Why do I keep harping on interest on reserves? Because, IMHO, the Fed’s decision to start paying interest on reserves contributed at least as much as the failure of Lehman Brothers or any previous event did to the liquidity crunch of 2008:Q4, which led to a deepening of the recession that had begun in December 2007.

That the liquidity crunch marked a turning point in the crisis is itself generally accepted. Bernanke himself (The Courage to Act, pp. 399ff.) thinks so, comparing the crunch to the monetary collapse of the early 1930s, while stating that the chief difference between them is that the more recent one involved, not a withdrawal of retail funding by panicking depositors, but the “freezing up” of short-term, wholesale bank funding. Between late 2006 and late 2008, Bernanke observes, such funding fell from $5.6 trillion to $4.5 trillion (p. 403). That banks altogether ceased lending to one another was, he notes, especially significant (p. 405). The decline in lending on the federal funds market alone accounted for about one-eighth of the overall decline in wholesale funding.

For Bernanke, the collapse of interbank lending was proof of a general loss of confidence in the banking system following Lehman Bothers’ failure. That same loss of confidence was still more apparent in the pronounced post-Lehman increase in the TED spread:

The skyrocketing cost of unsecured bank-to-bank loans mirrored the course of the crisis. Usually, a bank borrowing from another bank will pay only a little more (between a fifth and a half of a percentage point) than the U.S. government, the safest of all borrowers, has to pay on short-term Treasury securities. The spread between the interest rate on short-term bank-to-bank lending and the interest rate on comparable Treasury securities (known as the TED spread) remained in the normal range until the summer of 2007, showing that general confidence in banks remained strong despite the bad news about subprime mortgages. However, the spread jumped to nearly 2–1/2 percentage points in mid-August 2007 as the first signs of panic roiled financial markets. It soared again in March (corresponding to the Bear Stearns rescue), declined modestly over the summer, then showed up when Lehman failed, topping out at more than 4–1/2 percentage points in mid-October 2008 (pp. 404–5).

These developments, Bernanke continues, “had direct consequences for Main Street America. … During the last four months of 2008, 2.4 million jobs disappeared, and, during the first half of 2009, an additional 3.8 million were lost.” (406–7)

There you have it, straight from the horse’s mouth: the fourth-quarter, 2008 contraction in wholesale funding, as reflected in the collapse of interbank lending, led to the loss of at least 6.2 million jobs.

But was the collapse of interbank lending really evidence of a panic, brought on by Lehman’s bankruptcy? The timing of that collapse, as indicated in the following graph, tells a much different story.

The first of the three vertical lines is for September 15, 2008, when Lehrman went belly-up. Interbank lending on the next reporting date — September 17th — was actually up from the previous week. Thereafter it declined a bit, and then rose some. But these variations weren’t all that unusual. As for the TED spread, although it rose sharply after Lehman’s failure, the rise reflected, not an actual increase in the effective federal funds rate (as the “panic” scenario would suggest), but the fact that that rate, though it actually declined rapidly, did not do so quite as rapidly as the Treasury Bill rate did:

OK, now on to those other vertical lines. They show the dates on which banks first began receiving interest payments on their excess reserves. There are two lines because back then two different sets of banks had different “reserve maintenance periods,” and therefore started getting paid at different dates. (The maintenance periods have since been made uniform.) Those (mostly smaller) banks with one-week reserve maintenance periods began earning interest on October 15th; the rest, with two-week maintenance periods, started getting paid on October 22nd. The collapse in interbank payments volume coincides with the latter date. Notice also that the collapse continues after the TED spread has returned to a level not so different from its levels before Lehman failed.

If you still aren’t convinced that IOR was the main factor behind the collapse in interbank lending, perhaps some more graphs will help. The first shows the progress of interbank lending over a somewhat longer period, along with the 3‑month Treasury Bill rate and (starting in October 2008) the interest rate on excess reserves:

To understand this graph, think of the banks’ opportunity cost of holding excess reserves as being equal to the difference between the Treasury Bill rate and the rate of interest on excess reserves. Prior to October 15th, 2008, the opportunity cost, being simply equal to the Treasury Bill rate itself, is necessarily positive. But when IOR is first introduced, it becomes practically zero; and shortly thereafter it becomes, and remains, negative. Mere inspection of the chart should suffice to show that the volume of interbank lending tends to vary directly with this opportunity cost.

Once the interest rate on excess reserves is fixed at 25 basis points after mid-December 2008, things get simpler, as the volume of interbank lending varies directly with the Treasury Bill rate. Here is a chart showing that period, with the opportunity cost itself (that is, the Treasury Bill rate minus 25 basis points) plotted along with the volume of interbank lending:

Now, it would be one thing if Bernanke were merely guilty of misunderstanding the cause of the decline in interbank lending, without having actually been responsible for that decline. But Bernanke was responsible, as was the rest of the Fed gang that took part in the misguided decision to start rewarding banks for holding excess reserves in the middle of a financial crisis.

What’s more, it is hard to see how Bernanke can insist that the Fed’s decision to pay IOR had nothing to do with the drying-up of the federal funds market given the justification he himself offers for that decision earlier in his memoir, which bears quoting once again, this time with emphasis added:

[W]e had been selling Treasury securities we owned to offset the effect of our lending on reserves… . But as our lending increased, that stopgap measure would at some point no longer be possible because we would run out of Treasuries to sell….The ability to pay interest on reserves…would help solve this problem. Banks would have no incentive to lend to each other at an interest rate much below the rate they could earn, risk-free, on their reserves at the Fed (p. 325).

Yet when he turns to explain the causes of the collapse in interbank lending, just eighty pages after this passage, Bernanke never mentions interest on reserves. Instead, he blames the collapse on panicking private-market lenders, while treating the Fed — and, by implication, himself — as a White Knight, galloping to the rescue. “As the government’s policy response took effect,” he writes, “the TED spread declined toward normal levels by mid-2009” (p. 405). What rubbish. We’ve already seen why the TED spread went up and then declined again. And although interbank lending itself revived somewhat during the first half of 2009, it declined steadily thereafter, ultimately falling to lower levels than ever.

And the Fed’s “policy response”? According to Bernanke, it had “four main elements: lower interest rates to support the economy, emergency liquidity lending…and the stress-test disclosures of banks’ conditions” (409). Let Kevin Dowd tell you about those idiotic stress tests. As for “lower interest rates,” they were proof, not that the Fed was taking desirable steps, but that it was failing to do so, for although the Fed did get around to reducing its federal funds rate target, its doing so was a mere charade: the equilibrium federal funds rate had long since fallen well below the Fed’s target, and the subsequent moves merely amounted to a belated recognition of that fact, without making any other difference. Finally, although the Fed’s emergency lending aided the loans’ immediate recipients, as well as their creditors, it contributed not a jot to overall liquidity, the very point of IOR having been — as Bernanke himself admits, and as I explained in my first post on this topic — to prevent it from doing so!

As the next chart shows, IOR, besides contributing to the collapse of interbank lending, also played an important part in the dramatic increase in the banking system reserve ratio. The vertical lines represent the same three dates as those referred to in the very first chart. Although the ratio did rise considerably following Lehmans’ failure, it rose even more dramatically — and, quite unlike the TED spread, never recovered again — after the Fed started paying interest on excess reserves:

To better understand what went on, here is another diagram, this one showing banks’ choice of optimal reserve and liquid asset ratios as a function of the interest paid on bank reserves:

In the diagram, the vertical axis represents the interest rate on reserve balances, in basis points, while the horizontal axis represents the reserve-deposit ratio. The picture shows two upward-sloping schedules. The first is for reserve balances at the Fed, while the second is for liquid assets more generally, here meaning (for simplicity’s sake) reserves plus T‑bills. The horizontal line shows the yield on T‑bills at the time of implementation of IOR, here assumed to be a constant 20 basis points. The two dots, finally, represent equilibrium ratios, the first (at the lower left) for before the crisis and IOR, the other for afterwards. Note that, the high post-IOR ratio reflects, not just the interest-sensitivity of reserve demand, but that, with IOR set at 25 basis points, reserves dominate T‑bills. Thus, although the demand for excess reserves may not be all that interest sensitive so long as the administered interest rate on reserves is less than the rate earned by other liquid assets, that demand can jump considerably if that rate is set above rates on liquid and safe securities.

