Do we ever rise from the floor?

Paul Krugman has responded to my argument that the distinction between money and short-term debt has been permanently blurred. As far as I can tell, our disagreement is not about economics per se but about how we expect the Fed to behave going forward. Krugman suggests my view is based on a “slip of the tongue”, a confusion about what constitutes the monetary base. It is not, but if it seemed that way, I need to write more clearly. So I’ll try.

Let’s agree on a few basic points. By definition, the “monetary base” is the sum of physical currency in circulation and reserves at the Fed. The Fed has the power to set the size of the monetary base, but cannot directly control the split between currency and reserves, which is determined by those who hold base money. The Fed stands ready to interconvert currency and reserves on demand. Historically, as Krugman points out, the monetary base has been held predominantly in the form of physical currency.

However, since 2008, several things have changed:

  1. The Fed has dramatically expanded the size of the monetary base;
  2. The percentage of the monetary base held as reserves (rather than currency) has gone from a very small fraction to a majority;
  3. The Fed has started to pay interest on the share of the monetary base held as reserves.

Krugman’s view, I think, is that we are in a period of “depression economics” that will someday end, and then we will return to the status quo ante. The economy will perform well enough that the central bank will want to “tap the brakes” and raise interest rates. The Fed will then shrink the monetary base to more historically ordinary levels and cease paying interest on reserves.

I’m less sure about the “someday end” thing. The collapse of the “full employment” interest rate below zero strikes me as a secular rather than cyclical development, although good policy or some great reset could change that. Regardless, if and when the Fed does want to raise interest rates, I think that it will not do so by returning to its old ways. A permanent institutional change has occurred, which renders past experience of the scale and composition of the monetary base unreliable.

To understand the change that has occurred, I recommend “Divorcing money from monetary policy by Keister, Martin, and McAndrews. It’s a quick read, and quite excellent. Broadly speaking, it describes three “systems” that central banks can use to manage interest rates. Under the traditional system and the “channel” system, an interest-rate targeting central bank is highly constrained in its choice of monetary base. There is a unique quantity of money that, given private sector demand for currency and reserves, is consistent with its target interest rate. However, there is an alternative approach, the so-called “floor” system, which allows a central bank to manage the size of the monetary base independently of its interest rate policy.

Under the floor system, a central bank sets the monetary base to be much larger than would be consistent with its target interest rate given private-sector demand, but prevents the interbank interest rate from being bid down below its target by paying interest to reserve holders at the target rate. The target rate becomes the “floor”: it never pays to lend base money to third parties at a lower rate, since you’d make more by just holding reserves (converting currency into reserves as necessary). The US Federal Reserve is currently operating under something very close to a floor system. The scale of the monetary base is sufficiently large that the Federal Funds rate would be stuck near zero if the Fed were not paying interest on reserves. In fact, the effective Federal Funds rate is usually between 10 and 20 basis points. With a “perfect” floor, the rate would never fall below 25 bps. But because of institutional quirks (the Fed discriminates, it fails to pay interest to nonbank holders of reserves), the rate falls just a bit below the “floor”.

If “the crisis ends” (whatever that means) and the Fed reverts to its traditional approach to targeting interest rates, Krugman will be right and I will be wrong, the monetary base will revert to something very different than short-term debt. However, I’m willing to bet that the floor system will be with us indefinitely. If so, base money and short-term government debt will continue to be near-perfect substitutes, even after interest rates rise.

Again, there’s no substantive dispute over the economics here. Krugman writes:

It’s true that the Fed could sterilize the impact of a rise in the monetary base by raising the interest rate it pays on reserves, thereby keeping that base from turning into currency. But that’s just another form of borrowing; it doesn’t change the result that under non-liquidity trap conditions, printing money and issuing debt are not, in fact, the same thing.

If the Fed adopts the floor system permanently, then the Fed will always “sterilize” the impact of a perpetual excess of base money by paying its target interest rate on reserves. As Krugman says, this prevents reserves from being equivalent to currency and amounts to a form of government borrowing. So, we agree: under the floor system, there is little difference between base money and short-term debt, at any targeted interest rate! Printing money and issuing debt are distinct only when there is an opportunity cost to holding base money rather than debt. If Krugman wants to define the existence of such a cost as “non-liquidity trap conditions”, fine. But, if that’s the definition, I expect we’ll be in liquidity trap conditions for a very long time! By Krugman’s definition, a floor system is an eternal liquidity trap.

Am I absolutely certain that the Fed will choose a floor system indefinitely? No. That is a conjecture about future Fed behavior. But, as I’ve said, I’d be willing to bet on it.

After all, the Fed need do nothing at all to adopt a floor system. It has already stumbled into it, so inertia alone makes its continuation likely. It would take active work to “unwind” the Fed’s large balance sheet and return to a traditional quantity-based approach to interest rate targeting.

Further, a floor system is very attractive to central bankers. It maximizes policy flexibility (and policymakers’ power) because it allows the central bank to conduct whatever quantitative or “qualitative” easing operations it deems useful without abandoning its interest rate target. Suppose, sometime in the future, there is a disruptive run on the commercial paper market, as happened in 2008. The Fed might wish to support that market, as it did during the financial crisis, even while targeting an interbank interest rate above zero. Under the floor system, the Fed retains the flexibility to do that, without having to offset its support with asset sales and regardless of the size of its balance sheet. Under the traditional or channel system, the Fed would have to stabilize the overall size of the monetary base even while purchasing lots of new assets. This might be operationally difficult, and may be impossible if the scale of support required is large.

