The bounds of monetary policy on Planet Earth

I read too much from monetarists and quasimonetarists and progressive monetarists and what not that monetary policy is what we need, that fiscal is unnecessary.

For the moment, let’s put aside the big disputes about whether macro demand-side remedies are a good idea. Let’s stipulate that they are, that increasing aggregate demand or accommodating people’s elevated demand for the medium of exchange or whatever would be a good thing. Woo hoo!

Here’s Bryan Caplan Arnold Kling, stipulating exactly that, despite some skepticism:

Intuitively, the equilibrium effect of a one-shot helicopter drop that doubles the money supply is to permanently double nominal income. If this leads to a stealthy, stable reduction in real wages, then output and employment go up permanently, too. Otherwise the price level doubles. Either way, there’s no reason for nominal income to recede as time goes on.

In short, if you think that boosting nominal income is the cure for recession, here’s yet another reason to prefer monetary to fiscal stimulus. One burst of expansionary monetary policy increases nominal income forever. One burst of expansionary fiscal policy increases nominal income for as long as the extra spending continues. At best.

I’m not sure Caplan is right on the economics here. His post seems to assume a world in which base money and bonds are imperfect substitutes. Some people might say that’s normal, and call the other situation a liquidity trap. But if so, liquidity trap is probably the new normal. The Fed has signaled (ht Aaron Krowne) they may pay interest on reserves at the overnight interest rate indefinitely under a so-called “floor” regime. I wish more economists would update their models for a world in which interest is paid on reserves as a matter of course. Interest on reserves represents a permanent policy shift that had been planned since 2006. It was not an ad hoc crisis response that can be expected to disappear. If interest is paid on reserves at the overnight rate and short-term bond markets are liquid, then short-term bonds and base money are perfect substitutes and a helicopter drop performed by the Tim Geithner dropping bonds from an F-16 would be as effective (or ineffective) as Ben Bernanke dropping dollar bills from his flying lawnmower.

But there is one big difference. Timothy Geithner is legally allowed to give away money for nothing. He does it all the time! He writes checks to Social Security recipients, gives money to welfare recipients and oil companies and big pharma. He even writes checks to me when my accountant or George W. Bush decide I’ve paid too much in taxes! Ben Bernanke, on the other hand, would go to jail for stuff like that. Sure, he has the printing press. “Operationally”, as the MMT-ers like to put it, he is entirely unconstrained. His checks never bounce. Why can’t he devalue the dollar, or use the threat thereof to upgrade inflation expectations? The economic law of supply an demand has not been repealed, but neither has US law. By law, the Federal Reserve can only engage in financial asset swaps. It shoves money out the door in exchange for some financial asset that colorably has the same value as the money it has dished.

Helicopter drops by the Federal Reserve are illegal. Helicopter drops by the Treasury happen all the time. Every law ever passed that overpays for anything, that has some manner of a transfer component, is a helicopter drop. I think all of us, left and right, delightful-smelling and stinky, can come together in a big Kumbaya and agree that most Federal spending has a transfer component, and is therefore a helicopter drop to some degree. It would not be a big deal for Congress to pass some law with even bigger, badder transfer components. They love to outdo themselves.

I think on the technocratic right, monetarists tend to think that helicopter drops by the Fed would be fairer than fiscal policy that launders transfers through expenditures. On the left and hard-crank right are people who don’t see the Fed as very fair at all, and emphasize the institution’s inclination to support certain interest groups when it does find ways of sneaking transfers through its legal shackles. My view is, a pox on both your houses, but it sucks that we are roommates. Macroeconomic policy by fiscal expenditures directed to politically favored groups is awful, unfair, and corrosive of the body politic. Macroeconomic policy by asset swaps that are quietly mispriced is awful, unfair, and corrosive of the body politic.

That’s the way it is here on Planet Earth (or at least on Planet USA, which is arguably at some remove from Planet Earth). Of course, we could change things. We could enact a law that instructed the Fed to engage in fair, perfectly transparent, helicopter drops as an instrument of macroeconomic policy. And boy would I support that! We could, as Matt Yglesias suggests (riffing on the work of Beowolf and the MMT-ers), have the Treasury issue some giant platinum coins and give them out to everyone. The difference between those two policies would be, well, no difference at all.

To the degree that our problem is on the demand-side and stems from private-debt-overhang-induced risk aversion or a desire to hoard money, we know the solution. That problem, if it exists, will go away if we give everyone money. But giving everyone money is not conventional, authorized, monetary policy. It requires new law. Politically, the law it requires would be hard law, because it shifts the distribution of risk in our very unequal polity. If we were to give everyone $20,000 tomorrow, whether it’s Ben or Timothy signing the checks, debt-overhang goes away as a macroeconomic concern. I believe, to some degree, in the demand-side story, so I’d wager that real GDP and employment would rise as well. But we would risk a step up in the price level, and therefore a devaluation in real terms of fixed-income claims and bank equity. Under status quo policy stagnation, near-term macroeconomic risks are borne primarily by the poor and marginally employed. With demand-side stimulus, whether designed by Scott Sumner via the Fed or Matt Yglesias via the Treasury, those risks would shift to financial savers, who in aggregate hold the bulk of their portfolio in the form of fixed-income securities, and who also hold the testicles of members of Congress.

The fiscal vs. monetary policy debate has gotten tiresome and distracting. If you think we need demand-side action, say specifically what you think we should do. If it’s a helicopter drop, whether by Fed or Treasury, then we need new law. Push it, and tell the self-styled realists and pragmatists to fuck off. If you think the Fed’s existing toolkit of running asset swaps and controlling the rate of interest on reserves would be enough if only they set expectations properly, then we still need new law. The Fed is not going to target NGDP or a price level path over any relevant time frame without a change in governance structure or mandate. People on the left and right and especially the technocratic center who like to see the Fed as a loophole through a dysfunctional Congress are kidding themselves. The Fed is a political creature, not some haven for philosopher-economists in togas who will openly consider your ideas. Get over it and get your hands dirty.

Update: Oops! I originally confused one of the excellent bloggers over at Econlog for another, misattributing Bryan Caplan’s post to Arnold Kling. Huge apologies to both, and many thanks to @derridative for pointing out the error.

Update History:

  • 31-Aug-2011, 12:45 a.m. EDT: Added update noting my group-blog dyslexia re Bryan Caplan & Arnold Kling, thanks @derridative! Updated text to Caplan, but left Kling struck through once to emphasize the error. Added ht to Aaron Krowne for Fed “floor” article. Changed “an institional” to “the institution’s”.
 
 

107 Responses to “The bounds of monetary policy on Planet Earth”

  1. Alex Godofsky writes:

    Scott Sumner has repeatedly made the argument that monetary policy remains effectively in a liquidity trap precisely because the liquidity trap will (is expected to) end at some point. If the Fed really is going to deliberately create a permanent liquidity trap, then yeah, it’s neutered itself.

    That said, the Fed can make itself effective again by either 1) conducting OMOs on long-term bonds (or even private securities) or 2) ending interest on reserves. The latter really should be an easy sell politically…

  2. [...] Steve Randy Waldman, “The fiscal vs. monetary policy debate has gotten tiresome and distracting.”  (Interfluidity) [...]

  3. [...] I’d throw up a link to this nice debunking of the fiscal vs. monetary policy debate at interfluidity. It seems incredible that [...]

  4. [...] interfluidity » The bounds of monetary policy on Planet Earth (tags: monetary-policy fiscal) [...]

  5. Detroit Dan writes:

    I see this as what the MMT people have been saying along, with a few policy opinions and colorful remarks thrown in. Progress!

  6. Andy Harless writes:

    The Fed is not going to target NGDP or a price level path over any relevant time frame without a change in governance structure or mandate.

    That may be true, but I think the only coherent interpretation of the current mandate is that it requires the Fed to do NGDP targeting or something similar. And as I (and others) have pointed out, NGDP targeting is a special case of the “Taylor rule” approach that the Fed appeared to be following prior to 2008. It’s very hard to justify the past 3 years of policy in terms of the Fed’s current mandate. The law is the law, and whatever traitors like Rick Perry and Ron Paul (may they both be hanged!) may say, I don’t think it’s inappropriate to be upset when the Fed fails to follow current law.

  7. Andy Harless writes:

    Crap, there’s a problem with my /a tag. [Fixed! —SRW]

  8. Steve Roth writes:

    Alex Godofsky: “the Fed can make itself effective again by … ending interest on reserves. The latter really should be an easy sell politically…”

    I note that in the August 9th OMC minutes:

    “A few participants noted that a reduction in the interest rate paid on excess reserve balances could also be helpful in easing financial conditions.”

    I asked Scott Sumner and Arnold Kling in their comments:

    “If the Fed, tomorrow, dropped IOR to zero or even negative, what do you predict the effects would be on:

    Inflation
    NGDP
    Employment”

    Scott, self-admittedly, didn’t give an answer. No response from Arnold. Would love to hear from knowledgeable others.

    Would we then be into the game of setting IOR expectations? Pretty far removed from the real economy at that point, so transmission mechanisms become subject to debate, at least…

  9. Max writes:

    We’re in this political trap:
    1. Debt/GDP is high, so can’t use fiscal policy (according to conventional wisdom)
    2. Debt/GDP rises
    3. goto 1

    Somehow you have to convince the people who are terrified of a rising debt/GDP that dithering will only result in debt/GDP going up indefinitely while the economy stagnates.

  10. Fed Up writes:

    It seems to me what you are really asking is if an economy needs more medium of exchange, how should that occur.

    Next, you would need to go over the different types of medium of exchange.

  11. Steve

    You note the following concern:

    With demand-side stimulus, whether designed by Scott Sumner via the Fed or Matt Yglesias via the Treasury, those risks would shift to financial savers, who in aggregate hold the bulk of their portfolio in the form of fixed-income securities

    If you agree that that aggregate demand-boosting policies will raise real economic activity, then real returns and real interest rates should also increase. Savers, therefore, ultimately benefit from such a policy.

  12. JKH writes:

    “Not some haven for philosopher-economists in togas who will openly consider your ideas”

    Although a proper playing field is still useful for the debate between fiscal and monetary.

    Perhaps a variation on:

    http://www.youtube.com/watch?v=ur5fGSBsfq8

    I think (Sumner’s) idea to drop interest on reserves would work particularly well in this forum.

  13. rsj writes:

    I enjoyed this post immensely.

    I think what is happening here is that some economists have a certain mental model in which real and monetary effects are cleanly separated, even to the point of transactions occurring in different markets; there are “real” markets in which, supposedly, barter occurs, and then there is a money market. Relative prices are set in the barter markets, and then everyone waits to see what the outcome is in the money market in order to get a nominal price. The only transmission mechanism from one to the other is sticky prices or some other form of market imperfection.

    Everything “monetary” must be the purview of the central bank, as it is purely a money market phenomena. Hence the belief that fiscal operations are incapable of altering the price level — they occur in the real markets, and so are conducted with barter. By assumption, they can only alter relative prices, but not the general price level.

    This also explains the arguments by Summer that we *need* a quantity theory of money to pin down the price level. The need is manufactured by the paradigm — it is not enough that supply and demand in all markets sets all prices, because in the barter markets, only relative prices are set.

    Sure, this is a stereotype, but I were an economic anthropologist, I would call this a founding myth or paradigm within which much discussion occurs. It is a useful filter for non-economists to understand what economists are trying to say.

    Back on planet earth, everything happens with monetary exchange; all decisions to borrow, spend, or lend can be characterized as monetary policy — in the sense meant by Summer when he talks about “monetary policy” — because even if they do not affect the quantity of outside money, they do alter the equilibrium quantity of deposits and bonds held by each sector in the economy.

  14. Alex — you’d think zero IOR would be a no-brainer, both politically and as a matter of using the tools available near the zero bound. it’s not like zero IOR has never been done; it was all that was ever done prior to 2008. heck, you’d think that negative IOR would be on the front-burner. the politics should be great, the fiscal cost is negative and borne by banks (though we can squabble over its ultimate incidence). plus it’s just — not a tax but the removal of a subsidy created by the unprecedent expansion in reserves & simultaneous payment of IOR.

    but no. doesn’t happen? why is that? to what interests are monetary policy makers most accountable?

    you just can’t take politics out of policy. or if you can, our “independent” central bank cannot.

    (note long-dated and/or riskier OMOs generate a subsidy to financial asset holders, while reductions in IOR withdraw a subsidy. to which of the two does the Fed seem more open?)

  15. DD — glad you approve, i guess…

    Andy — You’ve every right to be upset. Your interpretation of current law is certainly reasonable, but it is not undeniable. So long as there is significant ambiguity in the Fed’s mandate, how it will be interpreted is a political question. NGDP targeting likely implies at least periods of “catch-up” inflation during which creditors have to give back windfall disinflation gains, and perhaps implies occasional unanticipated inflation, when RGDP proves unable to follow close behind the target. Creditors and banks have every reason to prefer a memory-less, disinflation-biased price stability commitment. If we want NGDP targeting, we will have to unambiguously make that the Fed’s mandate, or else generate external political pressure sufficiently string to counter the Fed’s bank-centric governance structure. (Alternatively, we could change the Fed’s insular, bank-dominated, anti-democratic governance structure.)

    In human affairs, being right and being relevant are very different things. Economists as a group often treat the Fed as though it were different, like some kind of disinterested court of macroeconomic affairs. That is and has always been incredibly naive.

    So be upset. And play hardball. You don’t have to persuade Ben Bernanke. He would already agree with you, if he were not in a stuck in a political context where he cannot agree with you. It’s not his mind you have to change but his circumstance.

