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:
- The Fed has dramatically expanded the size of the monetary base;
- The percentage of the monetary base held as reserves (rather than currency) has gone from a very small fraction to a majority;
- 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.