by your comment: surely IOER reduced the cost to banks of holding excess reserves, and to that extent, according to the very theory you outline in your second paragraph, reduced the money multiplier. No one claims that central banks can "force" a multiplier of any particular value to obtain. But by altering the cost of holding reserves relative to that of not doing so, they can influence the value of that multiplier.

      The very fact that several central banks, including Japan's, have turned to negative rates, reflects those authorities' own belief that the rate of interest paid on excess reserves is an important determinant of the demand for such reserves and, consequently, of the equilibrium money multiplier. There is much controversy concerning whether or not negative reserves have in fact had the stimulus effect that those authorities anticipated. But it is by no means clear that they worked other than as the simple theory predicts. On this see Scott Sumner's recent EconLog post, http://econlog.econlib.org/archives/2016/03/the_medias_blin.html

      If negative rates are expansionary, positive ones are contractionary. And that can only be understood to mean the the former boost, while the latter suppress, money multipliers.

      • "If negative rates are expansionary, positive ones are contractionary. And that can only be understood to mean the the former boost, while the latter suppress, money multipliers." As always boiling it down to the fundamental truth. Thank you George.

    • George Selgin
    • Surely, if tomorrow the Fed announced it was now paying 10% IOER the money multiplier would be impacted negatively. If the Fed stopped paying IOER, there would be a positive impact. It is all relative. The fact is that the Fed is paying greater IOER than what banks currently perceive their potential net gains to be buy putting those reserves to work.

  • Market Fiscalist

    I was thinking about what would happen if a CB decided to target a high level of NGDP growth while (for some reason) they had to pay positive IOR.

    If the CB was aggressive enough in pursuing its policy – saying for example that any NGDP undershoots will be compensated for by NGDP overshoots in future years – then I believe they would hit the target even with IOR.

    I therefore conclude that the 0.25% IOR paid since 2008, while causing bank lending (and other bank asset purchases) to be lower at any point in time than it would have been without IOR, had a relative minor effect in the general scheme of things, beyond being a symbol of the half-hearted nature of the feds response to the crisis – which focused mostly on the need to accommodate the public's desire to store wealth in money form, and the desire to provide the bank with a source of profit in troubled time, rather than the need to use monetary policy to get the economy out of recession.

    • George Selgin

      Market Fiscalist, I am not at all as sure as you are that a Fed commitment to NGDP level targeting would have allowed it to achieve it's targets even with IOER. Fresh reserves can only contribute to increased spending to the extent that they aren't hoarded as excess reserves. A Fed commitment of the sort you are contemplating might therefore have led to a still greater accumulation of such reserves than has actually occurred. And there is, for reasons I summarize in this post, nothing "minor" about the consequences of such a massive increase in both the absolute size of the Fed's balance sheet and its relative share of bank-based financial intermediation.

      Bottom line: without IOER the Fed might have restored NGDP with much less Quantitative Easing, and therefore without creating the many problems that a gigantic Fed balance sheet now poses. That seems to me a very serious consequence of the Fed's misguided decision to reward banks for not-lending in the middle of a severe contraction.

      • Market Fiscalist

        I struggle to fully believe that if everything else had been the same and the only difference was no IOER, that the disastrous fall in NGDP could have been avoided and with less money creation than actually took place, but am happy to defer to your vastly superior level of expertise in this area.

        However, if the fed had committed to an NGDP target, and had further committed that it would make up any shortfall against the target in future years , then this would in effect have been committing (if necessary) to higher inflation in future, which New Keynsians (like Paul Krugman) have accepted is a sufficient condition for "conventional" monetary policy to work even at the ZLB. This is the basis for my claim that an aggressive and credible NGDPLT could have succeeded even with IOER in place (though clearly IOER would still have been sub-optimal).

        • George Selgin

          "I struggle to fully believe that if everything else had been the same
          and the only difference was no IOER, that the disastrous fall in NGDP
          could have been avoided."

