On Shrinking the Fed's Balance Sheet

balance sheet, credit allocation, Interest on Excess Reserves, money multiplier money, reverse repos
"Piggy Bank," by Ken Teegardin, CC BY SA 2.0 https://www.flickr.com/photos/teegardin/6097066382

balance sheet, credit allocation, Interest on Excess Reserves, money multiplierIf you're a regular Alt-M reader (and may the frost never afflict your spuds if you are), I needn't tell you that I'm the last person to exalt the pre-2008 Federal Reserve System. Among other things, I blame that system for fueling the 2003-2006 boom, and for creating a credit famine afterwards. I also blame it for contributing to the dot.com boom of the 90s, for the rise of Too Big to Fail in the 80s, for the  inflation of the 70s, and for the disintermediation crisis of 1966, to look no further back than that.

Yet for all its flaws that old-time Fed set-up was a veritable monetary Shangri-La compared to the one now in place. For while the newfangled Federal Reserve System is no less capable of mischief than the old one was, it also has the Fed playing a far larger role than before in commandeering and allocating scarce credit.

Monetary Control, Then and Now

You see, back in those (relatively) halcyon days, the Fed got by with what now seems like a modest-sized balance sheet, the liabilities of which consisted mainly of circulating Federal Reserve notes, supplemented by Treasury and GSE deposit balances and by bank reserve balances only slightly greater than the small amounts needed to meet banks' legal reserve requirements. Because banks held few excess reserves, it took only modest adjustments to the size of the Fed's balance sheet, achieved by means of open-market purchases or sales of short-term Treasury securities, to make credit more or less scarce, and thereby achieve the Fed's immediate policy objectives. Specifically, by altering the supply of bank reserves, the Fed could  influence the federal funds rate — the rate banks paid other banks to borrow reserves overnight — and so keep that rate on target.

Today, in contrast, the Fed presides over a vast portfolio, with assets consisting mainly of long-term Treasury securities and mortgage-backed securities, instead of the short-term Treasuries it once held; and that portfolio is funded more by banks' holdings of substantial excess reserves than by circulating Federal Reserve notes. Yet instead of enhancing the Fed's conventional powers of monetary control, the ballooning of the Fed's balance sheet has sapped those powers by making it unnecessary for banks to routinely borrow from one another in the federal funds market to meet their legal reserve requirements. Consequently, the Fed can no longer target the effective federal funds rate, and influence other short-term interest rates, just by making modest changes to the stock of bank reserves.

So how does the Fed control credit now? Instead of increasing or reducing the availability of credit by adding to or subtracting from the supply of Fed deposit balances, the Fed now loosens or tightens credit by controlling financial institutions' demand for such balances using a pair of new monetary control devices. By paying interest on excess reserves (IOER), the Fed rewards banks for keeping  balances beyond what they need to meet their legal requirements; and by making overnight reverse repurchase agreements (ON-RRP) with various GSEs and money-market funds, it gets those institutions to lend funds to it.

Between them the IOER rate and the implicit ON-RRP rate define the upper and lower limits, respectively, of an effective federal funds rate target "range," because most of the limited trading  that now goes on in the federal funds market consists of overnight lending by GSEs (and the Federal Home Loan Banks especially), which are not eligible for IOER, to ordinary banks, which are. By raising its administered rates, the Fed encourages other financial institutions to maintain larger balances with it, instead of trading those balances for other interest-earning assets. Monetary tightening thus takes the form of a reduced money multiplier, rather than a reduced monetary base. The counterpart of that reduced multiplier is an increase in the Fed's overall command of the public's savings, for it's the public that ultimately supplies the funds that financial institutions in turn hand over to the Fed, by holding those institutions' IOUs.

Confiscatory Credit Control

As no one has yet come up with a catchy or at least convenient name for this new arrangement for credit control, allow me to propose one: "confiscatory credit control."  Why "confiscatory"? Because instead of limiting the overall availability of credit like it did in the past, the Fed now limits the credit available to other prospective borrowers by grabbing more for itself, which it then passes on to the U.S. Treasury and to housing agencies whose securities it purchases.

