Capabilities, constraints, and confidence

Mark Thoma offers a very thoughtful rejoinder to my post on whether the Fed should be given authority to pay interest on deposits. Mark’s comments range from specific, technical points to broad questions about governance. What follows is a quick response to some of the issues he raises. Do read his piece, The Fed Already Has a Blank Check.

My bottom line remains the same. Although the central bank does have the capability to unilaterally expand its balance sheet, it is subject to a variety of constraints that restrain it in practice. I am opposed to relieving the Fed of those constraints unless hard limits are placed upon the scale of its direct investment in the financial system, both to protect taxpayers from absorbing losses, and to support the long-term ability of financial markets to allocate real economic capital well.

I address some of Mark’s points specifically below.

  • Mark suggests that “the Fed already has a blank check”, because it could increase reserve requirements, rather than borrow funds, to sterilize the inflationary effect of printing cash. This is true in theory, but I think it would be very difficult in practice for the US central bank. The Fed has not used reserve requirements as an active instrument of monetary policy for a long time, and has allowed (encouraged) them to atrophy, with an eye towards eliminating them entirely. (See here and here.) Reserve requirements could be reinvigorated, of course, but not easily or quickly. They would have to be restored over time and in careful consultation with banks, whose enthusiasm for the project would be less than overwhelming.

  • You’ll hear no argument from me when Mark suggests that the Fed already has the power to do great harm. Poor monetary policy can lead to unnecessary recessions, or to credit and mis-investment booms that leave the economy structurally crippled. That an institution already has great and terrible power is no argument for handing it yet another means of mischief-making.

  • While central banking has always entailed risk, customary and statutory constraints usually reduce the likelihood of harm. Any asset can lose value, but restricting Fed purchases to short maturity Treasury securities limits the risk of capital losses, and importantly, distributes gains from seignorage to all taxpayers. Purchasing or lending against more speculative assets provides a subsidy to particular sectors and institutions (undermining legitimacy), puts taxpayer funds at risk, and privatizes the gains of seignorage in the event of nonperformance. (Central bank cash that otherwise would have retired public debt are instead distributed to private parties and never returned.) Fair allocation of seignorage gains is one of the prime virtues of fiat money central banking. Lending against questionable collateral imperils that advance.

  • Mark correctly points out that the potential upside of the Fed’s bank investments is not merely, as I suggested, “about what [taxpayers] would have earned investing in safe government bonds”. The purpose of the central bank’s activism is to prevent harms to the public that might result from turmoil in the financial sector, and these foregone harms should be included in our calculus. But if we include nonfinancial benefits, we must also consider nonfinacial costs, such as the long-term effects of the “moral hazard”, a loss of information in asset prices (assets must be valued as complex bundles of economic claims and options on potential government support), and impaired political legitimacy of the central bank and the financial system as a whole. We must weigh these costs and benefits against alternative policies, not only a straw-man scenario under which all government agencies stand completely aside and watch helplessly as the world falls apart. Of course, in “real time”, the Fed did not have the luxury of reflection. But we do have it now. Mark and I would come to very different judgments about the nonfinancial costs and benefits of Fed policies. I assure you that, in general, Mark’s judgment is much better than mine. Nevertheless, cranks like me will aver that the long-term costs due to moral-hazard and information loss are inestimably large, that questions of legitimacy and favoritism will haunt financial capitalism for a generation, and that it would be possible (even now!) to adopt uniform procedures for managing the collapse and reorganization of institutions that could not survive without life support from the Fed. Who should be empowered to decide these issues? Ben Bernanke? Hank Paulson? I vote for the people that I voted for, warts and all.

I want to make clear that I don’t actually disagree with Mark on the technical question of whether an interest rate corridor is a good idea. So long as the Fed restricts itself to traditional monetary policy — that is, so long as it buys only Treasury debt with borrowed funds — I would support this change (mostly because an interest rate corridor is easier for non-experts to understand than open market operations).

Unfortunately, not only has the Fed resorted to unorthodox tools during an acute emergency, but all indications are that the central bank plans to expand its innovative practices and continue them indefinitely. The “unusual and exigent circumstances” under which the Fed’s extraordinary actions have been justified specifies duration about as precisely as the “global war on terror”. Mark has great confidence in the Federal Reserve, and sees little hazard in granting it more freedom to maneuver. I view the central bank as prone to catastrophic error, and wish to see its capabilities clipped, not enlarged. I think the consequences of centralizing private sector risk on public sector balance sheets will turn out be grave, and must oppose any tool that would make it easier for the Fed to continue to do so.

Finally, Mark writes regarding the occasional need for fast action in a crisis:

This is an old problem — how much authority should be centralized thereby allowing quick and immediate response during a crisis, and how much should be retained in slower, deliberative bodies like the House and Senate? The War Powers Act reflects this compromise — we want the ability to respond quickly to an attack or other military developments, but we worry about the concentration of power in the hands of a single individual. Centralization has the benefit of allowing a quick response to a crisis, but it risks being out of step with the democratic process. In the case of financial market emergencies, however, I have more faith in the Fed than in congress to act quickly and correctly. That’s partly because I have little faith in the ability of congress to quickly comprehend what the problem is and attack it directly and effectively — many of them admit to not having a clue about economics, and more worrisome are the ones who think they have a clue but don’t — but congress should not give up its oversight role.

I have little faith in Congress, and even less faith in the Fed. (That’s not, by the way, a reflection of the individuals running the place. Ben Bernanke is quite brilliant. But culture and ideology saddle the Fed with both blind spots and hubris.) I like Mark’s idea, though. I’d support a financial “War Powers Act” that would authorize emergency extensions of secured credit by the Fed to private actors deemed systemically important. But here’s my deal-breaker: That support would have to be withdrawn within 180 days, and would not be renewable. Six months is long enough for solvent institutions to counter a “liquidity panic” with full disclosure, for modestly troubled institutions to secure new capital, and for regulators to arrange an orderly unwinding of firms that cannot be made solvent and liquid within the statutory timeframe. Whaddaya say?

By the way, we’ll have our six-month anniversary of the first $40B in TAF financing in June.


45 Responses to “Capabilities, constraints, and confidence”

  1. Steve, you write in this post, ” I view the central bank as prone to catastrophic error, and wish to see its capabilities clipped, not enlarged.”, and this is a very big theme in your blog. But it’s important to realize that catastrophe is much more likely to happen with a very weak central bank, or essentially no central bank as with a gold standard, or some simplistic algorithm used to manage money supply (and even a long complicated formula or computer program is simple compared to the ultra-multidimensional, flexible, high level intelligence of a strong and logical human mind, using formulas and programs only as an aide. With highly complex situations, even long formulas and programs may be far too simple, relative to the analysis of smart and logical human brains, and may perform on average far worse).

    Please see graph 3, on page 7 of this paper by Carreras and Tafunell: . It shows U.S. GDP from 1831-2000. Look at the massive swings in GDP before the introduction of a strong basically Keynesian modern central bank towards the end of the depression. Talk about catastrophe, after catastrophe, after catastrophe. You don’t need to be an econometrician to see that volatility in the economy has been vastly lower in the 50+ year era of strong (essentially Keynesian) central banks.

    This not only prevents the great human suffering of depressions and recessions, it also raises total long run GDP, because these demand crunches result in a great deal of idle human and material capital that could have been producing if a powerful central bank had countered the demand crunch, essentially by increasing money supply and circulation. As I’ve recommended before, I recommend again as strongly as possible that you read the great Princeton Economist Paul Krugman’s book, “The Return of Depression Economics” (and “Peddling Prosperity”). It explains this with great intuition. If you can’t find the time to read this book now, please at least read his 1998 article in Slate, “Baby-Sitting the Economy”. In a few pages it gives great intuition on the importance of a strong fed in fighting recessions and ending them quickly. It’s available at: .

    Mark Thoma eludes to the enormous importance of recession and depression fighting in item 6 of his rejoinder to your post. You’re very critical of the fed’s performance and very concerned with it having a lot of power, but really; take a look at the historic GDP graph; recessions have been far less severe since we have had powerful, modern, central banks.

    Another of my analogies: Costly mistakes and abuses can happen from having a powerful police force, and there should be checks and balances, but, overall, far worse things would happen if we had a weak police force.

    By the way, do you remember we exchanged emails in March.



  2. By the way, you have a Trackback link, but I don’t see any Trackback URL to use for pinging. I just started my blog, using Blogspot. So far the software seems very good, but it didn’t come with Trackback. So I added it using Haloscan. The thing is, I pinged Mark Thoma and Dani Rodrik; Haloscan said it was successful, but it never showed up on their sites. Moreover, I’ve looked through the posts, and after several dozen, with hundreds of comments, I only saw one successful Trackback! Any info on this would be appreciated.