          Dagnabbit, I never said that! I said that the collapse could have been avoided with a much smaller value of Fed asset purchases. The point is simple: the bigger the multiplier, the smaller the increase in B has to be to result in any given increase in M and hence in MV=Py.

          • Market Fiscalist

            Apologies , I genuinely misinterpreted what you wrote. Of course I agree that with no IOER then the multiplier would be bigger, and more achieved with the same level of asset purchases..

          • George Selgin

            No worries, MF!

    • "which focused mostly on the need to accommodate the public's desire to store wealth in money form" Perhaps initially and for a very brief time this might have been the case, but a run up in stock and bond prices was and remains proof positive that the public has no overwhelming desire to hold cash. The asset purchases were made to create a wealth effect, which is btw documented in Fed minutes. Mission accomplished, for now.

      • Market Fiscalist

        'a run up in stock and bond prices' seems an almost certain side-effect of the public's desire to store wealth in money form and the CB accommodating it by swapping assets for new money!

  • Andrew_FL

    Figure 12 is very difficult to make heads or tails of with such large error bars, but the implication of the chart seems to be that the natural rate was about zero in the early 2000's, indeed, eyeballing it, that monetary policy has been continuously too tight for the last 20 years at least. Forgive me for saying this but that doesn't pass the laugh test!

    • George Selgin

      Well, leave alone the low estimates, then. The higher ones are at least not obviously laughable. Assuming they are roughly correct, the post-2008 period is unique.

      I do not by the way insist that any of these estimates are correct. I do believe, though, that if the Fed itself thinks that they are, that fact is hard to reconcile with its interest-on-reserves policy.

      • Andrew_FL

        Fair enough, I can agree with that.

  • Benjamin Cole

    Of course, excellent writing and blogging, even if I disagree here or there.

    I hope George Selgin devotes a post to helicopter drops, especially the money-financed fiscal program variety, now touted about by Lord Adair Turner. A guy with a name like that deserves deference, no?

    Anyway, would helicopter drops work in the here and now? I think so.

  • Benjamin Cole

    Oh, btw, I agree with Dan Thornton, my erstwhile nemesis, and his comments below!

  • To Alt-M:

    It is amazing how many smart conservatives argue against the Fed's power to pay interest on reserves. Consider an alternative view. George's comment begins by stating his view for the rationale for paying interest on Fed reserves. "[I]t was resorted to as a contractionary monetary measure, meant to prevent monetary expansion that would otherwise have taken place as a consequence of the Fed’s post-Lehman emergency lending operations."

    In support of that statement, George quotes Bernanke. In fact, however, his Bernanke quote says the exact opposite: "With this step, our lending facilities may be more easily expanded as necessary."

    THE CLEAR PURPOSE OF GRANTING AUTHORITY TO PAY INTEREST ON EXCESS RESERVES WAS TO LET THE FED "DO ITS JOB" AND LIQUEFY THE SYSTEM WHEN NEEDED. It let the Fed draw funds from banks around the country that had previously (since 1913) flowed (at lower rates) to a few large banks. Thus paying interest on reserves helps counter the large bank monopoly.

    After Lehman failed, the same thing that happened in the Great Depression happened again. All private sector funds flooded into Treasuries and deposits at a few VERY large banks (primarily JPM). As a result, the Fed was "strangled" with the inability to fund expansionary policies to the extent necessary to rebalance bond markets.

    In short, therefore, the power to pay interest on reserves was essential to providing the Fed a funding source for expansionary liquidity, NOT a "contractionary" move (though it could later be used to do that as well if and when we ever face inflationary trends). More, whether the reserves were required or not seems to be irrelevant. Indeed, while George says that interest should only be paid on required reserves, in fact the opposite seems to be the case if you consider why the Fed needed to attract the cash in the first instance.

    The proof if its effectiveness is in the statistics surrounding the implementation of that power. Movements in Fed Funds rates at the time the provision became effective is complete proof that its expansionary impact was necessary and correct. Near the end of the very first day the Fed accepted reserves that bore interest, the Fed Funds rate went absolutely bonkers. It skyrocketed right before the window closed.