When the central banks of other, and especially poorer, nations do this sort of thing, economists (including some who work for the Fed) refer to their policies, not as examples of enlightened monetary management, but as instances of financial repression. So it seems only fair to characterize our own central bank's similar policies in a like manner. Although it's true that financial repression has traditionally been practiced using the stick of high mandatory reserve requirements, whereas the Fed has instead been employing carrots in the shape of ON-RRP and IOER interest incentives, the ultimate result — more credit for the government, and less for everyone else — is the same. And though banks and bank depositors are better compensated for the governments' takings, that compensation comes at taxpayers' expense, because it translates either into an immediate reduction in Fed remittances to the Treasury or (as has been the case in fact) in an enhanced risk of reduced remittances in the future.

Whatever you call it, the Fed's new monetary control framework involves a dramatic increase in the Fed's credit footprint. To grasp the extent of the increase, have a gander at the chart below, showing the value of the Fed's assets expressed as a percentage of total commercial bank assets. Whereas in the months prior to June 2008, Fed assets amounted to less than 8 percent of those held by U.S. commercial banks, its relative size has since increased five-fold. Of this overall increase, $2.5 trillion has gone into Treasury notes and bonds, while $1.75 trillion has been invested in MBS and housing-agency debt securities.

Fed Assets as Ratio Commercial Bank Assets

Thanks to the combined effects of LSAP's, IOER, and ON-RRP, among other Fed programs and policies, the Fed now lords over a far greater share of the public's savings than it has at any time since World War II, when it resolved "to use its powers to assure at all times an ample supply of funds for financing the war effort." Even allowing, as many authorities do, that the Great Recession was a national crisis warranting a similar expansion of the Fed's role, that fact alone can hardly continue to justify the Fed's vast expansion now that the recovery is well-nigh complete.

Why should we mind a permanently enlarged Fed footprint? We should mind it because the Fed's mandate doesn't include commandeering a huge chunk of the public's savings; and we should mind it because the Fed isn't designed to employ our savings efficiently. Its business, like that of all modern central banks (but unlike that of, say, the Gosbank), is that of keeping the overall scale of credit creation within bounds consistent with macroeconomic stability, while leaving private financial institutions as free as is consistent with preserving that stability to decide how best to employ scarce credit.

The bigger the Fed's credit footprint, the more it interferes with the efficient employment and pricing of credit. By directing a large share of savings to purchases of longer-term MBS and Treasury securities, for example, the Fed has artificially raised both the prices of those securities, and the importance of the housing market and the federal government relative to the rest of the U.S. economy. It has also dramatically increased its portfolio's duration gap and, by so doing, the risk that it will suffer losses should it sell assets before they mature. In other words, the Fed has undermined its own flexibility, by increasing the likely cost, directly to the U.S. Treasury and indirectly to itself, of using open-market sales to tighten credit. Finally, by flattening the yield curve, the Fed's purchases have harmed commercial banks, the profits of which come mainly from borrowing short, lending long, and pocketing the difference.

Promises, Promises

The presumption that the Fed's credit footprint should be as small as possible was once shared by most experts, including Fed officials. For that reason, when QE was just getting started, and for some time afterwards, those officials were anxious to assure everyone that the Fed 's growth was only temporary.

In speaking at the LSE back in January 2009, for example, Ben Bernanke promised that

As lending programs are scaled back, the size of the Federal Reserve's balance sheet will decline, implying a reduction in excess reserves and the monetary base. …  As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy — namely, by setting a target for the federal funds rate.

Later that same year Fed Vice President Donald Kohn, speaking at a Shadow Open Market Committee meeting held here at the Cato Institute, complained that "the large volume of reserves is contributing to the loose relationship of our deposit rate and market rates," while assuring those present that the Fed would eventually "drain the banking system of excess reserves for that reason." [1]  In their April 2010 meeting, most FOMC members hoped that the Fed would dispose of all its QE1 assets within 5 years of its first post-crisis rate hike, while a few wanted it to start selling assets before its first rate increase. A year later the FOMC was still committed  to having the Fed dispose of its agency securities rapidly, so as "to minimize the extent to which the Federal Reserve portfolio might affect the allocation of credit across sectors of the economy."

Finally, when, in 2014, the Fed began to increase the magnitude of its ON-RRP operations, some FOMC members worried about that facility's influence on credit allocation. Nor were their concerns unwarranted. According to a study prepared by a group of Fed economists some months later, an enlarged ON-RRP program "would expand the Federal Reserve’s footprint in short-term funding markets and could alter the structure and functioning of those markets in ways that may be difficult to anticipate." Among other things, Fed experts feared that, by substantially increasing the Federal Reserve’s role in financial intermediation, the new facility "might magnify strains in short-term funding markets during periods of financial stress."