  3. Richard — Interesting cite, lots of nice graphs with a long sweep of history. That said, I can’t say I’m persuaded the graph you points to makes a strong case for central banks. The Fed started up in 1914, and GDP growth throughout its first 30 years was exceedingly volatile. “Ah hah!”, you say. “It is enlightened Keynesian central banking that made the difference!” Well, maybe. Maybe it was the Bretton Woods monetary arrangement, political stability in the post WW2 world, a diversification effect as the US economy grew large. After all, US GDP volatility merely converged to approximately Europe’s historical level post-1855, and there were no Keynesians then. So size/diversification seems plausible. The Depression itself is widely attributed to central bank errors, with people like Bernanke emphasizing its post-crash tightness and more Austrian-ish types criticizing the 1920s easy money. Arguments surrounding monetary policy from the 20s and 30s sound perfectly familiar to contemporary ears. I’m not sure so much has changed. We had obvious and costly central bank errors in the 60s and 70s, we endured the Volcker contraction in the 80s, we’ve had the post-Volcker “great moderation” that we may soon find was a misguided calm before a larger storm. Of course my story could be wrong, and yours right. It could be that whatever the Fed’s foibles, the central bank deserves credit for declining output volatility post WWII. But we’ve little evidence of that really, it’s like attributing a good economy to whoever happened to be President.

    I’m a big fan of Krugman’s Slate parables, and am very familiar with the Babysitting Co-op tale. I did and do find it interesting. It helped persuade me that a gold standard probably isn’t the best idea. But, it doesn’t much comfort me. The problem is that by construction, the Babysitting Co-op is a one good consumption economy, whereas in real economies, people have to make consumption and investment choices that can be distorted by monetary policy. My (hardly novel) critique of central banks is that they undermine feedback mechanisms in the economy with respect to capital allocation. BTW, I get the sense that Krugman himself has begun to revisit a variety of issues he wrote about in the 1990s. I doubt he’s pulled any full U-turns, but his writings now — about trade, about the power or impotence of central banks, about whether credit-booms might occasion hangovers that are difficult to avoid — strike me as more nuanced and cautious than his commentary from a decade ago.

    By the way, I was a central banking enthusiast before I was a critic. There is a great deal of cleverness in the mechanics of central banking, both in the transmission of “stimulus” (or its opposite), and in the distribution of medium-of-exchange rents to taxpayers broadly rather than to holders of a monetary commodity. I don’t suggest we go back to a gold standard. But I think central banks cause sufficient harm that we should be actively seeking to reform or replace them, rather than to celebrate the institutions that we have. At the moment, I think we are on the verge of a catastrophe due largely to central bank malfunctions (both here and abroad), and we should be strengthening, not loosening, those checks and balances you spoke of.

    Re trackbacks, that infrastructure is iffy at best. I have no idea whether or how it works on my own site, and I know that the trackback pings performed by my blogging software rarely leave any trace. (Sometime they do, though, which is a pleasant surprise when it happens.) My sense is that trackback spam got to be such a problem that most sites have simply disabled the function, or end up filtering most things out.

    By the way, in the comments here, you can include links rather than just URLs. (That’s not true on all sites, some permit links, some don’t.)

    And of course I recall our correspondence. I’m glad to see you’ve started a blog, and look forward to watching it develop.

  4. RueTheDay writes:

    Steve – re: Krugman’s babysitting co-op tale, it doesn’t really make any sense (because real balance effects would cancel it out) UNTIL you add in Minsky’s elements of financing being a prerequisite to real investment, financing representing contractual temporal cash flow commitments denominated in nominal terms, and fundamental uncertainty around future levels of profit to cover cash flow commitments made today (and the obvious fact that those commitments will still exist in the future even if the profit opportunities do not pan out). Then it all makes perfect sense. Then what Keynes actually wrote (as opposed to the neoclassical synthesis nonsense) all makes sense as well. Finance, in the sense that Minsky described it, is the missing link in macroeconomics, and makes all of the Ptolemaic epicycle analyses around wage rigities and exogenous shocks unnecessary.

  5. I say to Serlin, welcome aboard. I can make no case for the Fed having read various things about it since 1970 and followed it’s actions in real time. I say, and have said, repeal the Federal Reserve Act.

  6. RueTheDay writes:

    IA – While it’s great fun to put on the libertarian hat every now and then and rail on about abolishing the Fed, the regulators, the police, the government, etc., the reality is that as long as we are going to have a fractional reserve banking system, we have to have a central bank to act as a lender of last resort and we have to have deposit insurance. WHile the potential for moral hazard is high, experience shows that if there is one market that needs regulation, it’s the financial sector, due to a combination of inherent volatility and the potential for extreme negative externalities.

  7. Benign Brodwicz writes:

    The Fed is already a political body. The long history of excessive accommodation in the postwar period pretty much proves this–they’re mortally afraid of being blamed for recessions. Excessive accommodation causes asset bubbles (especially when there is essentially no close regulation of lending standards) funded by debt cascades, which, when the bubble pops, reverse, causing “debt deflations,” which the Fed can do nothing about, but which it will complicate by enabling further debt cascades in the midst of asset deflation and debt repudiation. The Government should concentrate on helping people, not financial institutions. Full discosure works. Let the financial institutions fail, and set up a dole (“print money”) to give to the unemployed to keep the pump primed. All the rest is simply sweeping it under the carpet, and implicit class warfare (“bail out the hedge funds, we don’t know what they’re doing, but they’re too big to let fail”). It is an age of larcenous financial tricksters.

  8. JKH writes:

    “Moral hazard” seems like a put option or an insurance policy with a socialized premium cost.

    In the case of the Federal Reserve’s intervention in the credit crisis, the premium will be the eventual cost to the Fed and therefore to the taxpayer. This is a contingent premium cost – it depends on further market developments.

    The put option is well out of the money. As an insurance policy it has a very high deductible. The deductible is the cost of the credit crisis to the private sector. At the micro level, the Bear Stearns deductible was most of its shareholder value. Estimates abound for the full financial system damage; $ 1 trillion is representative. And arguably there will be additional knock-on costs for GDP.

    So the taxpayer pays the premium.

    The private sector pays the deductible.

    The taxpayer and the private sector are arguably the joint beneficiaries.

    The insured value is the extent of the additional expected costs that would have been incurred without intervention, including the possibility of catastrophic financial implosion. Of course, such value can never be formulated with certainty, because it is a hypothetical cost avoided. But assuming such a formulation of the insured value (and many will not), it seems hard to believe that the eventual premium cost to the taxpayer and the payment of such a sizeable deductible by the private sector won’t justify paying for such insurance. When the object of the bet is the collapse of the US financial system, it approximates an economic version of Pascal’s wager.

  9. Hello all,

    I am reading Hayek’s Denationalisation of Money, wherein he explores the possibility of replacing a government’s monopoly on currency with a competitive market for domestic currencies maintained by private concerns. Thoughts?

    Thanks kindly for any insight.


  10. Steve,

    Generally what I would say about that graph is that yes volatility in the U.S. economy plummeted just about right at the time of the adoption of (at least largely) Keynesian policies by strong central banks, and it stayed that way for over 50 years, right up to today, but was it causal or coincidental?

    I would say it was almost surely highly causal, primarily due to information not in the graph – the very strong logic chains of Keynesian demand-crunch economics. And these are logic chains that rely only on extremely realistic and plausible assumptions. That’s the strongest evidence. You saw a nice chunk of it in the Krugman baby-sitting co-op article, and to see a lot more and with great intuition I recommend again Krugman’s books, “The Return of Depression Economics” and “Peddling Prosperity”.

    But other evidence for strong causation in the graph comes from timing, magnitude, and associated logic. The U.S. economy did become more large and diversified after the adoption of Keynesian policies in from about 1935 on, but it had been doing that to a large extent for the period from 1835-1935, and we saw no drop in volatility. The drop only came suddenly just about right at the time of strong use of Keynesian techniques by central banks. As far as political stability, stable periods like 1880-1910 had far greater volatility than during the Keynesian years.

    One big thing, though, which did occur just about simultaneously with strong Keynesian central banking, was simply strong bank regulation, FDIC insurance, etc. This, you could argue, deserves the credit for the decreased volatility. A quote from the text, “Money, Banking, and Financial Markets”, 3rd Edition, by Miller and VanHoose: “In the United States between the 1830s and 1930s, national banking panics seemed to occur in regular cycles of fifteen to twenty years.” (pages 35-36). But nonetheless, again, the strongest evidence is the very strong logic chains of Keynesian demand-crunch economics.

    I do think, like in any part of government, transparency is crucial (with, of course, a few exceptions, like some ongoing military operations), as are checks and balances. This can greatly increase performance. On that subject, another book I recommend is University of Texas Economist and Public Affairs Professor Robert Auerbach’s new book, “Deception and Abuse at the Fed”. I just got it and have only perused it, but it looks good. I think you’ll really like it.



  11. JKH — Too clever by half, methinks.

    The taxpayer doesn’t pay the premium. She writes the option. A premium is a small, certain predictable payment that indemnifies one against a large but uncertain risk. That is certainly not what taxpayers are paying. Taxpayers are the insurance company, not by any means the insured.

    The “deductible” would be the portion of losses absorbed by the insured, in this case the consolidated financial sector. The deductible so far has been absurdly low. It is not clear that the consolidated financial sector took any loss on the Bear deal, considering JPMs market cap increased by Bear shareholders’ losses. There was a painful redistribution within the private sector, yes. But overall, the public sector simply made more explicit its willingness to provide insurance for assets that were previously deemed uninsured. Some “deductibles” have been paid — write-downs within financial sector firms — but they have been paid only with public sector financing, and it is unclear that private parties will ultimately absorb most of the costs already allegedly paid.