  16. Steve R — I’m pretty skeptical that zero or moderately negative IOR would be sufficient to really change our circumstance, and I’d prefer to reduce people’s risk aversion by repairing balance sheets than to squeeze people to induce them to lend or spend. (I worry about the quality of lending and spending we’ll generate.) Still, if it were up to me and it remained politically impossible to do the right thing and salve balance sheets with transfers, IOR would be negative as the best we can do. (Negative IOR may or may not be within the current authority of the Fed; I think it’d have to be litigated. Zero IOR is definitely in its power.)

  17. Max — Sometimes I think we will inevitably manufacture some excuse for ourselves to escape the trap by letting debt/GDP explode. I worry a lot about the excuse, though. Whatever it is, it will have to be powerful enough to move the politics, something nearly everybody believes is critical. Those usually aren’t good things.

  18. Fed Up — I’m very interested in private / competitive / complementary currencies as a rule. But I’m not sure there are any candidates sufficient to accommodate people’s risk-motivated desire for financial savings. There is something very calming about having the full faith and credit of the sovereign or local mob boss standing behind your mattress full of paper…

  19. David — Suppose its true (as I think it is) that real growth would increase with expansionary policy. Then isn’t it in everyone’s interest, including that of financial savers? Are creditors who oppose expansionary policy simply mistaken as to their own interests, as I’ve read people conjecture recently?

    Maybe, but not necessarily. The case is very much like trade. In theory, since trade “makes the pie bigger”, it would be Pareto optimal with appropriate transfers. But without those transfers there are winners and losers, and the losers can lose far more than they gain despite the aggregate improvement. Backstopped creditors have lost nothing to this crisis, and many have even gained in narrow terms as their fixed payments have lost less in real terms than they would have anticipated when they purchased the assets. Expansionary policy might create more goods and services and more employment, but for creditors who won’t take one of the new jobs and whose labor income is small relative to their savings, that does nothing. For creditors to be mistaken, you have to argue that there will be an expansionary deflation, in the sense that their existing money will buy more thanks to the surfeit of new goods and service the expansion will engender. Despite positive measured inflation, that’s certainly possible. In a “good economy”, even creditors benefit from new technologies and an improved zeitgeist that doesn’t show up in CPI. But then they also lose narrow purchasing power, relative status, and the ability to command the reserve army of the unemployed when they require cheap services. Creditors might be better off over all post-expansion, but they might not be, they might lose big time. It shouldn’t be surprising that perfectly rational, medium-horizon creditors prefer a conservative, inflation-allergic policy.

    Over a longer term, you might argue that this conservatism is self-defeating, that eventually social unrest or a decay in civic society that leaves everyone in a poor situation should outweigh medium-term rational conservatism. I’d agree. But that’s a very speculative and uncertain view, and we should not be surprised that many creditors don’t share it.

    [Reviewing your comment, I see I've not addressed the point about real interest rates. Two things: 1) creditors do not in aggregate hold a zero-maturity portfolios, so the effect of a real interest rate rise is ambiguous: immediate capital losses, better reinvestment terms. If the real interest rate rise is accompanied by an upshift in the price level, they may take a large hit that the higher real interest rate will have a hard time undoing; 2) creditors' bargaining power starts out weak, there's likely to be a significant lag between expansionary policy and a substantial improvement in real rates, leaving some time for the value of their wealth to be impaired. It is a mistake to imagine that achievable low risk yields always rise to match price level shifts in some immaculate, infallible Fisher relationship. There have been many times and places where creditors have been unable to achieve a significant real yield on safe despite the context of a growing economy.]

  20. JKH — ;)

    RSJ — I love your explanation of the mainstream view of how the price level is pinned. It is very insightful and clear, and I think it’s accurate (that is, an accurate depiction of the mainstream view, not an accurate account of reality). There does exist at the fringe of mainstream journals the fiscal theory of the price level, which is perhaps too narrow (much narrower i think than the view you espouse, which gives a role to the shifting forward expectations of agents everywhere) but is still much richer than the central-bank obsessed view. I wish it got more play.

  21. JKH writes:

    Interest on reserves currently contributes about $ 4 billion in annual pre-tax revenue to the banking system.

    That’s probably somewhere in the range of 1 to 2 per cent of gross interest margins.

    So the removal of 25 basis points of revenue will affect overall banking system margins by at most ½ of a basis point.

    That’s not quite enough to set individual banks off on a rampage to discard their own reserves.

    Of course, the banking system can’t do this in aggregate anyway, and individual banks are actually cognizant of this. There’s some game theory involved in the resulting pricing response.

    I’ve yet to see any analysis of this anywhere.

    My starting point would be that an individual bank would be well advised to know what its “benchmark” share of system excess reserves might be, based on its share of system balance sheet. Thus, one of the large banks, whose balance sheet might account for 10 per cent of the system balance sheet, would have a benchmark of $ 170 billion in excess reserves. This would be a “neutral” excess according to its share. The cost of losing 25 basis points of revenue on that would be $ 425 million annually.

    Such a cost, as a neutral position, can be recovered by increasing margins elsewhere – say by increasing spreads on loans or reducing interest paid on deposits – or by increasing fees.

    Alternatively, a bank might calculate the cost or benefit of various “market share” strategies that might be designed to get rid of reserves at the competitive level. An increased market share of loans would shift excess reserves to other banks. A decrease in market share of deposits would have the same effect.

    The monetarist approach to this problem basically assumes that the response would be the latter, rather than the former. There is no rationale for such an assumption. Banks assume risk based on the allocation of capital, not on a competition to get rid of reserves.

    Required reserves historically have been treated as an interest margin cost for banks – a cost that is recovered in the pricing of loans for the most part – and before allowing for the cost of capital.

    The effect of reducing interest on reserves is the same kind of cost, at the margin, for the system as a whole.

    Banks would tend to meet this problem with a combination of strategies, some based on margin preservation, and perhaps some specifically targeted to market share expansion of lending or contraction of deposit taking.

    But the latter type of strategy would be subject to considerable pricing supervision and capital constraint, also taking into account the risk of cannibalization and self-destructive gaming behaviour.

    Conversely, the monetarist expectation for zero IOR essentially depends on the assumption of unbridled recklessness in risk taking, in order to get rid of reserves at the competitive level.

    That is a naive expectation, and an unlikely outcome.

  22. [...] Links on Chckens, the Canadian Economy and Ty Cobb September 1, 2011By Lance PaddockSteve Waldman is tired of the fiscal vs. monetary stimulus debate. Excellent discussion of the [...]

  23. vlade writes:

    @JKH:
    using a single-lever to push a distant target in a very complex and opaque system always depends on assumptions. Most of the time at least some of them are wrong, meaning the results are as you describe. One would have thought that economists would have figured it out that if you want to use a single-simple-lever policy, you have to apply it as close to what you want to move as possible.

  24. JKH writes:

    P.S.

    “So the removal of 25 basis points of revenue will affect overall banking system margins by at most ½ of a basis point.”

    Math dysfunction – probably closer to 4 basis points from total gross margin basis points.

    The more straightforward comparison is the (relatively) small dollar value of $ 4 billion in pretax revenue loss – versus a much higher gross margin to start with.

  25. Scott Fullwiler writes:

    JKH,

    I argued many of the same points over at Cullen’s blog not too long ago in a discussion with Kid (actually, not a discussion since it appears I came in too late to receive any response). Another point I made is that with a negative IOR banks would convert as much reserve balances as possible to vault cash (there’s obviously a physical limit)–that’s actually a way they can get rid of reserve balances in the aggregate, not that it matters. I don’t know how significant this would be relative to the other things you’ve mentioned, but I think you’re right that it would just cause all sorts of attempts to preserve margins via fees, portfolio shifts, etc. rather than reducing lending standards (and it’s strange that somehow this is seen as a good thing given recent history). Finally, you may recall that I said many of these things in my posts back in 2009 on negative IOR at NEP.

    Steve,
    Nice piece, and thanks for the link!

    RSJ,
    Beautifully said. My only disagreement would be that it’s “most” economists rather than “some” of them.

  26. [...] The bounds of monetary policy on Planet Earth [...]

  27. JKH writes:

    Scott,

    You may have been responding partly to my claim, “I’ve yet to see any analysis of this anywhere”.

    Of course, I recognize you’ve been covering the issue closely for a long time.

    I was thinking here of a particular kind of net interest margin analysis, where an individual bank tries to deal intelligently with the reality of an imposed $ 1.7 trillion excess reserve position from a systemic perspective, knowing that not all banks can succeed together with reserve discarding strategies to the degree they attempt such strategies. To the extent they each recognize that they all can’t do this successfully, together, there are pricing and capital limits to the extent they will attempt to do it individually. But pricing the net interest margin cost at least partly into other assets and liabilities is something they can attempt to do under their own criteria.

    Also, you might have noticed the nuance I’ve used to describe such strategies – e.g. “reserve discarding”, etc. These essentially translate to market share strategies, where banks could attempt to shift their share of reserves by shifting their complementary share of assets and liabilities. As you know better than anybody, this of course is not “lending reserves”. Rather, it’s moving their location around the system, based on the net effect of asset-liability management strategies on individual bank residual reserve positions.

  28. Detroit Dan writes:

    So would I be correct in assuming that there is a bit of false equivalency in this post, with regard to “the fiscal vs. monetary policy debate has gotten tiresome and distracting”? It seems most of the pointed remarks are deservedly directed at the monetary policy advocates.

    Certainly I have seen no shortage of specificity with regard to fiscal proposals, and the fiscal mechanisms seem much more straightforward. Enact laws which get more money to the income constrained and the money will be spent, with a significant fiscal multiplier effect…

  29. Scott Fullwiler writes:

    JKH,

    Actually, I was just agreeing with you. Nothing more than that, really, other than to point out that we’ve been on the same page on this. Just looked over my post above and I can see where you might have thought otherwise–I should have been clearer; sorry about that.

  30. TC writes:

    SRW,

    Amen, brother!

    Detroit,

    I am with you re: fiscal vs. monetary debate.

    But I think that SRW is justifiably angry at people who are economists and are avoiding the easy and obvious answer that the fiscal side can easily spend more money – that’s what it’s setup to do. Whereas the monetary side is pushing it’s legal and traditional actions.

    SRW,

    I’d point out that the fiscal side and “giving out money equally to everyone” are much closer in practice than the monetary side is. Let’s face it – giving every working citizen a payroll tax cut is really close to the same thing as giving every person a platinum coin.

    Changing the price of expensive assets that only a small portion of U.S. citizens have any meaningful holdings doesn’t even come close. ;)

    JKH and Scott,

    Nice one.

    I’ll just make it really clear: You’re saying fiddling with IOR won’t make much or any difference to getting even small amounts of loans going, much less having any meaningful impact on the economy.

    Your calculations assume the banks will make up for 100% of the loss of moving to zero IOR – it’s a “maximum impact” calculation.

    Even at maximum impact, this amount is small. Banks would probably be overjoyed with recovering 1/2 of that amount and not taking additional risk.

    Note that if they thought they could feasibly make more than this amount they would already be doing it. Even losing this much isn’t a big deal. It’s not so much money that losing it would seriously impact their operations.

    Why aren’t they lending it now, today, and passing up that measly 25bps?

    So the support for the standard monetarist position that reducing IOR to zero would spur lending? Quite weak stuff.

    So then we’re stuck in that land you describe where banks are trying to simply stuff money wherever they can.

    I keep thinking of the days in Japan where banks – big banks – would require underlings to look for yield. They couldn’t find any and they were forbidden from taking any risk, so they would deposit the money at other banks!

    I bet with negative IOR, we’d see a repeat of that phenomenon here. Banks

    .

  31. JKH writes:

    Quite interesting data on the system distribution of excess reserves here:

    http://www.fixedincomelive.com/2011/06/07/where-oh-where-are-those-excess-reserves/

    Not quite sure what’s going on with the foreign banks operating in the US.

  32. JKH writes:

    Sample data on excess reserve interest impact:

    Bank America for Q4 2010:

    $ 2.4 trillion assets
    137 billion in cash, much of which would be Fed deposits
    12.6 billion in interest margin for the quarter
    63 million in interest on cash for the quarter

    63 million is 1/2 of one per cent of the total margin

    Data page 134 here:

    http://media.corporate-ir.net/media_files/irol/71/71595/reports/2010_AR.pdf

  33. JKH writes:

    P.S.

    Net interest margin as a percentage of earning assets for BA above is 2.66 per cent

    (typical bank NIM metric)

    loss of interest on cash is the equivalent of little more than 1 basis point out of that 266

  34. Alex Godofsky writes:

    Why is more bank lending the only transmission mechanism being mentioned?

    Assuming that eventually we do exit the liquidity trap (or the Fed uses something other than short-term bonds for OMOs), then by creating more bank reserves eventually that will probably be transmitted into the rest of the money supply through bank lending, thus increasing expected future NGDP/price level etc. That expectation can spur greater nominal spending by everyone else right now, without the banks increasing lending at all right now.

  35. Fed Up writes:

    “18.Steve Waldman writes:
    Fed Up — I’m very interested in private / competitive / complementary currencies as a rule. But I’m not sure there are any candidates sufficient to accommodate people’s risk-motivated desire for financial savings. There is something very calming about having the full faith and credit of the sovereign or local mob boss standing behind your mattress full of paper”

    Actually, I was referring to the difference(s) between currency, central bank reserves, and demand deposits of the sovereign and how they are created.

  36. Fed Up writes:

    25.Scott Fullwiler writes:

    “Another point I made is that with a negative IOR banks would convert as much reserve balances as possible to vault cash (there’s obviously a physical limit)–that’s actually a way they can get rid of reserve balances in the aggregate, not that it matters.”

    I believe scott sumner has said that a negative IOR applies to vault cash too. If so, what happens then?