Alas, despite such concerns, and the progress of the recovery, the Fed has yet to take steps to shrink its balance sheet. Instead, it continues to reinvest both the proceeds from maturing Treasuries and  principal payments from its agency debt and MBS. More disturbingly still, arguments to the effect that the Fed should make its gigantic footprint permanent, or even increase it, seem to be gaining ground both within and beyond the Fed. (An early convert to the new view was Ben Bernanke himself, who, at a May 2014 conference in which yours truly also took part, declared that "There is absolutely no need or requirement for the balance sheet to go back to normal as monetary policy normalizes. The balance sheet could be kept where it is for a very long time if necessary.")

On the other hand, some other Fed officials, including St. Louis Fed President James Bullard, still hope to get the Fed to go on a diet. So, apparently, does Kentucky representative Andy Barr, who favors legislation that would give the Fed no choice but to shrink. Writing recently in Investor's Business Daily, Barr observed that the Fed's "enormous balance sheet puts taxpayers at risk, especially if interest rates rise, and distorts the free flow of capital that has sorely gone missing from our low-productivity recovery."

The Demand Side of Fed Shrinkage

Barr hopes that pending legislation "will include an effective strategy to shrink the Federal Reserve's balance sheet and limit its holdings to U.S. Treasuries." If that's what it's going to take to cut the Fed back down to size, I'm for it as well. But Barr's proposal begs the question, just what is an "effective strategy" for shrinking the Fed?

Most discussions treat such a strategy as being entirely a matter of setting a schedule, like those the FOMC has toyed with since 2010, for ending or limiting Fed re-investments of maturing securities and dividends, and (in more aggressive plans) for outright security sales. But there's more to it than that, because the size of the Fed's footprint is ultimately determined, not by the dollar-value of the Fed's assets, but by the real demand for its liabilities. The greater the latter demand, the larger the Fed is bound to be in real (that is, inflation-adjusted) terms.

Just before the crisis, the demand for Fed liabilities consisted mainly of the public's demand for paper dollars, about $800 billion of which were outstanding. The demand for Fed deposit balances, including banks' demand for reserves, was, in contrast, quite limited. The Treasury and the GSEs kept modest balances amounting in all to about $100 billion, while banks held even less, in reserves  barely exceeding minimum legal requirements. Today, thanks to IOER, ON-RRP, and other Federal Reserve programs and powers put into effect during the crisis, the demand for Fed balances has dramatically increased. Unless these special sources of demand are themselves dealt with, shrinking the Fed's balance sheet alone won't suffice to reduce the Fed's size, either in real terms or relative to the credit system as a whole. Instead, Fed asset sales will, other things equal, cause private financial institutions to reduce their holdings of assets other than balances at the Fed, so as to retain the same ratio of Fed balances to other assets.

The good news is that reducing the demand for Fed balances to pre-crisis levels is relatively easy. Today's exceptional demand is mainly the result of heightened bank liquidity needs combined with the Fed's practice of setting the IOER rate above the yield on Treasury securities, and on short-term securities especially. Banks' heightened liquidity needs initially stemmed from the crisis itself, but have since been sustained by the Fed's liquidity stress testing and, more recently, by U.S. implementation of Basel's Liquidity Coverage Ratio.[2]

But banks' liquidity needs alone don't account for their extraordinary demand for excess reserves, because Treasury securities are themselves high-quality liquid assets, which banks would normally favor over excess reserves for their higher yields. It's only because the Fed has been paying IOER at rates exceeding those on many Treasury securities, and on short-term Treasury securities especially, that banks (especially large domestic and foreign banks) have chosen to hoard reserves. Even today, despite rate increases, the IOER rate of 75 basis points exceeds yields on most Treasury bills.  Were  it not for this difference, banks would trade their excess reserves for Treasury securities, causing unwanted Fed balances to be passed around like so many hot-potatoes, and creating new bank deposits in the process. Because more deposits means more required reserves, banks would eventually have no excess reserves to dispose of.

Phasing out ON-RRP, on the other hand, would eliminate the artificial boost that program has been giving to non-bank financial institutions' demand for Fed balances.