The Fed could go back to the traditional approach and keep a switch to the floor system in its back pocket should a need arise. But why plan for a confidence-scarring regime shift when inertia already puts you where you want to be? Why go to the trouble of unwinding the existing surfeit of base money, which might be disruptive, when doing so solves no pressing problem?

From a central bankers’ perspective, there is little downside to a floor system. Grumps (like me!) might object to the very flexibility that renders the floor system attractive. But I don’t think the anti-bail-out left or hard-money right will succeed in rolling back operational flexibility that the Federal Reserve has already won and routinized. Every powerful interest associated with status quo finance prefers the Fed operate under the floor system. Paying interest on reserves at the Federal Funds rate eliminates the “tax” on banks and bank depositors associated with uncompensated reserves, and increases the Fed’s ability continue to do “special favors” for financial institutions (in the name of widows and orphans and “stability” of course).

Perhaps my read of the politics (and faith in inertia) will prove wrong. But the economics are simple, not at all based on a slip of the tongue and quite difficult to dispute. If the Fed sticks to the floor, base money and government debt will continue to be near perfect substitutes and theories of monetary policy that focus on demand for base money as distinct from short-term debt will be difficult to sustain. The Fed will still have an institutional “edge” over the Treasury in setting interest rates, because the Fed sets the interest rate on reserves by fiat, while short-term Treasury debt is priced at auction. When reserves are abundant, T-bill rates are effectively capped by the rate paid on reserves. Which means that, in our brave new future (which is now), reserves will likely remain a more attractive asset (for banks) than short-term Treasuries, so issuing base money (whether reserves or currency convertible on-demand to reserves by banks) will be less inflationary than issuing lower interest, less-transactionally-convenient debt.

 
 

56 Responses to “Do we ever rise from the floor?”

  1. acarraro writes:

    I am not sure I really believe that the equilibrium interest rate is negative. Especially in the US demographic growth is still positive, inflation is still targeted at 2% and while you could argue it slowed down, there is still innovation. Maybe lack of oil will push economic growth negative, but that doesn’t seem likely for a while yet.
    As a comparison, Japan had 0% target inflation and negative population growth. I think the situation is pretty different.
    I personally think your basic assumption that the Fed would rise the interest paid on reserves at the same rate to be quite a big departure from standard central bank behaviour. The interest might be keep at 25bp, but it’s unlikely it would be raised. I think IOR is just a subsidy to the banking system in a time of stress. I guess subsidies are difficult to unwind, but I doubt the subsidy will be increased…

  2. Ashwin writes:

    Steve – Krugman’s currency argument is irrelevant. The central bank cannot force economic agents (as a group) to hold any more “dead presidents” than it wants. Nor can it prevent agents from hold any less than they want. If the Fed prints 200 billion in notes and gives it to us, we’re likely going to just deposit it in the banking system and then buy liquid near-money interest-bearing assets with it. All the dead presidents will just flow right back to the Fed.

    And as I said in your previous post, I agree with everything except that you place too much weight on the introduction of interest on reserves. If government bonds and T-bills are liquid enough, then nobody can be forced to hold non interest-bearing deposits for any meaningful length of time. Let me take an example – let us assume that by 2020, rates are at 6%, the Fed has sold off all its QE holdings and is no longer paying interest on reserves. Therefore, my bank deposit pays me 0%. What are my options in this scenario? Most likely, I put most of the money in my “risk-free cash” bucket into an ETF/index fund invested in T-bills and that pays me say 5.80% with 20 bps for fees. When I need to make a payment, I simply convert these holdings into cash, say a day before the payment. An institutional player doesn’t even have to go through this exercise – he simply repoes his govt bond holdings for liquidity when he needs it.

    This near-moneyness of govt bonds is a much older phenomenon. Let me just give you a couple of quotes from an old Fed paper by Preston Miller in 1983 http://www.minneapolisfed.org/research/qr/qr712.pdf :
    “In the financial sector….higher interest rates make profitable the development of new financial instruments that make government bonds more like money. These instruments allow people to hold interest-bearing assets that are as risk-free and as useful in transactions as money is. In this way, the private sector effectively monetizes government debt that the Federal Reserve doesn’t, so the inflationary effects of higher deficit policies increase…..
    In recent years in the United States there have developed, at money market mutual funds, demand deposit accounts that are backed by Treasury securities and, at banks, deep-discount insured certificates of deposit that are backed by Treasury securities, issued in denominations of as little as $250, and assured of purchase by a broker. In Brazil, which has run high deficits for years, Treasury bills have become very liquid: their average turnover is now less than two days.”

  3. JKH writes:

    Krugman isn’t saying that the currency component of the base isn’t endogenously determined.

    Sumner says that sort of thing – not Krugman.

  4. Ashwin writes:

    JKH – so why did Krugman bring up the role of currency? If currency is just a residual determined by transactional convenience and the demand from the mafia, drug dealers etc then what can it possibly have to do with this discussion?

  5. vlade writes:

    Steve,

    bear with me while I sort this out in my mind. I take what you say about currency=reserves if both have the same “cost” (and liquidity is not very different – in fact, it’s harder to pay 1bn in cash than in reserves).
    The said, I have a few questions:
    what happens to the new money generated by the floor? it’s sort of an automated money printing. It can stay in reserves, increasing them further – or it can go out into the wild world and cause inflation. Thus, raising the floor on the reserves has chances of generating unwanted inflation. You say that the floor on the reserves would not be what drives the inflation expectations (as it would have to be then, since paradoxically higher floor would be more likely to generate higher inflation via faster automated money creation- at some stage anyways).