  37. Detroit Dan writes:

    If you’re looking for specifics, here’s MMTer Warren Mosler:

    So in conclusion, let me repeat these three, simple, direct, bipartisan proposals 
for a speedy recovery:
    • A full payroll tax holiday for employees and employers

    • A one time, $150 billion revenue distribution to the states
    • 
And an $8/hr transition job for anyone willing and able to work to facilitate
the transition from unemployment to private sector employment as the economy recovers.

  38. Fed Up writes:

    At my 4:46 comment, replace “demand deposits of the sovereign”

    with

    “demand deposits denominated in the sovereign”

  39. Joe Smith writes:

    I see a lot of angst over the level of debt (personal and government). Harsh austerity measures are proposed so the debt can be paid.

    What I do not see anywhere is an analysis of who holds the debt.

    In the middle ages when a sovereign became too indebted he liquidated his creditors. Are we to sacrifice the well-being of 100s of millions for the sake of sparing a few thousand (who may have so much money they would suffer nothing more than hurt feelings if we seized half their assets)?

  40. JKH, Scott, Vlade, TC, Fed Up re interest on reserves —

    JKH’s point is well taken that banks have multiple ways to respond to a reduction of IOR (or even negative IOR). It is naive to imagine that the full effect of that policy shift will be to cause banks individually to treat reserves like hot potatoes where collectively they cannot succeed. But at the margin, it would encourage some lending. Like most commenters in this thread, I see this as a second-best, limited application tool. In particular, I’d rather encourage the demand-side of funding rather than the supply side, for informational reasons. We want good projects shopping themselves to funders, and knowingly assuming the risk of first loss. Squeezing banks to lend-lend-lend is likely to produce a lot of marketing of leverage to consumers and asset speculators, rather than the development and initiation of smart real projects.

    Still, I do support a reduction of IOR, at least to zero. Again, at the margin, it does represent an easing of policy that is likely to encourage activity. My critique of encouraging the supply side rather than the demand side of funding applies to interest rate policy as well, yet ZIRP is where we have to be for now, until we put together better funding-demand-side macro stabilization institutions. For the same reason, zero or negative IOR is where we ought to be.

    Plus, as a matter of justice, I think IOR ought to be zero. JKH refers to “the reality of an imposed $ 1.7 trillion excess reserve position”, as though it is a burden. Banks have historically griped that uncompensated required reserves represent a tax. But although I’m sure it might seem that way from the perspective of an individual bank, zero-interest reserves are not a tax, they are the absence of a subsidy. Banks reserve position, in aggregate, is as JKH notes, externally imposed. But a zero-interest reserves does no harm to a bank, individually or in aggregate. Yes, it does represent a drag on accounting ROA, but that’s just because top-line assets are inflated by an artificial zero-risk, zero-return asset. Reserves have a zero risk weight for capital purposes, so a reserve position does not impair ROE or in any way constrain banks in expanding their revenue producing activities. When banks refer to uncompensated reserves as a tax, they are artificially claiming an opportunity cost against an opportunity that would not exist if there were no reserves in the system (and no reserve requirement, a la Canada). Eliminating reserves would not be equivalent to replacing those assets with loan-enabling capital. It would simply mean eliminating those assets as well as corresponding deposits, with no effect on banks’ capacity to earn.

    So positive IOR represents a subsidy to the banking system, one that I consider unjust and wish to see eliminated on other than technocratic grounds. On technocratic grounds, I think it would help things at the margin (under the status quo, unwise banking-system-centric approach to macro stabilization). So I think IOR should be zero.

    Negative IOR would represent a tax on the banking system. It would also help at the margin, in terms of encouraging lending, along with many other sorts of strategies for dealing with the cost, as JKH suggests. We should evaluate negative IOR as we evaluate any other tax, considering both fairness and technocratic implications. You can make a lot of arguments both ways about those. Since I view status quo banking as extracting a lot of underpriced options from the state, I’m sympathetic to various ways of taxing back those rents, and open to considering negative IOR to the degree that it seems like it would be helpful on technocratic grounds. But again, adjusting IOR strikes me as a very second best form of macro stabilization, and both practical complications and fairness arguments become more compelling when the number is below zero.

    One thing that is insufficiently discussed as a policy level is the use of diminishing IOR as a tool of monetary policy. As JKH and the MMT-ers as a group emphasize, bank lending in aggregate and at larger banks is not reserved constrained. But in the US, at smaller banks, bank lending is reserve constrained. Smaller banks in the US do not borrow from the Federal Funds market, avoid the Fed’s discount window like the plague, and so engage in precautionary savings of reserves by lending into the Federal Funds and repo markets. When last I checked, roughly the smaller 50% of US banks had no Fed Funds borrowing, while the largest banks obtained up to ~10% of their permanent funding as Fed Funds (this was pre-crisis data, through 2006 I think). It’s been famously demonstrated that the effects of monetary policy shifts in the US occur disproportionately through changes in behavior among smaller banks. If IOR was paid only on the first $X of reserves held beneath a single bank holding company, that would create an incentive to spread the system’s reserve away from the money center NYC banks (see the link JKH provided above) to smaller banks throughout the system, where at the margin, more reserves is likely to translate into a greater quantity of lending.

    Again, encouraging funding-supply is second-best. I’d rather encourage funding-demand. But diminishing IOR strikes me as a very low cost way of easing monetary policy, especially for smaller businesses who disproportionately work with smaller banks.

  41. JKH writes:

    SRW,

    There may be some slight confusion (in general, not necessarily with you) regarding the impact of compensation on required reserves versus QE excess reserves. I could have added to the confusion myself with some of my wording above.

    Two cases seem clear:

    a) Non-payment of interest on required reserves in an unambiguously non-zero interest rate range is clearly a tax on banks. If the Fed funds target is 3 per cent and if required reserves earn no interest, then non-payment of interest is a tax in the form of a cost to interest margins.

    b) Payment of interest on QE excess reserves is in fact necessary within an unambiguously non-zero interest rate range – in order to put a floor on the target policy interest rate. This will be the case for example when the Fed eventually hikes the Fed funds target rate before it has fully exited from its QE reserve position. And it’s a virtual certainty that such a condition will come to pass at some point in the future. If the Fed funds target rate is 2 per cent, and if excess QE reserves have not been fully drained at that point, payment of interest on reserves at 2 per cent will be necessary.

    Currently, at the zero bound, the issue of zero versus non-zero interest on QE reserves is slightly ambiguous. E.g. the Fed does have an operational choice whether to pay 25 basis points or zero basis points, without necessarily upsetting the operational apple cart – although there may be operational risks in paying no interest, which the Fed has pointed out.

    There is clearly a cost to bank interest margins if the rate is lowered from 25 basis points to zero. As noted above, my own view is that such a cost can be absorbed fairly easily by the banking system, in a variety of ways.

    While there is a nominal cost difference between the rate choice under zero bound QE, neither case resembles that of the more straightforward “bank tax” interpretation of the case where no interest is paid on required reserves and where interest rates are unambiguously non-zero otherwise, as noted in a) above.

    So we’re not really talking about a “bank tax” in this case. It’s quite different than the normal case of compensation for required reserves.

    I’ve referred to it as a “burden”. I intended that to refer largely to the idea that this big slug of reserves is a thing that the banking system drags around with it, until the Fed eventually drains it away when the system turns back toward “normal”. Perhaps “nuisance” would have been a better word. But it is what it is whether or not the compensation rate is 25 basis points or zero. I suppose I might take your point that it would be even more of a nuisance if no interest is paid, but I don’t see that leading to reckless capital allocation as a response.

    Regarding the question of capital allocation, you are correct that there is no capital cost against excess reserves as an asset, on a risk weighted asset basis. However, there may well be a question of non-risk weighted capital cost – in the sense of the non-weighted leverage ratio, which some regulatory measures still capture. Moreover, this may have had an effect on the failure of the banking system to fully arbitrage away the impact of zero interest paid on GSE reserves at the Fed – i.e. the failure to prevent fed funds from trading below the interest rate on reserves. I attempted to make this point here (Matt seemed to like it):

    http://mattrognlie.com/2011/08/13/a-primer-on-the-new-era-of-monetary-policy/#comment-822

    My point on the question of lowering the rate doesn’t really have much to do with the economics of compensation – it has more to do with the unrealistic expectations of those who expect it will increase lending in any material way. What I would expect is a cleaner sweep of related short rates – including the fed funds rate – down to zero, than currently exists. But this is a very marginal effect, and should only affect “zero risk” assets – those without a risk premium and without capital allocation consequences. I don’t track the bill rate closely, but I suppose it’s already around zero. And there may be a slight ripple out the curve. But I don’t see capital allocation for risk lending being affected significantly at all.

    Of course, what could happen is that the rate gets lowered to zero, and lending gradually picks up sometime later, and over time, for quite different reasons. Then I suppose the monetarists would claim analytical victory on the question of the IOR choice, no matter what the time lag.

  42. JKH writes:

    P.S.

    “But this is a very marginal effect, and should only affect “zero risk” assets – those without a risk premium and without capital allocation consequences.”

    What I should have said is that it won’t necessarily affect the risk premium. The BA interest margin stats I referenced above are a good general illustration of the importance of the risk premium as the required, dominant contributor to bank interest margins in a zero bound environment. The pricing and therefore the credit demand consequence of IOR adjustment won’t be material.

    One needs to decide whether the objective is the stimulation of credit demand/supply, or the “taxation of rents”. Whatever one’s view on the latter is, I wouldn’t favor an ineffective approach to the former as a catalyst for the latter.

  43. JKH — I disagree with very little of what you’ve written, but I will take issue with

    a) Non-payment of interest on required reserves in an unambiguously non-zero interest rate range is clearly a tax on banks. If the Fed funds target is 3 per cent and if required reserves earn no interest, then non-payment of interest is a tax in the form of a cost to interest margins.

    Required reserves that are supplied by the central bank are not a tax on banks in aggregate in (almost) any meaningful sense. In an accounting sense, they do represent a drag on interest margins, but that is because they amount to inflation of the denominator (the base of funding upon which interest is earned), not because they diminish revenues that would otherwise be earned absent the supplied required reserves.

    From the perspective of an individual bank, required reserves do look and feel like a tax, because an individual bank absolutely can earn more revenues if the reserve requirement is diminished (or it can engineer its way around via sweeps etc), permitting new loans to be financed at zero opportunity cost (reserves that would have to be borrowed from the Federal Funds market to support new lending no longer have to be borrowed). The reserve requirement increases an individual bank’s funding cost relative to what it would have been without the reserve requirement, holding everything else constant.

    But in aggregate, this reasoning is fallacious. In aggregate, the central bank supplies the reserves that in aggregate it demands banks hold. If we think of the banking system as a single bank, then the way it works is the monetary demands the bank holds $X in reserves, and it simultaneously deposits $X of reserves into the bank, demanding no interest payment on the deposit. It’s a no-op. Our one giant bank would certainly be better off if it had the interest-free loan from the monetary authority and no reserve requirement: that would be a subsidy. But the monetary authority doesn’t roll that way: it offers the loans at the level required to meet the requirement. The alternative case would be no reserves and no requirement, and the bank faces no first-order opportunity cost when it has lots of uncompensated reserves and a big requirement vs when it has tiny reserves and a tiny requirement. The spread the central bank earns on reserves is money that would have been earned by asset-holders outside the banking system, not money “taxed” from banks.

    (Some fraction of the monetary authority’s spread might represent proceeds from assets that would have been held by banks in a lower requirement/lower reserve regime. But even there, with a competitive banking system, the vast majority of proceeds from risk-free and near-risk free assets are paid to depositors. Deposit rates are almost always higher than risk-free rates, although that cost is diminished by the degree to which the bank attracts now-or-low-interest transactional deposits. Regardless, the fraction of the monetary authority’s spread that would have accrued to bank equityholders absent a reserve requirement regime is minimal, negligible to a first approximation. The incidence of the “taxation” implicit in high reserves falls almost entirely on nonfinancial end-users, who would have held interest-earning assets directly or indirectly via interest-bearing deposits.)

    It doesn’t look this way to an individual bank in a fragmented system, because of course the monetary authority doesn’t make an interest-free deposit, it purchases an asset from a customer, and the customer demands the market rate of interest on her deposit, yet required reserves go uncompensated. But the market rate of interest she achieves is diminished by the non-scarcity of reserves that the monetary authority creates relative to its reserve requirement and banks’ payment-clearing demand. And the price at which that non-scarcity of reserves causes deposit costs to settle at is a function not of the reserve requirement per se, but of the interest rate the monetary authority targets. The interest rate the monetary authority targets is a function of the level of activity it deems consistent with price stability. It sets the overall cost of funds to the banking system. If there is a high reserve requirement, a bank perceives its cost of funds to be “due to” the excess funding cost associated with carrying the reserves. If there were no reserve requirement, the central bank would set the rate slightly higher to achieve the same cost of funds. It is the cost of funds that the central bank is in the business of targeting.

    So, for the banking system as a whole, there is no tax on the banking system, whatever the scale of the reserve requirement, as long as the central bank is always in the business of setting the cost of funds and supplying a level of reserves consistent with that cost of funds. For individual banks, however, more reserve-efficient banks can earn more money than less-reserve efficient banks, and the reserve requirement “feels like” a kind of tax. But in aggregate it’s not. When all banks hit upon some scheme that makes them more reserve efficient, the central bank must increase the headline cost of funding to undo aggregate reduction in funding cost.

