Dormant for a while, the debate over India’s demonetization program of last fall has been revived by new evidence. The new evidence on note returns and GDP vindicates the critics, and has the defenders in strategic retreat.

To recap: On November 8, 2016, India’s Prime Minister Narendra Modi shocked the nation by announcing the immediate “demonetization” of the two largest rupee currency notes (Rs 500, worth about $7.50, and Rs 1000, worth about $15). Noteholders would have only 50 days to turn them in for new Rs 500 and Rs 2000 notes. The move, Modi promised, would sharply penalize holders of unaccounted “black money,” namely tax evaders, bribe-takers, professional criminals, and terrorists. Their currency hoards would become worthless — a welcome one-time wealth loss — or they would expose themselves to detection by trying to swap or deposit large batches. Anyone depositing a large sum in old notes would face scrutiny by tax authorities.

In order to keep the move a surprise (the better to catch the black money holders), new notes to replace all the discontinued notes had not been printed in advance. The cancelled notes represented 86% of the currency in circulation, and more than half of M1 (currency plus checking deposits), India having a highly cash-intensive economy with half the population unbanked. As criminals were far from the main users of currency, the impact was unavoidably felt well beyond the black-money set. A serious currency shortage immediately arose, with predictable consequences. Honest wage laborers in the huge cash economy went unpaid, honest construction projects came to a standstill, honest shopkeepers saw sales dry up, and honest businesses failed. Honest people wasted billions of hours waiting in queues to exchange old notes for the trickle of new notes.

As Shruti Rajagopalan and I noted in November last year, there was also a fiscal angle: for every billion of old rupee notes not turned in (for fear of being scrutinized), the government could issue a replacement billion and pocket it as one-time seigniorage revenue. For example:

if 20% of the old notes are never turned in, the government’s revenue windfall is up to Rs 2.9 trillion ($42.5 billion).

The destruction of the private wealth of non-redeeming old-note holders, combined with the revenue windfall to the government, makes the currency policy effectively a large capital levy, a massive one-shot transfer of wealth from the private to the public sector.

We speculated: “The wealth transfer to government may help to explain Prime Minister Modi’s enthusiasm for the currency cancellation and re-issue, despite its likely ineffectuality against black money.”

Economically literate defenders of demonetization have been fewer than critics. The most prominent defenders have been the well-known trade economist Jagdish Bhagwati of Columbia University together with his former students Vivek Dehejia and Pravin Krishna, and with his Columbia colleague Suresh Sundaresan.

In a December 2017 piece in the prominent Times of India, Bhagwati, Krishna, and Sundaresan (hereafter BKS) praised the demonetization program as “a courageous and substantive economic reform that, despite the significant transition costs, has the potential to generate large future benefits.” BKS recognized that “the process is inconvenient, and subjects many households to hardships,” but thought it worthwhile for “potentially increasing transparency and expanding the tax base and revenues to the government from taxes and surcharges.” The fiscal angle was foremost: since “unaccounted deposits will be taxed, this will yield a windfall for the government permitting large increases in social expenditures.” In addition, it would promote a “switch into digital transactions” and “put a major dent in counterfeiting.”

In an Op-Ed published on December 27, Bhagwati, Dehejia, and Krishna (hereafter BDK) defended the demonetization program entirely on the grounds that it would impose an effective capital levy. It was, they wrote, “a policy designed, in effect, as a one-time tax on black money.” They noted that the government’s revenue gain would not come just from replacing unreturned notes. Under “voluntary disclosure” rules promulgated after the initial announcement, depositors of old notes who acknowledged their holdings as illegitimate would also pay: “deposits of unaccounted money will be taxed at 50% — with a further 25% taken by the government … as an interest-free loan for a period of four years.” Thus there would be a one-time fiscal gain to the government not only from notes never returned, but also from notes returned under such terms.

BDK proposed the size of the revenue gain as a sufficient criterion for judging the success of the program: “at least from the perspective of its effectiveness in dealing with the black money issue, success has to be measured by the sum of tax revenue generated [from the 50% tax on acknowledged black deposits] and black money destroyed [i.e. revenue from replacing unreturned notes].” For the sake of illustration, they supposed (calling it an “estimate”) “that one-third [Rs5 trillion] of the approximately Rs15 trillion in demonetised notes is black money.” Then if by the end of the turn-in period “Rs1 trillion is unreturned, as is believed, and we further assume that only half of the remaining Rs4 trillion of black money that is returned falls within the tax net, the net gain works out to Rs1 trillion of black money destroyed and 50% times 2 trillion = Rs1 trillion in tax revenue.” With such a total fiscal gain of Rs2 trillion, “the government could reasonably claim this as a successful outcome.”

In a commentary on the BDK piece, Rajagopalan and I pointed out that, from the economist’s point of view, the costs of any measure must be taken into account before judging it worthwhile or efficient. What matters is effectiveness per unit cost. Unlike the earlier BKS piece, BDK had simply neglected the costs incurred in collecting revenue or suppressing black money through demonetization. We noted a think tank’s estimate of Rs. 1.28 trillion in losses during the transitional period from expenses of printing new notes, lost income of those waiting in queues, additional costs to banks tied up with exchanging currency, and (the largest item) lost business sales due to the currency shortage. It was then too early to replace the estimate of lost business with measured effects on GDP, but we noted that one percentage point of lost annual growth equals Rs1.45 trillion. These costs need to be set against the revenue. Even if the revenue were as high as Rs2 trillion, collecting it at a deadweight cost of 64% or more would be a very bad bargain.

Doesn’t it matter that the transfer in this case is coming from bad actors whose welfare one may disregard? No. In the above reckoning, as in standard tax analysis, the pure wealth-transfer losses of taxpayers don’t figure in the deadweight loss calculation, which only counts the costs associated with extracting the transfer.

BDK had noted in passing the argument “that the short- to medium-run economic impact post 8 November will be contractionary” due to a “temporary liquidity shortage induced by an insufficiently fast replacement of old notes with new notes.” But they dismissed on theoretical grounds that “this is not necessarily the only outcome possible.” Government could avoid a currency shortage by promptly providing new notes, they reckoned. This was a very odd line to take seven weeks into demonetization, given that the government was not in fact providing new notes sufficiently fast, and when the evidence of currency shortage was plain to see. Alternatively, they proposed, hoarded currency could come out from under mattresses, be deposited in banks, and actually expand M1 “via the classical money multiplier.” This was an odd line to take given that expansion of deposits (even should it happen) would not remedy the currency shortage being suffered by the unbanked half of India’s population.