    A lobbyist friend in DC called in a panic. Bank clients were telling him that the result of letting the Fed pay interest was calamitous. We subsequently learned that the reason for panic was, as usual, "stupidity" among a few traders at a few large bank trading desks. Arrogantly, they had doubted that correspondent banks would "abandon them" for the measly rates that the Fed offered to pay that day.

    WRONG!!!! Markets were in panic. By paying just a tiny return, the Fed was drawing funds in amounts that made the major banks' "offering" rates too low in the context of the flight-to-quality liquidity trap into which the Bush admin had plunged the nation.

    Caught short, the trading desk "dummies" had to pay huge overnight rates to get the last amounts of necessary funding to balance accounts as the Fed funds market was closing. They had placed their banks in an overnight squeeze by their own misguided hubris. Rather than admit stupidity, of course, they called lobbyists and tried to blame TARP.

    SURE ENOUGH, THOSE SAME "DUMMIES" BECAME A LOT SMARTER THE NEXT DAY.

    The next day, big bank trading desks that had been squeezed began to price with the Fed's rate in mind. All excesses of the first day evaporated. From that day on, the Fed had a "perfect" tool by which to moderate and modulate aberrant market conditions. Just like every other bank, if the Fed needs funds to balance its own cash needs (for expansion or contraction), all it has to do is "tweek" its reserve rate (up to raise funds and down to reduce them).

    With proper use of forward and reverse repo transactions, moreover, the Fed can address its own needs while having no impact whatsoever on the monetary aggregates that matter (M-1 and higher–M-0 having no impact whatsoever on the productive sector). There will, of course, be occasions when the Fed "slips" in the exercise of this power, but having that power also means the Fed can instantly correct any such "slip."

    One ought not start a discussion of the payment of interest on Fed reserves with 2006 (as George did). The discussion of this problem among modern economists began with Milton Friedman and Anna Schwartz in their seminal 1963 treatise. Friedman & Schwartz noted that the inability of the Fed to pay interest on excess reserves precluded the Fed from attracting those "excesses" away from being deposited at a few NYC banks (like JPMorgan) that consolidated such reserves from correspondent banks around the nation by paying the tiniest of rates. By that, they attracted all excess funds left at banks in the crash of '29-'33 (just as they had done in 1907 as well).

    Failure of those banks to recirculate that money led directly to the great "debt contraction depression" that Irving Fisher so properly described in his famous 1933 "Econometrica" article. Since the Fed could not draw reserves from banks by paying interest in competition with NYC banks, the prohibition against the Fed paying interest on reserves was a VERY significant cause of the Great Depression.

    It was the ability to divert funds from the Fed that gave JPM, etc., moreover, the ability to stymie any effort of the Fed to inject liquidity UNLESS those very large banks provided the Fed with those funds. As a consequence, the only way the Fed could generate liquidity was to beg Congress to spend money so it could monetize debts of the US Treasury.

    In short, by precluding the Fed from paying interest on reserves, Morgan's 1911 initial conception of the Fed was as a tool of a few large banks (mainly HIS bank) was confirmed. Combining that move with the 1925 USSC determination that a common law pledge with retained dominion "imputes fraud conclusively," the Depression era Fed was entirely impotent without Keynesian fiscal expansion (that, moreover, only proved entirely effective after the Assignment of Claims Act of 1940 allowed military contracts to be pledged as security for bank loans). Thus, in a financial sense, WW II was necessary to cure the Depression–a problem that could easily repeat if George's thinking led to elimination of the Fed's power to pay interest on bank reserves.

    Best,

    Chris

    • George Selgin

      Chris, you are twisting the truth. Bernanke's statement ""With this step, our lending facilities may be more easily expanded as necessary," refers to the Fed's ability to expand its emergency lending without contributing to a general increase in liquidity by making sure that the extra reserves thus created would not be lent. This is evident from any careful reading of his statement, and of those of numerous other Fed officials. The IOER program was EXPRESSLY adopted to compensate for the fact that, after Lehman's, the Fed had exhausted its ability to further expand its "lending facilities" (specifically, facilities for lending to AIG) via sterilization–the selling of Treasury securities in value equal to emergency loans granted)–which is what it relied upon until that points, and which explains the completely flat level of the Fed's balance sheet until then.