    Your point about what I would call second-order wrinkles is interesting. You are right that, even though risk-weighted capital rules the roost, regulators and funders are aware to some degree of old-fashioned absolute capitalization ratios, and a required reserves regime makes those look worse than they would have looked otherwise. But I think there’s little evidence that these considerations have much bound banks. Capitalization ratios in general are always compared against industry baselines, and the banking industry’s baseline absolute capitalization is always ungodly low. When there are large reserve requirements, everybody’s absolute capitalization looks smaller still, and regulators’ and funders’ expectations adjust accordingly. Again, for an individual bank, this contributes to the tax-like “feel” of required reserves. A bank that fails to minimize its reserve requirement will end up with lower absolute capitalization ratios than its peers, and may suffer differentially. But in aggregate, standards will be what they are, and the central bank will set overall funding costs to support activity in the context of those costs.

    Blah!

    Besides that, I agree with everything else you’ve said. I agree that banks (like humans) make high-level allocations between “risk-free” and risky investment, and that the elasticity of that allocation to the return or even cost of risk-free lending is probably less than monetary policy enthusiasts imagine. Near the zero bound, the opportunity cost of holding reserves can’t be made very large, so it is questionable whether allocations towards risky lending will change at all, as opposed to a lot of gaming to maximize the efficiency of the risk-free portfolio. (Even with negative IOR, very large negative values are impractical, eventually it becomes economical to hold physical cash, or indirect claims on stored physical cash intended to frustrate any tax on decalred vault cash. It’d take a lot of intrusive enforcement to effectively tax cash held by banks but not cash held by other parties.)

    I also agree that payment of IOR becomes nonoptional when ZIRP goes away while reserve quantities remain elevated. In theory, the Fed could drain all of its reserve injections (the famous “exit strategy”) prior to raising the policy rate. In practice, I think you are right that the Fed intends to adopt a “floor” monetary policy regime for an indefinite, which implies paying interest on reserves. But note that this is less unusual: the monetary authority always pays for contractionary policy, in the sense of reducing the spread it earns on outstanding reserves. Under traditional monetary policy, it pays no interest on reserves but reduces the quantity of assets on which it earns a spread. Under the floor regime, it reduces the size of its balance sheet more slowly but reduces the spread it earns on those assets by paying interest.

    It is at this zero-bound that IOR seems unfair to me. Under tighter policy, depositors bid for much the extra spread. Under ZIRP, competition for deposits is minimal among large banks holding the bulk of the excess reserves. At the margin, IOR works against the policy goal of expanded lending (although we might both be skeptical of the scale of this effect). Further, when reserves are plentiful, banks have little need to pay up for customers’ transactional accounts, and don’t compete away the subsidy. (Perhaps there are cross-subsidies of more competitive bank activities, some of which are captured by customers. But you could claim that about any profit center or subsidy.) At the zero bound, IOR works against macro stabilization goals at the margin and goes pretty much entirely to bank shareholders and excess compensation. I want it gone for those reasons.

    (You might argue that IOR contributes to macro stabilization goals by helping banks “earn” their way out of unacknowledged undercapitalization. But repairing banks through subsidy is the sort of financial stabilization policy to which I object most, as it implies enduring a zombie-bank recovery period, creates long-term moral hazard problems, and is simply very deeply unjust.)

  44. Fed Up writes:

    “Again, encouraging funding-supply is second-best. I’d rather encourage funding-demand. But diminishing IOR strikes me as a very low cost way of easing monetary policy, especially for smaller businesses who disproportionately work with smaller banks.”

    And, “At the margin, IOR works against the policy goal of expanded lending (although we might both be skeptical of the scale of this effect).”

    And, “At the zero bound, IOR works against macro stabilization goals at the margin and goes pretty much entirely to bank shareholders and excess compensation. I want it gone for those reasons.”

    Why should expanded lending be a policy goal? Why does almost everyone believe that the solution to too much debt is more debt, specifically that the solution to too much lower and middle class debt is more lower and middle class debt or more gov’t debt both owed to the rich?

    What if too much debt is actually macro destabilizing? What if you are trying to use the wrong medium of exchange? The way the system is set up now and under most circumstances, why should all new medium of exchange be the demand deposits from debt?

    Anyone, feel free to correct me here.

  45. JKH writes:

    SRW,

    “That is because they amount to inflation of the denominator (the base of funding upon which interest is earned), not because they diminish revenues that would otherwise be earned absent the supplied required reserves.”

    Not sure I’m following everything you’ve written (still absorbing).

    But here’s my up-front summary:

    The denominator (commercial bank funding base) does expand.

    But so does the interest cost of the denominator.

    E.g. those who sell bonds to the CB in order to accommodate a required reserve expansion expect a comparable risk adjusted rate on their resulting commercial bank deposit.

    The result is that the incremental commercial banking balance sheet slice that is added by CB asset expansion earns zero interest on reserves, but pays non-zero interest on deposits.

    So banking system interest margins decline – micro and macro – not only because the denominator expands, but because the incremental margin attributable to CB asset expansion is negative.

    And you can see this mirrored in CB profits – its marginal balance sheet slice is interest earning bonds funded by zero interest cost reserves. That increases CB profits, which get remitted to Treasury. That is a fiscal effect equivalent to that of taxes.

    But I think you may understand this. So I’m trying to fathom the rest you’ve written.

    Back in a bit, hopefully.

  46. Fed Up writes:

    “I also agree that payment of IOR becomes nonoptional when ZIRP goes away while reserve quantities remain elevated. In theory, the Fed could drain all of its reserve injections (the famous “exit strategy”) prior to raising the policy rate.”

    What about raising the reserve requirement?

  47. JKH writes:

    SRW,

    Hope this is working, in incremental bites.

    Didn’t follow you here:

    “If we think of the banking system as a single bank, then the way it works is the monetary demands the bank holds $X in reserves, and it simultaneously deposits $X of reserves into the bank, demanding no interest payment on the deposit.”

    The CB must acquire a private sector asset in order to inject the increase in required reserves to the system. E.g. it could purchase a bond from a non-bank or provide LLR directly to a bank. The result in both cases will be a new interest paying liability for the banking system in a non-zero rate environment. Non-interest earning reserves on the asset side. An incremental negative interest margin slice for the banking system.

    In the case of a bond purchase, I have assumed here and before that the CB buys the bond from a non-bank. But even if it buys from a bank, there is an incremental negative margin effect for the banking system.

  48. JKH writes:

    SRW,

    “If there were no reserve requirement, the central bank would set the rate slightly higher to achieve the same cost of funds. It is the cost of funds that the central bank is in the business of targeting.”

    I see what you’re getting at.

    You may be saying/inferring that the banks can recover the cost of what I’ve referred to as a tax through pricing. In the absence of that “tax”, you claim the CB will set interest rates higher, which will accomplish the same net result, more or less.

    But does that really mean it’s not a tax?

    Doesn’t the same logic potentially apply to taxation costs in general?

    And if, as I said, the CB is effectively remitting the reserve “tax” to Treasury, the banks could be partly passing it through to customers in pricing, and partly absorbing it in return on capital.

  49. rsj writes:

    Regarding the IOR discussion, let me take this opportunity to plug replacing IOR with an asset tax (a tax on all non-CB liabilities) combined with tax credits for interest payments made (to all liabilities except those deemed bank capital by regulators).

    What the government is really trying to do with IOR is to put a floor under borrowing costs, to prevent excess private sector credit expansion.

    But there are countless ways of imposing costs that do not include government payments. We can all agree that the government is able to use its taxation power to impose costs on basically every conceivable industry, so why not do the same for the banks?

  50. JKH writes:

    SRW,

    I suppose any tax on banks could be “transformed” instead to an increase in the general level of interest rates, which would show up (with some lags) in incremental asset revenue through CB “seigniorage”, and an equivalent increment to the CB’s remittance of profits to Treasury, which is all equivalent fiscally to the original tax.

    So why pick on required reserves?

    :)

  51. JKH writes:

    RSJ,

    I KNEW that’s where this was heading.

    :)

  52. JKH writes:

    RSJ,

    I haven’t spent specific time on your proposal, but I’ve seen that Beowulf is head over heels on it.

    Is it basically a tax on interest margins?

  53. rsj writes:

    JKH,

    LOL. I hope I am not spamming this board.

    It’s not a tax on NII per se, it’s an asset tax meant to ensure that banks would not make loans unless they earn enough in interest income to pay the asset tax. In this way, we can put a floor under lending rates, which is the point of the exercise. If it were a tax on NII, then banks could lend at low rates, earning a low NII, and therefore paying a low tax.

    But in terms of capturing economic rents, this can be viewed as being similar to a tax on NII because, for example, if banks pay low interest on deposits they would get fewer tax credits. Banks would, to first order, be indifferent between obtaining funding from deposits versus from bonds, as the interest payments saved on being funded by deposits would correspond to a loss of tax credits; the seignorage obtained by providing the private sector with deposits would be captured by the tax as well.

    It’s an attempt to create the ideal system in which banks earn their income from credit analysis and risk pooling rather than maturity transformation per se.

  54. JKH writes:

    RSJ,

    Was writing this as you posted:

    I can’t do it justice in a brief read, but my impression is that your proposal is a taxation of deposit gathering interest margins, either through direct taxation or through nationalization of bank deposit gathering. But even if you nationalize the full banking system, loans and deposits, there isn’t enough incremental revenue in it to make a huge impact on the fiscal position – $ 100 billion a year or so – very material, but not overwhelming. And nationalizing the deposit gathering side – through direct taxation or ownership – could wreak havoc on capital requirements and asset pricing for the other side. What is in effect a tax on half the system could drive pricing up on the other half, if it remains private sector.

  55. JKH writes:

    RSJ,

    Not sure how familiar you are with bank internals, but banks do calculate net interest margins separately for loan and deposit sides – via internal transfer pricing. And they transfer price on a matched maturity basis. So they actually calculate the deposit specific “rent” margin that I think you’re after in your proposal, more or less.

  56. So, I’ve been writing this for a while, and there’s been lots of traffic. I think I am basically agreeing with JKH@48.

    JKH — One way to think about it is just in terms of incidence.

    The central bank’s real earnings are, in a sense, a tax on someone. Even that is a step too far, because the entity that accepts no-interest money for an asset does so voluntarily. Banks don’t and aren’t expected to pave the way for that transaction by offering a comparable rate on the cash. In the end, that happens, rates tend to equilibrate. But that the moment that an individual sells a bond for cash at a price, that is not due to any support by the banking system. The central bank pays a small premium. So calling the CB’s earnings a “tax” might be overstated. But it’s something close: Someone who otherwise would have been receiving revenue from an asset no longer does, in favor of the central bank.

    So where is the ultimate incidence of that opportunity cost? Upon whom does it ultimately fall? Do bank profits and compensation vary as a function of the central bank balance sheet, and in what way?

    I think, as stylized facts, we’d find that when the central bank eases, that tends to increase bank profitability, as it creates opportunities for banks to accept maturity risk, often with a tacit commitment to hold rates low for a long enough period that modest maturity risk will be rewarded. Expansions also create opportunities for banks to take on credit risk that would otherwise be uneconomic. I don’t think we’d find, even prior to interest on reserves, that periods of central bank balance sheet expansion were periods of declining bank profitability (although they often follow periods of declining bank profitability). Even before payment of interest on reserves, I think banks found it more congenial to do business in an environment where rates are declining and CB balance sheets are expanding than under the opposite circumstance.

    That suggests, although it does not slam-dunk prove, that the cost of the revenue earned by the central bank is borne by agents outside of the banking system.

    An interesting question would be the effect of levels rather than changes in the size of the central bank balance sheet. Suppose no interest on reserves are paid. Are banks more or less profitable, measured in terms of ROE not ROA, when the central bank’s balance sheet is large or small?

    My sense is that the size of central bank’s balance sheet, absent IOR, has pretty much no effect on banking industry profitability. The reason for this non-effect, I’d claim, is that banks earn a very small fraction of the interest paid on assets that resemble the central bank’s portfolio: government debt with a short-maturity bias. Short government debt is simply not a very profitable asset for banks to hold. Under any environment, bank funding costs pretty much match the return on these assets. To the degree that banks hold them, they hold them for convenience and liquidity. Interest earnings on these asses accrue to end users, because end users hold them directly or because banks pass through the earnings to depositors. When the central bank expands its balance sheet, it…

    (1) buys up these assets, as part of a program to
    (2) reduce short-term interest rates

    Suppose the central bank purchases the assets from our one big bank. Let a lot of time pass, so we’re not talking about the effect of transient opportunities during the period of expansion. In the new equilibrium, the bank’s revenue are lower, as is its ROA. But the rate it pays to depositors is also lower, and the size of the lending spread may change. The effect on ROE is a priori ambiguous — does the lending spread increase sufficiently to compensate for the lost revenue?

    But in practice, I think it is unambiguous. Reserves as a fraction of bank balance sheets are small, the hit to revenue is smaller than the change in funding costs. Especially at low interest rates, funding costs fall much more quickly than lending rates. The lending spread does not fully compress even in equilibrium, for lots of reasons having to do with the intricacies of credit markets. If the expansion is successful, banks find more profitable projects to lend to under the low interest rate regime than they would have under the high interest rate regime, as projects that were uneconomical with a credit spread become uneconomical. Over all, banks (I claim, I’ve not checked this empirically) are more profitable, not less, when the central bank balance sheet is large, even after transient opportunities associated with the expansion have passed. The arithmetic implication of that is that the opportunity cost associated with the expansion, the increased revenues of the central bank, fall on other parties.

    We’re not disputing the accounting: It is absolutely true that an expansion of uncompensated reserves implies interest-payable financing of a non-interest-bearing asset, replacement of an interest-bearing asset with a non-interest-bearing asset on bank balance sheets. In a narrow sense, it looks like a tax. But three variables change: the rate of return on the asset portfolio, the size of the asset portfolio, and the cost of funds. My claim is that the “terms of trade” nearly always change in banks favor in a manner that offsets that tax, that monetary expansions are in fact targeted to alter those terms of trade, to create profitable lending opportunities for banks and to reduce their funding costs. The incidence of the central bank’s revenue increase falls on parties other than bank shareholders.

