A confederacy of dorks

It is, to be sure, only a baby step towards world peace.

But it is a step! Market monetarists will lie with post-Keynesians, the parted waters will turn brackish, as we affirm, in unison: Paul Krugman and I are both inarticulate dorks. Further, it is agreed, that David Beckworth, Peter Dorman, Tim Duy, Scott Fullwiler, Izabella Kaminska, Josh Hendrickson, Merijn Knibbe, Ashwin Parameswaran, Cullen Roche, Nick Rowe, Scott Sumner, and Stephen Williamson are all dorks, albeit of a more articulate variety. I say the most articulate dorks of all are interfluidity‘s commenters.

To mark the great convergence, there will be feastings and huzzahs from all. Or at least from everyone but Paul Krugman and myself, since during feastings, it is the most inarticulate of the dorks who tend to find themselves on a spit. Wouldn’t you all prefer to eat plastic apples?

For those not tired of spectacle, let us continue our pathetic grope towards clarity. Paul Krugman asks two questions:

My questions involve whether interest on excess reserves changes any of the fundamentals of monetary policy and its relationship to the budget. That is, does IOER change the fact that the Federal Reserve has great power over aggregate demand except when market interest rates are near zero, and the related fact that when we’re not in a liquidity trap there is an important distinction between debt-financed and money-financed deficits?

My answer to both questions is no.

My answers are “no” and “depends how you define ‘liquidity trap’”. But brevity is the soul of wit, and I’ve a reputation for witlessness to maintain. So let me elaborate.

First, let’s make a distinction that sometimes gets lost. Paying interest on reserves (excess or otherwise) and operating under a “floor system” are not the same thing. A floor system does require that interest be paid on reserves, but that is not sufficient. A floor system also requires an abundance of reserves (relative to private sector demand), such that the central bank would be unable achieve its target interest rate without paying interest at or above the target. David Beckworth is right to emphasize the question of whether interest is paid on reserves at a lower or higher rate than the central bank’s target. (Beckworth phrases things in terms of the short-term T-bill rate, but the T-bill rate is capped by the expected path of the target rate, as long as the central bank’s control of interest rates remains credible and reserves are abundant.)

When a central bank effectively targets an interbank rate, but the rate of interest paid on reserves is less than the target rate, the following statements are all true: 1) base money must be “scarce” relative to private sector demand for transactional or regulatory purposes, so people accept an opportunity cost to hold it; 2) there is a direct link between the quantity of base money outstanding and short-term interest rates, they cannot be managed independently; and 3) the opportunity cost borne by the public is is mirrored by a seigniorage gain to the fisc — money is different from debt in the sense that it is cheaper for the sovereign to issue.

When the IOR rate is equal to or above the target rate, all of that breaks: base money may be abundant relative to private demand, the link between the quantity of base money and interest rates disappears, “printing money” is at least as costly to the fisc as issuing short-term debt.

When the IOR rate is below the target rate, we are in a “channel” or “corridor” system (of which traditional monetary policy is a special case, with IOR pinned at zero). When the IOR rate is at or above the target rate, we are in a “floor” system, under which the distinction between “printing money” and “issuing debt” largely vanishes.

Krugman and I can enjoy an ecstatic “kumbaya” on both of his questions (no visuals please!), if he is willing to define as a liquidity trap any circumstance in which the central bank pays interest on reserves at a level greater than or equal to its target interest rate.

I agree full stop that “the Federal Reserve has great power over aggregate demand except when market interest rates are near zero”, even in a floor system. But, as Nick Rowe correctly points out, the source of this power is the Fed’s ability to affect demand for, rather than the supply of, money. And not just for money! When the Fed sets interest rates, it alters demand for money and government debt as a unified aggregate. What keeps the Fed special under a floor system is an institutional difference. The Fed issues the debt it calls “reserves” at rates fixed by fiat, while Treasury rates float at auction. The Fed leads, then Treasury rates follow by arbitrage. The Fed is powerful by virtue of how it prices its debt, not because it is uniquely the supplier of base money.