    So say the floor is divorced from the inflation rate. But you say that short-term debt is the same as money => same as reserves. That means, I can, via repo market, fund myself at the floor (or near floor) rate for short term. Which would mean I can fund myself (assuming I have enough UST to lend out in the firs place) at low rate over long term, not the “inflation fighting” rate Fed has – whatever that is (when I know the short-term rates are going to be low for long time, I’ll arb away any forwards that are much higher than the current ones…).

    Clearly, that means that inflation fighting instrument then is not an interest rate anymore, but the reserve requirements (which Fed would use to suck money out from the system) – which then IS break with the regime inertia you put in as an argument. So the regime intertia will have to be broken one way or another, and I believe it’s more likely to be broken with going back – since the “interest rates to fight inflation” meme is much stronger and in the public, so breaking with it publicly is less acceptable than with the floor and changing the “inflation fighting instrument” to reserve requirements.
    In fact, what I find most likely scenario is a combination – where Fed will keep a floor, but reset it to zero (which is something not practically different from the situation quo ante as I understand it), with the right to change it if it feels like it.

  6. Max writes:

    The technical discussion of how interest rates are set, while interesting, I feel misses the larger point. Monetization isn’t considered dangerous because it affects interest rates. It’s considered dangerous because it makes government debt safe (if it wasn’t already), and thus makes the “government budget constraint”, well, not a constraint. More of a suggestion, which an irresponsible fiscal authority could ignore.

  7. Dan Kervick writes:

    Steve, here is my question about the floor system as you have described it: Once reserve balances are so very high, then what is the point of the interbank interest rate target. In the conventional picture, as I understand it, the importance of the interbank rate is that it influences the commercial borrowing rate, because the bank has to maintain a profitable spread between the expected return on their new loans and the price they have to pay for acquiring additional needed reserves.

    But if banks rarely have to acquire additional reserves to expand their lending, then the price at which they would have to acquire them, if they did have to acquire them, is irrelevant. The central bank might have a great tool of targeting the overnight rate, but at the cost of rendering the overnight rate irrelevant to all but some marginal number of banks that are short reserves.

    Would’t the ideal be to some “natural” balance of aggregate reserves – the level that is just sufficient to accommodate the daily payment obligations – so that if banks in the aggregate seek to expand lending they also need to acquire more aggregate reserves.

  8. [...] Your Base Are Belong To Us, Continued (Still Wonkish) Steve Randy Waldman replies reasonably to my post about the currency domination of the monetary base. But I think we’re still having [...]

  9. K writes:

    Steve,

    “If the Fed sticks to the floor, base money and government debt will continue to be near perfect substitutes and theories of monetary policy that focus on demand for base money as distinct from short-term debt will be difficult to sustain.”

    This would be a compelling argument if it weren’t for the fact that those doing the sustaining have already managed to do so in the face of well stabilized zero-reserve corridor economies like Australia and Canada. If they can ignore part of reality I don’t see why they can’t persist and ignore all of it. And currency, as Ashwin points out, is a total red herring.

    “so issuing base money (whether reserves or currency convertible on-demand to reserves by banks) will be less inflationary than issuing lower interest, less-transactionally-convenient debt.”

    I.e. QE is (mildly) contractionary.

    Apart from Ashwin’s objections, which I fully agree with, everything you’ve written here strikes me as very, very right. Great piece!

  10. Dan Kervick writes:

    I still don’t understand Krugman’s point – articulated again this morning in his response to this post – about the need to “sterilize” the trillion dollar coin if it were issued.

    Yes, if the Fed puts a trillion dollars in Treasury’s account in exchange for the coin, it has expanded the monetary base. But Treasury can’t spend a single additional penny with that balance, beyond what it was scheduled to spend anyway. Nor do tax payments to the government change.

    The counter-argument is supposed to be that there will be a trillion dollars less in Treasury borrowing that leaves reserves in the system that would otherwise be drained. But as Krugman recognizes, those reserves are already earning interest which makes them equivalent from a monetary policy point of view to balances held in short-term securities accounts. The only effect then is to shift government interest payments from the Treasury to the Fed.

    The point is that the Treasury (and the consolidated government) is a black box as far as economic impact is concerned. All that matters is what comes in and what goes out, not the absolute size of the balance. If Congress ordered the Fed to credit a quadrillion dollars to Treasuries account, but changed no fiscal policies, then nothing important changes. The balance just permits the Treasury to emit dollars via spending without issuing bonds and swapping them for dollars first. Those who have the dollars end up earning the same interest from holding the dollars rather than exchanging the dollars for bonds, and the interest payments move from the treasury to the Fed.

  11. Detroit Dan writes:

    Dan K– Even if banks don’t have to acquire reserves, the interest on reserves represents the opportunity cost of the loan. If the rate is higher, then the rate the bank charges for the loan will have to be higher to make money on the loan.

    Ashwin, K– Very well said. Thanks. We’re all MMT now, or some variation thereof…

  12. K writes:

    I don’t understand what Krugman is saying in his new piece. Let’s say they can’t redeem the coin because congress won’t authorize the borrowing. Then then market interest rates can’t just rise off the floor. Why would anyone *ever* borrow at a high interbank rate when they can just settle by actually transferring low IOR reserves? Or think about it this way: if a bank has too little excess reserves to make a payment, every other bank will be scrambling to *lend* them the money at a slight premium above IOR since those banks will otherwise be earning IOR on those reserves. The interbank rate simply *cannot* rise significantly above IOR with anything remotely resembling the current quantity of reserves. The basic framing of his argument is just wrong.

    The fact is, having a big coin on balance sheet could be a real problem. Lets say inflation starts to rise and the size of the coin exceeds the sum of public currency demand and required reserves by some amount x. This means that the Fed is powerless to raise the target-rate-to-IOR spread above whatever level is consistent with banks wanting to hold a quantity of excess reserves in the amount of x. If x is a big number (a few hundred billion) then the target rate (the interbank market rate) will be stuck at IOR.

    So if they want to raise the interbank rate they *have* to raise IOR. The problem with *that* is that the Fed’s assets (the coin) don’t earn interest, so they *can’t* pay IOR without being in the red. I don’t know the Fed’s budgeting rules, but I’d be surprised if they are authorized to operate in insolvency. Don’t they have to make up deficient equity from the treasury? And doesn’t that need to be approved by congress? Sounds to me like they would be stuck, unable to hike rates without congressional approval. And in case of inflation that could lead to hyperinflation for which Obama could easily get the blame (he made the coin). So congress would have every incentive *not* to fund the Fed. Which means a full blown hyperinflation.

    Even a small probability of exiting the liquidity trap in the next couple of years  resulting in hyperinflation would immediately raise inflation expectations thus possibly setting off the self-fulfilling hyperinflationary chain of events. The only way the white house would ultimately be able to limit the damage would be via some kind of MMT-style fiscal austerity inflation control. I guess it’s all possible but seems like a suboptimal path.

  13. K writes:

    I’m pretty sure, BTW, that my reasoning is exactly the reason the administration kiboshed The Coin. They talked to the Fed who responded with “are you out of your mind?!?!?!” It would be the end of Fed independence, and while MMTers surely think that putting monetary control in the hands of the treasury is a good idea, senior Fed officials definitely don’t.

  14. wh10 writes:

    Steve,

    I am on board with you, and it appears Krugman is as well, at least as far as the economic implications of money-printing vs. debt under an IOR regime.

    But I think this logic can be taken one step further, which is to say, even *prior* to IOR, we were in “liquidity trap” conditions, as defined by your point that “printing money and issuing debt are distinct only when there is an opportunity cost to holding base money rather than debt.” This is because, as Scott Fullwiler has pointed out to Scott Sumner and Paul Krugman in past debates, the CB cannot do proactive OMOs (i.e., increasing or decreasing the monetary base independent of defending the target federal funds rate) without driving the federal funds rate to 0 or the ceiling rate. In other words, prior to IOR, if the Fed were to do QE, the FFR would have plummeted to 0, given all the excess reserves, bringing us to classic Krugman liquidity trap conditions. The only way to support a positive FFR above 0 with QE (which is essentially proactive OMOs) is to pay IOR – again, liquidity trap conditions as you point out in this post. So, in other words, it doesn’t appear you can ever escape liquidity trap conditions. Which is also to say thinking about the monetary system through the lens of liquidity trap conditions reflects a misunderstanding of how monetary policy works. I think this is the point Greg Ip was trying to make as well.

    Do you agree with this?

  15. Steve Williamson writes:

    You mostly have this right, and Krugman is confused. I wrote about this in two posts:

    http://newmonetarism.blogspot.com/2013/01/floor-systems.html
    http://newmonetarism.blogspot.com/2013/01/more-on-floor-systems.html

    The Fed is looking ahead, and thinking about the consequences of operating under a floor system for a long time. In some cases, Fed economists are being sent on expeditions by management to look for reasons why the floor system might have advantages. Actually, I think it makes essentially no difference to how policy works.

  16. wh10 writes:

    Dan, interesting point on whether IOR impacts bank lending rates if banks don’t need to acquire additional reserves when they lend. If that were the case, then perhaps the Fed would have to distinguish the rate on required reserves vs excess reserves. That way, every time a bank lends, the opportunity cost is earning the rate on excess reserves vs. required reserves. But at the moment, it would appear that banks don’t face an opportunity cost to lending if they can keep earning the same interest rate on required reserves as they do on excess reserves (provided they are awash in excess reserves). Technically, it appears the Fed does currently view the interest rate on required vs excess reserves as separate policy levers: http://www.federalreserve.gov/monetarypolicy/reqresbalances.htm

  17. Morgan Warstler writes:

    Isn’t the IOR with massives reserves a paranoid argument that banks are not yet balace sheet sound?

    If you start from premise that Fed is STILL most concerned with home prices. Not a bad guess, I’ve said all along when you want a truly honest discussion on current Fed thinking, listen to Greenspan, who has been adamant the true boogie man is PRIME rate mortgage holders jingle mailing if prices fall.

    You look around and see (I have a personal career interest here) a recent decision on new mortgage lending (much tougher standards).

    Karl does a nice job here: http://www.forbes.com/sites/modeledbehavior/2013/01/14/housing-in-2013/

    The new home market is doing well right now because the current stock of SFH is being bought up and turned into rentals for a new REIT asset class.

    I by your thesis for many reasons…. new normal here to stay. But I keep seeing this pattern (delusional perhaps).

    Example: #mintthecoin

    To me the issue was that if the fed had to suddenly stop buying TBills to inflation rate target ad just sel T-Bills, that’d be OK.

    But the Fed is currently ALSO buying MBS -to prop up housing market (the claim also because there aren’t enough T-Bills)

    And it isn’t obvious to me how Fed would KEEP buying MBS while selling tBills and all the while trig to hit target. The point being it seems like another proof point, the fed DOESN’T WANT home prices to fall, but cannot let new bad loans enter market.

    So if housing is still precarious, that’d make many bank books still precarious, and IOR can’t be ended because they are still rebuilding?

  18. Detroit Dan writes:

    wh10– I forgot about the distinction between required reserves and excess reserves. Currently, the Fed only pays interest on excess reserves, correct?

    Assuming that most banks have will excess reserves, then the opportunity cost of loans will be the interest rate on excess reserves. Even If a bank were short excess reserves, it would have to pay the rate on excess reserves to acquire the additional reserves to make the loan…

  19. wh10 writes:

    Detroit Dan, check the link I posted. The Fed pays interest on both.

  20. Dan Kervick writes:

    Detroit Dan – Currently the Fed pays interest on both excess and required reserves.

    http://www.federalreserve.gov/monetarypolicy/reqresbalances.htm

  21. JW Mason writes:

    I understood Krugman to be saying that in a world of IOR significantly above zero, we need to change the definition of base money. Reserves held for their yield are not base money, in that scenario; when we talk about “the money multiplier” we should start talking about “the currency multiplier” instead. I’m not sure (and don’t actually care) if that argument is coherent, but I think it’s what he was saying.

    The interesting question to me is whether SRW is right that zero interest rates are here for good. The beginning of wisdom in this is to forget about the “natural rate” and ask whether there’s been a secular fall in desired expenditure relative to income at any given interest rate. I think there’s reason to think there has been. The shareholder revolution (and neoliberalism in general) has permanently shifted investment demand downward, by depriving firms of the low-cost pool of internal funds that formally financed investment. Another way of looking at this is that the effective (as opposed to legal) owners of nonfinancial corporations’ earnings have shifted from long-tenure professional managers, who were happy to convert those earnings to fixed capital since they were tied to the firm anyway; to rentiers with a strong preference for holding their wealth in financial form. This means that new investment needs to pass a much higher hurdle rate than before. (One nice way of seeing this empirically is the rise in Tobin’s Q after 1980 from less than 0.5 to around 1.) There may also have been a decrease in physical capital as a source of profits, toward IP-type rents; this would also tend to depress investment demand.

    These are secular shifts, not cyclical. The cyclical phenomenon is the intermittent masking of this long-term fall in investment demand by asset bubbles, first tech then real estate. In the absence of a bubble inflating expected returns, desired investment even at zero interest rates may not be enough to sustain full employment.

  22. Detroit Dan writes:

    K– I don’t follow a couple of your points.

    Are you saying that the possession of a $1T coin would not allow the Fed to pay interest on reserves under certain conditions (Fed “insolvency” as interest rates rise)? That doesn’t seem right to me, as I don’t think the Fed can be insolvent. Anyone else care to comment on this?

    And I can’t even begin to comprehend this: “Even a small probability of exiting the liquidity trap in the next couple of years resulting in hyperinflation would immediately raise inflation expectations thus possibly setting off the self-fulfilling hyperinflationary chain of events.”

  23. JW Mason writes:

    I also agree with Ashwin. The important thing is not IOR that money proper doesn’t enjoy any liquidity premium over short-term Treasury debt. The only point I would quibble with him on is that “the near-moneyness of bonds” is an idea that goes back a lot further than 1983. keynes says, in a footnote in chapter 13 of the General Theory:

    we can draw the line between “money” and “debts” at whatever point is most convenient for handling a particular problem. For example, we can treat as money any command over general purchasing power which the owner has not parted with for a period in excess of three months, and as debt what cannot be recovered for a longer period than this; or we can substitute for “three months” one month or three days or three hours or any other period; or we can exclude from money whatever is not legal tender on the spot. It is often convenient in practice to include in money time-deposits with banks and, occasionally, even such instruments as (e.g.) treasury bills.

    Of course, there is a connection between the substitutibility of base money for T-Bills, on the one hand, and IOR, on the other — but the causality runs from the former to the latter. Once the liquidity premium of base money has gone, then in the absence of binding reserve requirements the Fed *must* pay interest on reserves if it wants to target a short-term interest above zero. The alternative, of course, would be to raise reserve requirements.

  24. Detroit Dan writes:

    Dan K– Thanks. That makes it simpler. I see the rate is the same for both required and excess reserves (1/4%)…

  25. Dan Kervick writes:

    JW Mason @21 – That’s a really interesting, and somewhat disturbing, analysis.

  26. Detroit Dan writes:

    JW– You lost me in this sentence:

    “Once the liquidity premium of base money has gone, then in the absence of binding reserve requirements the Fed *must* pay interest on reserves if it wants to target a short-term interest above zero.”

    Perhaps an example would help…

  27. [...] money is not just a consequence of payment of interest on reserves by the Fed (as Steve Waldman argues). If short-tenor government bonds are liquid enough, then no one needs to hold non interest-bearing [...]

  28. K writes:

    “I don’t think the Fed can be insolvent.”

    They can certainly have negative equity. Then what? There must be a mechanism to make them whole (just like there is a mechanism for automatic dividends to Treasury in case of profits). Who authorizes the make-whole mechanism? (Or maybe I’m wrong and they can just operate in a state of perpetual unbounded deficits.) Anyone?