The last chart I’ll trouble you with today tracks changes in total commercial bank reserves, interbank loans, Treasury and agency securities, and commercial and industrial loans, from mid-2006 through mid-2009, this time with a single vertical line only, for October 22, 2008, when IOR was in full effect:

The chart shows clearly how the beginning of IOR coincided, not only with a substantial decline in interbank lending (green line), but in a leveling-off of other sorts of bank lending, which later becomes a pronounced decline. For illustration’s sake, the chart shows the course of C & I lending only; other sorts of bank lending fell off even more.

Don’t get the wrong idea: I don’t wish to suggest that IOR was responsible for the post-2008 decline in bank lending, apart from overnight lending to other banks. There’s little doubt that that decline mainly reflects the effects of both a declining demand for credit and much stricter regulation of bank lending, especially as Dodd-Frank and Basel III came into play, Nor do I believe that merely eliminating IOR, as opposed to either reducing the regulatory burdens on bank lending, or resorting to negative IOR (as some European central banks have done), or both, would have sufficed to encourage any substantial increase in bank balance sheets, and especially in bank lending, after 2009, when most estimates (including the Fed’s own) have “natural” interest rates sliding into negative territory. But as I noted in my first post in this series, when IOR was first introduced, natural rates were, according to these same estimates, still positive. And one thing IOR certainly did do, both before 2009 and afterwards, was to allow banks, and some banks more than others, to treat trillions in new reserves created by the Fed starting in October 2008, not as an inducement to expand their balance sheets, but as a direct source of risk- and effort-free income. (Note, by the way, how, just before IOR was introduced, but after the Fed stopped sterilizing its emergency loans, bank loans and security holdings did in fact increase along with reserves.)

Moreover, it’s evident that the FOMC itself, rightly or wrongly, sees IOR as continuing to play a crucial part in limiting banks’ willingness to expand credit. Otherwise, how can one possibly understand that bodies’ decision last month to raise the rate of IOR (and, with it, the upper bound of its federal funds rate target range) from 25 to 50 basis points? That decision, recall, was aimed at making sure that bank credit expansion would not progress to the point of causing inflation to exceed the Fed’s 2 percent target:

The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective. Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent. The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

Bernanke’s implementation and defense of IOR would be more than bad enough, were it not also for his particular determination to avoid repeating the mistakes the Fed made during the Great Depression. “[M]ost of my colleagues and I were determined,” he says, “not to repeat the blunder the Federal Reserve had committed in the 1930s when it refused to deploy its monetary tools to avoid a sharp deflation that substantially worsened the Great Depression” (p. 409). Among the Fed’s more notorious errors during that calamity were its failure to expand its balance sheet sufficiently, through open-market purchases or otherwise, to offset the dramatic, panic-driven collapse in the money multiplier during the early 1930s, and its recovery-scuttling decision to double reserve requirements in 1936–7.

Of course, Bernanke’s Fed didn’t commit the very same mistakes committed by the Fed of the 1930s. But, as David Beckworth had already recognized by late October 29, 2008, it made remarkably similar ones that also resulted in a collapse of credit. “History,” Bernanke credits Mark Twain with saying, “does not repeat itself, but it rhymes” (p. 400). If you ask me, Bernanke himself was a far better versifier — and a far worse central banker — than he and his many champions realize.

[Cross-posted from Alt‑M.org]

The history of China’s banking system in the first half of the 20th century offers powerful insights into the conduct of monetary policy and the consequences of government intrusion into banking and monetary institutions that are well worth considering today. Monetary economists and monetary historians would do well to study China’s example, and, in particular, Chang Kia Ngau’s 1958 book, The Inflationary Spiral: The Experience in China, 1939–1950. As you’ll see, sound money and sound banking matter a great deal in creating a harmonious and prosperous society.

In 1905, during the final years of the Qing Dynasty, the first government bank, the Hupu Bank, opened in Peking. It was established by the Imperial Ministry of Revenues when China was still on the silver standard to help finance government deficits by issuing paper currency (see specimen above). In 1908, the bank was renamed the Ta Ching Government Bank (Great Qing Bank), and in 1912, under a new charter, the bank became known as the Bank of China. Another government bank of issue, the Bank of Communications, was established in 1908.

The constant pressure for central and provincial governments to increase spending beyond revenues led to attempts to suspend convertibility. For example, in 1916, President Yuan Shih-kai of the Republic of China ordered the Bank of China and the Bank of Communications to halt convertibility of their bank notes, and the public was instructed to accept those irredeemable notes at par. The largest note-issuing bank, the Shanghai Branch of the Bank of China, refused to comply with the president’s order and was able to defend its notes against a bank run. The Peking Branch of the Bank of China, however, complied with the order, as did the Bank of Communications (Chang: p. 5).

In Manchuria, officials imposed the death sentence on individuals who exchanged irredeemable bank notes at less than par. Despite this severity, there were heavy discounts on provincial government bank notes “which placed a very real limit on the extent to which these issues could be increased.” By 1922 all irredeemable notes from the Bank of China and the Bank of Communications were withdrawn (Chang: p. 5). The public then slowly regained confidence in paper currency as banks recommitted to redeem their notes in silver.

Institutional Limits on the Quantity of Money

In March 1928, the Bank of China sought to enhance the credibility of its currency by embarking on institutional reform to limit note issue. The bank established a “Supervisory Committee” in Shanghai, comprised of members from the Chamber of Commerce, the Bankers’ Association and the Native Bankers’ Association, designed to ensure that the bank had sufficient silver backing for its notes. The Committee published quarterly reports on the bank’s reserve position that were certified by a public accountant (Chang: p. 6).

This institutional check on the credibility of the bank’s promise to honor its commitment to maintain a convertible currency was also adopted by the newly created Central Bank of China, as well as by the Bank of Communications and private banks. To quote Chang (p. 6), “The public became less wary of holding bank notes, and note circulation increased rapidly in the years after 1928. Sound currency gradually drove the unsound notes of the provincial banks out of circulation except in Manchuria and Canton” (emphasis added).

Currency Reform

The silver backing of bank notes was relaxed by the rule change that allowed banks to back up to 40 percent of their note issues with government bonds, and, in November 1935, the central government replaced the silver standard with a foreign exchange standard. The currency reform provided that only notes issued by the Central Bank of China, the Bank of China, and the Bank of Communications would be acceptable as legal tender, and would henceforth be called “the Chinese National Currency” (CNC). Silver could no longer be used to back bank notes, and the public would have to return all monetary silver to a government appointed Currency Reserve Board or to its agents in exchange for CNC (Chang: p. 7).

Those who drafted the new currency plan had recommended additional measures to safeguard the value of money: (1) make the Central Bank of China independent of the Ministry of Finance; (2) establish a Supervisory Committee to limit note issue and avoid inflation; and (3) rationalize government financing to minimize deficit spending and debt monetization. However, those sensible measures were never instituted and instead bank notes in circulation were increased from CNC $453 million in 1935 to nearly CNC $1.5 billion by mid-1937 (Chang: p. 8).

Fiscal Dominance, Inflation, and Repression

Demands on the fisc increased during the Second Sino-Japanese War (1937–1945). The lack of central bank independence and the lack of any hard anchor for the price level under a pure government fiat money system led to an inflationary spiral. During the early war years, from 1937–39, inflation in “Free China” (areas not held by the Japanese) averaged 40–50 percent per year; inflation then accelerated to 160 percent per year until the end of 1941, and during the last four years of the war averaged more than 300 percent per year (Chang: p. 12).