    That’s why I think that to a first approximation, it’s reasonable to imagine that the central bank buys the assets from a customer who demands no interest on the deposit. Obviously that’s counterfactual: there is no special pool of deposits that result from CB balance sheet expansions, on which interest is not paid. But in aggregate, post expansion, bank funding costs have declined as if the CB had injected deposits into the old funding mix interest free, offset by an asset that pays no interest.

    Ultimately, this is a claim that depositors have very little bargaining power after a monetary expansion, so it is they who absorb the costs of central bank seigniorage. I think that’s an accurate claim. The central bank expands precisely when end users are demanding insured deposits and selling other assets, and contracts when end users try to divest themselves of deposits. By targeting the interbank rate, the central bank fairly precisely monitors and opposes any change in the aggregate demand for deposits, supplying reserves when that aggregate demand is high (and end users demand little interest), withdrawing reserves when aggregate demand is low (giving back the interest to customers who purchase disintermediated assets). Under an interbank interest rate targeting regime, banks pass through the effects of reserve transactions to end users. If anything, I think banks net-benefit when CB balance sheets are large, and net-lose when they contract, suggesting the incidence of CB revenues falls more than 100% on end users: banks tag along and get to tax when the CB gets to tax, they both take a share of the elevated demand for guaranteed deposits.

  57. JKH writes:

    SRW,

    Wrote this while you posted:

    Backtrack – I’m not sure this is right:

    “If there were no reserve requirement, the central bank would set the rate slightly higher to achieve the same cost of funds. It is the cost of funds that the central bank is in the business of targeting.”

    The reserve requirement is an outright reduction in interest margin as I described.

    The commercial bank can attempt to recover that cost via some combination of asset pricing, liability pricing, and return on capital adjustment.

    But I don’t think the CB can replicate the reserve “tax effect” through its own policy interest rate setting. The reserve “tax” affects margins. The CB’s policy rate doesn’t necessarily impact commercial bank asset-liability spreads – only the general level of asset and liability rates. The commercial banks manage spread pricing around the general level of the CB policy rate.

    Similarly, the CB can’t really replicate such a reserve “tax” at the level of its own profit remittance. If it increases rates, it will increase its seigniorage, but at the same time it will increase the cost of debt floated publicly by Treasury.

    So while the CB’s profit remittance to Treasury will reflect the effect of a given reserve “tax”, it cannot replace that reserve tax effectively by substituting its own policy rate adjustment.

  58. Scott Fullwiler writes:

    SRW,

    Two things:

    “The reserve requirement increases an individual bank’s funding cost relative to what it would have been without the reserve requirement, holding everything else constant.”

    Yes, that’s what people mean when they call no IOR with RR a “tax.” Potato, po-tah-to.

    “But at the margin, it would encourage some lending.”

    Nope (or, at least “nope” until I see a well thought out answer consistent with banking on Planet Earth, which I have yet to see, not that it’s not possible). At the margin, it will encourage greater demand for loans, so you will get more lending, but that’s different from saying banks lower their lending standards. First, remember, making loans doesn’t mean you lose reserve balances, necessarily–reserve balances are about payment flows. Second, a bank with marginal loss in NIM–and it’s unclear in my view and in JKH’s that this would happen anyway, at least in an economically significant way given ability to shift costs and shift assets–would be rather irrationally taking on additional risk of capital loss to compensate, which wouldn’t sit too well with regulators (not that I couldn’t imagine, say, a non-bank FI doing so, but that’s different and still not necessarily smart). Third, we already know what gets banks to lower lending standards–it’s the perception that borrowers will have greater ability to repay or collateral will be increasing in value. This whole thing sounds a bit to me like the assumption that QE will create spending simply because you’ve replaced bonds with deposits, as if converting my retirement portfolio to cash leads me to the completely irrational act of spending it–not much different to assume a bank with lower NIM puts it’s capital at greater risk.

    Fed Up,

    Vault cash is not reserve balances. Only reserve balances earn IOR or would be taxed with a negative IOR since they are the deposits at the Fed. To tax vault cash would require a tax on currency, not a tax on ER. The official measure of ER does not include vault cash, regardless what someone’s theoretical view may be.

  59. JKH writes:

    SRW,

    I don’t think you’re going to find a link between CB asset size and commercial bank profitability prior to 2008 simply because there is no issue regarding CB asset size per se as it affects bank balance sheet management. Excess reserves were never more than a pittance – unless you go back to the Great Depression – the next most recent earliest episode of QE. This is all a function of the fact that the CB sets the rate of interest, and in doing so requires very little in the way of reserve quantities to be effective in a normally functioning market.

    So the test of your hypothesis about CB balance sheet size and profitability can really only relate to the special case of 2008+ QE.

    I agree that periods of easing IN GENERAL correspond to periods of better profitability for banks. The financial crisis may be an exception, depending on how you define easing (e.g. Sumner’s view that they’ve effectively been tightening even as rates approached zero).

    And given the relatively puny level of required reserves as a percentage of overall deposits, the “tax” effect hasn’t been a huge issue for a long time. I noted it mostly for comparison with the QE excess reserve case.

  60. JKH writes:

    As an aside, I must say that I fail to see how ANYTHING that is included in the calculation of a commercial bank net interest margin does not qualify as “rent” in the world of, say, Bill Black. In other words, where does this critique end, short of full nationalization? I think that as a general statement it may be true that retail deposit banking effectively subsidizes bank lending, although that is not certain in my mind. But if that’s true, it almost certainly means that privatized bank lending rates would be higher than they are, without retail deposit banking.

  61. JKH — A reserve requirements “looks like” a tax if you look at the interest margin / lending spread, and that’s irreducible. If you subtract out the non-interest-generating reserves while holding the cost of funding constant, you’d compute a better interest margin. We agree on this.

    The question is whether a reserve requirement is ultimately a tax on bank ROE. (Let’s simplify and ignore for the moment the split of returns between formal equity holders and variable compnsation employees who are implicit equity holders.)

    My claim is that it is not.

    1) Mechanically, the smaller interest margin gets spread over a larger asset base, given the same capital. Here’s where the “imagine reserves are backed by interest-free deposits” intuition is helpful.

    2) Depending on the circumstances, as you suggest, the bank may be able to offset the interest margin compression via pricing. My conjecture is that it is not right to think of the central bank as simply adjusting levels while the spread holds constant, but that expansions are associated with factors that offset the mechanical compression associated with the reserve injection. I’ve not documented this conjecture, and it could be wrong. But I think it is right.

    If we have a dispute, let’s be clear on what it is. It is not about the interest margin accounting. It is about ROE. My claim is that reserve expansion, especially without an increase in a reserve requirement, do not much affect bank ROE except via a funding rate channel which would obtain even in a near-zero reserve environment.

    It is fallacious to equate a change of margin with a change of profitability. Quantities matter.

    Monetary policy ultimately targets the quantity of lending activity. Reserve expansions without an increase in reserve requirements decrease margins directly, but increase quantities and indirect effects work to expand, or at least to offset the compression of margins. (Margins are ultimately larger when interest rates are lower.)

    Reserve expansions along with expansions in the quantity of required reserves don’t necessary increase the quantity of lending. Ceteris paribus, the reserve requirement compresses margins, and so, holding quantities constant, compresses profitability. But ceteris may not be paribus: the incidence in the increase in reserve requirements may fall on the bank or it may fall on depositors, depending on who has greater bargaining power. I’ll concede a good deal of uncertainty over this case: In the US and other Western economies, increases in reserve requirements are rare. In China, increases in reserve requirements are common, but the deposit rate is administered, so who takes the hit is a political choice.

    I do claim, under conventional monetary policy, that the incidence of the cost of an expansion of zero-interest reserves without an expansion of reserve requirements falls almost entirely or perhaps even more than entirely on depositors rather than banks. Again, this is an empirical claim I’ve not verified. But I think it is true, and it is not incoherent.

    The CB’s “tax” is a function of the size of its balance sheet, the assets it owns, and the interest it pays or does not pay on reserves. The CB may reduce the amount of its direct seigniorage when it raises rates, because it must reduce the size of its balance sheet or increase the interest it pays in order to do so. Raising rates needn’t not raise revenue for the central bank. Increased reinvestment rates can be overwhelmed by a reduction in balance sheet size. The scale of reduction in the size of the balance sheet required to raise rates will be related to the interest it pays on reserves. When the spread between bond rates and IOR is large, small changes in the Fed’s balance sheet have large effects. When the spread is small, the Fed will have to shrink its balance sheet dramatically to raise rates. It’s pretty clear under current circumstances, when the US Fed raises rates it will lose not gain profitability.

    In the US, the CB’s “tax” is very high now — it’s bought a lot of long assets and MBS and even credit, with a large spread over the 25 bps IOR. The central bank’s profits do not seem to be coming at the expense of bank profitability. I claim that CB profitability and commercial bank profitability covary positively, not negatively as the “reserves are a tax on banks” story would suggest. (Again, I should try to verify these claims; I’m trying to articulate what I think, in doing so it’s clarifying what I need to verify.)

    The CB affects bank profitability by 1) setting levels: lowering the level of rates increases banks profitability, both because of transient opportunities during the period of reduction and because credit spreads don’t fall one-for-one with levels; 2) by the premium it pays when it engages in direct transactions with its primary dealers; 3) by the penalty rate and haircut it does or does not to require in order to rediscount bank assets; 4) by virtue of regulatory decisions, which may enhance or impair bank profitability, short-term or long. I don’t think there’s any evidence that the size of the CB’s balance sheet much affects bank profitability (measured as ROE, not margins), and I do think that increases in demand for bank deposits provokes both increased profitability of private banks and increases in the balance sheet of central banks.

  62. JKH @ 60 & RSJ — I think the critique that bank funding costs are really subsidized by convenience yields generated by the state ends precisely in RSJ’s “Option 1: Ban The Rents“.

    That might or might not be good policy. In theory, there is a strong case that the subsidy implicit in bank funding is worth paying in terms of the high quality, decentralized investment it engenders. The state subsidizes capital formation by distributing the convenience yield associated with holding money to savers, entrepreneurs, and bankers.

    This case has been harmed by the experience of the last decade, but perhaps not fatally. If we could reform banks as institutions so that they did a better job of allocating real capital, I’d say it was a slam dunk case. There are lots of subsidies in the world that are worth paying.

    But so long as banks seem to self-deal egregiously and allocate capital poorly, the case for having the state appropriate the convenience yield associated with its money, whether to allocate resources directly or to distribute them to some alternative capital allocator, will grow.

  63. Scott —

    “Potato, po-tah-to.”, but as a political matter it’s important. As a taxpayer, I do not wish to surrender interest on reserves to status quo banks. If I can demonstrate what I think is true — that despite accounting appearances, reserve expansions are not harmful to bank profitability but “tax” the general public, I’ll have an easier time making my case. The difference between taxing something and withdrawing a subsidy is sometimes lost on economists, but never on politicians.

    I won’t argue much on the effectiveness of zero/negative ROE on encouraging lending. I don’t love macro stabilization by encouraging lending in the first case, but it’s a big part of the status quo lever, and until we move to a better regime it’s what we’ve got. I’ll weaken my claim a bit, and say “At the margin, there are plausible mechanisms by which it might be expansionary, and IMHO few plausible mechanisms by which it would discourage lending. So while our expansionary strategy, however unfortunately, is to expand lending, we are better off going to zero IOR than not.”

    BTW, I know that, e.g. Warren Mosler, might argue that a contractionary income effect associated with reducing interest payments by the state would offset any expansionary effect. I think that’s a reasonable argument for, e.g. China, where non-affluent households save in rate-capped deposits. Given the distribution of claims in governments and banks in the US and the low marginal propensity to consume among claimants who receive IOR and bond coupons, I don’t find that claim persuasive. I think reducing the hurdle rate to lend in the US pretty clearly expands activity, despite depriving income to bondholders. If deposit and lending rates were administered separately, then perhaps raising deposit rates while reducing lending rates would be an option (though I wouldn’t like its distributional implictaions).

  64. rsj writes:

    JKH,

    Let me step back a bit, as we may be talking past each other.

    1. From a macro-point of view, the goal of interest rate management is to put a floor on the lending rates. This is merely another way of saying that the goal is to impose costs on borrowers. I’m claiming that the natural way to do this is to impose costs on banks, which are passed onto borrowers. The most natural way of imposing costs is to tax, rather than to pay interest to banks. I.e. it should not cost the government anything to impose costs on the private sector. Rather, this should be a revenue generating operation for the government.

    2. Accepting #1 — do you accept #1? — the question becomes whether, if banks do not find provision of depositor services as being profitable, the costs of the government in providing these services would exceed the revenues obtained from the tax.

    I think the answer is clearly no.

    The government currently pays roughly the 5-7 year risk free rate on the federal debt, which is roughly the size of MZM. Banks pay the MZM own rate.

    As long as the government can provide MZM services for less than the spread between 5 yr treasuries and the MZM own rate, then the government will come out ahead.

    Assuming a 3% spread, that means that the government must be able to provide vanilla deposit services for less than about $200 B per annum. To put things into perspective, the post office currently maintains branches across the country and employs a half a million people for about $80B per annum, but the job of the post office — moving physical goods across the nation — is substantially more costly than the job of providing depositor services, the bulk of which can be done electronically (and much of which can be done online).

    3. Independent of #2, there is the issue of economic rents. An economic rent is earned not by looking at the existence of a NIM, but whether the price of the service exceeds marginal cost. You can have price = marginal cost, and still have a producer surplus, which for the banking system would correspond to some level of net interest income.

    But for the banking system, it’s clear that price > marginal cost. You can look at everything from providing depositor services to the current debate over credit card interchange fees to see that the banking system as a whole is not competitive. And that means that should they lose the economic rents from providing depositor services (or interchange fees), then they will not increase lending rates one for one with the loss in profits.

    They will increase lending rates by substantially less than that, and the loss of revenue will be borne by fewer bonuses specifically and lower FIRE sector compensation, which is currently far in excess of the compensation provided by other sectors of the economy.

    As a result, fewer of the most talented people will be drawn into finance and will enter more productive sectors of the economy.

    To the degree that this forces up lending rates, then the government can respond by lowering the tax. We can then have a quantitative debate about the size of the government revenue benefit.

    But the total benefit will also include the better allocation of productive resources stemming from a reduction in what is effectively a tax on the non-financial sector — often on the most vulnerable members of the non-financial sector, such as small businesses and low income households who are hit with high interchange fees and high deposit fees, respectively.

  65. RSJ — I like your piece very much, but you are basically proposing the end of status quo banking. The driving force of banks as institutions, their comparative advantage over a million other forms of financial intermediary, is that banks funding costs are subsidized by the convenience yield associated uniquely with money issued by the state. Banks are mechanisms whose function is to convert seigniorage into investment on commercial terms rather than government expenditure. Given how status quo banks currently behave, I’m very open to proposals that would shift these rents to other sorts of institutions. But I’m not so sure how great an idea it would be to just formally let the state capture those rents without devising some alternative practices of decentralized, state-subsidized capital allocation.

  66. Scott — I should say that the plausible mechanism by which zero / neg IOR encourages lending is pretty straightfoward.

    At the margin, lower IOR encourages banks to replace reserves with other assets. Lending does not deterministically engender reserve outflows, but stochastically it does. The larger your deposit base, the greater the likelihood that some customer will order outgoing transfers, depleting your reserve balances. If you are in a contest to lose reserve balances, or if your incentive to retain reserve balances is diminished, at the margin your incentive to create deposits that might become outflows has increased. If there was a loan that you were indifferent to funding when IOR was 25 bps, you may wish to fund it when IOR is 0 bps.

    There is nothing unearthly about this conjecture. As a quantitative matter, it’s unclear how much it will help, that depends on how much potential lending is within (some_stochastic_factor x 25 bps) of a margin. I agree with you and with JKH that this is probably a lot less than monetarists sometimes claim. But I doubt that it is zero.

  67. rsj writes:

    SRW,

    I agree that we need a de-centralized capital allocation mechanism, but we do not need a de-centralized depositor provider. I am not arguing that the government take over *lending*.

    The association of depositor services with lending is a gold-standard anachronism. In the era of electronic fiat money, we do not need to combine depositor institutions with lending institutions at all. Other than inertia (and vested interests), there is no natural reason why the two types of services should be performed by the same entity. The core competencies are different. Being good at lending requires credit analysis, whereas provisioning of depositor services is infrastructure based — maintaining a secure payment infrastructure, plus some customer service. The government can handle the infrastructure aspect quite well — we can debate the customer service :)

  68. Fed Up @ 46 — The Fed could raise reserve requirements rather than pay IOR or drain reserves when it wishes to raise rates. But this would be disruptive. The Fed hasn’t raised reserve requirements in decades, has permitted them to be largely eliminated in practice, and telegraphed its intention to eliminate them explicitly eventually. It is an option, but I doubt it’s one that the Fed will reach for.

    Fed Up @ 44 — I agree with you; I very much dislike encouraging bank lending as our means of macro stabilization, precisely because it results in too much indebtedness (and too little collaboration via equity arrangements). My strong preference is that we shift from bank-centric monetary policy to stabilization via transfers, or via a well-designed employer of last resort program, or via some institution that subsidizes equity investment rather than loans.

    But if I am restricted to working within the current paradigm of trying to expand lending, zero IOR will I think help at the margin. At least it won’t hurt loan growth.

    Again, the whole paradigm is wrong. Loan growth is a bad goal. To the extent we succeed, bad loans will be made and will come back to haunt us. Sustainable demand that is met by equity-financed enterprises should be our goal. We shouldn’t have negative IOR, we shouldn’t have ZIRP, we shouldn’t have any of it. We should generate demand and promote entrepreneurial, small-busness equity investing.

    But within the broken paradigm, where expansion equates to encouraging lending and depression equates to insufficient debt finance, zero / neg IOR is worth trying. And for the moment, that broken paradigm is where we are stuck.

    Fed Up @ 25 — In practice it would be very hard to tax vault cash without taxing cash holdings generally. Bankers would outsource storage of vault cash in a second, and hold claims on the storage companies. This could be banned, or tracked and taxed, but then just think of some clever and more subtle means of indirectly holding cash. Suppose I lend to your “real estate project”, but we make a side deal that says you’ll do nothing of the sort but hold my cash. You can stamp out any one of these schemes, but the variations are endless.

  69. RSJ — I agree with you entirely on the deposit side. I see little reason to have depositing all mixed up with lending, when the risk and therefore capital for the loans is supplied by the state.

    But you propose on the lending side taxing back the seigniorage rents, or controlling them by setting banks cost of funding higher than the rate paid by the state to depositors. The immediate effect of that proposal would be to dramatically curtail lending and investing by the banks investment funds that would lend the funds advanced by the state. To generate the level of lending we consider healthy, we’d need to drop those rates to, well, whatever level currently generates sufficient lending under the bank system, a heavily subsidized rate. We’d end up reproducing the bank system with a bit more clarity about the role of depositors (delaying consumption, not investing) and the role of the state (explicitly investing and bearing risk).

    Again, I love the idea of making those lines clear, getting rid of the pure fiction that banks are intermediaries between private savers and entrepreneurs. And I love the idea of distributing whatever rents we need to distribute to encourage sufficient capital formation to institutions much better arranged than status quo banks. But we’ve got to fill that part in a bit more, I think.

    BTW, there is a famous paper that argues that depositing and lending go together under the rubrick of a common competence, “liquidity management”. I think that’s unpersuasive, especially on a forward-looking and prescriptive basis, given that fiat-currency-issuing sovereigns face no liquidity constraint. But, worth a look if you haven’t:

    Kashyap, Anil, Rajan, Raghuram, and Stein, Jeremy, 2002, Banks as liquidity providers: an explanation for the coexistence of lending and deposit-taking, Journal of Finance 57, 33-73.

  70. Joe Smith — A lot of the economic issues of the day are boiling down to “austerity” vs. “jubilee” (with the important caveat that people invested via the banking system already got there jubiliee, despite pretensions of prudence and many of their eagerness for austerity). It’s a very epic sort of conflict, one I hope our society proves better adept going forward at navigating than it has thus far.

  71. Detroit Dan — I actually do have arguments against fiscal absolutism as well, some of which have come through in these comments. I do think zero / neg IOR might help a bit, although I don’t like the broad paradigm of expansion via loan supply. I think Warren Mosler is wrong, as a practical matter, in “advanced” economies, to suggest that low interest rates are contractionary due to their effect on incomes. In principle, low interest rates have conflicting macro effects, a contactionary income effect and an expansionary spur to investment. In practice, the distribution of savings in the US is such that, in aggregate, bondholders’ low propensity to spend or invest directly means the expansionary effect on investment is far larger than the contractionary income effect. (In China, WM’s insight strikes me as very useful. Michael Pettis, who is excellent on China, certainly agrees.)

    But you are right — in this piece my barbs are mostly directed to the monetarists. That’s because they are the ones whose intransigence represents the dominant view, and is used as an excuse to prevent more open policy experimentation. I think that the monetarists get a lot right. But dogmatic opposition to anything fiscal, and false claims that fiscal is inherently impotent and near worship of our deeply flawed central bank, demand challenge if we are going to give ourselves the freedom to try anything useful. Fiscal absolutists are, for the moment, policy upstarts. To the degree they are mistaken, they are not blocking anything. But monetary absolutism is the decades old consensus (really detente) among mainstream economists, and is deflecting us from doing helpful things.

  72. rsj writes:

    SRW,

    “The immediate effect of that proposal would be to dramatically curtail lending and investing by the banks investment funds that would lend the funds advanced by the state”

    That may well be the case — and to the degree that it is, it will be a function of the inherent inertia in this system.

    But the lending market is basically real estate. I believe this market is already competitive. Particularly as banks can securitize mortgages. This limits the ability of banks to charge an additional premium to borrowers for loans they keep on their own books.

    The issue is that banks have additional revenue sources from markets that are not competitive. By taking away those markets, it will be difficult for banks to drive up margins in the more competitive markets. There would be a transition period no, doubt, but looking at the OECD, we see many nations in which credit flows freely and yet bank employees do not earn anywhere near the compensation levels that are earned in the U.S., and financial sector profits are a substantially smaller share of GDP.

    In many ways this is similar to the healthcare debates. Those who say that doctors will refuse to work or medical equipment manufacturers will refuse to supply goods need only look at what is happening throughout the OECD. The U.S. is the outlier here, and there is no reason to believe that we cannot have good financial services, insurance, or medical care with monopolistic competition if we reduce the revenues of these sectors by 1/2.

    I think the biggest obstacle is the belief that our current system is the result of some form of broad competitive optimization in which profits have already been driven to zero, so that there is no free lunch available. Finance and healthcare are gorging on free lunches. There are plenty of free lunches.

  73. vimothy writes:

    But you are right — in this piece my barbs are mostly directed to the monetarists. That’s because they are the ones whose intransigence represents the dominant view, and is used as an excuse to prevent more open policy experimentation.

    Is this really true, though?

    Often the dynamics of internet debates do not reflect equivalent debates in the real world (or, as the phrase goes, “in real life”). For instance, based on arguments on the blogosphere, Austrians vs. Old Keynesians is the predominant cleavage in economic thought—but neither is actually present in the classroom. Here we have monetarists as the mainstream and an MMT-type critique of their failure to properly account for fiscal policy.

    The internet debate between those who prefer monetary policy and those who prefer fiscal policy is really two groups of people talking past one another, because they are using two different frames of reference. To the fiscal group, the question is: can fiscal policy raise aggregate demand? They see that the answer is obviously yes it can, and, given that aggregate demand is self-evidently deficient, which suggests that monetary policy is not working, would like to see a greater reliance on fiscal policy. But the monetary group, who are not, in my opinion, monetarists, but rather modern macroeconomists using the tools of modern macro, ask a completely different question. That question is: what are the welfare effects of the two policies? Based on a welfare analysis, they conclude that monetary stimulus dominates fiscal stimulus, even at the ZLB.

    Here, as an e.g., is what I would call a mainstream approach to this particular conundrum: Mankiw & Weinzierl (2011), “An Exploration of Optimal Stabilization Policy”. http://www.economics.harvard.edu/faculty/mankiw/files/Exploration%20of%20Optimal.pdf

    But until both groups agree what the question is, they are hardly likely to come to any agreement or compromise about the answer.

  74. JKH writes:

    SRW,

    We seem not to be communicating effectively yet on what I see as some very simple analytics around this question of required reserves in a non-zero rate environment.

    For exposition, three stages:

    1. No required reserves
    2. CB imposes required reserves earning no interest in a non-zero rate environment
    3. Commercial banks react through asset-liability pricing, etc.

    In the second stage, the CB imposes required reserves and then must supply those reserves to the system by acquiring assets. After it does so, there are two components to the immediate interest margin effect on banks:

    a) Balance sheet size (denominator effect)
    b) Absolute dollar margin (numerator effect)

    In the usual case where the CB acquires assets from non-banks, the banking system balance sheet will increase by the amount of reserves as assets and the same amount deposits as liabilities. That will reduce the interest margin expressed as a percentage of assets. Also, the interest margin will decline ADDITIONALLY because the incremental balance sheet contributes a negative absolute dollar margin, assuming the banks pay non-zero interest in a non-zero rate environment.

    In the case where the CB acquires assets from banks, there is no denominator effect but there is still a numerator effect.

    The critical aspect regardless of the denominator effect is that there is in both cases an assumed negative interest margin contribution that reduces its dollar size (numerator).

    The second stage is a tax, in my view.

    The third stage represents the banking system’s adjustment to “ceteris paribus”, though pricing adjustments, etc. as we’ve discussed. I don’t think we disagree much there.

    The third stage is the partial or full cost recovery of the tax, in my view.

    I think we’ve not been communicating in part because I’ve been interpreting stage 2 as the evidence of whether or not there is a tax, and you’ve been interpreting that as stage 3. That’s just semantic ordering.

    Yet I’m still not sure you agree with me on the dollar margin effect in stage 2, so we may still disagree on the interest margin accounting.

    And, given the absolute margin compression in stage 2, ROE will decline, assuming E is unchanged.

    And all of the above relates only to the question of required reserves – not the question of QE reserves.

    (I’ve not referenced a potential fourth stage – the CB reacts with a policy rate change – because as noted already, interest margins are a matter of at least partial symmetry. Banks can adjust through asset and/or liability pricing. CB reaction is necessarily asymmetric. It can adjust the level of interest rates up or down – but it can’t necessarily predict the resulting distribution of that change across consequent commercial bank asset and liability pricing changes.)

    And I view this simple case of required reserves as a preamble to, but separate from, the more complicated question of the impact of QE reserves and their pricing.

  75. JKH writes:

    SRW,

    Now a few preliminary points on the case of QE reserves, which is separate from the case of required reserves. The case of required reserves assumes implicitly that there is no additional QE reserve injection – i.e. excess reserves are minimal, as in pre-2008. Conversely, the case of excess reserves can assume away the presence of required reserves, to keep the two types of reserve effects analytically separate.

    With that, QE reserves are different, because they are excess reserves. Required reserves are not excess reserves. So the question now becomes, how does the banking system respond to the presence of excess reserves – in great size – that are not required?