In March 2017, Bhagwati was quoted by the Indian newspaper Firstpost making the surprising claim in an email interview that demonetization had actually promoted economic growth: “On the effects of demonetisation on growth, I should say that I was the one economist who had argued (with my co-authors), from first principles, that demonetisation would increase, not diminish, growth. And that is exactly what appears to have happened.” The factual basis for saying that it appeared to have happened was not clear.

In a March 30 piece, BDK cited a new 2016Q4 GDP report as showing that GDP had suffered “only a modest dip … of roughly half of a percentage point” below pre-demonetization projections. This was not an increase in growth. But they counted it a victory compared to “the economic disaster that the critics had imagined.”

The debate over demonetization was revived this month (September 2017) after the Reserve Bank of India finally announced the count of returned currency. It announced that 99 percent of the discontinued notes, Rs 15.28 trillion out of Rs 15.44 trillion, had been returned. As Vivek Kaul has noted, “The conventional explanation for this is that most people who had black money found other people, who did not have black money, to deposit their savings into the banking system for them.”

The trivial size of unreturned currency of course obliterates BDK’s projection of a government seigniorage windfall.

What about BDK’s other projected source of revenue, the 50% tax on acknowledged black deposits? Whereas in BDK’s scenario, black currency holders would make Rs2 trillion in voluntary-disclosure deposits, which would yield Rs 1 trillion in revenue, the actual collections under the scheme were reported in April at Rs 23 billion, or 2.3% of the BDK-imagined sum. Such paltry revenues mean that demonetization, from the fiscal perspective, was all pain and no gain.

The accumulating evidence on economic growth, meanwhile, has become damning. Between July and September 2016, India’s GDP grew 7.53 percent. Between January and March 2017 it grew 5.72 percent. Former head of the Reserve Bank of India Raghuram Rajan, now returned to the University of Chicago, links the drop to demonetization: “Let us not mince words about it — GDP has suffered. The estimates I have seen range from 1 to 2 percentage points, and that’s a lot of money — over Rs2 lakh crore [i.e. trillion] and maybe approaching Rs2.5 lakh crore.” Kaul adds that GDP does not well capture the size of the informal cash sector, where the losses from demonetization were greatest.

In response to the RBI report and GDP data, and to their credit, BDK have substantially retreated from claims of success to what can be regarded as the claim that there is still a chance to break even. They have recently written:

First off, it must be conceded that if demonetisation is to be judged narrowly on the basis of the triple rationale originally advanced … , it would at best be unclear if it could be accounted a success. For, little black money was literally “destroyed” and there is scant evidence that the policy had much if any impact on counterfeiting or terror finance.

Although they acknowledge that they “overestimated the quantum of black money that would ultimately be unreturned” and thus overestimated the seigniorage gain, they still contend that the “money deposited into bank accounts can also generate fiscal gain, as these will invite the scrutiny of tax officials.” For about two-thirds of the deposits of old currency by value, even though no admission was made and thus no 50% tax was paid, the sums deposited were large and “are mostly open to scrutiny by tax officials.” Thus it is conceivable that tax investigators may eventually squeeze taxes and fines out of them, and it is premature to rule this out.

Conceivable, but unlikely. The investigatory capacity of the tax authority is finite and it already has its hands full, as Vivek Kaul spells out in detail.

BDK concede: “Should, however, the government fail in identifying and taxing black money deposits in any significant quantity, we can all conclude that demonetisation will have failed in achieving its primary goal.” Welcome as this reasonable concession is, the converse does not follow: whether even significant eventual revenue counts as success depends on how it compares to the sizable costs of demonetization. A deadweight burden of less than 100% seems highly unlikely.

BDK add an odd coda. They acknowledge transition costs in the program actually followed, but suggest that it could have been otherwise:

in principle, had demonetisation occurred without transition costs — for instance, if old notes could have been seamlessly converted or deposited within a few days after 8 November, or if demonetisation had been pre-announced to occur with a lag, allowing time for an orderly remonetisation — there could only have been largely upside gain without any downside cost.

It is hard to square this with BDK’s earlier statements that demonetization without secrecy would have been pointless because it would not have caught out the black money holders. Are BDK saying that if the aim had been merely to introduce new notes with better anti-counterfeiting features, the Modi government’s demonetization program was an unnecessarily costly way of doing it? Well yes, the critics have said that all along. High transition costs were a feature and not a bug of the dramatic scheme to penalize black money by surprise.

[Cross-posted from Alt‑M.org]

The “big news” from Janet Yellen’s recent press conference, which was hardly news at all to those who have followed the Fed’s past announcements, was that Fed officials, having long promised to eventually undo much if not all of the vast balance sheet growth brought about by the Fed’s various QE operations, and having delayed paying the piper for as long as pressure from without permitted, are finally about to get started.

But don’t imagine that Fed staff have been idle during the long delay. On the contrary: they spent much of it developing their highly scientific balance-sheet reduction strategy, first revealed back in June. As the Fed doesn’t seem to have given that highly scientific plan a name, I hope I may take the liberty of proposing one. Let’s call it “Operation SNAIL.”

In case you haven’t guessed, the acronym stands for “Stall Now And Inch-along Later.” For if there’s any clear point to the strategy the Fed has chosen, it’s to shrink as slowly as possible — more slowly, even, than it would if it merely allowed maturing assets to passively roll-off its balance sheet.

A purely passive unwind would, to be sure, have been problematic, for it would have meant slimming down at a very uneven pace, with bunches of assets rolling off the Fed’s balance sheet during some intervals, and relatively few rolling off in others.

The Fed has chosen to address only the first of these problems, by placing varying limits or “caps” on the value of assets it will allow to roll-off its balance sheet during any particular month. Starting in October with maximum roll-offs of $6 billion in Treasuries and $4 billion in MBS, it plans to increase the caps by those same amounts every three months for a year, after which they’ll remain fixed at $30 billion for Treasury securities and $20 billion for MBS. Whenever the value of maturing assets of either sort exceeds its assigned cap, the Fed plans to reinvest the difference.

Following this plan it will take until sometime in 2020 for the Fed to slim-down from its current $4.5 trillion in assets to a bit more than $3 trillion, or well over three times its (not exactly svelte) size before the crisis. It’s a diet of sorts, to be sure. But then, so is skipping the cheesecake now and then.