Following the war, the Nationalist government continued to rely on the printing press to finance deficits, inflation spiraled upward, and the government imposed wage and price controls to suppress inflation.[1] Direct measures were also used and “economic instability finally led to a general loss of confidence in the Nationalist government, and total collapse of political and social morals followed” (Chang: p. 367).

Lessons

Several lessons emerge from China’s experiences prior to the Communist Party takeover in 1949. The first lesson is that long-run economic growth and prosperity depend on “respect for the soundness of private enterprise and banking.” When the government engages in massive debt monetization, the resulting inflation destroys “popular confidence in banking institutions” (Chang: p. 368).

Second, allocating capital to state-owned enterprises crowds out private investment. “Overzealousness in forcing the pace of economic development [by supporting state-owned enterprises] often results in little more than the destruction of private capital formation, thus defeating the very purpose of development” (Chang: p. 368).

Third, the inclination of underdeveloped countries to inflate means that “the establishment of an institutional framework for budget control and the independence of the central bank are of paramount importance for the long-term welfare of the population” (Chang: p. 368).

Fourth, “once inflation is under way, the government is perforce led to the path of increasing intervention and direct control.” Thus, inflation inevitably leads to the loss of economic and personal freedom as the government imposes wage and price controls and allocates resources. Corruption becomes endemic (Chang: pp. 368–69).

Fifth, the experience of Nationalist China shows “without equivocation that the complexity of modern economic life defies the grasp of any single individual” (Chang: p. 369). This point may seem trivial but is one that Nobel laureate economist F. A. Hayek often emphasized in such works as “The Use of Knowledge in Society” and The Fatal Conceit. Central bankers who favor pure discretion in the conduct of monetary policy — as opposed to rules — are prone to think that their intricate macroeconomic models capture the complexity of the real economy and that they can accurately forecast the path of the economy. In contrast a rules-based regime recognizes the difficulty of monetary planning and the benefits of what legal scholar Richard Epstein calls “simple rules for a complex world.”

The most important lesson, perhaps, is that “inflation is no less an enemy of the free society than Communism and, as we have seen in China, may be a harbinger of a Communist triumph” (Chang: 369).

Conclusion

China’s economic experiences during the first half of the 20th century reinforce fundamental principles about the importance of sound money and banking, fiscal rectitude and economic freedom for creating a harmonious society. It also suggests that the adoption of a rules-based monetary regime, which limits money creation and allows competing currencies, also deserves further attention.

____________

[1] This was the second time the Nationalist government resorted to wage and price controls; the first use was in December 1938. However, enforcement was difficult because as Chang (p. 343) notes, “The public … was antagonistic to all forms of government controls on the economy; still prevalent was the laissez faire view that market problems would best solve themselves if only the government would not interfere.”

[Cross-posted from Alt‑M.org]

Of the many bemusing chapters of the whole interest-on-reserves tragicomedy, none is more jaw-droppingly so than that in which the strategies’ apologists endeavored to show that paying interest on reserves did not, after all, discourage banks from lending, or contribute to the vast accumulation of excess reserves.

Apart from resting on logic that’s bound to bring a smile to the face of anyone reasonably conversant with the rudiments of Money and Banking 101, these demonstrations fly in the face, both of the original justification for IOR, as offered by Federal Reserve officials themselves, and of the Fed’s recent decision to double IOR (and, with it, the upper-bound of the Fed’s federal funds rate target range) so as to prevent inflation from rising above the Fed’s 2 percent target.

Now, unless general understanding of basic monetary economics has deteriorated even more than I suspect it has over the course of the crisis and recovery, that understanding still sees inflation as a consequence of “too much money chasing too few goods.” But money can either chase after goods, or rest in bank vaults (or in the virtual vaults consisting of deposits at the Fed). It can’t do both. Thus the logic (and for once it is logical logic) behind the Fed’s decision, both in October 2008 and last month, to check inflation by raising the interest return on bank reserves.

Now on to the exhibits. I start with another passage from the Richmond Fed article by Walter and Courtois referred to in my earlier post. There I noted how these authors shared Bernanke’s own understanding of the Fed’s decision to introduce IOR in October 2008. “Once banks began earning interest on the excess reserves they held,” Walter and Courtois write, “they would be more willing to hold on to excess reserves instead of attempting to purge them from their balance sheets via loans made in the fed funds market.”

Perfectly correct. Nor do Walter and Courtois suggest that there was anything wrong with the Fed’s understanding of what it was up to. Yet, some paragraphs later, the same authors declare that banks’ subsequent accumulation of excess reserves

has mistakenly been viewed by some as a sign that the Fed’s lending facilities — the goal of which has been to maintain the flow of credit between banks, and therefore from the banking sector to firms and households — have not worked.

Now, this is already rather confusing, for as we’ve seen, according to these authors themselves, the whole point of IOR was, not to “maintain the flow of credit” in the sense of keeping it from shrinking — for shrink it most certainly did — but to make sure that the Fed’s additions to the total stock of reserves did not increase that flow, which is to say, did not serve to arrest the flow’s decline.

But let us set our befuddlement aside, in order to allow our authors to dispute the view that the vast post-IOR accumulation of excess reserves was evidence that the Fed’s emergency loans and asset purchases weren’t serving to “maintain” an adequate flow of credit:

To the contrary, the level of reserves in the banking system is almost entirely unaffected by bank lending. By virtue of simple accounting, transactions by one bank that reduce the amount of reserves it holds will necessarily be met with an equal increase in reserves held at other banks, and vice versa. As described in detail in a 2009 paper by New York Fed economists Todd Keister and James McAndrews, nearly all of the total quantity of reserves in the banking system is determined solely by the amount provided by Federal Reserve. Thus, the level of total reserves in the banking system is not an appropriate metric for the success of the Fed’s lending programs.

A gold star to all who spot the fallacy here. For those who can’t, it’s simple: “reserves” and “excess reserves” aren’t the same thing. Banks can’t collectively get rid of “reserves” by lending them — the reserves just get shifted around, exactly as Walter and Courtois suggest. But banks most certainly can get rid of excess reserves by lending them, because as banks acquire new assets, they also create new liabilities, including deposits. As the nominal quantity of deposits increases, so do banks’ required reserves. As required reserves increase, excess reserves decline correspondingly. It follows that an extraordinarily large quantity of excess reserves is proof, not only of a large supply of reserves, but of a heightened real demand for such, and of an equivalently reduced flow of credit.

And what about Keister and McAndrew’s 2009 paper, which Walter and Courtois refer to as the locus classicus of their argument? As Jamie McAndrews has generously contributed, in the course of several recent email exchanges and also in his published works, to my own understanding of the whole IOR business, I’m pleased to report that a careful reading of that paper does not support the conclusion that Walter and Courtois draw from it. On the contrary: Keister and McAndrews understand that, unlike the total quantity of reserves, the quantity of excess reserves is a function of banks’ willingness to lend. Moreover, they remind their readers that the Fed began paying interest on reserves “to prevent the increase in reserves from driving market interest rates below the level it deemed appropriate given macroeconomic conditions,” and that it was only owing to IOR that banks willingly held on to so many excess reserves instead of lending them away.

But while the 2009 paper by Keister and McAndrews cannot be said to confuse the determinants of banks’ excess reserve holdings with those of banks’ total reserves holdings, the same cannot be said of an August 27, 2012 Liberty Street Economics post by Keister and Gaetano Antinolfi. Antinolfi and Keister explicitly deny that the Fed, by lowering the interest return on excess reserves, might encourage banks to “lend out some of these ‘idle’ balances.” Why not? Because, according to their reasoning, “lowering the interest rate paid on reserves wouldn’t change the quantity of assets held by the Fed.” Since lowering the rate of IOR is also unlikely to increase the share of the monetary base consisting of currency rather than bank reserves, it follows that it “will not have any meaningful effect on the quantity of balances banks hold on deposit at the Fed.”