      This is, by the way, the first time I've ever felt compelled to resort to ALLCAPS to make a point here. But such is the degree to which you misrepresent the truth, and thereby attempt to make me appear to represent it, that I can't resist venting even in print.

      I will turn to your early Fed history later. It is also far from correct.

    • George Selgin

      And by the way, I'm not a "conservative," and never have been. Cato itself is a libertarian think tank. Personally I am–well, what I am _ought_ to be perfectly beside the point.

    • Chris, clearly the Fed failed to buy commercial paper as the shadow banks were destroyed. That caused all those bad loans to migrate to the big banks and they hoarded cash. They were not going to lend. And IOR didn't exactly help stop this cash hoarding did it? The Fed finally got around to buying commercial paper from the banks through the CPFF, but by that time, the middle class had lost the value of their houses. Surely the Fed could have bought commercial paper much earlier, like in mid 2007. The law was not yet passed to allow it, but how else would you save the middle class? The Fed fiddled while the middle class burned.

      • George Selgin

        Gary, the Fed explicitly turned to IOR as a substitute for sterilized emergency lending, the whole point having been to prevent credit that was being channeled to troubled firms from "spilling over" into the rest of the economy. The two statements to which you refer above are, in fact, contradictory. The second is a correct statement of the Fed's understanding of its actions, at least during QE1. The other is therefore problematic, except to the extent that the Fed believed that by merely _redistributing_ credit to AIG etc. from the rest of the economy it was "promoting the flow of credit to firms and households."

        • Yes, they are contradictory. Glad you noticed, George. 🙂 But it is the same double talking NY Fed who made both statements in the very same article!!

    • Chris, I have a question. What do you think about these two slightly contradictory NY Fed statements regarding IOR?

      1. A steep rise in excess reserves cannot be interpreted as evidence that
      the central bank's actions have been ineffective at promoting the flow
      of credit to firms and households.

      2. It is important to keep in mind that the excess reserves in our example
      were not created with the goal of lowering interest rates or increasing bank lending significantly relative to pre-crisis levels.

  • gchakko

    How do you define capital in our techno-world? If your brain cannot genuinely think you have no capital, you are lost. Redefining Capital means, recognising
    know-how / know-why base as pure capital; knowledge is the basis of scientific discovery and material accomplishments. Reminds me of Francis Bacon.

    Mr. Grand Economist, you will not survive without science innovations, irrespective of Kondratiev / Schumpeter cycles posing as grand insights. I sincerely believe that Nobel Prize winners in economics are not worth any serious attention anymore, because they exude self-pleasing theories; not to forget everyone steals technology from the other behind. It is ridiculous to feign that know-how, which is product of natural human innovative brain for survival reasons, is not asset capital which is what most banks want people cheat into in denying it. Facon parler, Excuse moi !

    Since the U.S. has jumped out of BW (Bretton Woods) insidiously under Nixon, now you pay for it. The U.S. has lost its power. Period. My advice to the RR Bankers is that you immediately distribute the wealth to the poor in a controlled manner, what you swindled out of them. If you haven’t caught the message, my predictive intuition is, that, you would face like the French Revolution, an anaconda strangling the claimed $500 Trillion RR (Rothschild-Rockefeller Bankers)-Bankers, a mythical power in assets including gold. Trail-blaze the practical possible; give up your Zachaeus customs officer syndrome. After all, you do not need such wealth accumulation under the garb of security. Remeber please what the Yoga Masters warns. The breath that God has breathed in you is your only asset. Once it is stopped, all magterial wealth is of zero use. Then why accumulate wealth and wield to control them

    George Chakko,, 22/05/2016 02:35 am