    Finally, the very term moral hazard derives from insurance. It refers precisely to the propensity of the insured to behave recklessly because they know they are covered. Even if there had been some proper insurance arrangement, with premia paid and a deductible actually covered, the behavior of the financial sector ex ante is evidence of moral hazard, which is being spectacularly ratified ex post by the public sector’s response to the crisis. Insurance contracts must be very carefully designed to avoid moral hazard. Our ad hoc insurance arrangement had few such controls. An insurance arrangement where one party both pays both the premia and the claims while another party behaves more recklessly in full awareness of this (even though they do bear some “deductible” risk) is exactly what critics claim it to be — a scam in which reckless gains are privatized while costs are socialized. That the ultimate insurer arguably has more to lose by not paying the claim than by paying under these circumstances makes the proper analogy ransom, not any reasonable form of insurance.

  12. Frank — Funny you should ask. I have that book on order. I think it quite possible that ideas that presently seem unthinkably radical will within the next few years become topics of serious debate. I think technological changes might render practical some monetary ideas that previously would have been nice in theory but too cumbersome to implement. I’ve not read the Hayek book, but I do think it’s worth considering this sort of idea.

  13. Richard — We won’t settle the question of whether new practices in central banking were responsible for apparent diminished GDP volatility in the postwar US. I agree that it is a plausible factor, but also think lots of things are plausible, including the things you point to — post New Deal regulatory changed, Bretton Woods and the US privileged position in the postwar West, etc. Plus, we have to be forward-looking. I wouldn’t be ranting all the time if I didn’t think that we’ve gotten our economy into a pickle, and that central banks (not just the Fed, actually the Fed more by omission than comission) have been played a key part in that. BTW, the pickle isn’t the credit-crunch — that’s just a symptom of a progressive illness, for which the aspirin currently on offer is not wise treatment. The pickle is an economy whose production capabilities and consumption requirements are very out of whack, and which doesn’t produce tradable goods or services in sufficient quantity or low enough cost to cover the gap. Central banks “accommodated” this imbalance, which ordinary feedback mechanisms otherwise might have prevented.

    I always enjoy Krugman’s writing, and hope to read the books you suggest. The Auerbach book certainly sounds up my alley, though I’m not sure how much it would challenge my view…

    By the way, it is true that banking panics were a regular feature of the American economy up through the Great Depression and New Deal reforms. But is there any evidence that harmed real economic growth? Financial losses, insolvencies, etc. are wrenching, but they are part of the feedback mechanism that ought to guide capital allocation. Perhaps in those times the benefits of “feedback” were outweighed by the harms of the crises. But it’s worth noting that the US economy grew quite nicely, despite regular financial sector volatility. I do not suggest that those were benighted times, or that we should go back to a gold standard or unregulated “free banking”. But to some degree, there may be a tradeoff between the frequency and amplitude of financial crises. Frequent bouts of loss-taking that keep investors ever vigilant may be better than Minsky transitions from complacency to catastrophe. There’s an achilles heel to this sort of argument — what about ordinary savers, who really oughtn’t be spending a lot of time on “due diligence” or losing their savings when all they want is a bank? But that strikes me as an argument for distinct financial sectors — a regulated, low risk, fee-for-service financial utility sector, and an investments sector in which one participates at risk, and failures are frequent, normal, and tolerable.

  14. Frank — Commenter “Independent Accountant” has occasionally touched upon the Denationalization of Money on his blog.

  15. JKH writes:

    SRW –

    Thanks. My interpretation did have a back-asswards feel to it. Yours is much clearer.

    But I think the two are more complementary than contradictory.

    The core moral hazard idea as you’ve described it is clear. The private sector engages in reckless risk taking, with the expectation that the public sector provides some level of insurance against the downside. The private sector pays nothing for the insurance, and it will make its claim if losses get big enough.

    My focus was on the role of the Federal Reserve, as one element in a set of public institutions constituting an “insurance company” funded by the taxpayer. Assuming the Fed, as a constrained institution within that framework, acknowledges its exposure to primary moral hazard, I think it’s reasonable for them to take action to manage that exposure. In that sense, the Bear Stearns intervention was not a definitive payout under moral hazard, so as much as a milestone in managing the size of the ultimate claim. We don’t yet know what the Fed’s ultimate loss will be. It’s going to be a function of what they took onto their balance sheet. They haven’t yet paid out a claim in the sense of realizing losses on their balance sheet or income statement. They’ve only set the terms on the Bear Stearns deal and structured a number of unusual intervention mechanisms. There is exposure to be sure, and it may be increasing. But I don’t think this has yet cost the taxpayer in realized dollars. Moreover, although talking his book, Bernanke insisted at the Congressional hearings that Bear Stearns was not a bail-out. That sounds like he was arguing he wasn’t paying an insurance claim. Not yet. And he further maintained he did not expect an ultimate Fed loss due to intervention.

    There is no small degree of risk in the moral hazard claim function itself. Risk takers are always making a bet as to the extent of the backstop. For a given level of risk taken, and a given level of losses that result, the sharing of the loss between the deductible and the claim is uncertain at the outset. The strike price is unknown. The “insurance company” ends up setting the strike at the time of the payout. This is a complicating risk factor for those presumptively long the benefits of moral hazard, although one they’d prefer to not being long at all.

    Therefore, I interpret the Fed’s actions with Bear and its restructured intervention facilities not so much as paying out a definitive moral hazard claim at this point, as taking out reinsurance on its ultimate exposure to moral hazard. The Fed’s intervention was an acknowledgement of its exposure to moral hazard, but also an attempt to prevent something much worse from happening. That sounds like an element of taking out insurance to me. The premium is uncertain, but contingent premiums are not uncommon in exotic options, and the subject of macro moral hazard, reinsured or not, seems exotic enough. I see your final point on “ransom”, but that’s not my view of what happened. And interpreting the Fed’s actions in the way I’ve described doesn’t contradict your point that they are exposed to primary moral hazard throughout this operation. I didn’t mean to infer they weren’t, or that it’s a good thing they are.

  16. JKH,

    I have been following this and the previous discussion with interest and lagged understanding.

    I presume that you are the JKH I had a discussion about how far the Fed controls interest rates on Brad Setser’s blog about a year ago?

    I have a clarifying question about recent Fed operations that I would grateful if you or any other reader could answer: what term lending is the Fed doing? The press release of March 7th gave me the impression that the Fed are lending $100bn of 28 day money to primary dealers as well as the TAF (and the primary dealer credit facility announced on March 16th which lends overnight only).

  17. JKH writes:

    RE –

    Yes, the same.

    I don’t find the fine details of the Fed’s programs to be gripping drama, so I’d answer your question incorrectly if I attempted.

    Try David Kotok at Cumberland Advisors as a source. He watches it like a hawk, and comments frequently with detailed updates on its progress:


    (Congratulations on your blog. I’ve been meaning to drop by. I hope to at some point, and perhaps we can pick up our discussion.)


  18. Steve,

    Thanks for the pointer. I’m interested to learn your thoughts on Hayek’s book. I’ll report back when I’ve finished it. (Could be 2-4 weeks, as I have work deadlines ahead).


  19. RueTheDay writes:

    Just saw the following FT article linked over at NakedCapitalism:


    Apparently, a number of European banks are gaming the system and creating junk securitized debt for no reason other than to take advantage of ECB liquidity programs that accept broader lines of collateral.

    It would be naive to assume that this isn’t happening or won’t happen soon in the US with the TAF and TSLF.

    The Fed should be a lot more concerned with this sort of nonsense than with fretting over their balance sheet constraints.

  20. Benign Brodwicz writes:

    Who says the reduction in volatility is a good thing? There’s plenty of evidence for a preference for an “optimal” amount of risk hard-wired into folks. The evolutionary biologists tell us it’s to keep our adaptive mechanisms tuned up–not the natural selection type, but day-to-day adaptability. We need to let more volatility happen, so that we don’t get fat and stupid, as we have recently. Mainstream economists completely miss the boat on this one. Government’s job is to help reduce the adverse impacts on folks during adjustments, not to postpone necessary adjustments and sweep problems under the carpet, as is being now.

  21. anon writes:

    Bernanke Requests Power to Pay Interest on Reserves (Update3)

    By Craig Torres and Scott Lanman

    May 16 (Bloomberg) — Federal Reserve Chairman Ben S. Bernanke asked Congress to give the Fed immediate authority to pay interest on reserves deposited by commercial banks, seeking to streamline efforts aimed at alleviating credit strains.

    The payments would help officials push money into the banking system without influencing the main policy rate, by giving lenders an incentive to leave funds with the Fed. Congress already passed a law giving the central bank the authority, starting in October 2011.

    “We recommend that the date be changed to make the legislation effective immediately,” Bernanke wrote in a May 13 letter to House Speaker Nancy Pelosi, a California Democrat. “Congress recognized that payment of interest on reserves would contribute to the efficiency of the financial system.”

    Pelosi, after speaking to Bernanke, is reviewing “the feasibility” of meeting his request, said Nadeam Elshami, a spokesman for Pelosi.