Because phasing out ON-RRP makes more reserves available to banks, while reducing IOER rates reduces banks' own demand for such reserves, both policies are expansionary. They don't alter the total supply of Fed balances. Instead they serve to raise the money multiplier by adding to banks' capacity and willingness to expand their own balance sheets by acquiring non-reserve assets. But this expansionary result is a feature, not a bug: as former Fed Vice Chairman Alan Blinder observed in December 2013, the greater the money multiplier, the more the Fed can shrink its balance sheet without over-tightening. In principle, so long as it sells enough securities, the Fed can reduce its ON-RRP and IOER rates, relative to prevailing market rates, without missing its ultimate policy targets.

In practice, the Fed may prefer (if it isn't forced) to shrink its portfolio according to a preset schedule, rather than at whatever rate it takes to compensate for a declining demand for Fed balances. In that case, it has another tool it can use to keep a lid on credit: its Term Deposit Facility. As the Federal Reserve Board's own description of that facility  explains, by inducing banks to keep term (rather than demand) deposits with it, the Fed drains as many reserve balances from the banking system. So, to the extent that the Fed's gradual asset sales fail to adequately compensate for a multiplier revival brought about by its scaling-back of ON-RRP and IOER, the Fed can take up the slack by sufficiently raising the return on its Term Deposits.

And the Fed's federal funds rate target? What happens to that? In the first place, as the Fed scales back on ON-RRP and IOER, by allowing the rates paid through these arrangements to decline relative to short-term Treasury rates, its administered rates will become increasingly irrelevant. The same changes, together with concurrent assets sales, will make the effective federal funds rate more relevant, by reducing banks' excess reserves and increasing overnight borrowing. While the changes are ongoing, the Fed would continue to post administered rates; but it could also revive its pre-crisis practice of announcing a single-valued effective funds rate target. In time, the latter target could once again be more-or-less precisely met, making it unnecessary for the Fed to continue referring to any target range.


[1] Kohn also observed, by the way, that "the high volume of reserves evidently has not increased bank lending or reduced spreads of rates on bank loans or other assets relative to, say, Treasury rates," while acknowledging that "an increase in lending and narrowing of spreads on bank loans is a necessary and desirable aspect of the return to better-functioning markets and intermediation to promote economic growth." That sounds to me rather like an admission that QE was, up to that point at least, a flop.

[2] The Liquidity Coverage Ratio (LCR) calls for banks to have enough unencumbered "high quality liquid assets" (HQLA) to meet a 30-day stressed liquidity outflow scenario. Banks that rely heavily on wholesale funding are subject to a higher required LCR than those funded chiefly by retail deposits. The different requirements accounts for the fact that larger U.S. banks hold a disproportionate share of total excess reserves. Although the U.S. first began enforcing Basel-based LCR requirements in January 2015, it appears that U.S. banks that were to be subject to those requirements started accumulating qualifying liquid assets in 2013.

  • Ray Lopez

    Oh George, you're so old fashioned. Your fellow economist Dr. Scott Sumner says the Fed balance sheet doesn't matter. The Fed going from $1T to $4T on its balance sheet is no big deal. Further, he claims that even if you remove every eighth bill in the Fed reserves, it would not matter (as happened in fact in Moldova, when 1/8th of the money was stolen from central bank members). Don't believe? Go to the comments section of Sumner's TheMoneyIllusion (http://www.themoneyillusion.com/?p=32339) and read for yourself. Change with the times George! Money doesn't matter… (in a weird way, Sumner is acknowledging money is neutral, and not only does money have no real effects but no nominal effects either, a sort of hyper-neutrality)

    • George Selgin

      Well Ray, you're right about my being old-fashioned: most trendy monetary economics is but a passing fad, after all. But even I agree that, in the long run at least, it isn't the nominal size of the Fed's balance sheet that matters, but it's real share in financial intermediation. What's more I say as much in the post. On the other hand, the arch New Classical suggestion that money generally doesn't influence real magnitudes is one that, assuming it ever deserved serious consideration (I for one don't believe it did), ought to have been killed and buried in the deepest and most inaccessible of tombs following the recent crisis.

      As for money being "hyper-neutral," tell that to the next Venezuelan you meet.

  • I find interest on reserves absurd: what's the Fed (effectively the taxpayer) doing paying anyone to hoard cash? If the Fed wants to raise interest rates it should raise banks' minimum reserve requirements. The Chinese central bank periodically alters commercial banks' minimum reserve requirements I seem to remember reading somewhere.