In his Econbrowser blog post on the subject, James Hamilton illustrates the progress of the Fed’s unwind in several nice charts, including the one reproduced below. Besides showing the slow pace of the unwind, the chart also shows that $3 trillion or so is as low as the Fed is likely to go: by the end of 2020, it’s balance sheet will start swelling once again.

In comparison, were the Fed committed to getting its balance sheet back on its pre-crisis trajectory by the end of 2020, it would be planning on slimming down by at least another $500 billion, and perhaps by as much as another $1 trillion.

Why So Slow? Why So Little?

Were the Fed’s plan the only way for it to achieve a smooth unwind, its snail-like pace might be justified. But it isn’t: the Fed might easily have provided for a smooth unwind, at a faster pace, by combining higher roll-off caps with occasional active asset sales during low roll-off periods.

And what about the limited extent of its planned diet? Hamilton argues, correctly, that so long as the Fed sticks to its present operating framework, the volume of reverse repos it conducts, as well as the value of Treasury balances held with it, will remain highly volatile, and that it will take “a lot of reserves sloshing around the system to cover that kind of variation.” However, as Hamilton also notes, such changes as would make all that extra cash unnecessary are neither revolutionary nor difficult to implement. Instead, they consist of things like “changing the way it conducts reverse repos, using temporary open-market operations to add or withdraw reserves as needed to offset changes in the Treasury balance, or moving to a true corridor system for controlling interest rates” (my emphasis).

Hamilton’s last suggestion brings us to the true crux of the matter, which is that, despite all its talk of “normalization,” which to the general public means getting back to its pre-crisis ways, the Fed has no intention of normalizing its operating procedures. That is, it doesn’t plan to return to its pre-crisis, zero-IOER “corridor” system, or to any other sort of corridor arrangement. Instead, it wants to keep the (leaky) “floor”-type system it introduced in October 2008. In a floor system, banks are kept flush with excess reserves, and monetary control is exercised, not be adjusting the quantity of reserves so as to achieve a particular equilibrium federal funds rate, but by manipulating the interest rate the Fed pays on banks’ required and excess reserves holdings, alone or along with the Fed’s overnight reverse-repo (ON-RRP) rate. Because an abundant supply of excess bank reserves is a necessary feature of any floor-type operating system, the Fed’s decision to retain such a system is the proximate reason why it’s planning to stay pudgy.

Budget Maximizing Bureaucrats

I wrote “proximate” because the question remains: why is the Fed so hung-up on its post-crisis floor system? If you think the answer is “Because it allows for improved monetary control,” kindly let me know your address and hat size so I can mail you a dunce cap. For far from it being the case that the Fed’s new operating system has proven its worth as a means of overall monetary control, it is largely owing to that system that the Fed has failed for the better part of six years now to hit its two-percent inflation target.

If that failure strikes you as inconsequential, or even desirable, consider that its cause — a flawed monetary transmission mechanism that lacks the usual link between growth in the stock of bank reserves on one hand and growth in the broad money stock on the other — poses the grave risk of a far more spectacular failure the next time we face a substantial decline in the velocity of broad money like the one that struck in 2008. And if you don’t believe that, consider that the Fed’s moneyless (“Portfoli-O-Matic”) transmission mechanism has already had one “stress test” — the one administered between late 2008 and 2015, which it failed miserably, by proving incapable of transforming $3.5 trillion in fresh reserves into more than a few percentage points of NGDP growth, or far fewer than were required to restore that growth to its pre-crisis path.

If successful monetary control isn’t the Fed’s first priority, what is? In a word, fatness itself. That is, the Fed likes having a big balance sheet for the same reason that bureaucracies generally like having big budgets to play with. A big budget translates into more generous salaries, lavish facilities, and, other perks. Most importantly, it enhances to the Fed’s prestige.

And if you don’t think Fed officials care about prestige, you may be entitled to a second dunce cap, because they care very much indeed. According to someone I know who was part of the Fed’s deliberations at the time (but who prefers to remain anonymous for now), “the prestige of the central bank” was the answer he was given when he wondered out loud, before a gaggle of top Fed officials in the 1990s, what the Fed had to lose by dispensing with reserve requirements, as central banks in most other advanced economies had already done by then. It was chiefly owing to this desire to maintain its prestige that the Fed sought then, and has sought ever since, to come up with various schemes for making up for the erosion of demand for its liabilities caused by banks’ resort to sweep accounts.

Because it allows a central bank to expand its balance sheet arbitrarily without unduly altering its overall monetary policy stance, a floor system is a central bank bureaucrat’s dream-come-true. It allows the central bank to vastly increase its size and earnings, ergo its prestige. It also makes it easier than ever for the central bank to effectively buy-off two powerful interests that might otherwise look askance at its aggrandizement, namely, (1) the U.S. Treasury and (2) the banking industry. That the biggest banks and most politically influential banks receive a disproportionate share of the Fed’s interest payments only adds to the scheme’s overall efficacy.

Since the late 2000s, seigniorage passed along from the Fed to the Treasury has almost tripled in real terms. At the same time, the Fed’s expenses, which account for that portion of its earnings that it doesn’t pass on to the Treasury, have also grown substantially, mostly owing to its interest payments on bank reserves. According to The Economist, and as can be seen from the chart reproduced from it below, the Fed will pay out $27 billion in interest this year, and is expected to pay out $50 billion in 2019. Once its planned unwind is complete, the Fed expects to continue paying out about $10 billion a year in interest, which is still a tidy bit of baksheesh.

Source: “Is the Federal Reserve Giving Banks a $12bn Subsidy?” The Economist, March 18, 2017

Cracking Yellen’s Code

If the Fed’s unwinding plan is really based on its determination to maintain its current, bureaucratically advantageous operating system, how did Yellen manage to avoid revealing any hint of this in her recent press conference? The answer is that she didn’t: the hints are there, as they were in some of Yellen’s past press conferences. Only the hints were so cleverly ciphered that Yellen could be understood to being saying just the opposite of what she was really saying!

Specifically, in reply to questions about the Fed’s future plans for monetary control, Yellen says that the Fed intends to use changes in “the fed funds rate” rather than adjustments to its balance sheet as its chief means of monetary control. This reply could be taken to mean that it won’t be engaging again in Quantitative Easing, and that it plans to return eventually to pre-2008 style fed funds rate targeting. The interpretation squares well, after all, with the Fed’s claim that it is intent on “normalizing” monetary policy.