None of this means (qua Nick Rowe) that “monetarism” is refuted. “Market monetarists”, for example, argue that level/path targets are better than rate targets; that targeting nominal income would be better than targeting the price level; and that “monetary policy” operates via a variety of channels, including expectations about future macro policy. I think they are correct on all counts. They may need to rethink stories that place the quantity of base money (as distinct from debt) at the indispensible heart of macro policy, but revising those stories would make the rest of their perspective stronger, not weaker. (I owe Scott Sumner more detailed comments, but those will have to wait.)

Nor does monetary management at the floor invalidate “mainstream Keynsianism”. The consolidated government/central-bank manages the quantity, maturity, and yield of the paper it emits, as well as patterns of spending and the taxation. Even under a floor system, it is coherent to argue, for example, that macro policy should be confined to rejiggering yield, except at the zero bound when it might be necessary to expand the quantity of liabilities. We give yield management the name “monetary policy” and quantity management the name “fiscal policy”.

Some post-Keynesians take the inverse view, that macro policy should prefer managing quantity to paying yield. They suggest operating under a floor system with IOR set at zero. That is equally coherent.

I really meant it when, in the initial post of this series, I said that there’s no grand ideological point here.

But it matters very much that we get the mechanics right. We’ll make consequential mistakes if we fail to revise intuitions that were formed when T-bills paid 10% and the monetary base paid zilch. Quantitative easing might still be inflationary via an expectations channel, by virtue of the intent it communicates. But the policy’s mechanical effect on the velocity of (base_money + govt_debt) is almost certainly contractionary when the Fed replaces short-term debt with higher-yielding reserves. (I don’t think we know what QE does when longer-term debt is purchased, other than complicate the work of pensions managers.) Izabella Kaminska’s deep point that “monetary policy” helped remedy a shortage of safe assets during the crisis makes no sense unless you get that money is now yieldy government debt rather than a hot potato to be shed. That condition is not inherently related to the number “zero”.

Perhaps I have sufficiently demonstrated that I am the least articulate dork of all, so let’s leave it there. Most of the posts cited in the first paragraph are far better than anything I’d ever write, so do read those. If you are a dork, that is.

Update: See also this conversation between Ashwin Parameswaran and Frances Coppola, which took place just before my series of posts began! Parameswaran tweeted on January 7:

In a world of interest-bearing money, money = govt bonds & The “liquidity trap” is a permanent condition, not a temporary affliction.

Thanks to Mike Sankowski, who mentioned this in a comment that I failed to follow up on.

Update II: More dorkishness! John Carney, Stephen Ewald, Scott Fullwiler, Robert P. Murphy, Negative Outlook, Nick Rowe, Michael Sankowski, Joshua Wojnilower

Update History:

  • 16-Jan-2012, 3:10 a.m. PST: Added bold update pointing to related, prior Parameswaran / Coppola conversation.
  • 16-Jan-2012, 3:45 a.m. PST: Added “the” before “velocity”.
  • 16-Jan-2012, 10:50 a.m. PST: Added second bold update, with more related links. Will keep adding names there without tracking that in the update history. Also added a link to Bryan Caplan’s great piece on velocity, where I use the term “velocity”.

24 Responses to “A confederacy of dorks”

  1. [...] De relatie tussen ‘base money’ en ‘M-3′ geld. Een schema. var addthis_product = 'wpp-262'; var addthis_config = {"data_track_clickback":true,"data_track_addressbar":false,"ui_language":"nl"};if (typeof(addthis_share) == "undefined"){ addthis_share = {"templates":{"twitter":"Lux et Veritas: {{title}} {{url}} (via @jessefrederik)"}};}Update Zo ongeveer op het moment dat ik dit stukje gepost had kwam er nog een nieuwe post van Waldman binnen. [...]

  2. vbounded writes:

    Krugman and I can enjoy an ecstatic “kumbaya” on both of his questions (no visuals please!), if he is willing to define as a liquidity trap any circumstance in which the central bank pays interest on reserves at a level greater than or equal to its target interest rate.


    The liquidity trap in this case is that “extend and pretend policies” (i.e., sanctioned fraud) mean lots of folks don’t have the ability or incentives to borrow and lend taking much risk. Interest on reserves is a tool to allow the Fed to brake monetary policy without rendering these kinds of persons unable to pay obligations in the ordinary course as would occur using various other techniques.