Here is that silly fallacy again: for the question isn’t whether a lower rate of IOR can reduce banks’ total reserve balances. It is whether it can reduce their excess (“idle”) balances by inducing them to lend more. For while such lending wouldn’t serve to reduce the aggregate stock of reserves, it would lead to an increase in the nominal quantity of bank deposits, and a proportional increase in banks’ required reserves. So, even as they caution their readers that “Language Matters,” Antinolfi and Keister blunder badly by neglecting to heed the crucial distinction between the total quantity of bank reserves, which no amount of bank lending can alter, and the quantity of excess reserves, which, by means of sufficient bank lending, might always be reduced to zero.

Speaking of language, one of the peculiarities of how it evolves, according to my own (admittedly inexpert) observations, is the particular tendency of bad language memes to go viral. Once upon a time, some moron imagined that “incentivise” was a word, and the next thing you knew every other moron couldn’t wait to slip it into a sentence.

In the same way, bad monetary analysis has a way of spreading like a wildfire. So I suppose it was only to be expected that Antinolfi and Keister’s “proof” that lowering IOR wouldn’t promote bank lending would be cited approvingly (or at least not disapprovingly) by numerous other commentators. Jon Hilsenrath reported favorably on Antinolfi and Keister’s argument for the Wall Street Journal’s Real Time Economics blog, as did Jonathan Spicer for Reuters, while Mark Thoma included a large chunk of their post in a post of his own, without expressly endorsing it, but also without suggesting that there was anything wrong with it.

The mistaken understanding of Keister and McAndrews (or, as now seems more likely, the correct understanding of Keister’s own contribution to that work) likewise became, in some quarters at least, the popular understanding. Thus, according to Frances Coppola, writing for Forbes,

The volume of excess reserves in the system is what it is, and banks cannot reduce it by lending. They could reduce excess reserves by converting them to physical cash, but that would simply exchange one safe asset (reserves) for another (cash). It would make no difference whatsoever to their ability to lend. Only the Fed can reduce the amount of base money (cash + reserves) in circulation. While it continues to buy assets from private sector investors, excess reserves will continue to increase and the gap between loans and deposits will continue to widen.

Nor, according to Ms. Coppola (writing in another Forbes column), has IOR anything to do with it:

Banks are not being paid not to make loans. They don’t lend out reserves to customers. They only lend reserves to each other. By competing with banks in the market for reserves, the Fed controls the price at which they lend reserves to each other. It has nothing whatsoever to do with customer lending.

There you have it: banks can hold on to reserves, and yet lend all they wish to (though not, for some reason, overnight). Such a marvelous business! Whoever said that one can’t have one’s cake and eat it, too?

Well, banking would indeed be a marvelous business if it worked as our expert at Forbes assumes. Alas, it is not so marvelous at all in fact. For despite what Ms. Coppola claims, banks do, in effect, lend “reserves” to customers no less than to other banks. The lending of “reserves” is more apparent in the overnight market simply because it is reserves per se that borrowers in the market are after, for they need extra reserves to avoid shortfalls that would otherwise subject them to penalties, or to what amounts to the same thing: a visit to the Fed’s discount window.

If, on the other hand, a businessman borrows $500,000 from a bank, it isn’t cash itself that the businessman wants, but other things that can be got for the cash. But as soon as the proceeds of the loan, originally received as a deposit balance, are drawn upon for the sake of acquiring these other things, the withdrawals, whether by check or draft, lead quickly to redeposits in other banks, and thence to a $500,000 adjustment to the pattern of interbank clearings and settlements at the expense of the lending bank and in favor of rival institutions compared to what would have been the case had it not made the loan.

All this is entirely elementary. Yet it is not just the folks at Forbes that don’t get it. Here is what The Economist had to say back in December 2009 about the piling-up of excess reserves:

The point is that the Fed is not trying to increase lending by increasing reserves; it is trying to increase lending by lowering long-term rates and directly supplying credit to borrowers who can’t get it elsewhere. Higher reserves are the unintended byproduct. Well, unintended or not, couldn’t all those excess reserves spur credit growth and inflation? No. Reserves have not been a relevant constraint on bank lending for decades, if ever. Bank lending is constrained by customer demand and by capital. Right now, loan demand is moribund (in spite of a zero federal funds rate) and capital is in short supply.

Although it is certainly true that the Fed wasn’t trying to get banks to lend more, it did not itself believe that reserves were not a “relevant constraint on bank lending.” If it had thought so, it would not have bothered sterilizing its pre-Lehman lending, and it would not have resorted post-Lehman to paying interest on excess reserves. Jose Berrospide has it right when he says that, once that policy was in place,

banks sold assets worth selling, such as treasuries and [other] government securities, because the return on those assets was almost zero. Banks accumulated cash and excess reserves at the central bank because of the interest earned on reserves balances.

The Fed’s creation of vast quantities of fresh reserves did not result in a like increase in bank lending, not because reserves had ceased to be a relevant constraint on lending “decades before,” but because, thanks to IOR, “the marginal return on loans [was] smaller than the opportunity cost of making a loan” (ibid.).

Nor, as I pointed out in my previous post, was bank lending capital constrained except for a brief time during 2009. After that, many banks held both excess reserves and excess capital. As for lending being “constrained by customer demand,” oh puh-lease! The quantity of loans demanded, which is what the writer ought to be talking about, depends on the rate charged. The problem is that no bank was willing to lend for, or to buy assets yielding, less than the rate paid on reserves themselves.

Economists seem lately to have built a little cottage industry around the notion that those old-fashioned accounts of bank lending, what with their reserve multipliers and clearing losses and all that, are passé. To subscribe to them is to be hopelessly out of fashion. Well, call me an old fogey if you must, but I say, show me some au courant writings on the matter, and I will show you some fashionable nonsense.

[Cross-posted from Alt‑M.org]

In this past summer’s controversy over whether Alexander Hamilton’s image should be replaced on the $10 bill, outraged commentators made many extravagant claims on behalf of Hamilton’s wisdom in matters of money and banking policy. For example, Ben Bernanke blogged that “Hamilton was without doubt the best and most foresighted economic policymaker in U.S. history,” citing among other evidence that “over the objections of Thomas Jefferson and James Madison, Hamilton also oversaw the chartering in 1791 of the First Bank of the United States, which was to serve as a central bank and would be a precursor of the Federal Reserve System.”

Now that the controversy has cooled we can take a more informed perspective. There is no denying Hamilton’s importance and influence, or that his life story is compelling, as evidenced by the sold-out hip-hop musical Hamilton currently running on Broadway. But the wisdom of his policy advice, and the merits of the First Bank of the United States (BUS), are another matter.

To describe Hamilton’s Bank accurately, one should note that Congress owned one fifth of its shares, and chartered it exclusively, that is, made it the only bank allowed by law to branch nationwide. (State governments chartered banks, but each state denied entry to banks with charters from other states.) The BUS monopoly franchise was among the chief of the objections of Jefferson and Madison, and deservedly so. One nationwide bank is better than none, but many is better than one. Creating a legal monopoly where open competition could and should prevail is hardly a mark of good or foresighted economic policy.

Many modern-day historians miss this point, and laud Hamilton as a man of unerring financial genius. Robert E. Wright and David J. Cowen, in their 2006 book Financial Founding Fathers: The Men Who Made America Rich, write of Hamilton’s “creative genius, as he became the architect and chief advocate of a powerful national bank.” They claim that “Hamilton’s thought was often far in advance of that of most of his contemporaries,” as when he was early to advocate a national bank. They quote Hamilton’s 1781 statement that “in a National Bank alone we can find the ingredients to constitute a wholesome, solid and beneficial paper credit,” and add: “He was correct.” They call Hamilton’s 1790 Report on the Bank “a masterpiece that cogently explained the importance of banks in a capitalist economy.” They credit Hamilton with the following argument, as though it made good sense: “Next, he stressed that all the great powers of Europe possessed public banks and were indebted to them for successful trade and commerce. The implications of the comparison were clear: if young America wanted to join the ranks of the elite powers, it too would have to create a banking infrastructure.” In much the same way, Hamilton would elsewhere argue that if the leading European nations have protective tariffs, we should have them too. The error should be plain.