    “And I can’t even begin to comprehend this…”

    That’s standard New Keynesian intertemporal consumption optimization. If a rational agent sees that there is a probability of high future inflation that will lead her to advance consumption ahead of the inflation event. Advancement of consumption plans by economic agents *leads* to raised inflation expectations for the period in which the agents plan to increase consumption. And recursively on back to the present. So expectations of future inflation *leads* to increased current consumption and inflation. And if current inflation rises then the spot real rate falls. If it falls below the natural rate, runaway inflation will commence so the Fed must raise the spot nominal rate. Which they can’t…

  29. wh10 writes:

    K, I don’t know the legislation, but I don’t see how operating in negative equity impairs the Fed’s ability to continue its monetary operations. They make reserves out of thin air, always. In other words, the Fed doesn’t require funding to do what it does, operationally. Perhaps it would temporarily scare some uninformed market participants, as all this “money-printing” does today. That’s my take, anyways. Perhaps I am missing some important nuances.

  30. Ashwin writes:

    Goes without saying that I agree with K. The point in the first para of K @12 can’t be repeated enough.

    JW Mason @ 23 – I agree that the idea is a lot older. The first instance of repo can be traced back to the East India Company in the early 18th century which bought English govt bonds and repoed them for cash with the Bank of England. My point is more that during the 50s, govt bonds were definitely not near-money for anybody. But innovations gradually eliminated this t-bill/money distinction as Leijonhufvud amongst others has noted. But you know all of this – we’ve both read the same Leijonhufvud paper! http://www-ceel.economia.unitn.it/staff/leijonhufvud/files/wick.pdf

  31. JW Mason writes:

    Detroit Dan-

    Remember, the policy rate is the interest rate on overnight loans of reserves between banks. So for the Fed to raise the Federal Funds rate without raising IOR, they need to get banks to pay a positive interest rate to borrow an asset with a yield of zero. The only reason banks would do that is because they need to hold that asset to meet statutory reserve requirements, or for transactions purposes. If reserve requirements don’t bind, and reserves are no more liquid than T-bills, then neither of those conditions apply, and there is no reason for banks to accept such a negative spread. So they won’t borrow reserves at a rate above IOR.

  32. JW Mason writes:

    Ashwin,

    Yup. That Leijonhufvud paper should be required reading for any discussion of this stuff.

  33. JW Mason writes:

    standard New Keynesian intertemporal consumption optimization

    It’s not clear it’s a good description of the real world, though. Can you think of any historical examples of sudden hyperinflations, or of hyperinflations that didn’t involve large, ongoing monetized fiscal deficits?

  34. Peter K. writes:

    @21 JW Mason,

    That sounds like a reasonable explanation to me. When did this secular shift begin? Aroudn 1980? Of course the changes are political (hence political economy) – and what would the term be? The financialization of the economy? – and if political they can be reversed so Krugman is technically right that one should never say never.

    But Krugman was wrong (or Waldman was unclear) about saying there was a “slip of the tongue.” What confused me was that Krugman added he hears the argument all time. Is he referring to the MMT school? They don’t agree that we’ll be stuck in a liquidity trap indefinitely do they?

    What’s new to me is Waldman (and Ip/Duy’s?) call that we could be in a liquidity trap for a very, very long time. I think we’ll probably get another bubble given the lack of significant financial sector reforms. Will they have to lower rates on IOR to zero and go beyond to pop it?

    Hopefully Japan will show us the way out.

  35. JW Mason writes:

    K is right that by law the Fed’s net worth is always zero, with positive profits being transferred to the Treasury at the end of the year. Losses by the Fed were basically impossible before the crisis, since its liabilities did not pay interest. (I suppose it could lose money on foreign exchange operations, but I’m pretty sure those always or almost always showed positive profits as well.) I also am curious about what exactly would happen in the case where the Fed showed a loss for the year. But given what we saw in the fall of 2008, I am 100% certain that what would *not* happen, is that the Fed would throw up its hands and accept runaway inflation if Congress did not act. There is clearly an enormous amount of flexibility there, and a very strong (excessive, IMO) commitment to price stability.

  36. Dan Kervick writes:

    K and Detroit Dan, I have tried for two years to find a straight answer to the question you raise, and have run into a wall every time. The most recent relevant discussion I can think of is this one by Ed Dolan:

    http://www.economonitor.com/dolanecon/2012/09/19/could-qe3-cause-the-fed-to-go-broke/

    But unfortunately, I don’t think it answers the question. Economists constantly turn the question into one about various purely economic or financial notions of “insolvency”, and whether being in one of these states would require the Fed as a matter of sound economic policy to recapitalize. But my question – and I think the one you two are asking – is a legal one: What is the Fed legally permitted to do? Under what rules is it required to operate? Is there a position which would legally trigger a Treasury “bailout” or some other unusual governmental intervention in the Fed’s operations. I have never been able to find a single clear article or document that answers these questions directly.

    My conjecture – based on the idea that if such a legal concept of insolvency could be invoked, the Fed’s many Austrian critics would have produced the legal goods by now – is that there is no such position, and that the legal or regulatory notion of insolvency is absolutely inapplicable to the US central bank, and that the Fed is not prohibited from running a position of negative equity forever – even if it determines not to do so as a matter of monetary policy. And as the ultimate source of US monetary assets, the Fed could never be “made whole” by something external to the Fed – not even the Treasury.

    For that matter, I think the very ideas of financial “assets” and “liabilities” lose meaning in application to the central bank, and that these terms are used by the Fed only as a useful but imprecise communication tool: a way of describing the operations of the central bank in a language people in finance understand, but which apply categories to the Fed that are really unsuitable for thinking about its ultimate role.