But that interpretation is wrong. What Yellen’s words really mean is that the Fed plans to keep its current IOER-based operating system going. The changes in the “fed funds rate” to which Yellen refers are really changes to the Fed’s IOER and ON-RRP rates, which define the upper and lower bounds, respectively, of the Fed’s current fed funds rate “target range.” It follows that when Yellen says that the Fed won’t be implementing monetary policy by means of balance sheet changes, she doesn’t just mean that it will no longer engage in post-2008 style Quantitative Easing. She also means that it won’t be making use of conventional (that is, pre-2008 style) open-market operations to influence an otherwise market-determined federal funds rate. All this in turn requires that banks be kept flush with excess reserves, and that the Fed maintain a correspondingly enlarged balance sheet.

How do I know this? Do I have a specially-made Enigma-type machine designed to crack Fed code? I do not. But I have talked to Fed officials, and kept up with Fed publications, and all indications from those support my understanding, as does the theory of bureaucratic behavior to which I referred previously.*

In other words, I might be wrong. But who wants to bet on it?

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* For example, the New York Fed just recently published a Liberty Street post defending the Fed’s interest payments on required reserves, and promising a follow-up post that will address “the payment of interest on excess reserve balances and discuss some of the benefits to the financial system of operating in a reserve-abundant regime.” The lack of any reference to the costs of operating a “reserve-abundant” regime gives the game away.

[Cross-posted from Alt‑M.org]

According to a new national poll just released by the Cato Institute, Americans know very little about the Federal Reserve. Not surprising. But among those who are familiar with its work, most think it should not be setting interest rates.

The poll, conducted in collaboration with YouGov, surveyed a nationally representative sample of 2,000 Americans.[1]

Only 20 percent of those surveyed said they have heard of the Federal Reserve and “understand what it does very well.” Fifty percent said they had heard of the Fed, and 22 percent said they had heard of it, but were not sure what it does. Six percent said they had never heard of the Fed before.

We then asked whether Fed officials or the free market should determine interest rates in the economy. Perhaps unsurprisingly, 44 percent said they hadn’t thought enough about the issue to have an answer. While fewer than one in four said the Fed should manage rates, nearly a third said the free market should. Focusing only on those with an opinion, a majority (58 percent) said they preferred the free market system determine rates.

When asked about the Fed’s independence, 57 percent said that the Fed operates independently while 38 percent said that it is influenced by Congress and the President. These responses were closely tied to education. Among those with post-graduate degrees, 70 percent said the Fed is independent while only 53 percent of those without a college degree thought so.

We also asked whether people thought that the Fed helped to stabilize the economy. The responses were mixed with 38 percent saying it does, 24 percent saying it does not, and another 36 percent saying they hadn’t heard enough to say. Responses were even more equally split when we asked about the Fed’s role in the 2008 financial crisis. While 30 percent said the Fed cut short the crisis, 33 percent said it had no impact, and another 33 percent said that it was a cause of the crisis. These responses were highly correlated with political views. Among those identifying as very liberal, 52 percent said that the Fed helps stabilize the economy and 23 percent said that the Fed was a cause of the financial crisis. Among those identifying as very conservative the views flipped: 50 percent said that the Fed was a cause of the crisis while only 26 percent said that the Fed helps stabilize the economy.

Ultimately, these findings highlight the urgent need for more education about what the Fed does, what it doesn’t do, and what it shouldn’t do. Cato’s Center for Monetary and Financial Alternatives was founded in part to provide just such an education to the public. While it’s disheartening to see how much we’re needed, it seems it’s a good thing we’re here.

Find the full survey results and analysis here.

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[1] The Cato Institute 2017 Financial Regulation Survey was designed and conducted by the Cato Institute in collaboration with YouGov. YouGov collected responses online May 24–31, 2017 from a national sample of 2,000 Americans 18 years of age and older. Restrictions are put in place to ensure that only the people selected and contacted by YouGov are allowed to participate. The margin of error for the survey is +/- 2.17 percentage points at the 95% level of confidence.

[Cross-posted from Alt‑M.org]

Today the Federal Reserve is set to announce the schedule for unwinding its balance sheet. This is a step in the right direction, but it also has the potential to increase the risk of a recession.

It’s past time to reduce the Fed’s balance sheet because its role in the economy is unnecessarily large. But without adding a strategy to eliminate the Fed’s interest payments on excess reserves that discourage bank lending, the Fed risks tightening monetary policy to the point where at best it makes it even harder for the Fed to hit its inflation target – and at worst risks another recession. Ultimately, the Fed must unwind its balance sheet in combination with ending interest on excess reserves in order to put the economy on a more solid monetary foundation.

George Selgin has been writing about the problem extensively in these pages and elsewhere. In particular, see his article “On Shrinking the Fed’s Balance Sheet,” and his American Banker piece with Norbert Michel on the Fed’s precarious balance sheet situation.

Watching the Fed’s announcement closely? The press release will appear here. And Yellen’s press conference can be viewed here.

[Cross-posted at Alt‑M.org]

The Fed’s persistent failure to reach its 2 percent inflation target ever since that target was first made explicit in 2012 has elicited a great deal of commentary in the last couple months, from economists, journalists, and some Fed officials themselves. And well it ought to, for whatever one may think of the Fed’s choice of target, the fact that the Fed has been persistently falling short of it suggests that something is awry, if not with U.S. monetary policy, then perhaps with the U.S. economy more generally.

Although plenty of explanations have been offered for the inflation shortfall, none of them is even close to being satisfactory. Bias or “noise” in the inflation numbers? Bias would explain things if the Fed were targeting some supposedly “ideal” measure of inflation. But it isn’t: it’s targeting the rate of change of the Personal Consumption Expenditure (PCE) index, and so long as that measure of inflation falls below the Fed’s target, the Fed isn’t “really” hitting its self-assigned target, even if the “real” inflation rate is higher than the PCE index suggests. As for noise, it should make the Fed just as likely to overshoot as to undershoot its target. Unemployment still isn’t quite low enough? Despite what some foolish Phillips-curve reasoning suggests, putting more people to work doesn’t make things more expensive. The public’s long-run inflation expectations are down? No doubt. But surely that’s a result, rather than a cause, of the persistently low values of actual (or measured) inflation?

Aggregate Demand is Part of the Story (But Only Part)

Of existing explanations, the least question-begging emphasize the fact that total spending, or its statistical counterparts such as nominal GDP, just hasn’t been growing rapidly enough to achieve the Fed’s inflation target. As Mickey Levy puts it in a paper he gave at last week’s SOMC meeting,

Obviously, if nominal GDP had accelerated in response to the Fed’s aggressive easing as planned, both wages and inflation would have risen faster, and inflationary expectations would be higher.