    • George Selgin

      Given present, high excess reserve holdings, and their uneven distribution among banks (many more at large and foreign banks), raising required reserves would be a very messy alternative–and one that would dramatically undermine the international competitiveness of U.S. banks, while doing nothing to reduce the Fed's giant footprint! Past experience also suggests that raising reserve requirements is a very unreliable means of monetary control. Consider 1937-8!

      Much better to reduce banks' demand for excess reserves, while also shrinking the supply of reserves by letting the Fed's balance sheet decline.

      • I'm not convinced, for the following reasons.

        1. Reserves always have been unevenly distributed between banks: that's why some have to borrow reserves from other commercial banks or the central bank. A bank which is short of reserves is one which has done a relatively large amount of lending recently. There is no reason for central banks or taxpayers to help it out of its predicament.

        2. The government and central bank of a country should not give any sort of artificial preference to domestic banks as compared to foreign owned ones. In a genuine free market, all participants compete on an equal footing.

        3. Re the Fed's "giant footprint", there are arguments for making it even bigger. Milton Friedman and Warren Mosler argued for an abolition of government debt: i.e. they claimed the only state liability should be base money. I don't think their arguments were without merit.

        • George Selgin

          "Milton Friedman and Warren Mosler argued for an abolition of government
          debt: i.e. they claimed the only state liability should be base money." That Friedman ever said any such thing comes as a surprise to me! He did say that the return on currency should ideally match that an maturity-adjusted government debt, but that is hardly the same thing! Kindly supply a source.

          • The source is his 1948 American Economic Review paper “A
            Monetary and Fiscal Framework….”. See para starting “Under the proposal…(under the heading “Operation of the proposal”).


          • George Selgin

            Thanks. I had forgotten this element of Friedman's 1948 100% plan. But — thank goodness! — Friedman never returned to that very early, and extremely odd, proposal in his later writings.

          • I find the whole question as to what proportion of state
            liabilities should be interest yielding extremely complicated. Haven’t got to
            the bottom of it. For example the idea that borrowing is justified to fund
            investment (e.g. in infrastructure) is debatable and for two reasons.

            First, investment does not justify borrowing if you happen to
            have cash to fund the investment. A taxi driver will not borrow to buy a new
            taxi if he happens to have enough cash. And states have a limitless source of
            cash: the taxpayer plus states can print money.

            Second, education is one HUGE investment, but for some
            strange reason the advocates of state borrowing never claim education should be funded entirely via borrowing.

      • Spencer Hall

        First of all, and contrary to Milton Friedman, IBDDs (required or excess) are not a tax. A brief “run down” will indicate just how cost-less, indeed how profitable – to the participants, is the creation of new money. If the Fed puts through buy orders in the open market, the Federal Reserve Banks acquired earning assets by creating new inter-bank demand deposits. The U.S. Treasury recaptured about 98% of the net income from these assets. The commercial banks acquired “free” legal reserves (and clearing balances), yet the bankers complained that they didn't earn any interest on their balances at their District Reserve Banks.

        On the basis of these newly acquired free reserves, the commercial banks created a multiple volume of credit & money. And, through this money, they acquired a concomitant volume of additional earnings assets. How much was this multiple expansion of money, credit, & bank earning assets? Thanks to fractional reserve banking (an essential characteristic of commercial banking) for every dollar of legal reserves pumped into the member banks by the Fed, the banking system acquired about 93 (c. 2006), dollars in earning assets through credit creation.

        • Spencer Hall

          No. You increase international competitiveness by driving
          the CBs out of the savings business (which would also make them more profitable). Then domestic banks become the low cost provider. And there is nothing messy about legal reserves. They should applied to all deposit liabilities (unrelated to excess reserve balances), regardless of their skewedness. And monetary policy should limit all reserves to balances in the District Reserve banks (IBDDs), and have uniform reserve ratios for all deposits, in all banks, irrespective of size. 37-38 obviously, is totally irrelevant.

          • Spencer Hall

            Nobel Laureate Dr., Milton Friedman (see, Carol A. Ledenham’s Hoover Institution archives) pontificated that: “I would make reserve requirements the same for time and demand deposits”. Dec. 16, 1959.

  • Spencer Hall

    Unlike QE "interest rate" operations, with the "Death Star", (which targets "RPDs", See Paul Meek, 1972), it's un-necessary to hike (in order to "tighten"). We are assured of a protracted economic depression (one worse than the Great Depression, as long as IBDDs are continually remunerated).