    The benchmark federal funds rate, the overnight lending rate between banks, has at times diverged from policy makers’ target in recent months as banks attempted to manage their reserves amid the credit crunch. The fluctuations also came as officials stepped up provision of liquidity to the banking system.

    Bernanke, 54, and his colleagues have started twice monthly auctions of cash to banks and opened lending to securities dealers to revive credit markets. Officials have also accepted mortgage debt and other asset-backed securities as collateral for loans.

    `Vast Sums’

    Interest payments on reserves may give policy makers the ability “to inject potentially vast sums of money into the system without having an impact on the federal funds rate” said Tony Crescenzi, chief bond market strategist at Miller Tabak &Co. It would also “put a floor under” the rate, he said.

    Congress would need to approve the accelerated timetable for the payments, which would then require the president’s signature.

    Banks are required to hold a proportion of their customers’ deposits in an account at the Fed. If the Fed paid interest on surplus reserves, banks would be less inclined to dump the funds into the money markets, pushing the federal funds rate lower.

    The New York Fed’s Open Market Desk is charged with buying and selling Treasuries with 20 Wall Street securities firms to keep the federal funds rate close to the target set by the Federal Open Market Committee. The desk has struggled to keep it stable as banks raised and lowered their reserves, removing or injecting funds into cash markets.

    Rate Fluctuations

    On May 14, for example, the benchmark rate fluctuated between 1.75 percent and 7 percent. On April 23, the range was 1 percent to 10 percent.

    Under the current statute, the Fed may pay interest “at a rate or rates not to exceed the general level of short-term interest rates” starting in October 2011.

    The U.S. central bank cut the federal funds rate target to 2 percent April 30 and indicated it may hold off on further reductions. The Fed’s Board of Governors discussed paying interest on reserves in a closed session the same day.

    Central bank staff began discussions this month with Congress on bringing forward the date that interest can be paid. Fed officials are considering how the program would work, including the rate the Fed would pay.

    Pelosi “will continue to work with” Representative Barney Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, “to examine the feasibility of enacting” the early interest payments, Elshami said.

    Frank called the Fed’s proposal “reasonable” in a May 7 interview. The change would give “some help to the banking system, and it is fair,” he said. “I’m supportive.”

    Bernanke sent a copy of his letter to Frank and Representative Spencer Bachus of Alabama, the top Republican on the House Financial Services Committee.

  22. safe_as_apartments writes:

    Does anybody know of a respectable attempt to calculate the benefits of increased risk-taking on the part of the financial system?

    It seems obvious to me that over the last 25 years we’ve suffered several severe mis-allocations of capital to unbridled animal spirits. However, I’m not aware of the benefits; perhaps someone has taken a stab at articulating them. If I’m going to insure (as a taxpayer) the financial system, I want to know what I’m getting for my money.

  23. RueTheDay writes:

    “On May 14, for example, the benchmark rate fluctuated between 1.75 percent and 7 percent. On April 23, the range was 1 percent to 10 percent.”

    So much for the discount rate potentially providing a ceiling on the “corridor” when we get one.

    I still fail to see how paying an interest rate on reserves will do much good. As Steve said in an earlier post, it becomes a one shot deal – the Fed injects the reserves and they come right back to the Fed to earn interest rather than being loaned out. The Fed is essentially “giving” the reserves to a bank and then paying interest to that bank on the reserves the Fed just created. Sounds dysfunctional to me.

    The real problem is that the wrong tools are being applied here. Manipulating the quantity and price of reserves in the banking system does not address the asset price deflation and resulting insolvencies and bankruptcies. All it can do is prevent the payments system from collapsing. This is a necessary but not sufficient solution. The Fed is like a farmer with a bag of seed corn but no arable land and no irrigation system, and rather than looking for land and water they’re focusing on trying to build a popcorn popper.

  24. JKH writes:


    It is not uncommon for isolated Fed Funds transactions to register well above the discount rate. This can happen very late in the business day. Short banks that have done a particularly poor job in managing their cash positions (e.g. unanticipated outflows) must scramble to cover their positions, and long banks will charge an exorbitant rate to lend to them, knowing that the shorts fear the stigma of going to the discount window. The shorts will usually pay whatever is charged to avoid that. It’s all part of the game. It’s peer punishment for bad cash management. And it happens when there are thousands of banks moving cash around the system.

    This type of isolated rate dispersion is not particularly important. What’s important to the Fed is that the average daily trading level for the funds rate, applying to the vast number of system transactions over the course of the day, should not deviate far from the target Fed funds level. Otherwise the Fed will adjust supplied reserves to get it back in line. The average level is known as the “Fed effective” rate, and it is calculated for each day of trading. That’s the rate for which the discount rate is a natural ceiling. This will be the case in either the current system or the corridor system. (It’s also the case that the credit crisis has increased the normal volatility of the Fed effective rate relative to the target rate.)

  25. RueTheDay writes:

    “It’s also the case that the credit crisis has increased the normal volatility of the Fed effective rate relative to the target rate.”

    That was exactly (one of) my points. My other point being that this all amounts to rearranging deck chairs on the Titanic.

  26. Steve,

    You write, “By the way, it is true that banking panics were a regular feature of the American economy up through the Great Depression and New Deal reforms. But is there any evidence that harmed real economic growth? Financial losses, insolvencies, etc. are wrenching, but they are part of the feedback mechanism that ought to guide capital allocation.”.

    But with banking panics we’re not talking about mistakes and ineficiencies made by logical, sophisticated managers with high levels of information, and then the system just purges and penalizes those mistakes. We’re talking about illogical and unneccessary panics that occur largley as a result of a massive asymetric information and externality problem, and then they become a self fulfulling prophesy. They often happen even when there’s little or no fundamental reason for them, due to the huge lack of information and expertise on these things by regular people, which is pretty much everyone except the tiny sliver of the population who have studied, and trained, in depth in these areas of the economy.

    So many of the mistakes made by people regarding economics (including lots of trained economists) come from acting as though their models are exactly reality. When a model assumes, as most of the basic ones do, that everyone in the economy has perfect information about everything, perfect expertise and education about everything, and perfect rationality, this is fine, as a way of isolating some of the important factors in an economic situation, to see better how they work by looking at what they do in isolation from other factors.

    But then after you have isolated all of the important factors and studied them in various models, you have to ask what happens in reality where they are all combined together. What will be the agregate of all of the forces pushing in their different directions with different amounts of strength. How will the results be altered by the inclusion of the real phenomena that all people don’t have Ph.D.s in every subject, and don’t have 100% of every single sliver of information in the economy stored and constantly updated in their brains.

    And now a big tangent into academia (but I think it’s worth the diversion):

    The above questions are obviosly what a good economist should ask and really think about, but a lot of economists don’t. Moreover, sadly, there’s a penalty to most economists for spending much time thinking about this kind of thing, because most are evaluated almost completely on publication production, and they will usually produce a lot more if they just save time and act as though the models are given, then micro-specialize in an area, and just do lots of little probes based on taking the models as given.

    For most economists it’s dangerous to their career advancement to spend much time thinking about the intuition, and how the models apply to the real economy, and how relaxing the assumptions changes the results, and how things outside of their micro-specialized area relate and interact. This kind of overall intuitive thinking and analysis, reading intuition books like “Peddling Prosperity”, etc., can take a lot of time away from what is for most economists their fast bread and butter – assuming the models are reality, taking them as givens, and doing some little probes or emperical tests. There’s a lot of pressure not to take too much time away from that, at least for the 99% of economists not at top universities, because it’s publish or perish.

    I myself spend huge time on intuition, the bigger picture, and interelations, as well as important subjects that the insular gatekeepers of the top academic journals turn their noses up at, like much of behavioural and especially personal finance, and normative and practicioner corporate finance. Society would really benefit if academics would bring their advanced statisitcal and theoritical skills to the effort to advance these areas, but because those who pay for most academic work – politicians and voters – can understand very little of the jargon and math in the papers, they can’t distinguish research which is highly socially benificial way from research with much less social benefit.

    This big asymetric information problem fosters a lot of ineficiency. It allows journal editors and department heads to get away with a great deal of insularity. As for myself, luckily, our business and investment activities have done very well, and we have enough money saved that we don’t really need university income, so this obviously makes it a lot easier for me to just go off and work on what I want to work on.

    Economists at the top universities, however, do, in fact, have more leeway to think about intuition, and how the many aspects of the economy as a whole intererelate, rather than just focusing on a micro-specialization. And tenure certainly decreases the penalties for not cranking out a lot of publications, but there’s still a lot of pressure to publish even at the top universities and among those with tenure, so there’s still very strong pressure to crank out pubs and not spend too much time thinking about intuition, and what happens in the real and broad economy where the neat assumptions don’t hold.

    I am being very critical of economics and finance academia, but as I said in my second May 11 post: Academia may have serious flaws and waste, but it’s essentially the only game in town for so much of the important things it does, and the good that does come out is so valuable it’s immensely worth having to pay for the waste that’s hard to fight in academia’s insular world of massively asymmetric information.

    End of tangent, now back to banking panics, recessions and depressions:

    These just aren’t efficient market feedbacks, like companies overinvest in high speed internet cable, and so capacity gets too big for consumer demand and they start losing money and go out of business, sending the message to not move more money into internet cable. And even in that case, externalities could make the market message an ineficient one, where a strong govenrment role can increase efficiency and welfare.