Scott Sumner has made essentially the same point: “The only way to have low inflation despite low RGDP growth,” he observes,

is if the Fed has such a tight monetary policy that NGDP growth remains slow. And that’s exactly what they’ve done since 2009. If you produce 4% NGDP growth year after year after year [when the norm has been substantially higher] then why be surprised that inflation remains low?

In fact, as David Beckworth pointed out recently, using the chart reproduced below, since the third quarter of 2009 NGDP has grown at an average rate of just 3.4 percent, compared to 5.4 percent between 1990 and 2007 and 5.7 percent for the full “Great Moderation” period of 1985–2007:

According to Beckworth the decline reflects “a monetary regime change” consisting in part of the Fed’s having failed to allow spending to “bounce back at a higher growth rate during the recovery” as it had done in past recessions.

But while explanations that attribute the Fed’s failure to reach its inflation target to slow NGDP growth have the distinct virtue of taking the equation of exchange (MV = Py) seriously (which is more than can be said for some of the others), they still beg the question: why hasn’t the Fed achieved higher NGDP growth?

To observe that it hasn’t done so because it hasn’t been directly targeting NGDP won’t do. After all, a 2 percent inflation target implicitly calls for whatever NGDP growth rate it takes to achieve 2 percent inflation. Arguments to the effect that the Fed has failed to achieve 2 percent inflation because it has failed to achieve 5 percent NGDP growth (or some such number) instead of 3.4 percent growth do no more than state the original question in slightly modified form.

The Regime Change that Matters

In fingering “regime change” Beckworth gets closer to the truth. Only the regime change that really matters isn’t the shift away from level to rate targeting that he emphasizes. It’s the switch, in October 2008, from the Fed’s conventional monetary control arrangements, with a market-based fed funds target achieved with the help of open-market operations, to its current IOER-based (leaky) “floor system” — in which the fed funds rate is moved up or down by raising the rate of interest the Fed pays on banks’ excess reserves, either alone or together with the rate it offers in its overnight reverse repurchase (ON-RRP) agreements.

What does the Fed’s switch to a floor system have to do with the low inflation and NGDP numbers we’ve been seeing ever since? Bear with me, and I’ll explain.

To do so I must first explain in a bit more detail how a floor system works. In so doing, I’m going to abstract from the role of ON-RRPs, for those aren’t actually part of an orthodox floor system, in which the IOER rate alone serves as the central bank’s policy rate. In the U.S., the situation is complicated by the fact that various GSEs keep balances at the Fed, but aren’t eligible for interest on those balances. Consequently banks and those GSEs can mutually profit by having the GSEs lend their excess Fed balances to the banks for a rate somewhere between the IOER rate and zero. To partially address this “leak” in what would otherwise have been a solid IOER-based federal funds rate floor, the Fed offered the GSEs and some other non-bank financial institutions the opportunity undertake reverse repos with it, thereby establishing a solid ON-RRP subfloor below the leaky IOER-rate floor. This arrangement serves to limit the extent to which the effective fed funds can fall below the IOER, although it still allows it to vary between that rate and the ON-RRP rate, as can be seen in the chart below. Those two rate therefore serve as upper and lower “bounds” of the Federal Reserve’s post-2008 fed funds rate target “range.”

A Floor System Calls for Substantial Excess Reserves

Abstracting, then, from the “leakiness” of the Fed’s IOER-rate floor, and the presence of an ON-RRP rate sub-floor, the basic idea of a floor system is that the interest rate on excess reserves displaces the fed funds rate as the key monetary policy rate. That’s because, in an ideal (leak-free) floor system, banks would neither lend nor borrow federal funds, whether from other banks or from non-bank financial institutions. Instead, they find it more profitable to hold excess reserves. A necessary and sufficient condition for this is that the IOER rate be sufficiently high relative to equivalent private-market rates of interest. In that case, banks will find it more attractive to hold excess reserves than to lend in private overnight markets, including the fed funds market. So long as they accumulate sufficient excess reserves, they can also protect themselves against any need to borrow funds overnight to meet either their net settlement needs or their legal reserve requirements. Of course the banks will find it especially easy to accumulate excess reserves if the Federal Reserves creates large quantities of fresh reserves, as the Fed did through its various rounds of quantitative easing. Still in the long run what matters most for the existence of a floor system is, not that any particular nominal quantity of reserves should be available, but that banks should have a robust demand for excess reserves, as they will only so long as such reserves yield a sufficiently attractive return.

In an orthodox floor system, such as is established when these conditions hold, the market for bank reserves functions as in the diagram below, taken from Marvin Goodfriend’s locus classicus on the subject:

As the diagram shows, so long as banks hold sufficient excess reserves, monetary policy becomes a matter of making desired changes to the IOER rate alone. Through arbitrage those changes will influence other interest rates. Changes in the actual stock of bank reserves, on the other hand, are neither necessary nor sufficient to influence the general state of interest rates. Instead, banks holdings of excess reserves increase and decline in lock-step with shifts in the supply of total reserves, leaving not only interest rates but lending, spending, and the inflation rate largely unchanged.

Whence the Deflationary Bias?

You’re still wondering what all this has to do with the Fed’s persistent undershooting of inflation. Trust me, I’m getting there!

It might appear that the switch from a conventional to a floor system should make no difference in the Fed’s ability to pursue whatever policy it wishes. After all, all that has changed is the mechanism by which the Fed pursues its policy targets, rather than its ability to set and pursue those targets. Whereas before, to loosen (or tighten) policy, the Fed may have had to increase (or reduce) the available supply of bank reserves, now it only has to lower (or increase) the IOER rate. So, why shouldn’t it be able to lower that rate enough to get inflation to 2 percent, or whatever other figure it prefers?

The answer is that, while in principle it could achieve a higher rate of inflation by lowering its IOER rate sufficiently (or, in the actual case, by lowering both its IOER and ON-RRP rates sufficiently), it cannot generally achieve any inflation rate that it wants while also maintaining a floor system. On the contrary: as I’ll explain in a moment, although the masterminds behind the Fed’s turn to a floor system don’t seem to have realized it, maintaining such a system necessarily introduces a deflationary bias in monetary policy.