Hamilton modeled the Bank of the United States after the Bank of England. But in truth, the monopoly privileges of the BOE and other national banks of Europe were badges of mercantilism, and drags on financial and economic activity by comparison with free competition in banking services. A more wholesome, solid, and beneficial credit system could be observed in Scotland at the time, with free entry into nationwide branch banking. Hamilton’s “masterpiece” was oblivious to the benefits of competition in banking, much less the separation of banking and state. In his banking policy views, as in his tariff policy views, Hamilton was a retrograde mercantilist.

Wright and Cowen note that in drafting his plan for the Bank, “Hamilton also drew on Adam Smith’s seminal work, An Inquiry into the Nature and Causes of the Wealth of Nations, where financial matters, including the advantages of banks and bank money, were amply and ably discussed. Hamilton must have brimmed with excitement as he read Smith declare that ‘the trade of Scotland has more than quadrupled since the first erection of the two publick banks at Edinburgh.’” They should also have noted that in his able discussion Smith — the penetrating Scottish critic of mercantilism — did not defend monopoly privileges in banking, but argued for free competition (see below). The “publick” banks of Edinburgh were chartered non-exclusively (note that Smith refers to the two earliest; later there would be a third plus dozens of non-chartered joint-stock banks that were similarly sized and equally branched nationwide), and were completely privately owned. Nor were they great engines of the state, as the Bank of England was according to Smith. Unlike the BOE or the BUS, which were created in large part to lend the national government money, the Bank of Scotland was actually prohibited by its 1695 charter from lending to the government.

The policy conclusion of Smith’s chapter on banking (Book II, chapter II of the Wealth of Nations) bears quoting here:

The late multiplication of banking companies in both parts of the United Kingdom, an event by which many people have been much alarmed, instead of diminishing, increases the security of the public. … By dividing the whole circulation into a greater number of parts, the failure of any one company, an accident which, in the course of things, must sometimes happen, becomes of less consequence to the public. This free competition, too, obliges all bankers to be more liberal in their dealings with their customers, lest their rivals should carry them away. In general, if any branch of trade, or any division of labour, be advantageous to the public, the freer and more general the competition, it will always be the more so.

In light of Smith’s clarity and correctness here, it is actually a telling criticism of Hamilton to note that he read Smith on banking, because it means that he ought to have known better when he promoted monopoly privileges. Although Hamilton’s Report on the Bank alludes to Smith’s understanding of how banking promotes the wealth of a nation, Hamilton either didn’t understand Smith’s policy message — the more banks competing the better — or rejected it as not helpful to his own mission of empowering the federal government, for which his chosen means was to forge an alliance between the government and a new privileged financial elite.[1] Smith’s policy here was wise, and Hamilton’s not.

In brief, contrary to what is nearly the conventional wisdom, Alexander Hamilton was not “far in advance” of contemporary thinking on banking. He was decidedly retrograde in pushing for an exclusive nationwide bank with a sweetheart government deal. He was not a creative policy genius so much as a persuasive second-hand dealer in discredited mercantilist ideas.

____________________________ [1] Here I draw upon a dissertation chapter, unfortunately not available online, by Nicholas Curott.

[Cross-posted from Alt‑M.org]

In a recent blog post, St. Louis Fed Vice President David Andolfatto suggests that central banks “consider offering digital money services (possibly even a cryptocurrency) at the retail and wholesale level.” His reasoning is straightforward. Bitcoin, he observes, offers a host of benefits, most of which relate to its role as a payment device. It enables individuals to transfer funds more cheaply than traditional payment mechanisms. But it also has shortcomings, the chief of which, Andolfatto claims, is its short-run price volatility.

As an alternative, Andolfatto points to “Fedcoin” — a central bank-issued cryptocurrency proposed earlier by J.P. Koning. In theory, Fedcoin would employ the same blockchain ledger technology as bitcoin to transfer funds between accounts. However, as Koning explains, “One user — the Fed — would get special authority to create and destroy ledger entries, or Fedcoin.” To what end? According to Koning, “The Fed would use its special powers of creation and destruction to provide two-way physical convertibility between both of its existing liability types — paper money and electronic reserves — and Fedcoin at a rate of 1:1.” Hence, Fedcoin would offer the payment system advantages of bitcoin — the ability to transfer funds cheaply — without its excessive purchasing power instability.

In an earlier post on the topic, Andolfatto goes even further by claiming that “the Fed is in the unique position to credibly fix the exchange rate between Fedcoin and the USD.” And, lest one think his claim applies exclusively to Fedcoin, he clarifies that “the Fed has a comparative advantage over some private enterprise” issuing a distinct cryptocurrency “backed by USD at a fixed exchange rate.”

Although Andolfatto is right to claim that the Fed — or any central bank for that matter — has a comparative advantage in issuing substitutes that are accepted at par with its other liabilities, it is certainly not in a unique position to issue a digital, P2P (peer-to-peer or person-to-person) cryptocurrency that is accepted at par. There are all sorts of par-valued, dollar-denominated private digital monies. In the US, private banks issue electronic balances that exchange at par with the dollar. There are also P2P monies that trade at par. The notes and coins issued by a currency board are P2P (in the sense of person-to-person and that they need not be cleared by a central authority). And, since an orthodox currency board holds sufficient reserves by definition, it will maintain par acceptance. Private banks in Scotland and Northern Ireland issue circulating notes that exchange at par with the British pound. Clearly, private providers are capable of supplying either a digital or P2P money that trades at par with an established official currency.

In fact, there is even today at least one dollar-based, privately-provided digital, peer-to-peer cryptocurrency. Billed as the world’s first stable digital currency, NuBits (an altcoin governed by the Nu protocol) has only deviated from its $1 par value by $0.025 or more on fourteen days — and only twice for two consecutive days — since it was launched on September 23, 2014. In other words, NuBits are remarkably stable in terms of the dollar. Figure 1 tells the whole story:

How does the Nu protocol maintain a fixed exchange rate between its NuBits and the dollar? In brief, its owners (“NuShareholders”) vote to adjust the supply of NuBits in circulation to equal current demand for NuBits at exactly $1. Those interested in all the details should consult the original white paper and discussion forum. I sketch out the basics below.

The Nu protocol relies on the premise that demand for NuBits will tend to grow over time. For a fixed-supply cryptocurrency, like bitcoin after it reaches the 21-million-coin cap, an increase in demand increases its price and market capitalization (i.e., price times quantity of coins). The increase in the market capitalization, or network value, of a fixed-supply cryptocurrency accrues to coinholders as their coins appreciate. For NuBits, in contrast, an increase in demand only increases the market capitalization — not the price. The increase in the market capitalization, or network value, of NuBits accrues to NuShareholders, who (through custodial grants) create and sell new NuBits for $1. Revenues generated through the sell of these newly created NuBits are used to cover operating expenses and pay dividends to NuShareholders. Hence, NuShareholders are residual claimants on the network value of NuBits and, as such, have an incentive to maximize the value of the NuBits network.

NuShareholders stand ready to create and sell NuBits anytime demand increases because it generates the revenue used to pay their dividends. In other words, we can be pretty confident there will be sell side liquidity in the market for NuBits. Any buyer will be able to find a seller at $1. But how and why would NuShareholders produce buy side liquidity? Or, to state the matter another way, how and why do they contract the supply of NuBits in circulation when demand decreases?

NuShareholders have several mechanisms to decrease the supply (or effective supply) of NuBits in circulation when demand decreases, thereby offsetting a reduction in price. Originally, NuShareholders would simply vote to pay interest to NuBit owners who agree to “park” a balance of NuBits for a period of time. When a user agrees to park a balance of NuBits, the balance is marked as parked on the blockchain and cannot be spent for the agreed upon park period. When the agreed park period expires, control of the balance is returned to the owner along with the interest earned. Park rates vary by duration and are adjusted regularly by NuShareholders to ensure that enough NuBits are effectively (if only temporarily) removed from circulation when needed.

Recent updates offer additional mechanisms to reduce the supply of NuBits. NuShareholders can vote to increase the transaction fee, which, rather than being distributed to participants (as is the case with bitcoin and most other cryptocurrencies), is permanently destroyed. They might also vote to convert some NuBits to NuShares. This process, known as “NuBits burning,” is described as follows:

In the event of parking rates being offered for a prolonged period of time, NuShareholders can vote to create new NuShares that are sold through auction. The proceeds from this auction would then be used to purchase NBT on the open market, at which point the purchased NBT would be destroyed permanently by the custodian. The net result would be a dilution of equity value for all NuShareholders in order to reduce the outstanding supply of NBT in circulation. This price support mechanism allows NuShareholders to reduce the supply of NBT to match periods of contracting demand.

With these mechanisms, NuShareholders are able to manage the supply of NuBits in circulation to maintain par acceptance with the dollar.

Why would NuShareholders incur the costs to maintain par acceptance in the face of a negative, transitory shock to the demand for NuBits? Essentially, NuShareholders believe that, as Nu protocol developer Jordan Lee states in the original white paper, “Temporarily losing peg will harm the value of the network.” They are surely right. After all, there are a lot of alternative cryptocurrencies available. The unique feature of NuBits is that it has a fixed exchange rate with the dollar. Abandoning that commitment would render NuBits no better than the competition. To boost the network value — and maximize their dividends — NuShareholders must protect the fixed exchange rate.

Is the Nu protocol the answer to all our monetary economic prayers? Absolutely not. First, it would not seem to meet the robustness standards of a “real monetary rule,” as outlined by George Selgin. Unlike the automatic (if crude) supply protocol of bitcoin and most other cryptocurrencies, the NuBits supply protocol depends on voting NuShareholders. Second, it can — by definition — be no more stable than the dollar. Widespread adoption of NuBits would provide no refuge from the Fed’s monetary mismanagement.

Nonetheless, one might appreciate that the Nu protocol offers the advantages of transferring funds with blockchain ledger technology, like bitcoin, without the disadvantages of bitcoin’s short-run price volatility. Although the Fed has a comparative advantage in issuing substitutes that are accepted at par with its other liabilities, it is far less likely, as Andolfatto acknowledges, to offer a permissionless, privacy-protecting cryptocurrency. The Nu protocol provides a pseudonymous cryptocurrency that trades at par with the dollar. In other words, it is already doing precisely what advocates of FedCoin hope a central bank-issued cryptocurrency would do.

[Cross-posted from Alt‑M.org]

On December 3, Congress passed a new highway and transit bill allocating $305 billion over the next five years. Part of the funding, allegedly $35.8 billion, will be taken from the Federal Reserve’s capital account. Further details on the maneuvering between the Senate and House versions, and Fed objections, are here, here, and here. Under the final compromise bill, about 8 percent of the Fed’s $35.8 billion contribution will involve a diversion of dividends from commercial banks, but the remainder is just a silly and deceptive gimmick for covering future federal expenditures. Both the banks and the Fed failed in their last-minute efforts to curtail these provisions during the debate over the omnibus spending bill that Congress passed last week.

To appreciate exactly what these provisions will do, we need to examine more closely the nature of the Fed’s capital account. The Fed is only nominally owned by its member banks, which comprise all nationally chartered banks and eligible state-chartered banks that choose to join. Member banks are required to hold an amount equal to 6 percent of their own capital and surplus in the “shares” of their respective district Federal Reserve Banks. Half of this amount is paid in; the other half is subject to call by the Fed’s Board of Governors. As member banks increase or decrease in size, their holdings must be adjusted accordingly. Obviously these “shares” are not like ordinary shares. They cannot be bought or sold on a secondary market, nor are they in any sense residual claims to the Fed’s earnings.

In exchange for these “shares,” member banks get a few limited privileges. Prior to 1980, the Fed’s check clearing and discount window was confined to member banks, but since then all banks and other depositories have access to both of these, with a market fee now imposed for check clearing. Member banks still get to choose six of the nine directors of their respective district Fed Banks, but only with severe constraints, which have gotten more severe with the passage of the Dodd-Frank Act. This gives banks some slight formal and circuitous influence over Fed policy.

But the main benefit of these “shares” is the dividend they pay, until now fixed by law at exactly 6 percent of the paid-in portion of a member bank’s capital. This is a bad deal for banks whenever inflation and nominal interest rates are high but a very good deal since the financial crisis. These “shares” therefore are financially more like debt than equity, in which member banks pass on funds to the Fed, which in turn buys Treasury securities (almost exclusively in the past) and now mortgage-backed securities. The member banks are in effect indirectly loaning money to the government in exchange for a fixed 6‑percent return.

The Senate version of the highway bill would have reduced the members dividends to 1.5 percent, with the remaining 4.5 percent payable by the Fed to the U.S. Treasury. When member banks unsurprisingly and strongly objected, the House struck out this provision to replace it with a second way of tapping into Fed capital explained below. The bill’s final compromise ties the dividend for member banks with more than $10 billion in assets to the interest rate on 10-year Treasury bonds, currently 2.2 percent, up to a maximum of 6 percent. This will release for payment to the Treasury an estimated $2.8 billion over the next five years. In essence, it constitutes a trivial reduction in the interest cost of government borrowing, annually about a quarter of a percent of the government’s current interest costs of over $200 billion (and this is net of existing Fed remittances to the Treasury).

This feature of the bill also makes more obvious the fact that the so-called “ownership” of the Fed by private banks is little more than a requirement to fund the Treasury. The reduced dividend over the long run may decrease the attractiveness of Fed membership for state-chartered banks. Given that the Fed power over non-member banks is now almost as extensive as over member banks, that hardly seems to matter much. The one attractive aspect of this way of funding is that, rather than increasing the total level of government spending, it merely redirects outlays from banks to transportation.

The paid-in portion of member bank “shares,” however, is only one of two components of the Fed’s capital account. The other component, labeled “surplus,” comprises residual Fed earnings from interest on its assets.[1] The House version of the bill, instead of diverting dividends, proposed employing this surplus capital, which today amounts to $29.3 billion, to cover new expenditures on highways and transit. Congress in the past has imposed levies on the Fed’s surplus, starting in 1933, when it took half to fill the coffers of the new Federal Deposit Insurance Corporation. In 1997 and again in 1998, Congress pulled out $100 million, and in 2000 it extracted $3.7 billion. Yet in each of these cases, the Fed replenished the surplus out of subsequent earnings. The House, in contrast, intended to empty the account permanently. The compromise version of the bill that passed both houses caps the Fed’s surplus capital at $10 million, with the remaining being passed to the Treasury, supposedly providing $33 billion of extra revenue over the next five years.

Until now, the Fed has almost always kept the value of surplus capital equal to the value of the other, paid-in component of the Fed’s capital, a mere reflection of that half of member bank “shares” that have not been paid in. Only briefly have Federal Reserve district banks ever drawn down their capital surplus, at least 158 times according to 2002 study by the General Accounting Office (since renamed the Government Accountability Office). This step was taken so as to absorb losses the Fed had incurred, mainly through its foreign-exchange operations, between 1989 to 2001.