    The central bank can hold the obligations of private sector entities, and does so for the sake of monetary policy objectives, but these obligations are not genuine “assets” of the central bank in the sense of being items of positive value for the bank. The Fed never “needs the money” – nor does it somehow become richer when it gets it. Similarly, the central bank can have payment obligations to the private sector, but these obligations do not represent items of negative value for the central bank, and the central bank doesn’t become poorer when it emits money. And the whole notion that currency in circulation, though nominally a liability of the bank, is genuinely an liability (commitment representing negative value to the entity that has the commitment), seems troublesome.

  37. o. nate writes:

    While the “floor” system is an interesting idea, I think it remains to be seen whether it would really work in practice. Apparently, New Zealand is going to try it, but it’s quite a leap from there to suppose that the Fed is about to embark on such a radical shift in policy. Tellingly, the paper talks quite a bit about Fed control of base money and interest rates, but never mentions the Fed’s actual mandate, which is to control inflation and unemployment. It remains to be seen whether a floor policy would be consistent with the Fed’s ability to hit its mandate, especially once we move out of a liquidity trap environment.

  38. Detroit Dan writes:

    JW– Thanks. That makes sense.

    Dan K– Thanks for the response on central bank solvency. Sounds right to me…

  39. Dan Kervick writes:

    Detroit Dan and K – Here is a 2002 General Accounting Office report that discusses some of these issues:

    http://www.gao.gov/assets/240/235606.pdf

    From the “Results in Brief” section at the beginning:

    The Reserve Banks use their capital surplus accounts to act as a cushion to
    absorb losses. The Financial Accounting Manual for Federal Reserve
    Banks says that the primary purpose of the surplus account is to provide
    capital to supplement paid-in capital for use in the event of loss. Federal
    Reserve Board officials noted that the capital surplus account absorbs
    losses that a Reserve Bank may experience, for example, when its foreign
    currency holdings are revalued downward. Federal Reserve Board officials
    noted, however, that it could be argued that any central bank, including the
    Federal Reserve System, may not need to hold capital to absorb losses,
    mainly because a central bank can create additional domestic currency to
    meet any obligation denominated in that currency. On the other hand, it can
    also be argued that maintaining capital, including the surplus account,
    provides an assurance of a central bank’s strength and stability to investors
    and holders of its currency, including those abroad. The growth in the
    Reserve Banks’ capital surplus accounts can be attributed to growth in the
    size of the banking system together with the Federal Reserve Board’s policy
    of equating the amount in the surplus account with the amount in the paidin
    capital account. The level of the Federal Reserve capital surplus account
    is not based on any quantitative assessment of potential financial risk
    associated with the Federal Reserve System’s assets or liabilities.
    According to Federal Reserve officials, the current policy of setting levels
    of surplus through a formula reduces the potential for any misperception
    that the surplus is manipulated to serve some ulterior purpose. In response
    to our 1996 recommendation that the Federal Reserve Board review its
    policies regarding the capital surplus account, it conducted an internal
    study that did not lead to major changes in policy.

    The way I read this paragraph is that the Fed’s decision to maintain a capital surplus account to offeset potential operating losses, and to set the level of this account through a formula, is not a matter of statutory requirement but rather a Fed policy choice. It follows this practice to communicate “an assurance of a central bank’s strength and stability to investors and holders of its currency” and “reduce the potential for any misperception that the surplus is manipulated to serve some ulterior purpose”.

  40. K writes:

    Dan,

    You are right. That doesn’t sound like there is any statutory requirement that they be “solvent”. But I tend to agree with JW Mason that “that the Fed would throw up its hands and accept runaway inflation if Congress did not act.” First and foremost, these guys are bankers. Operational constraints binding or not, they are not going to bankrupt the Fed by *any* definition of the word “bankrupt”. Thinking more about it though, there is a another possible solution. The Fed could preemptively, while they still have excess capital, hike rates to e.g. 10% and announce that they are going to drive the economy into deep and permanent depression before any possible threat to their balance sheet materializes. That would save the Fed if the economy collapses fast enough. Nasty, but I wouldn’t put it past them under the circumstances.

    The most likely outcome, as I said above, is that inflation would be stabilized by the treasury spending, but in coordination with the Fed in order to keep the equilibrium nominal rate around zero (which I also believe happens to be the preferred MMT outcome).

    JW Mason,

    “It’s not clear it’s a good description of the real world, though”

    No. But you shouldn’t *ignore* the competitive equilibrium of rational agents. If consumers believe that there *will* be a big inflation in 6 months I am quite certain you will get inflation *now*. The more distant and lower the probability, the less inflation you will get. But it’s a continuum and I don’t see the case for no effect.

  41. Dan Kervick writes:

    But you shouldn’t *ignore* the competitive equilibrium of rational agents. If consumers believe that there *will* be a big inflation in 6 months I am quite certain you will get inflation *now*.

    That’s a good point K, and my feeling is that ultimately that is what killed the platinum coin, whether the arguments came chiefly from Fed officials or Treasury officials. Monetary authorities have to take account not just of what people should think, if they are deeply informed and fully rational, but what they will think given that they are what they are. A lot of people don’t even understand the the executive requires congressional authority to spend. No matter what the operational details of platinum coin deposits and their effect on debt issuance and reserve balances might be, the popular response among many people would have been “Oh my God! Barack Obama just printed money equal to the entire annual deficit in the basement of the White House, and is now spending like a madman!”

    It’s frustrating that this White House is so conservative, and is unwilling to mount ambitious public communication efforts to defend ambitious and activist policies. But that’s what we’ve got.