To see why, recall that, to maintain a floor system, the IOER rate has to be high relative to corresponding market rates. Otherwise banks won’t be inclined to accumulate and sit on substantial excess reserves. Instead, they’ll increase their lending in wholesale and other markets that offer them better risk-adjusted returns. To serve as a floor (and forgetting about GSE-based leaks), the IOER rate must be an above-market rate.

That the Fed’s IOER rate has in fact been kept above corresponding market rates is easily shown by comparing it to its closest private-market counterparts. Of those the closest is probably the Depository Trust & Clearing Corporation’s GCF (General Collateral Finance) U.S. Treasury and Agency-Based MBS Repo rate index. The next figure shows how the IOER rate has generally been kept above, and often well above, that comparable market rate:

A comparison of the IOER rate and yields on various shorter-term Treasury securities tells a similar story:

As can be seen, whenever market rates have tended to increase, the Fed has made a point of having its IOER rate keep up with those changes. It has done so, moreover, despite the fact that it has persistently fallen short of its inflation target. Clearly the rate adjustments cannot be justified by appeal to the Fed’s desire to stick to that target. They can, on the other hand, be accounted for as inevitable consequences of the Fed’s determination to keep its shiny new (albeit leaky) floor system going.

A Wicksellian Perspective

I’m still not quite done, for I’ve yet to explain in the clearest way possible why a floor system introduces a low inflation bias in monetary policy. Doing that requires that I appeal to Knut Wicksell’s understanding of how an economy’s rate of inflation depends on the relation between its central bank’s chosen policy rate and the economy’s corresponding “natural” rate of interest. According to Wicksell, a policy rate set below its “natural” level will tend to promote inflation, while one set above its natural level will tend to promote deflation.

One can quibble with the details of Wicksell’s argument, as I myself have done by noting that a nation’s inflation rate depends, not just on its central bank’s monetary policy stance, but on the state of economic productivity, among other things. (For this reason I think it better to speak of an above-natural policy rate inevitably leading, not necessarily to deflation or disinflation, but to an excessively low rate of NGDP growth.) The point remains that a central bank that tends to set its policy rate too high will also tend to generate less inflation than it wants.

To see that this is exactly what will happen if a central bank insists on preserving a floor system, imagine that we are back in the pre-2008 monetary control regime, with no IOER and a market-determined fed funds rate. Assume as well that the rate is both on target and at it’s “natural” level — that is, the Fed’s target is consistent with a modest (if not zero) rate of inflation.

Now suppose the Fed decides to switch to a floor system. To do that, it first has to set an IOER rate at least as high as the established fed funds rate, and therefore either at or above the natural funds rate, so as to encourage banks to accumulate excess reserves, in anticipation of boosting the supply of reserves. These steps are needed to get the fed funds market onto the flat portion of the reserve demand schedule shown in Goodfriend’s diagram above. Thenceforth, to stay in the new regime, as natural rates increase the Fed must increase the IOER as well. While a below-natural IOER rate will undermine the floor system by causing banks to shed their excess reserves, an above-natural IOER rate won’t. A permanent floor system is, for this reason, a recipe for monetary over-tightening.

Obviously, if the Fed decides to introduce a floor system at a time when policy is already tight, so that the going fed funds rate is already an above-natural rate, the switch will tend to result in additional over-tightening, since it must involve introducing an IOER rate that’s at least as high as the already excessively high established fed funds rate. Something like this appears, in retrospect, to be what happened in October 2008.

A Missing Piece

My explanation for the Fed’s persistent tendency to undershoot its inflation target is still not quite complete. For it rests on the underlying premise that the Fed is determined, by hook or by crook, to maintain a floor system of monetary control. What proof have I of that?

It is a good question. My answer is, first of all, that the proof lies at least partly in the pudding. For, as I’ve stated, were it not for its determination to keep a floor system in place, it would be difficult to explain the Fed’s insistence upon raising its policy rate despite falling short of its inflation target. Further evidence consists of the Fed’s present normalization plan, which calls for eventual increases in the federal funds rate by close to 175 basis points. So far as Fed officials have indicated, that increase is to be achieved entirely by means of equivalent increases in the IOER rate. In short, if the Fed has any intention of ever returning to its pre-IOER operating system, or to a true “corridor” system in which the IOER rate serves not as an upper but as a lower bound for the fed funds rate, it has given no indication of it. On the contrary: having spoken to several Fed insiders on the matter, I’m assured that the Fed has every intention of sticking to the present system.

Why it should wish to do so is a different matter. I’m pretty sure that part of the reason is that Fed authorities are themselves unaware of the over-tightening bias present in a floor system. They applaud, on the other hand, the fact that a floor system allows them to separately manage interest rates on the one hand and the state of bank liquidity on the other. In recent Congressional testimony,I likened the Fed’s gain in flexibility in a floor system — its being able to set its policy rate however it likes, while altering the supply of bank reserves however it likes — to the gain an automobile owner might secure, in being able to turn the wheel as much as she likes, while also stepping on the gas peddle however much she likes, by shifting from Drive to Neutral. The problem, of course, is that, while the driver seems to have more options, the car no longer gets her where she wants to go.

The Solution

What do you suppose it is? The Fed has to abandon its misguided floor system, the sooner the better, by moving to reduce its IOER rate, instead of increasing it — as it has been planning to do. As the rate falls from above market to below market, the money multiplier will revive; and that revival will, believe you me, prove more than adequate to boost spending enough to get the PCE inflation rate to 2 percent — and beyond. To keep it from getting too high, the Fed will have to plan on more aggressive balance sheet reductions or resort to its Term Deposit Facility or both. All this is difficult, but not impossible. The Fed can certainly do it if it tries. What it can’t do is stick to the present floor system and reliably hit its inflation target.

[Cross-posted from Alt‑M.org]

About a month ago, a Facebook post drew my attention to an attempt, by Casey Pender of Prague’s CEVRO Institute, to test my thesis that free banking contributes to NGDP stability using statistical evidence from Canada, which had a relatively free banking system between 1867, the year of Canada’s confederation, and 1935, when the Bank of Canada was established.

In “Some Odd Data on Free Banking in Canada,” a blog post discussing his preliminary findings, Pender reports that he had hoped to be able to show that Canada, from 1867–1935, had a more stable NGDP percent change from year to year than the U.S. And I thought this would be an easy and quick historical example that I could use to bolster my underlying theory. But things seem like they just ain’t so.

Instead, in comparing the fluctuations of Canadian and U.S. NGDP using data from the Macrohistory database, Pender found that Canadian NGDP was not less but more volatile. Moreover that conclusion held not just for the full 1870–1935 sample period, but also for the sub-period 1870–1914, which omits various extraordinary Canadian government interventions during WWI and the Great Depression.