    With panics, the market messages become extremely ineficient and detached from fundamentals. You get self fulfilling prophesies that don’t just lead to purging of ineficiency, they lead to severe demand crunches that result in enormous amounts of unneccesarily idle human and material capital for long periods of time, and this certainly lowers wealth creation. Without Keynsian measures, in the long run prices would come down, and that would releive the demand crunch, but as we saw with the great depression, the long run can be very long, and great human suffering and trillions of dollars in lost production can be the cost of waiting when you didn’t have to. This is why Keynes said, “In the long run we’re all dead.”

    Moreover, any market message regarding bad capital allocation is still there whether the central bank increases the money supply or not. If there is overbuilding of fiber optic cable, prices and profits for fiber optic cable relative to prices and profits for other activities don’t change when the money supply is increased. Smart businessmen still won’t put their new money into relatively low profit, overbuilt fiber optics. They will put it into more promissing industries.

    A quote from Krugman to sum it up: From “The Return of Depression Economics”, page xv:

    Most economists, to the extent that they think about the subject at all, regard the Great Depresion of the 1930s as a gratuitous, unneccesary tragedy. If only Herbert Hoover hadn’t tried to balance the budget in the face of an economic slump; if only the Federal Reserve hadn’t defended the gold standard at the expense of the domestic economy; if only officials had rushed cash to threatened banks, and thus calmed the banking panic that developed in 1930-31; then the stock market crash of 1929 would have lead only to a garden-variety r
    ecession, soon forgotten. And since economists and policy makers learned their lesson – no modern treasury secretary would echo Andrew Mellon’s famous advice to “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate…purge the rotteness out of the system” – nothing like the Great Depression can ever happen again.

    Then Krugman goes on to say that many have not learned these lessons, and we are not doing enough.

    I also strongly recommend you read Krugman’s 1998 Slate article, “The Hangover Theory”. This really gets to the heart of things and teaches a lot in just a couple of pages. A quote to whet your apetite, “A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the “Austrian theory” of the business cycle—a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire.”, and one more quote, because I’d really like to motivate you and the other readers to read this article:

    Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it’s not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?

    Finally, I’d like to give an analagy to help show the ineficiency of banking panics. At a football game if others start standing up for a better view, then it’s best that you stand up too, and eventually everyone may stand up. But almost all would be better off if everyone had stayed seated. As Cornell economist Robert Frank would say, standing up is “smart for one, dumb for all”, and this is the title of chapter 10, of a book of his I highly recommend, “Luxury Fever”. An important quote from that book: Despite the mythology actively propagated by Republicans, Adam Smith, “although he is widely remembered for his account of why the indivigual pursuit of self-interest often promotes social ends, he was under no illusions that this was always the case.” (page 171)



  27. RueTheDay writes:


    A slump is most certainly not just about an excess demand for money. That’s the nonsensical “Keynesian” view of economic cycles that unfortunately pervades academic macroeconomics. It also has absolutely nothing to do with what Keynes actually wrote in the General Theory. If it were true (it isn’t) then the solution would not be to print more money, rather, there wouldn’t need to be a solution since real balance effects would render it a non-issue. Real balance effects are the bane of pretty much every “hoarding” theory of slumps. Keynes was quite aware of real balance effects when he wrote the GT. Unfortunately, when Keynes was “synthesized” into neoclassical economics, his real theory was erroneously reduced to a hoarding theory. Predictably, this ultimately led the macroeconomics mainstream down the path of New Keynesian economics (where prices and/or wages are sticky) and New Classical economics (where slumps are caused by exogenous shocks), because once you acknowledge real balance effects, you have to either keep the hoarding part and explain why the price mechanism doesn’t work (sticky wages/prices) or discard the hoarding and ascribe the slumps to something exogenous. Yet Keynes, in addition to acknowledging real balance effects, explicitly noted that his theory was not one of sticky wages and prices when stated that a fall in wages would actually make the problem worse.

    Keynes’ GT is a theory that starts with the recognition of time, uncertainty, and money and builds a structure where the key determinant of the path an economy takes is the level of investment. Investment is inherently unstable (though in a way that creates “regular irregularities”) due to the relationship between money interest rates (determined in the money market, this is where excess demand for money comes into play) and real investment driven by uncertain future estimates of profitability. The IS-LM model was crude attempt at capturing the intricate relationships Keynes described, without the time and without the uncertainty, and it led mainstream macro down a dead end path. Ultimately, the processes Keynes described are inherently dynamic and can’t be shoehorned into comparative static equilibrium models. A good starting point is Fisher’s later papers on debt-deflation and anything written by Hyman Minsky.

    Krugman has authored a book entitled, Development, Geography, and Economic Theory, that, among other things, describes the geo-spatial location theories of economic development proposed by von Thunen and others. He argues that while these are rich theories with considerable explanatory power, they were never accepted into mainstream economics nor are they ever likely to be. The reason? While they have tons of empirical support, and while they most certainly can be mathematically modeled, they can’t be represented by the type of model mainstream economists like (equilibrium models of constrained optimization). Minsky’s models of financial instability fall into the same category and thus suffer the same fate. Mainstream economics has become what Lakatos labeled a degenerate research program. While we await a Kuhnian revolution (which may well be driven by the current crisis), I suggest folks read as much Fisher, Minsky, and Schumpeter as possible. Maybe pick up a few Steinbeck novels too.

  28. JKH writes:

    “That was exactly (one of) my points.”

    I’m sorry, but it wasn’t your point at all.

    Your point, by construction, related to the intra-day volatility of the fed funds trading rate relative to the discount rate, as exemplified by the isolated trade outliers referenced in the Bloomberg article. I made my comment on the relative unimportance of that measure.

    My point, which you quote, was on the inter-day volatility of the fed effective rate relative to the target rate. This is a completely different measure and reference point. It’s a smoother series because it’s a series of daily averages. It measures how closely the Fed is keeping the average fed level around target over time. My comment was only that this series had naturally become more volatile with the challenges of the credit crisis; not that the average daily fed level was spiking through the discount rate level.

    As an example of the difference, the Bloomberg article mentioned the date of May 14, when a single funds trade registered at 7 per cent.

    Here is the Fed effective rate from May 12 to May 15 (from the Fed’s web site):

    May 12 13 14 15

    Fed effective 1.88 1.93 2.03 2.03

    So the fed effective on May 14 was nowhere near the single trade outlier of 7 per cent. It was close to the current target level of 2 per cent, and well below the discount rate of 2.25 per cent. My point was that the volatility of the Fed effective numbers around the target of 2 per cent is probably more than what it would be without the credit crisis, because the Fed’s job is more difficult in this environment. But the Fed effective series is still very contained relative to single trade spikes.

    On your other point, by no means is the Fed “essentially giving the reserves to a bank and then paying interest to that bank on the reserves the Fed just created.” The Fed makes discount loans to banks that are short fed funds. It would pay interest to banks that are long fed funds. They’re different banks. The result is an effective redistribution of reserves where needed. That’s the point.

  29. RueTheDay writes:


    I was somewhat muddled in the posts to which you responded.

    Re: Point 1 – When the discount rate is relatively close to the fed funds target rate (as it historically has been), then volatility in the relationship between the effective fed funds rate and the target necessarily translates into volatility in the relationship between the effective fed funds rate and the discount rate. The only way for a corridor system to bypass this would be for the Fed stand ready to supply an unlimited amount of funding stigma-free via the discount window. Then and only then would it be impossible for the interbank rate to exceed the discount rate.

    Re: Point 2 – Yes, you are correct, so long as the total quantity of reserves is to remain unchanged and some banks are long and some short on reserves. Then the Fed is just redistributing reserves between banks. I was responding more to comments that paying interest on reserves would allow the Fed to inject an unlimited amount of reserves into the system while maintaining a floor on the fed funds target. In such a case, the Fed would be increasing the total amount of reserves in the systems, and the excess reserves would simply come right back to interest bearing accounts at the Fed.

  30. JKH writes:


    Point 1

    Absolutely Agree.

    From a practical perspective, I doubt that the effective fed rate breaches the discount rate very often. That would require a longer statistical study to verify. I’m guessing it’s happened from time to time when the Fed is in the midst of an aggressive tightening cycle, and has followed up with a Fed funds target increase fairly quickly – i.e. it has let the funds rate drift up in anticipation of taking imminent action to hike the target rate.

    You’ve raised an interesting technical point, though. The idea that the discount rate is etched in stone as an absolute ceiling even for the fed effective rate probably isn’t absolutely necessary in an operational sense. It’s probably no more necessary in the corridor than it is in the current system. But given the stigma relationship of the discount rate to the funds rate, it seems like a natural upper bound. I do think that sustained levels of the fed effective rate exceeding the discount rate would be dysfunctional relative to the normal spread relationships and incentives – except on a very temporary basis as I noted above.

    Point 2

    Agree Again

    Remember that paying interest presumably replaces the need to drain excess reserves from the system through open market operations. This is a mechanical reserve/rate management facility. Unlike our comments on the discount rate as a slightly ambiguous ceiling rate, it should put an unambiguous floor rate on the effect of excess system reserves on the fed funds rate trading level (although maybe there’s some exceptional wrinkle here that I can’t think of right now).

    Furthermore, and more to the point of the credit crisis and your point I think, the Fed will be able to increase aggregate system reserves well above required levels, thereby opening up the possibility of increasing the size of its balance sheet, and its asset intervention activities, without wrecking its control of the funds rate. (Given the nature of our discussion, we can see that “control” is very much a relative term, but “enough control” is the operative idea.) The facility to increase total reserves and balance sheet size in a functional way makes this approach (paying interest on reserves) quite different than the open market approach.

    In this type of analysis in general, it’s always useful to remember that the behaviour of individual banks in the system is often different than the behaviour of the system as a whole (i.e. the behaviour of the “average bank”). The Fed controls the system setting, which is a constraint in total, while individual banks sort out their cash positions in different directions within that constraint. I think your last point was on aggregate system behaviour rather than individual bank behaviour, which is why I mention this.

  31. Richard Serlin,

    I totally agree with you about academic economics. I came to economics from a scientific background, and have often been frustrated by how what I regard as critical questions in economics go unanswered because they are considered too practical or too difficult to be amenable to the particular style of analysis which has become de rigueur for academic economists. The discussion with JKH that I referred to earlier was about how central banks are supposed to control interest rates. Given the vast amount written about monetary policy, one would have thought that this question would be either old hat, or a white hot research topic. In fact, it remains in doubt, although this problem is usually glossed over; if you find this difficult to believe, read Ben Friedman’s NBER Working Paper 7420 or Woodford’s Money in the Information Economy from Jackson Hole 2001. I have worked both in a central bank and in academia, and never found anyone able to explain it to me rigorously. And by rigorously, I mean with the support of facts and logic, not some mathematical gymnastics only made possible by assuming the mechanisms that are the key unknown in the first place. From my point of view, one positive about this state of affairs is that, because so many economists are wasting their time stirring existing wisdom, there may still be potential for amateurs to make breakthroughs, provided that you can (a) get the evidence and (b) present your ideas (hence I blog).

  32. Rebel Economist,

    I basically agree with what you’re saying in your comment which begins with “Richard Serlin”, on 5.18.2008 1:26pm. I do think important new ideas can be presented from economists not at top universities and others, but it’s time consuming; you can often get them published in top journals, but only if you spend a lot of time first learning all of the related literature, and then show how it relates and doesn’t, and use similar theoretical form. You also have to learn a great deal of mathematics and statistics to model and present it technically and formally — so this largely precludes those without Ph.D. knowlege people, who have great ideas, but don’t have the technical skills to do the above.

    I’m sure that many people have thought of lots of ideas that later won Nobel prizes, but they didn’t have the technical skills to write them up formally to get them published. Later someone from Harvard does write it up formally, and with the formality and the pedigree it gets published.

    Even if you do have the Ph.D., it can be hard to take the time to go into a long term project to produce something really new, when there’s constant pressure to crank out safe,sure out fast publications.

    So it can be tough, but if you can spend the time, and have or acquire the technical skills, it can be done.

  33. Rebel Economist,

    Let me add that posting the ideas in a blog is good. You at least have prehaps some record that you thought of it first, but it’s far far better to get it published in as prestigious an academic journal as possible. It will take a lot more time, but that’t the way to really get credit and have a positive impact.

    Sometimes you have an important origonal idea, but it will take maybe years before you have the time to construct a whole fancy technical model and paper with it. Still, there’s more that you can do in the short run than just put it on blogs. Many prestigious journals publish notes and letters. I have a personal example, what I think is an important insight in finance that I hadn’t seen at least explicitly in the finance literature. I got it published as a letter in “The Economists’ Voice”, a journal who’s editors are Nobel Prize winner Joseph Stiglitz, and top economists Aaron Edlin and Brad DeLong (a big econ blogger).

  34. flow5 writes:

    Ignore any and all interest rates, as “triggers” to guide open market operations. The money supply can never be managed by any attempt to control the cost of credit.. In other words, it is impossible to use interest rates as a vehicle to effect monetary policy – unless the objective is to feed a rampant inflation.

    The decline in the asset types that require legal reserves, and the decline in reserve ratios on these assets, has effectively eliminated all constraints on the creation of new money &credit, i.e., the elimination in reserves against large CDs in 1980, repurchase agreements against Government &agency securities in 1980, against E-Dollar funding in 1990, against non-transaction accounts in1991, &the reduction in reserve ratios on transaction deposits from 10% to 8% in 1992, etc.

    A parallel situation existed prior to the DIDMCA in 1980. The number of member banks that dropped their membership to the system, continued to grow, until the non-member banks owned c. 37% + of the banking system’s assets. .Years have passed, and these precedents were forgotten – i.e., why membership for the non-member banks was compulsory.

    According to the bankers, the system’s stringent and exigent rules (reporting, reserves tax, maintenance req., etc.), were deterrents, and made membership less profitable. So when the bankers complained, Congress capitulated, and sought under the guise of deregulation, to accommodate their constituent’s interests (which became the harbinger of all future legislation (that being deregulation has been political, not economic).

    Just as the percentage of member banks continued to erode prior to the DIDMCA, today the percentage of zero-bound banks continues to rise. Data as of May 2002 estimated the number of zero-bound banks at approximately 70%. What volume of assets is held by this 70%, or that held by the remaining 30% of accounting-bound banks, is indeterminate.

    Nevertheless, there is broad agreement among professional economists, that legal reserves or statutory reserve requirements have reached the threshold where they are no longer binding/constraining [their indirect evidence]

    (1) operate with lower volume of non-interest-bearing reserve assets (2) increase in ATM networks

    (3) tightened cash inventory

    (4) excess clearing balances/reserves

    (5) deposit sweeps

    (6) decline in applied vault cash

    (7) decline in required reserve balances – IBDDs

    (8) clearing balances exceed required reserves

    (9) increase in surplus vault cash.

    It was true that the legislation in 1980 was driven by the need to incorporate all money creating institutions under the aegis of the Reserve Authorities, in order to regulate some combination of total, excess, net-borrowed, free, and required reserves, (the rate and direction of movement of these components) and thereby administer proper control over the money supply.

    Since 1942 money creation has become a system process (excess reserves disappeared, and thus money creation was no longer likened to “pushing on a string”). I.e., no bank, or minority group of banks (from an asset-holding standpoint), can expand credit (create money), significantly faster than the majority banks expand.

    So if the accounting-bound banks hold 80 percent of all bank assets, an expansion of credit by the zero-bound banks, and no expansion by accounting-bound banks, will result, on the average, of a loss in clearing balances equal to 80 percent of the amount being checked out of the zero-bound banks.

    I.e., if the accounting-bound banks hold a substantial majority (70-80%) of the assets of the entire system, the Fed could (through the accounting-bound banks) attain an acceptable degree of control over the money supply. Unfortunately, this economic restraint is becoming less and less effective as the proportion of total bank assets held by accounting-bound banks continues to decline.

    The technical staff’s studies have centered on the number of banks, rather than the growth in the volume of the zero-bound bank’s earning assets – a blunder – because as the system expands, so does the rate-of-change in member commercial bank credit. This is evidenced by the “money multiplier” (MM) or the system’s “expansion coefficient” (fractional legal reserves).

    From 1996 until 2006, “MM” rose at the fastest pace in the Fed’s history – 48% increase in 10 years (the period corresponding to Greenspan’s conundrum). During roughly this same time frame, housing prices climbed 83% in 5 years (Case-Schiller).

    Before the latest breakdown, it took 35 years for the “MM” to double (1977-2005), the same rate as in the previous 30 years (1947-1977), – a predictable path. Consequently, “MM” (an important measuring instrument), has been undermined (defined by commercial bank credit divided by legal reserves).

    This in and of itself, is prima facie evidence that the Fed has lost any current way of monitoring, or controlling, the legal reserves, of any of our money creating, or potentially money creating, depository institutions.

    It is an a priori conclusion that by the time the volume of assets held by the zero-bound bank earning assets reaches 50%, it will be impossible for the Federal Reserve to control the growth of money supply. I.e., all prudential reserve banking systems have heretofore “come-a-cropper”.

    Money creation by private profit institutions is not self-regulatory – the “unseen hand” simply does not function in this area. Invariably the systems created too much money, speculation became rampant, inflation distorted and destroyed economic relationships, confidence that the banks could meet their convertibility obligations eroded, “runs” on the banks caused mass banking failures, and entire economies were left in ruin.

    With this historical record to draw from the pertinent question is: Why is Congress and our Monetary Authorities allowing zero-reserve or zero-bound banking to grow on an unregulated, prudential reserve basis? I.e., New Zealand pioneered this approach and subsequently lost control of its money supply sending interest rates soaring to 8% + and their currency to 25 year highs. The answer is indeed why?

    And when the ”Financial Services Regulatory Relief Act of 2006 goes into effect, and the provisions thus granted are concluded, the money creating depository institutions will be uncontrollable on two devastating fronts: (1) pegging interest rates & (2) zero reserve requirements.

    Why? Because the Fed cannot control interest rates, even in the short-end of the market, except temporarily. The effect of a series of temporary pegging operations (the one-day cost-of-carry on Government bonds), as guide posts, is indirect, and varies widely over time, and in magnitude. And cost, obviously, is not a significant factor determining the volume of borrowing (see Jan 82 – Jan 83).

    Why inflationary? The effect of tying open market policy to a FFR target is to supply additional (and excessive) legal reserves to the banking system when loan demand increases. Since the member depository institutions have no excess reserves of significance, the banks have to acquire additional reserves, to support the expansion of deposits, resulting from their loan expansion.

    If the aggregate of their bids for Federal Funds pushed the rate above the bracket set by the “trading desk” this would automatically trigger buy orders, which then ultimately led to an excessive volume of (1) Open Market Purchases, (2) Reserve Bank Credit, and (3) Legal Reserves. Soon a multiple volume of money is created on the basis of any given increase in legal reserves.

    Since “MM” has been emasculated, what the net expansion of the money supply will be, won’t be known until long after the fact. This is the process by which the Fed has financed the
    rampant real estate speculation which has characterized the 3d millennium.

    From the monetarist’s perspective, the only tool at the disposal of the monetary authorities in a free capitalistic system through which the volume of money can be controlled is legal reserves and reserve ratios.

    I.e., monetarism involves controlling the volume of total reserves, not the volume of non-borrowed reserves as administered by Paul Volcker. This mis-guided procedure lead to the ill-advised “abandonment of a reserves-based targeting procedure”.

    It is no happenstance that the FFR went to 22.4% under Volcker’s purview (the 79-83 non-borrowed reserves-based targeting procedure). During this period, at times 10% of all reserves were borrowed. Under this operating procedure, legal reserves grew at an astronomical 15% annual rate in the last 6 months of 1980. And today, in contradiction to Volcker’s experiment, the Central Bank under Bernanke, utilizes borrowed reserves exclusively.

    To expand the money supply there must first be a net expansion of Federal Reserve Bank Credit. When this is the objective of monetary policy, buy orders for governments (usually Treasury bills) are executed through the “trading desk” in the Federal Reserve Bank of New York for the accounts of the 12 Federal Reserve Banks. Thus the volume of IBDDs is almost exclusively related to the volume of Reserve Bank Credit.

    The Fed finances these purchases through the creation of new inter-bank demand deposits (IBDDs). These are the initial legal reserves of the member commercial banks. These are member bank legal reserves and they can be converted dollar-for-dollar into Federal Reserve Notes.

    There are two immediate effects of these operations: (1) Treasury bill quotes rise, rates go down, and (2) excess legal reserves are injected into the banks, thereby putting downward pressure on the FFR. This is the short-run.

    The reserve assets (legal reserves) that all money creating institutions are required to hold should be of a type the monetary authorities can quickly ascertain and absolutely control. The only type of bank asset that fulfills this requirement is inter-bank demand deposits in the 12 Federal Reserve District Banks, owned by the member banks (IBDDs).

    This was the original definition of the legal reserves of member banks in the Federal Reserve Act of Dec 23, 1913 (Owen-Glass Act) and it is still the only viable definition (June 21st, 1917- November 30th,1959 requirements pertaining to assets – Reg. D).

    The time is long past for the Congress to require that balances (IBDDs) in the Federal Reserve Banks be the sole legal reserves of all banks. If this reform is not made, all other reforms will be of little consequence.

    The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves. Under the monetarist’s doctrine, the first rule of reserves and reserve ratios should be to require that all money creating institutions have the same legal reserve requirements, both as to types of assets eligible for reserves, as well as the level of reserve ratios. The DIDMCA went only this far. Now Congress has given the Board of Governors permission to pursue a zero-reserve req. policy.

    Then, to be successful, (to use legal reserves as both a credit-control device, and as a forecasting tool), member commercial banks must have uniform reserve ratios, for all deposits, in all banks, irrespective of their size (10% at a minimum – across all deposit liabilities – or equal to the existing reserve ratio on all transaction deposits).

    This is corroborated by 7 years of deliberation in which the 1931 Fed. Res. Committee’s recommendation to change the method of computing reserve requirements was: (1) uniform percentage requirements against the volume of deposits of all classes at all banks, (2) requirements against debits to deposits. This significant and yet confidential document wasn’t de-classified (released to the public) until Mar 23, 1983.

    Under the current policy, fixing lower reserve requirements for time deposits is just a method, and an illogical method, of reducing the average reserve requirements for the banks. It encourages bank customers to opt for high liquidity, &higher yielding, deposit accounts/new money (whose growth is unrestrained by the standard devices of reserves and reserve ratios).

    Despite the study and press to the contrary, the conclusion is unmistakable, monetarism has yet to be tried. Thus do we create for ourselves problems which never should exist.

  35. flow5 writes:

    (1) Ben S. Bernanke

    Chairman and a member of the Board of Governors of the Federal Reserve System. Chairman of the Federal Open Market Committee, the System’s principal monetary policymaking body.

    At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections.

    2) European Central Bank (ECB) Central Bank for the EURO

    The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level…

    3) Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco

    You will note that I am casting my statements about the stance of policy and the outlook in very conditional terms. I do this because of the great uncertainty that surrounds these issues. Frankly, all approaches to assessing the stance of policy are inherently imprecise. Just as imprecise is our understanding of how long the lags will be between our policy actions and their impacts on the economy and inflation. This uncertainty argues, then, for policy to be responsive to the data as it emerges, especially as we get within range of the especially as we get within range of the desired policy setting.

    (4) Thomas M. Hoenig

    President of Federal Reserve Bank of Kansas City

    Monetary policy must be forward-looking because policy influences inflation with long lags. Generally speaking a change in the Federal funds rate may take an estimated 12-18 months to affect inflation measures….But the course of monetary policy is not entirely certain. &will depend on how the economy evolves in the coming months.

    (5) William Poole*

    President, Federal Reserve Bank of St. Louis

    However inflation is measured, economists agree that monetary policy has at most a minimal influence on the rate of change in the price level over relatively short time periods—months, quarters or perhaps even a year. Central banks are responsible for medium- and long-term inflation—such inflation, as Milton Friedman wrote, is a monetary phenomenon that depends on past, current and expected future monetary policy. As a practical matter, the medium- to long-term likely is a period of two to five years.

    (6) Robert W. Fischer – President Dallas Federal Reserve Bank

    November 2, 2006:

    “In retrospect [because of faulty data] the real funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been. In this case, poor data led to policy action that amplified speculative activity in housing and other markets. The point is that we need to continue to develop and work with better data.”

    (7) Governor Donald L. Kohn

    I think a third lesson is humility—we should always keep in mind how little we know about the economy. Monetary policy operates in an environment of pervasive uncertainty—about the nature of the shocks hitting the economy, about the economy’s structure, and about agents’ reactions. The 1970s provide a sobering lesson in the difficulty of estimating the level and rate of change of potential output; these are quantities we can never observe directly but can only infer from the behavior of other variables.

    First, there is no ambiguity in forecasts. In contradistinction to Bernanke (and using his terminology), forecasts are mathematically “precise” (1) nominal GDP is measured by monetary flows (MVt); (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters; (3) “money” is the measure of liquidity; &(4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;

    Friedman became famous using only half the equation, leaving his believers with the labor of Sisyphus.

    The lags for monetary flows (MVt), i.e. proxies for real GDP and the deflator are exact, unvarying, respectively. Roc’s in (MVt) are always measured with the same length of time as the economic lag (as its influence approaches its maximum impact; as demonstrated by a scatter plot diagram).

    Not surprisingly, adjusted member commercial bank “free gratis” legal reserves (their roc’s) corroborate/mirror both lags for monetary flows (MVt) –— their lengths are identical.

    The lags for both monetary flows (MVt) &”free gratis” legal reserves are indistinguishable. Consequently it has been mathematically impossible to miss an economic forecast. There are no inaccuracies, just some non-conforming &unavailable data This is the “Holy Grail” &it is inviolate &sacrosanct.

    The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly.

    Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP. Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard. They should represent a rolling moving average.

    Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets (housing being most notable), it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 percentage points. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.

    Some people prefer the devil theory of inflation: “It’s all OPEC’s fault.” This approach ignores the fact that the evidence of inflation is represented by actual prices in the marketplace. The “administered” prices of OPEC would not be the “asked” prices were they not “validated” by (MVt).

    Dr. William Poole: The depreciation of the dollar is something that is not explicable. And the way I like to phrase this – I like to put my academic hat back on. If you look at academic studies of forecasts of the exchange rates across the major currencies, you find that the forecasts are simply not worth a damn.

    Your best forecast of where the dollar is going to be a year from now is where it is now. There is no model that will beat that simple model. And people have dug into this over and over again. Obviously, you can make a ton of money if you were able to have accurate forecasts.

    No one has been able to come up with a forecasting methodology that will make you a lot of money. And you can’t make money under the forecast that the dollar is the same as it is right now a year from now. I can go a step beyond that though – and this is what I think is really interesting.

    The academic literature is also full of papers trying to explain exchange rate fluctuations after the fact – after you have all the data that you can put your hands on – data that you can’t accurately forecast, but data that after you get your hands on it might logically explain the fluctuations of currency values. And those models aren’t worth a damn either.

    We cannot explain the fluctuations of currencies after they have occurred even with all the data that we can dig out. And therefore, to me, it’s completely unsupported idle speculation not only to make the forecast but to talk about
    why the dollar has behaved as it has.

    I know the financial pages and the traders love to talk about that, but I would challenge any of them to construct a model that would stand up to a peer review journal in economics or finance. The models just aren’t that good.”

    A post-event question from a Bloomberg reporter: “I was hoping you could elaborate a little bit on the implications of the weakness in the dollar right now… whether implications on inflation or just the economy in general.”

    “I don’t see any implications for inflation, at least with the magnitude of the depreciation that we’ve seen so far. The evidence is that – there’s a literature that looks at what’s called “pass through” – pass through of changes in domestic prices. And the evidence is that the pass through coefficient has gotten small and smaller.”

    If the world’s largest economy ($13b+) has a contraction in its economy, imports will fall, &export driven countries will suffer, exacerbating the negative (reversal) in the flow of funds, and any currency crisis. Forecasting results using 1 or 2 time series:

    Mexico crisis 2/17/1982 (not identified) – Peso was pegged

    ERM crisis Sept 1992

    Listed below, currency crisis that were predictable &preventable

    (1) Black Monday Oct 19 1987 (same day)

    (2) Mexico Peso crisis Dec 1994 (2 months early) Peso was pegged

    (3) U.S. dollar/Yen fall (3%) in Mar. 1995 (same month) (record trade deficit)

    (4) Asian financial crisis July 1997 (one month late) – without primary time series

    (5) Russian financial crisis Aug 1998 (same month)

    (6) Brazilian peso crisis Jan 1999

    (7) Argentina crisis Dec 1999-2001 Exports fell in 99 1st time in since 1991

    (8) Japanese financial crisis 1991

    Yea for these, our sterling pieces, all of pure Athenian mold — ARISTOPHANES, THE FROGS

    Monetary flows (MVt) peaked Oct. 1974 (the stock market bottom)

    Monetary flows (MVt) peaked Oct. 1982 (1 month after the stock market bottom).

    (MVt)’s lag for long-term rates peaked Sept. 1981 (this century’s peak in long-term interest rates).

    Monetary flows (MVt) peaked in Jun 1984 (the stock market bottom). 1 option trade beat Prechter’s trading championship record with his 200+ trades

    The stock market bottom of 1982 was identifiable a year and ½, earlier

    Go, presently inquire, and so will I, where money is. —- THE MERCHANT OF Venice

    1938-1940 roc’s in “free gratis” legal reserves pulled us out of the depression.

    1951 (Korean War) had the highest roc’s in inflation &in “free gratis” legal reserves since WWII.

    1973 had the highest roc’s in inflation &the highest roc’s of “free gratis” legal reserves ever.

    1979-1980 had the highest rates of inflation &the highest roc’s of “free gratis” legal reserves ever.

    “Black Monday” Oct. 19, 1987, coincided with the sharpest and fastest peak-to-trough decline in the roc for real GDP since 1915.

    The stock market’s 1QTR top in 2000 coincided with a +3.24 (roc) in Dec. 1999, which reversed to -.32 in Feb 2000. An historic reversal.

    Feb 27 coincided with the sharpest decline in 1) the absolute level of “free gratis” legal reserves, &2) &an historically large peak-to-trough reversal of roc’s for proxies on real GDP &the deflator.

    The policy rule is ex-post. (e.g, Taylor Rule).

    Bank debits &“free” legal reserves are ex-ante.

    Some people think Feb 27, 2007 started across the ocean In fact, it was home grown.

  36. To Rebel Economist again,

    My comment about how you can still publish in good academic journals with really new ideas after applying a lot of time and effort was basically for new ideas not in the areas where there’s a lot of snobbery or just exclusion. Such areas include many practitioner things, most of personal finance, normative corporate finance, and more.

    There, the gate keepers at the journals often really don’t want to publish anything in those areas often due to an unwarranted snobbery, or due to the fact that if such areas became big, it would make it harder to publish in their own areas, and it would make their own expertises less valuable and prestigious.

    For example, up until about 30 years ago, it was virtually impossible to get any behavioral finance published at all. Who gets to finally break the doors down to the top journals on these subjects? Usually someone who already is famous in the field, or at least has Ivy league pedigrees.

    A good example is Robert Frank of Cornell. For decades he’s been saying the very obvious and important thing that someone’s utility depends greatly depends on others consumption. In other words, the utility most people will get from a 2008 Honda Accord will depend greatly on what others are driving. If everyone else is driving 10 year old Kias it will be higher than if everyone else is driving Mercedes.

    Someday Frank may win a Nobel prize for discovering this “brilliant” idea that only a bizillion other people figured out by the time they were 5 years old. But Frank is perhaps the first one with pedigrees and a big reputation to push for it, put it into formal models, and start getting it published in top journals. And the gate keepers of those journals tried hard to resist in large part because these better and more realistic models made their own models, and the models they were expert in, less valuable.

    What do you do if you don’t have the big reputation? There’s still a lot more you can do than just put it on blogs. You can still often publish in practitioner journals or lower ranked academic journals, and this gives you good proof that you thought of it first when some famous guy later wins a Nobel for it. And it’s still valuable to formalize it and link it to the existing literature as much as possible.

  37. RueTheDay writes:

    I think you meant the “Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel”. Technically, there is no “Nobel Prize” in economics. ;-)

  38. martinb writes:

    I’ve been following this discussion for a while but I’m not sure what to make of it. It seems to me that the essential question that need to be solved for the monetary system we are currently living under is how to solve the issue of moral hazard. All other discussions seems vacuous. The central bank, in all countries affected, sits on the short term resources by it’s unique ability to print cash. The state sits on the long term resources because of it’s ability to tax the people. The only right starting point must be to look at these entities as a whole in an intertemporal model. We must thus minimize the hazardous expectations that arises in this world. There is clearly a problematic behaviour that arises with the expectations that the short term capacity of the central bank will be supported by the long term resources of the state That is, the latter will be forced to bail out the first which again will be forced to bail out the “system”.

    What is the solution? Frankly I don’t know. But I believe this is the essential question to be asked. Maybe I will do it in a future academic career. Hoping to be published in a publication that will have the crediblity to make policy of my solutions.

  39. martinb writes:

    To continue my post above:

    I don’t know of any government in the western hemisphere that has failed to come and support their central bank in a time of crisis. By any desing the state is the ultimate lender of last resort. It is the state that gives the central bank it’s directive to pursue an inflation targeting policy. The abolishment of this regime is never further away than a political directive.

    In a time of crisis the public will most likely want to punish the banks. But is this, under the current sytem, even possible without punishing the people themself? Do you really belive that laws and regulations can create a constraint on the central bank in this environment? Such solutions might just as well end up with politicians being forced to shoot themself in the foot.

  40. RueTheDay writes:

    Martin – While moral hazard is certainly a significant issue, it is not the central problem. It is a second order problem – solving it would eliminate some of the negative consequences of the palliative measures taken against the real problem, but would leave the real problem unsolved.

    I just picked up this week’s copy of The Economist, and it has an 18 page spread entitled, “Barbarians at the Vaul: A special report on the future of banking.” Very disappointing. There was considerable hand wringing over moral hazard, the perverse incentives associated with the compensation models prevalent in the industry, and the impact of financial instability on real economies. The articles quickly evolved into typical TINA-spiel. In the end, the recommendations amounted to the need for greater transparency though with the caveat that it should be market-driven rather than government-driven (yeah right), whining about fair market valuation accounting driving instability (I don’t see how you can be a free market advocate if you don’t believe in the efficiency of the price mechanism at a minimum), and modifying certain regulations to make them more countr-cyclical rather than pro-cyclical (this one has some merit). Very little about fundamental, substantive, structural reform.

  41. RebelEconomist writes:


    Thanks for your reply. Unfortunately, I could not read your letter in the Economist’s Voice, because I do not have access (at least not without using up my one-off guest access)……getting hold of journal articles is another challenge for amateur economists. Anyway, we are getting a bit off the topic of Fed operations!

  42. martinb writes:

    RTD: What is the central problem then?

  43. martinb writes:

    RTD: On a totally unrelated note. Im I right to suspect ou are swedish. Only a swede would know the difference of the real nobel prize and the fake one… :)

  44. RueTheDay writes:

    Martin – Not Swedish, American. The central problem is the ability of the financial sector, due to its position as the nexus of the payments system, to transmit instability throughout the rest of the economy.

  45. flow5 writes:

    Where did the “rarefied galaxy of theorems, lemmas, proofs, and assumptions” come from? It originated from the prevailing hubris on the Fed’s technical staff stemming from their Keynesian training. Lord Keynes advised them that interest was the price of money, not the price of loan-funds (see Alfred Marshall’s money paradox). They therefore decided that the money supply could be controlled through the manipulation of the federal funds rate (the rate paid by banks to banks holding excess legal reserves in the District Reserve Banks).

    The Fed can reduce federal funds and other money market rates temporarily, but only at the cost of losing control of member bank legal reserves. In other words, it is impossible to use interest rates as a vehicle to effect monetary policy – unless the objective is to feed a rampant inflation.