But since the Fed creates money, the surplus capital is basically an accounting mirage. There is no idle pot of cash sitting in the account.[2] Any money that has been paid into the Fed — either through the sale of assets, through repayment of loans made by the Fed, or even through interest the Fed has earned on its assets — is not counted in the monetary base. When the receipts come from private banks or the general public, the money is withdrawn from circulation at the moment the Fed receives it, temporarily vanishing. Only if the Fed again pays out that money, does the monetary base go back up. Of course, much of it is immediately paid back out, as the Fed rolls over its asset portfolio or covers its operating expenses, so there is a constant flow of base money in out. Yet otherwise, these Fed receipts merely create an accounting entry on the Fed’s balance sheet labeled either as “accrued dividends and other liabilities” or “surplus capital.”

Much of the Fed’s revenue, however, comes not from the private sector but directly from the Treasury, as interest on the Fed’s portfolio of Treasury securities. Prior to the financial crisis, this was indeed the primary source of Fed income, but now it accounts for just a bit more than half of the total ($63 billion out of total earnings of $116 billion for calendar year 2014), with nearly all of the remainder from interest on mortgage-backed securities. The effect of these Treasury interest payments on the monetary base is a bit convoluted, but broadly it works out the same as for other Fed earnings. The difference is that the money has already been pulled out of circulation by the Treasury.[3] Still, when the Treasury initially pays interest to the Fed, the net amount not paid out again appears on the Fed’s balance sheet as “accrued dividends and other liabilities” or “surplus capital.”

In other words, the surplus capital is merely an entry on one side of the Fed’s balance sheet matching assets on the other side. To be sure, those assets do earn interest. So one way of thinking about the Fed’s surplus capital is that it permits the Fed to hold interest earning assets without increasing the monetary base. But after covering its expenses, the Fed remits most of its earnings to the Treasury on a monthly basis. (Out of $116 billion in Fed interest earnings from all sources during 2014, $97 billion was remitted to the Treasury.) Thus, to the extent that surplus capital increases the size of the Fed’s balance sheet, any additional earnings are ultimately funneled back to the Treasury already.[4]

With no actual money in the surplus capital account to begin with, the Fed can only reduce the account in one of three possible ways. The most straightforward would be for the Fed to create $19.3 billion of new base money for the Treasury to spend. In the first year, surplus capital would be run down to $10 billion, with $19.3 billion of Fed deposits and currency on the same side of the balance sheet ultimately replacing this fall in capital.[5] The total on each side of the balance sheet would remain unchanged. The Congressional Budget Office estimates that future increases in the capital of member banks will require the Fed to continue funneling between $2 and $3 billion of “surplus capital” per year to the Treasury. Because this method increases the money supply and is mildly inflationary, the Fed will more likely sterilize the transfer in two other ways discussed by Ben Bernanke in a blog post criticizing the House plan.

One of these alternatives would involve the Fed immediately selling off $19.3 billion of Treasury securities and transferring the proceeds from those sales to the Treasury. This would reduce the Fed’s total balance sheet on both sides by the same amount, but keep the monetary base roughly unchanged, sterilizing the transfer. But since the Treasury securities sold are now owned by the general public rather than the Fed, the Treasury no longer receives Fed remittances for the interest paid on this portion of its debt. What the Treasury has gained in one lump sum it now looses in the form of future income from the Fed, with the present value of both approximately the same. In short, with no new revenue or increased taxation, the Treasury’s new transportation expenditures will merely increase government deficits.

The Fed could instead cover its payment of $19.3 billion to the Treasury by directly reducing its regular Treasury remittances. In effect, the Fed would still only be giving back to the Treasury what it has first received from the Treasury in the form of interest payments. Again, the Treasury will lose approximately as much as it gains. Recall that in 2014, total Fed remittances to the Treasury came to $97 billion. So all the Fed would have to do is reclassify $19.3 billion of its future excess earnings as a payment from the surplus capital. To simultaneously reduce the surplus account to $10 billion without selling off any assets, all the Fed needs to do is move $19.3 billion into “other liabilities and accrued dividends.”  Ceteris paribus, the balance sheet totals and the monetary base remains unchanged. The additional highway spending will still increase current and future budget deficits.

The Fed will probably use some judicious mix of all three methods to comply with the new requirement. Admittely, reducing the surplus capital from $19.3 to $10 billion also reduces the amount subject to call by the Fed Board from member banks. But since the Fed creates money, it has no need to exercise this call. This reduction in capital on call could decrease the extent to which the Fed can impose on bank shareholders any losses from a bank failure. Given how many other capital controls are placed on banks through the Fed, FDIC, and other federal agencies, it is hard to imagine that this will really have noticeable consequences.

In the final analysis, the only significant change for the Fed brought about by the highway bill is the adjustment in dividends paid to member banks, probably a desirable reform. The reduction in the Fed’s surplus capital, on the other hand, is an ineffectual cosmetic change, which the Fed can easily offset, raising the question of why Janet Yellen and other Fed officials have objected at all. The most insidious and misleading aspect of this attempted raid on the Fed is Congress’s ridiculous pretense that it will finance a spending hike without increasing taxes, increasing the deficit, or having the Fed print money. In reality, there are no other options.

——

[1] Prior to January 1, 2011, the Fed’s capital account included a third component, labelled “other capital,” which consisted of additional Fed earnings that had not yet been remitted on a monthly basis to the Treasury or paid out as dividends. Since then, this component has been removed from the capital account and relabeled as “other liabilities and accrued dividends.” But in practice, it works out the same as the surplus capital, except its total value, which is much lower, is more volatile.

[2] There is one minor exception. The Fed does hold as an asset some Treasury created base money in the form of coins, currently about $1.9 billion.

[3] I’ve abbreviated what happens for clarity. Most tax and other payments from the public to the Treasury are initially deposited in tax and loan accounts at assorted depositories. Since these Treasury bank deposits are not counted in the broader monetary measures, tax payments reduce the total money stock, ceteris paribus, but have no initial impact on the base. Before the Treasury makes expenditures, it transfers these deposits from the banks to the Fed, sometimes within a day or less. At that point, these transfers do reduce the monetary base. On the Fed’s balance sheet, bank reserves fall by the amount by which Treasury deposits at the Fed go up. The exact reverse occurs when the Treasury makes expenditures, except for when it pays interest to the Fed.

[4] Milton Friedman and Anna Jacobson Schwartz were well aware of the quasi-fictitious nature of the Fed’s capital accounts when in Appendix B, “Proximate Determinants of the Nominal Stock of Money,” of A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), pp. 797–798, they consolidated the Fed and Treasury monetary accounts by subtracting Fed capital from U.S. government securities on the asset side.

[5] Again I’ve abbreviated. Treasury deposits at the Fed will most likely go up with the initial fall in surplus capital, and the base will only increase as the Treasury draws down its deposits to spend the money.

[Cross-posted from Alt‑M.org]

In my last post regarding Ben Bernanke’s memoir, I took Bernanke’s Fed to task for electing to sterilize its pre-AIG emergency lending, thereby making sure that, while it was rescuing a small number of troubled firms, it was also reducing the liquid reserves available to others. It was doing this, moreover, at a time when increasingly worrisome economic conditions were giving rise to exceptional liquidity demands. The predictable result was an overall shortage of liquidity, which manifested itself in a collapse of bank lending and spending.

I now turn to an even more mind-bogglingly wrongheaded step taken by Bernanke’s Fed in the course of the financial crisis: it’s decision to pay interest on banks’ excess reserves.

The Fed began paying interest on reserves (IOR) in mid-October 2008, just after ending its program of sterilized lending. That these steps coincided was no accident, for interest on reserves was meant to be a substitute for sterilization, aimed at the same result, namely: that of making sure that the Fed’s gross asset purchases did not give rise to any corresponding increase in bank lending.

The Fed resorted to IOR because, by the time of Lehman’s failure, it had reduced its Treasury holdings to their practical minimum. Consequently, when it came to bailing-out AIG, the Fed found itself in a quandary: the bailout would mean an increase in the overall size of the Fed’s balance sheet, and a like increase in the monetary base. Other things equal, the increase would mean a loosening of monetary policy. Yet the Fed was determined to avoid such a loosening.