Here is Pender’s chart showing his results from the full sample period:

Having now been made privy to these findings, I suppose that you are looking forward to seeing ol’ Doc Selgin eat humble pie. Well, you can quit holding your breath ’cause that won’t be happening anytime soon. In fact, for the moment at least, I remain thoroughly impenitent.

How come? First of all, I never claimed that free banking alone could achieve any particular degree of absolute stability of nominal spending. What I have claimed is that, by tending to offset changes in the velocity of money with opposite changes in its quantity, free banking makes for a more stable relationship between the level of overall spending and the available quantity of base or high-powered money than might exist otherwise. To the extent that the available quantity of base money itself changes, however, the quantity of money will also tend to change independently of its velocity. Total spending will then tend to vary also.

What’s more, under an international gold standard regime like the one in place during Canada’s free banking episode, the amount of base money in any particular gold standard country was hardly likely to remain stable or grow at a very steady rate. On the contrary: changes in trade patterns and international capital flows were bound to routinely alter the distribution of gold among gold standard countries, just as changes in trade patterns and capital flows within individual countries are bound to alter the distribution of gold among those countries’ various regions. To the extent that it consisted of holdings of monetary gold, Canada’s monetary base was no less subject to change than the monetary base of, say, Nova Scotia.

In fact during the free-banking era Canada’s base money consisted of both monetary gold and paper “Dominion notes” first issued by the Canadian government in 1866. While some portion of these had to be fully backed by gold, there was also an un-backed or fiduciary component, the quantity of which rose from just $8 million in 1868 to $30 million by the outbreak of World War I. Until 1885 or so at least, those fiduciary issues, instead of being linked even loosely to gold flows, or otherwise regulated for the sake of economic stability, varied according to the Canadian governments’ fiscal needs. Consequently Dominion note issues tended to be an additional cause of irregular changes to Canadian NGDP.

A proper test of the theory that free banking helped to stabilize Canadian NGDP must therefore consider, not just fluctuations in Canadian NDGP as such, but the relationship between those fluctuations and underlying changes in Canada’s monetary base. So long as Canada’s NGDP fluctuations were driven by underlying changes in Canada’s stock of base money, instead of being independent of such changes, the fluctuations were perfectly consistent with the theory.

So, what does the record have to say about it? To find out, I had Tyler Whirty, the CMFA’s trusty RA, run some simple regressions for me, with Canadian NGDP as their dependent variable, and Canada’s stock of base money (M0) as the independent variable. The NGDP estimates are the same ones employed by Pender, from the Macrohistory database[1], while the monetary base numbers are from Metcalf, Redish, and Shearer (1998). So far we’ve looked only at the pre-WWI record, as that era is most aptly described as one of relatively unblemished free banking. We also ran the regressions both using raw data and after taking logs. I shall report only the log results, as those fit the data best; but the general conclusions to be reported here don’t depend in the least on the log transformations.

The results, shown in the next figure, are not just consistent but remarkably consistent with the theory, and especially so given that Canada’s arrangement involved some not entirely trivial departures from the theory’s assumptions, one of which is that paper money is supplied by commercial banks alone. (In fact, Canada’s banks were prohibited from issuing notes worth less than $5.) The regression R‑squared is .980254, while the coefficient on M0, about .80, seems quite reasonable allowing for the fact that some Canadian base money, including smaller Dominion notes, circulated instead of serving as bank reserves.

Although the Canadian results seem perfectly consistent with the theory, we still have to compare them with evidence from the U.S. as a step toward establishing that the stable relationship they point to might be attributable to Canada’s having had a free banking system: were a similarly close relationship to exist in the U.S. data, that would suggest that Canada’s distinct institutional arrangements, including free banking, didn’t really make any difference.

For our base U.S. regression, we drew again upon the Macrohistory database, using its U.S. NGDP estimates (which were originally developed by Louis Johnston and Samuel H. Williamson[2]). For the U.S. monetary base, we subtracted national bank notes from Philip Cagan’s monetary base figures: while Cagan himself justified including those banknotes by noting that they were practically claims against the U.S. Treasury, we exclude them because, despite that, they were neither legal tender nor capable of satisfying banks’ legal reserve requirements.

Because Cagan’s numbers only start in 1875, the U.S. regression covers a somewhat shorter period than the Canadian one.

While the results of the U.S. regression suggest a relationship between U.S. NGDP and M0 that’s broadly similar to the Canadian one (M0 coefficient .825), that relationship, as depicted in the next figure, is considerably less tight, with an R‑squared of .908. That the Canadian relation should be so much tighter now seems all the more remarkable, given both the relatively small size and openness of Canada’s economy, and its heavy dependence upon U.S. exports to the U.S.

To check the robustness of these U.S. results, we performed the same regression using Angus Maddison’s NGDP estimates in place of the Johnston-Williamson numbers. Although the R‑squared, of about .0935, is a bit higher in that case, the coefficient (.769) is similar:

In brief, both our Canadian regression results themselves, and a comparison of those results with results using U.S. data, seem fully consistent with the theory that free banking helps to stabilize the relationship between NGDP and the monetary base.

Does that mean they confirm the theory? Alas, it doesn’t. Freedom in banking is but one of many differences between the pre-WWI Canadian system and its U.S. counterpart. Furthermore, even if Canada’s more stable NGDP-M0 relationship were in fact due to its having had a relatively free banking system, it wouldn’t follow that my theory is correct. Free banking could well have contributed to the stable relationship in question for reasons apart from the one my theory points to. We know, for example, that branch banking — itself an element of free banking — made Canada’s system less fragile, and therefore less vulnerable to financial crises, than the U.S. system. We also know that financial crises tend to involve a collapse in bank credit and spending. So the relative stability of the Canadian NGDP-M0 relationship, instead of reflecting a tendency for changes in M to offset opposite changes in V, may instead simply have reflected a relative lack of banking crises and associated increases in the ratio of bank reserves to bank credit. Although all this is still good news for fans of free banking, it leaves my particular hypothesis unproven.

In short, while my theory has yet to be discredited, it also has yet to be confirmed. I hope that either Mr. Pender or some other enterprising econometrician will eventually settle the matter, one way or the other.

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[1] Òscar Jordà, Moritz Schularick, and Alan M. Taylor, “Macrofinancial History and the New Business Cycle Facts,” in NBER Macroeconomics Annual 2016, volume 31, edited by Martin Eichenbaum and Jonathan A. Parker. 2017. Chicago: University of Chicago Press.