  42. wh10 writes:

    Dan K, that just seems so sad to me. It’s an affirmation that a ton of people just do not understand the monetary system, to a potentially dangerous degree. So dangerous, in fact, that the Fed is reluctant to shake people from their ignorance for fear that it leads to (uncalled for) instability. Can we really not rid the world of ignorance rather than pretending the boogeyman exists?

  43. [...] at the target rate. Paul Krugman objected, but I think he was misunderstanding me, so I tried to clarify. He’s responded again. Now I think that the points of miscommunication are very clear and [...]

  44. JW Mason writes:

    If consumers believe that there *will* be a big inflation in 6 months I am quite certain you will get inflation *now*.

    Sure. But they won’t start believing that, unless you already have inflation now.

    The idea that inflation expectations are an *independent* determinant of inflation (as opposed to one channel by which past inflation influence current inflation) is one of the core tenets of monetarism, in both its original and modern (or “market”) forms. I think it is strongly falsified by the historical record.

  45. Detroit Dan writes:

    If the platinum coin option were used, my opinion is that nothing would happen. At first, there would be some jumping around in the markets, but time would pass and everything would go back to normal, in similar fashion to what has happened with the various QEs.

    The true vigilantes are the market participants who can tell when an actor (e.g. a central bank) is bluffing. But many people are afraid of “vigilantes” who would act without basis. Of course this is backwards.

    For example, the UK tried to peg its currency via the European Exchange Rate Mechanism in October 1990, but was forced to exit the programme within two years after the pound sterling came under major pressure from currency speculators, including George Soros (from Wikipedia. It’s generally beyond the power of a central bank to maintain a peg on its currency (they can always depreciate the currency, but can’t always cause it to appreciate or hold steady).

    Minting a platinum coin would present no such opportunities for vigilantes, as there would be no peg being established that they could break. People wouldn’t start spending and investing more. The U.S. dollar might drop a bit in value, but that would be a good thing for the U.S. economy. Any vigilantes betting on hyperinflation would lose their shirts as it became apparent that they were the ones bluffing…

  46. Dan Kervick writes:

    wh10, I agree it is sad. I am an optimist about the ability of the President and his team to instruct the public and eliminate this kind of ignorance. But the problem is that the White House has communicated a completely opposite message of fiscal conservatism and sound money sobriety for two years now in order to work toward some kind of budgetary grand bargain.

    These kinds of messages need to come from the political officials, I think, not the Fed. The Fed is always going to be reluctant to speak frankly in ways that could be seen as, however much truth is on their side, intervening in and taking sides on partisan political battles between the White House and Congress.

  47. wh10 writes:

    Dan, I think you need overwhelming buy-in and proactive support from the academic community and policy makers, too, if not first. I’m not sure we’re there yet, though.

  48. Dan Kervick writes:

    Yes wh10, I think you need a lot of authoritative and neutral people assuring people that there is no reason to think that an addition to the “money supply” that consists solely in putting a number on a government account balance, but does not otherwise change government spending and taxing policies or government interest payments, will be inflationary.

    A lot of headwinds. I just talked to a guy at work who thinks John Stewart just must be right in the Stewart vs. Krugman flap.

    But it would be interesting to see the public reaction to the discovery that the government (whether in the form of the Treasury or the Fed) in some way always has the option of setting its account balance at whatever number it wants. I assume a lot of people would start saying, “Explain again why we have to Fix the Debt?”

  49. Detroit Dan writes:

    Is there any historical precedent for a sustained panic based upon an accounting activity without any real economic effects?

  50. [...] 15, 2013 by Mark Thoma Tim Duy: Money and Debt, Continued, by Tim Duy: Paul Krugman responds to Steve Randy Waldman, noting that perhaps they are having a failure to communicate. I [...]

  51. Neil Wilson writes:

    “For example, the UK tried to peg its currency via the European Exchange Rate Mechanism in October 1990, but was forced to exit the programme within two years after the pound sterling came under major pressure from currency speculators, including George Soros”

    That’s not true Dan. The UK’s peg failed because the other side of the peg – the Bundesbank – didn’t intervene on the currency pair that they controlled.

    A currency peg is fully sustainable if the currency issuers on *both* sides of the peg target the same rate.

    Soros was just the private sector operator enacting the will of the Bundesbank to lower the peg the UK had set.

    The mistake was the UK trying to defend a peg in the wrong direction. A central bank can’t do that.

  52. SRW – Fantastic post. The wording in one section confused me a bit:
    “If the Fed adopts the floor system permanently, then the Fed will always “sterilize” the impact of a perpetual excess of base money by paying its target interest rate on reserves.”

    What do you mean by “sterilize” in this instance? I tend to think of sterilize as offsetting the change in the monetary base due to certain actions. However, in a floor system, the Fed has no need to prevent a further increase reserves. Thanks in advance for the clarification.

    JW, Ashwin, Dan K – Great discussion and thanks for the links. You already answered most of my questions.

  53. [...] this matter, since this is at the core of the recent debate between Steve Randy Waldmann (see here, here, and here) and Paul Krugman (see here and here) on the so-called “permanent floor.”  (It might [...]

  54. [...] are all dorks, albeit of a more articulate variety. I say the most articulate dorks of all are interfluidity‘s [...]

  55. [...] That prognostication, more recently made by Steve Randy Waldman, has generated an intense online debate about monetary operations, base money, the platinum coin and the so-called “permanent floor.” [...]

  56. Sergei writes:

    There is a bunch of central banks with negative equity. For instance Czech National Bank is one of them and interest rates in Czech Republic are even lower than in eurozone. I think Central bank of Chile also has negative equity. And Israel.