    Consider comparable stages for QE excess reserves as in the required reserve case:

    1. No QE reserves
    2. QE reserves
    3. Commercial bank response

    And we can add, at least as a contingency due to the apparent complexity of the QE case:

    4. Additional CB response through policy rate adjustment

    One question is what is the effect of QE reserves on the banking system interest margin? And the answer is quite different than the required reserve case. The answer is different because QE reserves can’t be compensated at a zero rate in a non-zero rate environment.

    So the margin effect in terms of absolute dollars (the numerator) is benign relative to the required reserve case, especially looking forward to the point where the policy rate begins to rise. And that means the ROE effect is benign. But there is a denominator effect, since the banking system balance sheet will be larger than the counterfactual case, because not all assets purchased by the CB under QE are assets that would have been held by the banking system in the counterfactual.

  76. JKH writes:

    Just to add at this point that QE reserve injection is equivalent to a “mini-Mosler” no bonds approach in its effect on the banking system balance sheet. The dollar impact on bank interest margins is minimal, the ROE impact is minimal (assuming unchanged E), while the denominator impact for the (dollar margin/assets) calculation obviously increases. The latter is not economically significant in a direct way.

  77. JKH writes:

    RSJ,

    Just a few comments, as I haven’t yet fully absorbed your proposal. Although I think I already summarized it, at least to my own satisfaction.

    I’d add that the combination of your proposal plus MMT “no bonds” would roughly double current levels of MZM offered by the banking system, while converting it all to government MZM liabilities. If left forcibly in that mode (i.e. without bonds or other liability modification), the same MMT tax analytics apply, only doubly so.

    “From a macro-point of view, the goal of interest rate management is to put a floor on the lending rates. This is merely another way of saying that the goal is to impose costs on borrowers.”

    First part OK, but I don’t follow the second part. If the goal is to put a floor on lending rates, it is simultaneously to put a ceiling on many deposit rates (but not all – e.g. wholesale term liabilities). Lowering rates imposes a comparative cost. Raising rates grants a comparative benefit. But establishing a particular level for deposit rates does neither in logic – unless the counterfactual is always biased upward, as in infinity. But why should it be?

    “The government currently pays roughly the 5-7 year risk free rate on the federal debt, which is roughly the size of MZM. Banks pay the MZM own rate. As long as the government can provide MZM services for less than the spread between 5 yr treasuries and the MZM own rate, then the government will come out ahead.

    Maybe – I’m not sure if the 5 -7 rate is the right “transfer price” for MZM. But taking into account branch banking costs, and assuming the resulting MZM profile is forced into the monetary system (the same as “no bonds”), then something like that, I think.

    Your $ 200 billion calculation ignores the fact that this margin is already taxable. And as I said, the entire after tax profit of the banking system is less than that (I believe; haven’t checked the numbers lately).

    In all, your proposal is obviously a structural upheaval of banking. But I don’t feel capable to assess the ultimate economics that you claim would be the benefit. My general impression also is that there is an ideological component inherent in the analytics.

  78. JKH writes:

    RSJ,

    Clarification on my “ideology” reference:

    I think that a great deal of what is wrong with the US financial system can be captured initially in the way in which the mortgage sub-system has been designed.

    As an initial approach, I’d prefer a top-down redesign of that rather than the top-down nationalization of deposit banking “rents”.

    Yours is an interesting proposal, but I think it should be considered as contingent on the resolution of the mortgage banking question first.

    There’s also too much desperation in general to punish various actors for excess compensation. That’s lashing out. It seems to be the driving motivation of too many. But that’s not solving the problem.

  79. Detroit Dan writes:

    SRW — Thanks as usual for the response and good discussion…

  80. Scott Fullwiler writes:

    SRW,

    Adding to the points JKH is making, which I agree with, I would say this:

    “If there was a loan that you were indifferent to funding when IOR was 25 bps, you may wish to fund it when IOR is 0 bps.”

    The problem here is the assumption that the loan rate hasn’t changed. If you cut IOR, that’s identical to cutting the policy rate if ER are in surplus, and so other rates quickly go to indifference levels, too.

  81. Scott — Sure. But both ordinary monetary policy (cutting the policy rate) and for cutting IOR, work despite the reequilibration if there are real economic projects or loans to end users whose returns don’t fall one for one with interest rates. Holding the price level constant, if I have an oil well that can generate a million barrels a year, requires a capital the energy equivalent of 800,000 barrels per year to drill, and requires that capital worth 1,000,000 barrels be tied up, that project will never be economical if my cost of capital is less than 20%, but can be profitable if my cost of cap is less than that, regardless of other interest rates. (Presumably the real max capital cost is less than 20%, because I want some compensation for my risk and some profit.) Lowering the interest rate increases the profitability of my project in an absolute sense. The equilibration of other rates reduces the opportunity cost of the project viz holding my capital in the bank, also pushing me from “no go” to “go”.

    Financial rates always find there way to internal equilibria and points of indifference rather quickly. But their levels do matter, because they sit next to real projects, and to borrowers whose incomes don’t directly adjust with rates. Which is why we do observe, pretty plainly I think, that activity and inflation pressures increase in the US when policy rates drop. A cut in IOR would have a similar effect.

    (“if ER are in surplus” — I’m sure I’m being obtuse and missing something obvious, but what is ER here?)

  82. JKH — I don’t think we’re disagreeing too much, and I appreciate your bearing with. I’ve been trying to use this discussing to test a long-held intuition (and thinking it through while I write, which is why the communication is less effective than it might be).

    On your three-step description of an accommodated required reserve increase: I agree that Step 2 looks like a tax, but argue that Step 3 shifts the incidence to bank clients, undoing any effect on dollar margins (even if lending spreads remain compressed). There is a cost to the private sector associated with any uncompensated reserve expansion (whether required or via QE). My claim is that it is borne by end-users rather than by banks. Banks issue of deposits is infinitely price elastic near the Federal Funds and discount rates. Customers’ acceptance of deposits is often price insensitive. By ordinary micro analysis, it shouldn’t be surprising that the incidence falls on depositors. (The same reasoning suggests that a cut in IOR should fall on depositors, but there is a zero-bound issue here, the fraction of deposits that is entirely uncompensated is high, and deposit rates are sticky around zero. It’s plausible that banks would fail to pass through the cost of a cut in IOR if doing so would require charging fees on deposits.)

    I’m not sure I understand, at the aggregate level, the distinction you are trying to draw between required reserves and QE reserves. At the aggregate level, putting aside discretionary use of the discount window which is usually quantitatively small, the aggregate level of reserves is exogenous to the banks. If the central bank injects a bunch of reserves for QE, how is that different for the aggregate balance sheet than if the CB did the same and declared that the new level of reserves must be held under penalty of law? The new level of reserves will be held in either case. Under a QE reserve expansion, individual banks aren’t forced to carry the reserves, but that doesn’t mitigate the effect on the aggregate balance sheet. Am I missing something?

    Obviously an uncompensated QE expansion is only consistent with a zero policy rate, and therefore a near-zero deposit rate. So, under these conditions, when the CB purchases an asset from a customer, it is obvious that we can look at the effect as an expansion of zero-interest deposits and backed by a zero interest asset, reducing lending margins but leaving dollar margins constant. This is the base case that underlies my intuition (and helps justify my discomfort with IOR at the zero bound).

    But it’s worth pointing out that the central bank even now earns a whole lot of money on its QE expansions, even paying 25 bps. It is creating opportunity costs for someone. If those costs are not being borne by banks (and they’re not, putting aside absolute balance sheet size wrinkles, ROE would unaffected by the swap if IOR were zero, and is enhanced with positive IOR), then they are being borne by customers. In the case of QE easing, we can clearly observe that balance sheet expansions correspond to a tax whose incidence falls on bank customers, not banks. When IOR is paid, if the zero-bound issue I’ve described is correct, QE balance sheet expansions tax customers at the full opportunity cost of the yield surrendered in asset sales to the central bank, and then tax the Treasury an additional 25 bps which is captured by bank equity. Away from the zero bound, with non-zero rates sustained by payment of IOR, the size of the CB balance sheet would represent a tax on depositors of (yield on CB portfolio – IOR).

    Are we close?

  83. rsj writes:

    JKH,

    “I’d add that the combination of your proposal plus MMT “no bonds” would roughly double current levels of MZM offered by the banking system, while converting it all to government MZM liabilities. If left forcibly in that mode (i.e. without bonds or other liability modification), the same MMT tax analytics apply, only doubly so.”

    No, this proposal is an attempt to replace the no-bonds and zero rate proposals, which I don’t support. From an economic point of view, my proposal is actually very conservative, and it arose as a thought experiment in which I tried to bridge the conceptual gap between Krugman and Rowe’s critiques of MMT and MMT itself:

    If you recall, the counter-argument to “no bonds” is that there is only so much seignorage income available, which is obviously true. In order to get households to hold additional levels of assets, the government will need to increase the interest rate paid or risk inflation.

    But these analysis ignore outside money, the supply of which is also seignorage. So instead of trying to force households to hold excess deposits (a strategy which I believe is counterproductive and distortive), allow the government to claim the full seignorage income available for public purpose, but no more. The government would sell bonds, but would need to simultaneously convert bonds to reserves to offset the reserve drain of the asset tax. Therefore the public would determine the level of seignorage income available by determining the size of MZM.

    As with any seignorage income, there are costs to the provisioning of money. The costs to the provisioning of deposits are well known, but I believe you are overstating them. Particularly as deposit services are supplied inefficiently by the banking sector (e.g. multiple bank branches in the same location, marketing costs, etc.).

    In terms of focusing on financial sector reform, conceptually this is a second order concern. First, you eat the free lunches, and second you eat the lunches that are worth paying for. Hence the focus on rent-seeking — that is a dead-weight loss for the economy under any conceivable economic policy. Now any time there are economic rents available, you have two effects. First, the existence of the rents are effectively a tax paid for by everyone else. That tax reduces output and employment. Second, economic actors orient themselves in such a way as to pursue those rents, which draws real resources into unproductive uses. When you squash those rents, it necessarily means that those eating the free lunches are no longer eating them — it may seem like “lashing out”, but it isn’t. It’s merely attempting to increase efficiency by removing the economic rents arising from private sector entities interjecting themselves into the seignorage process and extracting economic rents from the rest of the economy. It is no different than advocating for a single payer health plan to remove the insurance firms that have interjected themselves in the health-care delivery process. That is not “lashing out” at doctors or accountants, it’s just an attempt at increasing efficiency and removing that taxes that are levied on the rest of the economy in the form of unnecessarily high health care costs.

    In the case of finance seignorage, the taxes consist of the interest income that we must pay bond holders in order to supply the private sector with the MZM that it demands — the cost of delivery of MZM can be done for far less than the interest income paid out on an MZM’s worth of government debt. The difference is a dead-weight-loss, or a free lunch that we can eat, regardless of the details of mortgage lending reform.

    And let’s not forget the second order effects of political paralysis that prevents economic stimulus for fear of increasing the debt level with the concomitant loss in output. Under this proposal, there is no “money printing” in excess of what the banks require in order to meet their minimal reserve requirements. The government continues to sell bonds, but it also retires them when households signal that they prefer to hold MZM claims at the MZM own rate rather than longer dated bond claims at the higher yields.

    It is the natural thing to do, and in fact many models already assume that this is how the system works, which is why there is such fundamental disagreement between Krugman and MMT.

  84. rsj writes:

    In the above, I should have said “ignore inside money”. Typing too fast now.

  85. JKH writes:

    SRW

    “I agree that Step 2 looks like a tax, but argue that Step 3 shifts the incidence to bank clients, undoing any effect on dollar margins (even if lending spreads remain compressed).”

    I think we’re getting toward in synch there.

    “By ordinary micro analysis, it shouldn’t be surprising that the incidence falls on depositors.”

    I can tell you that “back in the day”, when Canadian banks carried mass quantities of uncompensated reserve deposits at the Bank of Canada, the cost of those reserves was factored explicitly into loan pricing. The loan principal was assumed funded by a combination of capital and deposits, and the cost of capital and the cost of deposits was calculated according to assumptions for those parameters. Then, through a “multiplier” type calculation (ironically), additional deposits were assumed to fund the reserve requirement generated by the original deposit funding for the loan principal, such that the resulting mix of loan and reserves was in mathematical balance against deposits and capital. Then, the break even required loan interest rate fell out of all that, given that the cost of capital was included in the mix. Just writing this, it is interesting (but not surprising), that the logic of that construction reflects the MMT theme that reserves “follow” deposits and the loans that create deposits. That calculation reflects the CB reserve injection required according to the system impact of a new loan, ceteris paribus. Anyway, you can see from this that the cost of reserves was factored into the loan pricing, in parallel with the cost of capital and the deposits required to fund both the loan principal and the accompanying reserves.

    At the end of the day, everything affects everything (there’s a great answer). It would appear from the calculation I described that the cost of required reserves is factored into loans rather than deposits, but who knows when all of the micro and macro bumping into each other is summed up?

    “I’m not sure I understand, at the aggregate level, the distinction you are trying to draw between required reserves and QE reserves.”

    The distinction is that above the zero bound, required reserves are not necessarily compensated (as in pre-2008 US). The central bank has no problem hitting its target with uncompensated required reserves. But QE reserves must be compensated in order for the CB to hits its target when the target is above the zero bound. The situation is strange now, because the Fed has the operational option of not compensating QE reserves, but has chosen to pay the pittance of 25 basis points instead. Anyway, the distinction poses different “tax” levels and absorption costs for the two types of reserves when the CB’s target rate is above the zero bound.

    “Obviously an uncompensated QE expansion is only consistent with a zero policy rate, and therefore a near-zero deposit rate.”

    Right, and a non-zero policy rate is only consistent with a compensated QE reserve position. And that’s going to be the case at some point during the Fed’s “exit” from QE. The Fed funds rate is going to start moving up well in advance of any ultimate draining of all QE reserves – even if the former doesn’t begin until several years from now.

    “QE balance sheet expansions tax customers at the full opportunity cost of the yield surrendered in asset sales to the central bank, and then tax the Treasury an additional 25 bps which is captured by bank equity.”

    Right – maybe think of it as an interest rate swap that amounts to a tax swap:

    The (consolidated) government pays floating (interest on reserves) and receives fixed (bond yield).

    The (consolidated) government pays a tax credit of floating, and receives a tax of fixed (interest payments are fiscal).

    Altogether, getting closer I think.

  86. Fed Up writes:

    Can someone set me straight here.

    With private debt and when the recipient’s demand deposit account is marked up, there is no 1-to-1 reserve account markup. So, when the private loan is “attached”, there is no 1-to-1 reserve account markdown. Correct?

    With gov’t debt and when the recipient’s demand deposit account is marked up, there is a 1-to-1 reserve account markup. So, when the gov’t loan/bond is “attached”, there is a 1-to-1 reserve account markdown. Correct?

    Thanks in advance.

    I hope to have some comments on SF@58 and SRW@68 later.

  87. Scott Fullwiler writes:

    Steve,

    Yes, I absolutely agree that a cut in rates will lead to a greater demand for borrowing for the sorts of cost of capital reasons you explain. And these projects will look better to banks as they are more likely to be NPV positive. I’ve already said I agree with that. But that’s all the equivalent of a cut in the policy rate, because you can’t cut IOR without cutting the policy rate unless the surplus ER are drained in the first place. And that’s not the same thing I meant by indifference levels–my interpretation of the argument made that IOR keeps banks from lending is that a project with a given NPV estimate would be a more acceptable loan without the IOR subsidy.

    This is all rather difficult to discuss with someone like you who understands banking, since the argument I am countering is one largely misunderstands banking. So, overall, if your argument at 81 has been the sum of your position all along, then it seems we do not have any real disagreement on this point.

  88. Scott — I don’t think we’ve been disagreeing very much at all. We have a similar understanding of things. The strongest claim I want to make is that directionally, at the margin, reducing IOR is likely to increase real expenditure. For all the reasons you point out, I don’t think we should expect a very dramatic effect. But if at the margin it will “help” (putting aside the usual, bad, side effects of stimulating funding supply rather than funding demand), and if its distributional effects are undesirable (a political as well as economic view, but my view on both counts), then we should cut IOR (without, of course, imagining that it will be a panacea).

    As a rule, when I play in the comments, I give myself license to write without editing, and often don’t proofread. That’s a time management thing; when I play, I try to respond to just about everyone, and perfectionism is a time sink. But my last response to you was particularly embarrassing for typos, incoherently half-done revisions and grammatical errors. Sorry about that! (This one I’m typing on my phone, so I’m sure it’ll be great!)

  89. Dan Kervick writes:

    I’m confused about the issue of interest on reserves.

    My understanding – based in large part on my reading of a paper by Scott Fulwiler, who commented above – is that given the contemporary institutional arrangements in banking, banks do not lend their reserves, nor are they really constrained in their lending by their current reserve levels. They make loans that seem like good loans to make, and then borrow the reserves – often from the Fed itself. Thus the only way the reserve requirement constrains lending is in relation to the cost of borrowing the reserves.

    Now if the Fed pays interest on reserves, isn’t that just another way of reducing the cost of borrowing those reserves? So isn’t interest on reserves actually the very kind of “loose money” policy that many monetary policy activists are always trumpeting these days?

    The alternative picture painted by the critics of interest on reserves is that the interest payments actually tighten money or restrict lending by making banks less likely to loan their reserves. But hasn’t that been demonstrated to be a false picture?

    The point surely isn’t whether the lack of interest is some kind of tax. Refraining from giving money isn’t the same thing as taking it away. Sure, without interest on reserves the banks don’t get as much margin as they would if . But what of it? The role of monetary policy isn’t to maximize bank margins, but to get the monetary behavior that is most conducive to a healthy economy.

  90. JKH writes:

    More re the comparison of compensated excess reserves versus uncompensated required reserves:

    With compensated QE excess reserves, the compensation rate on reserves affects banks’ cost of funds through pricing arbitrage (although the arbitrage between the reserve interest rate and Fed funds hasn’t been perfect, due to special factors such as treatment of GSE deposits with the Fed). Bank loan pricing is a partial function of this cost of funds (this may include a marginal, indirect effect on the cost of equity capital as well).

    The current environment is very unusual, because the Fed funds target rate is formally an interest rate range adjacent to the zero bound, rather than the zero bound point itself. Therefore, the Fed has given itself the flexibility to choose to set the interest rate on reserves at 25 basis points or zero or somewhere in between. If the Fed drops the rate from 25 basis points to zero, that will have a correlated effect on banks’ cost of funds (although not a perfect correlation as noted above). This could marginally reduce the required interest rate on new loans offered. That could marginally affect loan demand. But it won’t necessarily affect loan supply. The potential effect is primarily through loan pricing and demand – not because banks suddenly want to “get rid of” reserves simply because they no longer earn interest on them.

    With uncompensated required reserves, loan pricing is a function of the cost of funds required to fund the loan principal, plus the additional cost of funds required to fund the new reserve requirement associated with the new deposits required as funding for the loan. For a given change (say decline) in the Fed funds rate, the impact of the cost of funds change is therefore magnified when compared to the case of compensated excess reserves – because the funding requirement is larger for the same principal amount of the loan.

  91. JKH writes:

    P.S.

    “But it won’t necessarily affect loan supply.”

    Here I attempt to invoke Nick Rowe’s distinction between supply and “quantity traded”.

    Because demand changes, quantity traded may change.

    :)

  92. JKH writes:

    or something like that, may have it reversed

  93. Max writes:

    “If you recall, the counter-argument to “no bonds” is that there is only so much seignorage income available, which is obviously true. In order to get households to hold additional levels of assets, the government will need to increase the interest rate paid or risk inflation.”

    I’m struggling to understand what is meant by seignorage income. Is this currency * FedFunds? Or does it have to do with the yield curve, so seignorage comes from interest rate risk? Or something else?

    If you could somehow commit to permanently fixing FedFunds at 0%, then currency*FF would be zero, and also 30-year bonds would yield close to 0% (because no interest rate risk).

  94. Max writes:

    Regarding government provision of MZM to the public: this is already done via money market funds. It could be improved if the treasury offered variable rate bonds with a “put” option.

  95. mattski writes:

    I apologize for my ignorance, but every once in a while would it be possible to translate the debate–roughly–into common parlance?

    IOW, what is the gist of the disagreement here? And can the debate be reflected off this maxim: “everything rests on the tip of motivation.”

    Many thanks.

  96. Joe Smith writes:

    Steve Waldman – So if there is a “jubilee”, who specifically does that impact and by how much? If we are going to discuss jubilee then we need to know what it means in practical consequences.

  97. Fed Up writes:

    SRW@68

    “It (raising the reserve requirement) is an option, but I doubt it’s one that the Fed will reach for.”

    I agree, it is an option, but probably won’t be used. Just wanted to be sure it is an option.

    And, “Fed Up @ 25 — In practice it would be very hard to tax vault cash without taxing cash holdings generally. Bankers would outsource storage of vault cash in a second, and hold claims on the storage companies. This could be banned, or tracked and taxed, but then just think of some clever and more subtle means of indirectly holding cash. Suppose I lend to your “real estate project”, but we make a side deal that says you’ll do nothing of the sort but hold my cash. You can stamp out any one of these schemes, but the variations are endless.”

    SF@58

    “Fed Up,

    Vault cash is not reserve balances. Only reserve balances earn IOR or would be taxed with a negative IOR since they are the deposits at the Fed. To tax vault cash would require a tax on currency, not a tax on ER. The official measure of ER does not include vault cash, regardless what someone’s theoretical view may be.”

    First, does the official measure of required reserves (RR) include vault cash?

    Second and by memory only, scott sumner’s idea was to have a negative interest on (excess?) reserves. To him, this would also include vault cash. To him, this would mean if excess reserves were converted to currency, they would still be penalized. That is as far as I remember. I ASSUME he means the banks would then either spend the currency, buy back stock, increase dividends, or raise upper management pay. If that is what he means and if this somehow happened, I believe that to be a HORRIBLE idea AND an UNFAIR idea of how to create more medium of exchange.

  98. Fed Up writes:

    SRW@68

    “Fed Up @ 44 — I agree with you; I very much dislike encouraging bank lending as our means of macro stabilization, precisely because it results in too much indebtedness (and too little collaboration via equity arrangements). My strong preference is that we shift from bank-centric monetary policy to stabilization via transfers, or via a well-designed employer of last resort program, or via some institution that subsidizes equity investment rather than loans.

    But if I am restricted to working within the current paradigm of trying to expand lending, zero IOR will I think help at the margin. At least it won’t hurt loan growth.

    Again, the whole paradigm is wrong. Loan growth is a bad goal. To the extent we succeed, bad loans will be made and will come back to haunt us. Sustainable demand that is met by equity-financed enterprises should be our goal. We shouldn’t have negative IOR, we shouldn’t have ZIRP, we shouldn’t have any of it. We should generate demand and promote entrepreneurial, small-busness equity investing.

    But within the broken paradigm, where expansion equates to encouraging lending and depression equates to insufficient debt finance, zero / neg IOR is worth trying. And for the moment, that broken paradigm is where we are stuck.”

    As far as I can tell, the way the system is set up now, and the way the “powers-in-be” want it almost all of the time, all NEW medium of exchange HAS to be the demand deposits from a loan/bond, meaning it has to be borrowed into existence. IMO, too much indebtedness is almost always a problem so why is the system set up to create too much debt?

    Can stabilization be achieved thru the labor market by using retirement as an option?

    How can NEW medium of exchange be “equity-financed” (used loosely)?

    And, “But within the broken paradigm, where expansion equates to encouraging lending and depression equates to insufficient debt finance, zero / neg IOR is worth trying. And for the moment, that broken paradigm is where we are stuck.”

    We need a new “paradigm”. Basically and IMO, it comes down to this. How can the amount or velocity of the medium of exchange go down if debt is involved? How can the amount or velocity of the medium of exchange go down if there is ONLY CURRENCY AND NO DEBT involved?

  99. Fed Up writes:

    SRW said: “I’m not sure Caplan is right on the economics here. His post seems to assume a world in which base money and bonds are imperfect substitutes. Some people might say that’s normal, and call the other situation a liquidity trap. But if so, liquidity trap is probably the new normal.”

    Can I get your definition of a liquidity trap?

  100. fresno dan writes:

    I am shocked and appalled that helicopter money could go the the “delightful-smelling and stinky”
    No helicopter money to the stinky!!!

    Define stinky…

  101. Scott Fullwiler writes:

    Hi Fed Up

    No, vault cash doesn’t currently count as ER as the Fed measures them, and doesn’t count as any measure of reserve balances for paying IOR. If a bank has more vault cash than its RR, it is considered to met its RR and any reserve balances it holds are ER. So, vault cash can reduce RR but cannot count as ER even if held in excess of RR (again, according to how the Fed defines ER). Your understanding of SS’s views is about the same as mine; yes, that would require the Fed to redefine what ER is to include vault cash.

  102. Scott Fullwiler writes:

    Let me just add that the Fed’s definitions of ER and what does/doesn’t earn IOR are quite reasonable. If your bank paid interest to you on deposits, it wouldn’t also pay interest on cash you held in your safe at home. Likewise, the Fed pays interest on deposits banks hold in their accounts at the Fed, but it doesn’t pay interest on cash they hold in their “safes.”

    Also, regarding RR and ER, RR is defined by the Fed as “required reserve balances”; as such, as I noted already, ER can only be reserve balances in excess of required reserve balances, which would mean vault cash is not included. Again, as I also noted above, vault cash reduces the reserve requirement. Vault cash thus does not count toward meeting the requirement; only reserve balances do that.

  103. JKH writes:

    Scott and Fed Up,

    I always found the following Fed stat series to be a very useful reminder of the relationship between the various bank reserve components:

    http://www.federalreserve.gov/releases/h3/hist/h3hist2.pdf

    It’s also particularly useful for highlight the extraordinary difference between the Fed’s excess reserve management before the crisis – going back decades – and after the crisis. I used to try and make this particular point to monetarist bloggers, but have since given up on that, of course.

    Scott – it’s just semantics, but one of the categories is “vault cash used to satisfy reserve requirements”. Whether you phrase it as satisfying requirements, or reducing the net requirement, I think the substantive point you make is that vault cash is not a moving part in the real time dynamic of a bank managing toward its reserve requirement within a given calculation period. The vault cash credit is calculated and established as fixed at the beginning of the reserve calculation period, and netted out from what becomes the real time net requirement for reserve balances at the Fed. Then the bank commences managing its real time reserve balance with the central bank in order to meet that net requirement (which could be zero, if the vault cash credit meets or exceeds the requirement for the period). Hope I got that all right, but it should equate to the same difference as what you describe.

  104. Fed Up writes:

    JKH & SF, Thanks!!! I’ll try to keep all of that in mind.

  105. Scott Fullwiler writes:

    Right, JKH. Deposits and vault cash are set during the computation period and together they set RR = (reserve requirement ratio x deposits) – vault cash. And RR can’t be less than zero.

  106. Fed Up writes:

    “RR = (reserve requirement ratio x deposits) – vault cash. And RR can’t be less than zero.”

    That is what I was thinking. I just needed to see it in a simplified form.

    Also, per SF@102, if vault cash > RR, then ER still equals zero. Correct?

  107. Scott Fullwiler writes:

    FEd Up @106 . . . yes, exactly right.