    It is simply a tool to allow economists to execute the policies selected by politican factions based on raw incentives.

  3. Steve, I would argue that when the banking system is awash with reserves, the funds rate is ineffective and IOER in a way becomes the target rate. So the relationship between the funds rate and IOER is actually irrelevant.

  4. Detroit Dan writes:

    This post seems like meaningless gibberish to me. And I’ve come to expect remarkable clarity here.

    My experience is that once you engage the market monetarist on such concepts as “level/path targets are better than rate targets”, you’ve disengaged from reality.

    And I disagree with Krugman on the first question, and I think the empirical evidence is pretty simple on this. The Fed basically follows inflation in setting interest rates. This has some short term effects, but means nothing of consequence in the big picture. For God’s sake, just look at the relationship between inflation and interest rates over the last 70 years.

    Sometimes increaing complexity (nerdiness) is ill advised…

  5. Dan Kervick writes:

    … the source of this power is the Fed’s ability to affect demand for, rather than the supply of, money.

    How does this happen SRW? How can changing the policy rate influence the demand curve for commercial and household borrowing? If in the market for any product my suppliers’ costs go up, that has no influence on how much of the product I will be willing to buy at any given price, only on how much my supplier will be willing to supply at various prices.

  6. Luis Enrique writes:

    I’ve got myself in a muddle. I thought the liquidity trap was a bad thing, but if the floor system keeps us there, why is the Fed going to stick with it? Won’t it want to go back to the corridor?

  7. [...] discussion over the permanent floor has led to a (in my view) fantastic post from Steve Randy Waldman.  His key conclusions regarding how interest on reserve balances works are the following: [...]

  8. [...] say Paul Krugman and Steve Waldman remember the trillion dollar coin quite well. So do all of the people listed by Steve Waldman in [...]

  9. Luis, it’s not the floor system itself that keeps us in the liquidity trap, it’s very low interest rates, near-perfect equivalence of money and debt, and large amounts of excess reserves from QE. The policy transmission mechanism inevitably shifts to a floor system under these circumstances. IOR actually props up both the repo rate and the short end of the T-Bill yield curve.

  10. [...] A confederacy of dorks – interfluidity [...]

  11. [...] interfluidity » A confederacy of dorks My questions involve whether interest on excess reserves changes any of the fundamentals of monetary policy and its relationship to the budget. That is, does IOER change the fact that the Federal Rese… [...]

  12. Luis Enrique writes:


    See Ashwin’s tweet cited above, plus from previous SRW post: “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.”

  13. Andy Harless writes:

    OK, the Fed has two instruments, IOR and OMO’s, and two targets, the condition of the macroeconomy (which we can proxy with NGDP, though it is actually some mysterious combination of inflation and employment known only to the nonexistent collective consciousness of the Fed) and the health of the banking system. It sets its two instruments so as optimize the expected outcomes for its two targets. But since the instruments interact heavily, it’s somewhat arbitrary to say which instrument is affecting which target.

    The view in this post seems to be that, under a “floor” system, we should regard IOR as the lever that controls the macroeconomy and OMO’s as the lever that controls the banking system. Thus OMO’s are not inflationary: they are a microeconomic tactic that has little to do with macroeconomic outcomes. I have some sympathy for that view, inasmuch as it comports with what is likely to be the Fed’s own perception: when it wants to change macroeconomic conditions, it will change IOR, and when it wants to affect the health of the banking system, it will change its OMO policy.

    But I also find Scott Sumner fairly persuasive on this point. To hold the condition of the banking system constant, the Fed will have to adjust its OMO’s in response to its own changes in IOR. If it reduces IOR, liquidity will flow out of the banking system, and, to avoid making the condition of the system more precarious, the Fed will have to increase the base money stock. If it raises IOR, liquidity will flow into the banking system, and, to avoid paying for more liquidity than it wants, the Fed will have to reduce the base money stock. Holding the intended condition of the banking system constant, a change in IOR is an implicit promise of a change in OMO’s. Holding the intended condition of the banking system constant, the two changes are inseparable, so why should we associate the macroeconomic outcome with the former change rather than the latter?