It was to escape from this quandary that the Fed came up with the oh-so-clever idea of rewarding banks for not lending their otherwise unneeded reserves in the middle of one of the twentieth-century’s most severe economic contractions. You needn’t take my word for it. Here it is from the horse’s mouth:

We had initially asked to pay interest [in 2006] on reserves for technical reasons. But in 2008, we needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which had the side effect of increasing bank reserves, would lead short-term interest rates to fall below our federal funds target and thereby cause us to lose control of monetary policy. When banks have lots of reserves, they have less need to borrow from each other, which pushes down the interest rate on that borrowing — the federal funds rate.

Until this point we had been selling Treasury securities we owned to offset the effect of our [emergency] lending on reserves (the process called sterilization). But as our lending increased, that stopgap response would at some point no longer be possible because we would run out of Treasuries to sell. At that point, without legislative action, we would be forced to either limit the size of our interventions…or lose the ability to control the federal funds rate, the main instrument of monetary policy…[By] setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much [emergency] lending we did (Courage to Act, pp. 325–6).

Nor does Bernanke’s understanding of the Fed’s action differ from that of other Federal Reserve authorities. In December 2009, for example, Richmond Fed economists John R. Walter and Renee Courtois offered an almost identical account. The Fed’s emergency credit injections, they wrote,

had the potential to push the fed funds rate below its target, increasing the overall supply of credit to the economy beyond a level consistent with the Fed’s macroeconomic policy goals, particularly concerning price stability.

For a while sterilization solved the problem. But

following the failure of Lehman Brothers and the rescue of American International Group in September 2008, credit market dislocations intensified and lending through the Fed’s new lending facilities ballooned. The Fed no longer held enough Treasury securities to
sterilize the lending.

This led the Fed to request authority to accelerate implementation of the IOR policy that had been approved in 2006. Once banks began earning interest on the excess reserves they held, they would be more willing to hold on to excess reserves instead of attempting to purge them from their balance sheets via loans made in the fed funds market, which would drive the fed funds rate below the Fed’s target for that rate.

There you have it. The Fed paid banks to hold excess reserves, so that they would quit lending them, in order to make sure that the “overall supply of credit” did not exceed levels “consistent with the Fed’s macroeconomic policy.”

And what level of credit supply was it that the Fed was so anxious to not “exceed”? Perhaps the following chart will give you some idea:

If you are starting to forgive me for using the term “wrongheaded,” I have made my point.

When the Fed first started paying interest on reserves, it did so at a rate exceeding the rate at which banks were prepared to borrow from one another in the overnight (“federal funds”) market. Because this was the case, banks more-or-less withdrew from that market, leaving only some GSE’s, which had reserve accounts at the Fed but were not eligible for IOR, to participate in it. The observed average overnight rate for transactions among these institutions — the so-called “effective” federal funds rate — has been consistently below the interest rate on excess reserves:

Needless to say, after most banks withdrew from the overnight market, the overall volume of overnight loans declined substantially. Remember all that talk about how Lehman’s failure led to heightened concerns about counterparty risk, which caused the interbank market to seize-up? Well, that’s not what happened. Although some large banks had to cut-back on overnight borrowing in response to Lehman’s failure, small banks actually borrowed more. A Liberty Street Economics post, from which the following image is taken, supplies details.

It’s possible, of course, that the banks that were flush with excess reserves wouldn’t have lent those reserves even if they didn’t bear interest, because those banks were also short of capital. The thesis is at least plausible, since the Fed supplied fresh reserves to capital-starved firms by swapping them for mortgage debt and other illiquid assets. The exchange reduced the cash recipients’ (risk-adjusted) capital requirements, but did so only if they held on to the cash. As an alternative to having to raise new capital, the swaps were a bargain — and especially so once reserves bore a modest return.

According to Huberto M. Ennis and Alexander L. Wolman, capital shortages did at first discourage banks that held excess reserves from lending them. But already by late 2009 some “would have been able to use reserves to accommodate a significant increase in loan demand without facing binding capital constraints.” Two years later, the same authors report, “a significant proportion of the reserves held by large banks…could have been quickly used to fund loans without pushing these banks against their minimum regulatory capital levels.”

The reserves “could have been” used. But they weren’t. Why not? Ennis and Wolman conclude that, for banks that were no longer capital constrained, limited “loan demand was likely the main driving force behind banks’ lending behavior.” But that is just another way of saying that the anticipated return on loans was low compared to the return from not lending — that is, compared to the return on holding reserves.

It remains possible nonetheless that IOR made little difference, because the return on loans would have been below the return on reserves even if the latter bore no interest. That at least some “natural” interest rates, including the natural overnight rate, became negative during the crisis, and that a few may still be negative today, is the belief of more than a few economists. That includes authorities in charge of several European central banks. What’s more, it includes Janet Yellen, who in a recent paper observes that “the natural real rate fell sharply with the onset of the crisis and has recovered only partially,” and supplies the following chart summarizing extant estimates of the natural ffr:

If these estimates, or at least some of them, are correct, banks would have withdrawn from the federal funds market by early 2009 even without IOR.

But several caveats are in order. First, note that the natural ffr estimates turn decisively negative only in late 2008. This suggests that, if, instead of introducing IOR in the first place, the Fed had allowed its post-Lehman asset purchases to translate into increased bank lending, and especially if it had not sterilized its asset purchases before then, the natural funds rate might never have gone negative. As I pointed out in my post on sterilization, a collapse in aggregate demand means, among other things, a collapse in the nominal demand for all sorts of credit, and a corresponding decline in market-clearing nominal interest rates.

Second, and no less importantly, while overnight lending rates may have turned negative, not all lending rates did so. Returning the interest rate on reserves to zero would therefore have encouraged bank lending, even if it failed to encourage overnight lending. The one caveat is that, because the supply of overnight funds itself would have remained constrained, banks would still have had a greater than usual need for excess reserves to meet their settlement needs.

Finally, even allowing that nothing short of negative interest on excess reserves would have inspired banks to lend those reserves, it remains the case that IOR was a bad policy, in the sense that abandoning it would at least have been a step in the right direction.

For my part, I do not doubt that, whether negative IOR would have been ideal or not, positive IOR played an essential part in the vast post-2008 accumulation of bank excess reserves — an accumulation that proceeded in lock-step with the Fed’s large-scale asset purchases, thereby allowing the Fed to add trillions to its balance sheet, without contributing a jot to bank lending:

Here is where I must part company with some of my Market Monetarist friends. For while those friends hold, as I do, that IOR was counterproductive, and that Fed asset purchases might have been far more effective in boosting recovery without it, they have tended nonetheless to defend the Fed’s large scale asset purchases (“quantitative easing”). I think this was a mistake, both because it meant accepting the Fed’s own dubious (and hardly “monetarist”) theories about how LSAPs were supposed to aid recovery despite the non-lending of added reserves, and because it overlooked the very real adverse effects of those purchases, including the sacrifice of ordinary means for monetary control that they entailed.

There are, I realize, some who argue that IOR isn’t really equivalent to paying banks not to lend, and that it is therefore not to blame for their having accumulated so many excess reserves. Their arguments are, if anything, even more screwy than the logic — which those arguments manifestly contradict — underlying the Fed’s decision to resort to IOR in the first place. But this post is long enough, so I’ll turn to these arguments in Part II.

***

As it happens, just as I am completing this post, Janet Yellen is holding a press conference announcing what she regards as the Fed’s first steps toward the “normalization” of monetary policy that has become a policy desideratum in the wake of the Fed’s highly abnormal marriage of IOR and large-scale asset purchases. Of what do these steps consist? First, the Fed will raise its federal funds rate target by a quarter of a percentage point — a meaningless gesture, given (as Yellen herself understands) that the target was already above the “natural” funds rate before the hike.

Second, the Fed plans to double the rate of interest on excess reserves.

Madness.

[Cross-posted from Alt‑M.org]