[2] Louis Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” MeasuringWorth, 2017.

[Cross-posted from Alt‑M.org]

Prior to 2008, the Fed could accelerate or decelerate inflation by expanding or contracting the monetary base and therefore bank reserves with open market operations and/or with repo loans to dealers. Since 2008, however, the Fed has paid interest on excess reserves equal to or even higher than the effective federal funds rate. As a result, the banks are awash with excess reserves that have zero opportunity cost, and the Fed has lost its primary mode of control over the price level and inflation.

Pre-2008

Until 2008, bank reserves earned zero interest. Banks normally held only a tiny inventory of excess reserves to meet withdrawals and adverse clearings, typically well under 0.5% of checkable deposits. The federal funds market efficiently allowed banks with surplus reserves and no immediate borrowing partner to lend them to banks that were short on reserves or were able to expand loans. The fed funds rate that banks charge one another for one-day use of reserves was typically well below the average rate banks got on somewhat risky customer loans that required close supervision, but represented the risk-adjusted opportunity cost to banks of marginal excess reserves.

Under this regime, if the Fed expanded the base and therefore excess reserves, banks would scramble to lend out any excess reserves beyond this small inventory to businesses or consumers who wanted the loans to make purchases they could not otherwise make, thereby driving up prices and at the same time temporarily driving down the fed funds rate.

Similarly, it could decelerate inflation by contracting the base, leaving banks with either precariously small excess reserves or an outright reserve shortfall. As banks contracted loans and thereby deposits to restore their reserves, businesses and consumers would spend less. At the same time, banks would temporarily bid the fed funds rate up.

IOER since 2008

Since October of 2008, however, the Fed has paid interest on excess reserves (IOER) at or slightly above the fed funds rate, as shown in the figure 1 below:

Figure 1: Effective Fed Funds Rate and IOER

Since 2008, the Fed has more than quadrupled the monetary base though its QE I-III acquisitions of mortgage-backed securities and Treasury securities. These acquisitions were financed mostly through the creation of new excess reserve balances, shown in figure 2 below. Thanks to IOER, however, banks have been in no rush to lend these funds out, and instead are content to just sit on them. The Fed in effect is acting as a huge financial intermediary, borrowing reserve deposits from the banks at interest and lending them back to homeowners as mortgages or to the Treasury by investing in the National Debt.

Figure 2: Excess Reserve Explosion

This intermediation activity on the part of the Fed is not without adverse consequences, but has not in itself been inflationary, since IOER ensures that it is being financed with deposits that are savings instruments at the margin, rather than money per se.

When banks are awash with interest-bearing excess reserves, as they have been since 2008, there is little if any need for a fed funds market, since banks can earn interest simply by depositing surplus reserves with the Fed, and can obtain funds simply by withdrawing these deposits. To the extent there is a fed funds market, the fed funds rate should be essentially equal to the IOER rate. Indeed, the fed funds market has shrunk from over $300 billion in 2007 to barely $50 or $60 billion in recent years.

From late 2008 through November 2015, the IOER rate was only 0.25% and the fed funds rate itself was a little under 0.2%, neither of which is much different than zero -- recall that the FOMC typically moves its fed funds target in multiples of 0.25%, which is therefore its estimate of the smallest perceptible increment to the rate. However, the Fed’s IOER policy in fact made a difference for banks’ willingness to hold reserves, since they could be confident that when market rates rose, IOER would rise with them, so that there never would be an opportunity cost to holding excess reserves. Since late 2015, the IOER and fed funds rate have indeed risen together, to about 1.25% and 1.15% by July of 2017.

Although interest-bearing reserve deposits are themselves not particularly inflationary, the consumer deposits they support are free to drain off as currency. Currency in circulation, which does not pay interest, has almost doubled since 2007, while nominal GDP has only grown by 33.3%. Ultimately the price level must equate the supply and demand for all components of the money supply, including currency. Artificially low interest rates may have temporarily increased the demand for currency, but this situation cannot be expected to continue indefinitely.

Unwinding IOER

Unfortunately, abruptly restoring IOER to zero would potentially be very inflationary, given the Fed’s bloated balance sheet, since it would be equivalent to suddenly quadrupling the base under the pre-2008 regime.

I have no easy solution to this predicament, but recommend that the Fed immediately begin reversing its QE I-III acquisitions until the Base is approximately back to its 2007 level, adjusted for nominal GDP growth to approximately $1130 billion. Treasuries have a very liquid market and can be sold as quickly as the Fed acquired them. Mortgage-backed securities are much less liquid, but at a minimum the Fed should immediately begin allowing them to run down to zero by not reinvesting any interest or return of principal it gets from its mortgage portfolio. As it does this, it can temporarily hold IOER at its present level, thereby gradually creating an opportunity cost to excess reserves as the fed funds rate lifts off above IOER. Then, when it has restored control of the situation, it can lower IOER to zero.

Interest on Required Reserves (IORR)

Interest on Required Reserves, or IORR, is an entirely different matter than IOER. Before 2008, when IORR was zero along with IOER, reserve requirements acted as a modest excise tax on transactions deposits, and therefore gave banks a strong incentive to game them through the introduction of NOW Accounts, Money Market Deposit Accounts, Retail Sweep Accounts, etc. These “near money” de facto transactions accounts have left the concept of M1 narrow money hopelessly muddled.

However, there is no particular reason to have a special excise tax on transactions deposits, aside from the FDIC’s user fee for deposit insurance, since banks already pay income taxes on the income generated by their deposit-creation activities. I would therefore recommend retaining IORR, setting it at say the average of the fed funds rate over the previous two weeks, or slightly lower.

One beneficial but little-noticed provision of Dodd-Frank is that it rolled back the anti-competitive 1932 prohibition of interest on Demand Deposits. Retaining IORR would therefore permit the consolidation of NOW accounts, Money Market Deposit Accounts, and therefore Sweep Accounts into a single interest-bearing Demand Deposit category, thereby greatly simplifying monetary statistics.

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More from Alt-M on Interest on Reserves:

• Interest on Reserves, Part 1
• Interest on Reserves, Part 2 
• Interest on Reserves, Part 3
• Interest on Reserves and the Fed's Balance Sheet
• On Shrinking the Fed's Balance Sheet 
• IOER and the Banks' Demand for Reserves, Yet Again
• Our Unhinged Fed