    In the long run, unless there is a dramatic shift in the Fed’s preference regarding the condition of the banking system, it’s very clear that NGDP will be strongly correlated with the base money stock and very little correlated, if at all, with IOR. In the short run, it’s not clear which correlation will be stronger. (Even in the short run, as Scott points out, base money, at the very least, puts an upper constraint on expected NGDP, because IOR cannot go below zero.) I think there’s a strong case that, given the long run correlation, the presumption in associating an instrument with a target should be that we associate the base money stock with macroeconomic conditions. Hence OMO’s are inflationary, even if the commitment to do those OMO’s is inherent not in the OMO’s themselves but in a prior change in IOR.

  14. Luis,

    The liquidity trap keeps us in the floor system, not the other way round.

  15. Luis Enrique writes:


    Well, one of us is lost. our host describes the floor system as a choice, returning to the channel or corridor system being an alternative choice. He’s saying when the economy improves the Fed will retain the foor system, whereas Krugman thinks we would revert to old ways and no longer be in a liquidity trap. In previous post SRW writes: “if and when the Fed does want to raise interest rates, I think that it will not do so by returning to the old ways” so here’s clearly thinking of the floor system being used at higher interest rates.

    So here”s my confusion. SRW ways central banks have more power and flexibility under floor system, which is then described as a permanent liquidity trap, but the liquidity trap is more generally known as situation where monetary policy is ineffective. One possible solution to the puzzle is to claim monetary policy ineffectiveness under liquids trap is a myth,

  16. Andy Harless writes:

    Here’s another way to think about it. Why, first of all, do central banks think it’s a good idea to pay interest on reserves? What is the function of IOR? Essentially, I would argue, the central bank is hiring banks to provide themselves with liquidity insurance. For various reasons (systemic externalities, limited liability, etc.) banks aren’t likely to provide enough if left to their own devices (i.e., they tend, in the absence of IOR, to hold very thin excess reserves), so it’s efficient to pay them to provide more.

    But suppose this insurance were provided in a different manner and financed by the Treasury rather than the Fed. For example, the government could set up a fund, financed out of general revenues (which is to say, on the margin, by borrowing), which would provide an overdraft facility for banks. Banks could have allocations in the fund in proportion to their assets. And if a bank attempted a transaction that would cause it to be short required reserves (including in the case where there is no reserve requirement, so that “to be short required reserves” means bouncing a check at the Fed), the Fed would automatically create a loan from this government overdraft facility, much the way banks automatically create short-term loans for retail customers that have overdraft lines of credit. I’m not saying this is a good idea or that it would even work at all in practice, but as a hypothetical, it would serve the same function as IOR does now. But it would be paid for by ordinary Treasury borrowing rather than by a set interest rate paid by the Fed. Obviously in that case, we wouldn’t be having this debate: printing money would be just as inflationary as it is without the facility.

    Now it’s also possible that the government could determine the size of the facility by selling T-bills at set interest rate and allowing the facility to absorb the residual funds if it sold more than necessary to finance its other needs. Of course, that would be silly. But why would it be any sillier when the Treasury does it than it is when the Fed does it?

    Of course, there are reasons. When the Fed does it, to some extent the “size of the facility” — i.e. excess reserves — responds to changing needs of banks, so to some extent — but I think it’s limited — the Fed’s policy allows excess reserves to vary in the short run to accommodate day-to-day differences in banks’ need for liquidity insurance. The main reason, though, is that the Fed, being responsible for macroeconomic policy, believes that it’s a good idea to smooth interest rates in the very short run. And it’s probably right. If it wanted to do so, the Fed could set a target for excess reserves and then vary the interest rate on a daily basis to keep excess reserves close to the target. But who needs all those gyrations in the interest rate?

    OK, so in the very short run, the Fed is using IOR to accomplish interest rate smoothing — something it used to accomplish by setting a federal funds rate target and doing (or mostly just threatening) the necessary OMO’s to enforce it. In anything but the very short run, though, things are not very different than they were in the old days, except that the Fed has now hired banks to provide liquidity insurance for themselves, and coincidentally, since it’s convenient, it also uses this facility to smooth interest rates instead of using OMO’s to do so. Ultimately, still, if the Fed wants to raise expected NGDP, it will create base money, and if it wants to lower expected NGDP, it will destroy base money. Unless at the same time it is making a deliberate decision to change the size of its distributed liquidity insurance facility.