  • Mattyoung

    I am going to break the Fed actions into two groups. The first is the Fed makes arrangements to defeat artificial regulations. Second, the Fed is treating one of its member banks, Treasury with way too much weighting. In group one, they are stuck. Those GSE should be taking S&L risk, law prevents it. The second is the unmarked losses from not doing the first.

    Now the Fed is way off the balanced point, not likely to get back without a restructure something gonna give soon.

    • Mattyoung

      About the size. The bigger the sheet the smaller the weaker the response to liquidity requirements.
      More important, if the distributions of reserves favors large foreign banks, then the distribution of assets better favor large foreign banks, and they do not. Congress generated the assets, so Congress is an insurance agent, for the foreign depositers.

      Money management is all about the saver and borrowers balancing their own savings and borrowings. If the Fed sees large foreign deposits then its function is to balance large foreign loans; it should either do both or none. Otherwise, pricing will not work, holders of cash never know if they borrowed to much or saved too little because they cannot look at the Fed curve and see themselves. They see Congress instead, a recipe for catastrophe.

      • Spencer Hall

        IBDDs are not a tax. They are manna from Heaven (necessary clearing balances). Who needs the "black" E-$ market when you have Yankee bonds.

  • Spencer Hall

    People are just stupid. Reserves are "manna from Heaven". They are not a tax. To remunerate IBDDs is to suck the "life blood" (both credit and velocity) out of the economy. Remunerating IBDDs will destroy America period. I.e., all savings originate within the payment's system. And all savings are un-used and un-spent until their owners invest directly or indirectly via non-bank conduits (i.e., outside of the commercial banking system). Bank-held savings are the direct cause of both stagflation and secular strangulation period. This is inviolate and sacrosanct.

  • Spencer Hall

    Both these items are at absurd draining levels:

    reverse repos:

    2017-01-04 523213
    2017-01-11 414925
    2017-01-18 382877
    2017-01-25 361564
    2017-02-01 391779
    2017-02-08 374350
    2017-02-15 363909
    2017-02-22 425529

    Treasury's General Fund Account:

    2017-01-04 387.989
    2017-01-11 372.492
    2017-01-18 366.090
    2017-01-25 390.842
    2017-02-01 374.841
    2017-02-08 305.735
    2017-02-15 309.919
    2017-02-22 258.292

    • Mattyoung

      The later list is bothersome.
      Congress has 260 billion on deposit and 2.4 trillion on loan. Who is Congress? Congress either is definitely building the anti-gravity system, in secret. Or Congress is going belly up. We have to price that activity, or Treasury is taking a seigniorage stream (and we do not have a model for that), or the Fed is acting as taxing agent. Where does this all fit?

      I am proudly stupid on central bank semantics, but currency is about matching loans to deposits. I don;t see how we do it here.

      • Spencer Hall

        It messes with gDp forecasts (as transfer payments aren't included). Most modelers have recently figured this out.

        Loans = Deposits. Yeah, so the bank can't write a check against your deposits.

        • Mattyoung

          Loans tend to equal deposits in the odds making world.
          But the real issue here is the model for transfer payments that causes GDP estimates to go bad. The solution is for social security and medicare to bank directly with the Fed and the model gets incorporated into pricing. If we don;t, then the funds flow gets hedged by those with the real model. It is back to the function of currency banking, the currency banker either supports pricing or the currency function is replaced by inside deals. It seems fundamental.

          • Mattyoung

            A quick example.
            I follow the black labor market in California, and my observation is that this market has about a 10 point deviation relative to GDP out here. The deviation results because agents in our economy price the uncertainty of entitlement taxes. We do this on an individual search method. The currency banker is supposed to participate pricing. But as the black market grows or shrinks, the central banker loses and gains market share. Tax dollar pricing is fouled, the safe rate is not all that safe. If medicare and social security were a cash flow measure stream, by banking at the fed individually, then that whole exterior path through Congress is gone.

          • Spencer Hall

            Transfer payments are expenditures which do not directly finance current output. They are treated as a leakage and not tabulated in the BEA's gDp calculations. They are not a "final product".

            The descriptions used for a "black market" are spurious. Cash is green, not black. And so is its positive impact on the economy. A VAT might correct some of those discrepancies. However, VAT taxes should be "moderated" by an index to dis-incentivize CPI inflation.


  • Seth Levine

    Novice question: Is it a coincidence that a chart of "Excess Reserves of Depository Institutions" and "US Treasury securities held by the Federal Reserve" closely resemble each other? Does this imply that the Fed basically traded reserves (in the form or excess reserves) for USTs with its member banks? Thanks.

    • George Selgin

      Not a coincidence at all: the Fed did in fact trade reserves for Treasuries, and also for agency debt and MBS. That's essentially what QE was about. Usually, though, excess reserves don;t accumulate (though total reserves do) because the banks unload them for securities with higher yields. In this case, IOER exceeded yields on other safe short-term assets. So the banks preferred to pile-on excess reserves. It's a good way to make the Fed big, while not doing much to help the rest of the economy grow.

      • Seth Levine

        Thanks so much for this clarification. Given this, is it fair to say that: 1) by holding excess reserves, QE's effects were, in part, sterilized (by the amount of excess reserves held), and if so; 2) inflationary pressures should increase as excess reserves shrink, as the QE liquidity begins to transmit to the economy via lending activity (or any other way that may lead to the circulation of these excess reserves)?

        • George Selgin

          1. Yes. 2. Yes. You have the makings of a good economist, Seth!

          • Seth Levine

            Thanks for your kind words. Consider it a testament to the quality of work that you produce.

  • Philon

    I suspect that the Fed's extensive QE had very little influence over the allocation of credit. True, the Fed bought mainly longer term treasurys and agency mortgage-backed securities, but the supply of these products is very large and investors' demands for them are very elastic–there are many near-equivalents that make good substitutes. So the main effect was to increase the money supply; QE was (mostly) monetary policy rather than credit policy.

    • Spencer Hall

      After a reconciliation of the selling counter-parties, most Central Bank purchases were from the non-banks, however, the growth of the money stock was encumbered and thwarted by 2 principle policy blunders: (#1), a counter-cyclical increase in regulatory capital requirements (and a replinishment of bank capital used as a cushion to offset increasing levels of bad debt), which literally destroys the money stock (c. one trillion dollars destruction), and (#2), the destruction of money (savings) velocity associated with the dis-intermediation of non-bank conduits (the shadow banking system). Thus, R-gDp and N-gDp were reduced to subpar growth rates because of both a decline in volume X’s velocity, or AD.

      Since the largest credit worthy borrower is the U.S. gov’t., subsequent to the GD, there was no “pushing on a string” during the GR. There were only mis-directed, mis-allocated, targets for: “RPDs”.

  • Spencer Hall

    Hold on, this is waiting to be approved by Alt-M.

    What, you need to sort thru the forest of economic thought?

  • Spencer Hall

    The Fed is a central bank. It doesn't need to be concerned about the size of its balance sheet. The balance sheet will have to be expanded as debt monetization will be inevitable.

    • George Selgin

      Of course IT doesn't need to be concerned, Spencer. WE do! And how much debt it monetizes depends in part on the strength of opposition to such.

  • George Selgin

    Thanks for these observations, Hu; I agree, by the way, that there's no reason to eliminate IORR.

  • The simplest solution to this problem is to end the Fed outright. Repudiate the debt as quickly as possible as the readjustment process will then be forthwith. There should be no other concern if Americans desire preserving the spirit of America, that being Capitalism. Secession is inevitable as the bust is imminent and healthy. Deflation is necessary: http://austrianquips.blogspot.com/2017/01/deflation_22.html

    • Various scenarios could arise:
      1) Allow the excess reserves to enter into the economy as new loans, whilst rates are gradually ratcheted upward, a plan that I presume is in play at the moment. Systematic risk will ultimately set in at a certain point, which may only need to be a 3 or 4% in short-term yields.
      2) Sell off the excess reserves, allow the market to correct (which would lead to a massive market crash and secession as mentioned above), in hopes that the Union will stay in tact and later end the Fed. Conclusively, repudiating the debt.
      3) End the Fed, while repudiating the debt on the Fed balance sheet, which would shrink the balance sheets of the banks, cause a readjustment process and the predicament of secession as mentioned above.

      Debt repudiation would ultimately arrive after the treasuries are sold off in the Secondary Market, which would occur due to their near valueless nature during the crash.

      The best thing for us Libertarians to do is prepare everyone for the crash, the deflationary period, and remind every citizen about the array of methods of banking available in the Free Market, 100% reserves being of those available.