  17. @Andy Harless, “Why, first of all, do central banks think it’s a good idea to pay interest on reserves?”

    In the BoE’s case, it was about raising the elasticity of demand for reserves, and hence increasing the central bank’s control of moneymarket interest rates, as I explain in paragraphs 21-24 of this post: http://reservedplace.blogspot.co.uk/2009/04/easing-understanding.html

    Note that for this purpose it was enough to pay interest on required reserves, and provide an uncompetitive deposit facility for excess reserves that served as the floor for moneymarket interest rates. For the same reasons, when the Fed’s balance sheet can be contracted, I could see the Fed paying interest on required reserves, but not on excess reserves, bringing the Fed into line with best (normal) practice among other central banks. I am sure that this is why the Fed were asking Congress for permission to pay interest on reserves years before the financial crisis. The distinction between interest on required reserves and on excess reserves is a point that is not being brought out very clearly in this whole discussion.

  18. Sorry, read paragraph 20 too.

  19. jck writes:

    The Fed had a long running problem with banks meeting the bulk of their required reserve requirements with applied vault cash, this resulting in very low balance in their accounts to process fedwire payments and then heavy use of intraday credit.
    Implementation of IOR and IOER in the U.S have nothing to do with the crisis [as you know], velocity of reserves balance close to 200 times is no way to run a multi-trillion dollar economy.

  20. @jck, interesting fact, thanks. Why do the banks prefer to use vault cash though, which does not bear interest either?

  21. Becky Hargrove writes:

    Thank you for not just thumbing your nose at the divide with glee, and for remembering that bridges are not the kind of (induced) complexity that brings systems down in the long run. And may we always remember that, while plastic apples are a most utilitarian part of reality, they still cannot be digested!

  22. Luis,

    OK, I’ll clarify. The floor system has been “de facto” adopted by the Fed because of excess liquidity due to QE, very low interest rates and near-perfect substitutability of money and government debt. Those are the characteristics of a liquidity trap. Which is why I said that the floor system exists because of the liquidity trap, not the other way round.

    However, if and when interest rates return to more normal levels, the Fed has a choice whether to drain the excess reserves and return to its previous “channel” system, or retain the excess reserves and therefore the “floor” system. Steve is arguing for the second of these, Krugman (in effect) for the first. I think there is a third alternative, which is that it drains the excess reserves but reduces its reserve requirements to zero and adopts a “corridor” system similar to that operated by the Bank of England.

  23. Phil Prince writes:

    There are meaningful differences between currency, reserve balances, and short Treasuries, and they are reflected in the prices (rates) at which they trade. US Treasuries, especially Bills, are an excellent store of value which can be held by a non-bank outside of a bank balance sheet. Unfortunately they cannot be used for payment without going to a market to convert to reserve balances – a traditionally strong liquid market, granted, but a source of unavoidable operational and price risk. Currency is convertible to reserve balances by fiat (plastic apples), and can be held outside of risky bank balance sheets, but is just to bulky and difficult for institutional use. If you need more than $250,000 of immediate ability to pay, currency is no more useful than FDIC insurance. Reserve balances are in many ways the most useful thing of all – guaranteed nominal value that can be used for immediate payment – but only banks can have them. The rest of the world can only get to them through the extremely imperfect intercession of the banking system, with all the credit risk that comes from holding on balance sheet bank liabilities. And in a world of constrained bank asset ratios, it’s tough to get a bank to take non-retail deposits.

    A $100mm platinum coin, convertible by fiat to reserve deposits, would actually create a really useful tool for institutions to hold reserves directly, without bank balance sheet impact. In our current environment it would be very popular, and as interest on reserve balances was raised (raising the cost of the nonbank reserve holding), holders would convert them back into reserves as each holder reached the point at which the cost in foregone interest on other alternatives exceeded the value of the risks in those alternatives.

  24. John Hussman discussed this years ago: