James Hamilton has an excellent post on the Federal Reserve and its changing balance sheet today. If you haven’t been following this stuff obsessively, it’s probably the single best primer to get up to speed.

To my mind, there are three signal facts about the brave new balance sheet:

  1. The size of the Federal Reserve’s balance sheet has ballooned, more than doubling over a period of three months. If we take the FOMC at its word for it, it’s not going to shrink anytime soon. Given new programs already announced, we should expect the Fed’s balance sheet to continue to grow.
  2. On the asset side, only a small fraction of the Fed’s holdings are now US Treasury securities. Excluding securities lent to dealers, just 12.5% of the Fed’s assets are Treasuries. The Fed has expanded the scope of its lending, from depository institutions, to primary dealers, to money-market funds and commercial paper issuers, to issuers of asset and mortgage backed securities, and very soon to private investment funds that invest in asset-backed securities. The Fed also periodically lends to support firms in, um, special circumstances, such as JPM/Bear and more recently AIG.
  3. On the liability side, the Federal Reserve has dramatically increased the degree to which it funds its activities with zero-maturity bank reserves, upon which it is now paying interest.

The Federal Funds rate is now effectively zero. We have hit the so-called “zero bound”.

There are many ways of trying to make sense of all this. One broad-brush view is that for all its radicalism, the Fed is just a thermostat. As the private sector delevered, the Fed had to lever up (McCulley). As foreign central banks shift their portfolio from agencies to Treasuries, the Fed has to shift its portfolio from Treasuries to agencies (Setser). More broadly, as the private financial sector has become unwilling to issue short-term, liquid liabilities against long-term illiquid assets, the Fed has had to do so to avoid a disorderly collapse of asset prices (see Kling). One might imagine a canoe carrying a wild beast (that would be our “rational” private markets). The beast writhes and bends, and the Fed must throw its weight in the opposite direction to force the tipping craft upright despite all the upheaval.

“Stability” — price stability, financial stability — are to my mind like “liquidity“: qualities widely considered virtues that are often actually vices. Nevertheless, the Fed pursues these goals, and in the immediate term, the thermostat analogy works pretty well. I don’t doubt that we’d have tipped into steep deflation, outright collapse of core financial institutions and an in-the-streets economic crisis without the Fed’s extraordinary measures. Had the Fed not played thermostat from 2001-2003, perhaps the beast would have been chastened by a mild dunking, and today’s heroics might have been less inevitable. But it was stability über alles then, when the bubble first tried to burst, and now we are where we are.

So, thanks to the Fed, things are better than they might have been. But I think there is as much to squirm about than to celebrate in how the Fed has comported itself.

On the asset side, as has been widely noted, the Fed has been taking on extraordinary levels of credit risk. We do not know against precisely what collateral the Fed is extending its trillions in loans, and how conservatively that collateral is being valued. We wish Bloomberg luck in their lawsuit. (ht CR, Alea).

We do know that the Fed is becoming ever more brazen about its risk-taking. When the Fed made a non-recourse loan in connection with the collapse of Bear Stearns, Chairman Bernanke was summoned by Congress to discuss the unusual move. A non-recourse loan is economically something between lending and purchasing. The Fed has the authority to lend to whomever it pleases under “unusual and exigent” circumstances, but it is not empowered to spend outright what are in the end US taxpayer dollars. Anticipating objections, Dr. Bernanke was very careful during the Bear debacle to ensure that since the taxpayer would “own” most of the downside, it would also capture the upside. Still, he was called to account for what was widely understood to be an unusual move of very questionable legality. But now, under TALF, the Fed will extend non-recourse loans to just about anyone. The Fed will assume much of the downside, while private investors capture the upside. In my view, it is not quite legal for the Fed to extend non-recourse loans, and the practice should be curtailed. Non-recourse loans should be approved by Congress and executed by the Treasury department. The recipients of loans from the Federal Reserve should be bankrupt before taxpayers take losses. Remember, the Fed is an an unelected technocracy “cognitively captured” (as Willem Buiter puts it) by the sector it purports to regulate. Yes, Congress sucks. But the Fed sucks too, and the rule of law does matter.

For all of that, it is the liability side of the Fed’s balance sheet that is most interesting. The Fed is financing its gargantuan balance sheet expansion by conjuring unsterilized bank reserves. A year ago, there were less than $18B of reserves deposited at the Fed. Today there are $800B. A year ago the Fed wasn’t paying interest on bank reserves. Today it is.

Interest rates are, for the moment, excruciatingly low. But a subsidy to the banking system, once put into place, will be quite hard to dislodge. So, let’s imagine that the Fed will pay interest on bank reserves in perpetuity, that it will pay such interest at or near the risk-free short-term interest rate, and that the expansion of the Fed’s balance sheet is more or less permanent. How large a subsidy to the banking system do the interest payments on reserves represent? Some problems are arithmetically challenging, but not this one. The present value of a perpetual stream of market-rate interest payments is precisely the amount of the principal. Therefore, the present value of the Fed’s de facto commitment to pay interest to banks on $800B of freshly created reserves is $800B. We fought and wailed and gnashed our teeth over potentially overpaying for TARP assets. Meanwhile, we are quietly allowing the Fed give away, as a direct, literal subsidy, more than the entire $700B that Paulson was allowed to play with. Note there is no question about this being an “investment”: The interest payments that the Fed is now making to banks on its suddenly expanded balance sheet are not loans. The banks owe taxpayers absolutely nothing in return for this windfall.

Now the bankers will object, as they always do. Bankers have forever cried that they are required to hold reserves at the Fed, that to be forced to lend their cash interest-free to the central bank is a hidden tax. I hope we all understand by now that the pronouncements of the banking industry are about as reliable as a monthly statement from Bernie Madoff. The reserves in the banking system are created by the Fed, and the quantity outstanding is now enough to cover banks’ regulatory and settlement needs many times over. This is not in any sense “their” money. It is money the Fed printed in order to pursue its own objectives. The banks have no right whatsoever to earn interest on this money, and absolutely do not merit an $800B subsidy. Further, the core rationale for paying interest on reserves has disappeared entirely. Originally, the Fed wanted the power to pay interest on reserves so that it could expand its balance sheet to pursue “stability” goals without stoking inflation by letting the short-term interest rate fall to zero. Now the short-term interest rate has fallen to zero, and the dominant concern is that we are in a “liquidity trap”. Yet we are still paying the banks 25 basis points to hold this freshly created money at the Fed. James Hamilton, towards the end of his piece, points out that this is counterproductive. I want to point out that it is also obscene.

Now I have to admit that, personally, I feel a bit caught out, bent out of shape, gypped, by the whole paying-interest-on-reserves thing. A long while back, I argued against giving the Fed this power, because I knew they would abuse it. During the TARP debate, I did a one-eighty. At least the Fed, I reasoned, would only lend taxpayer money. If we took losses, the institutions that shoved them onto us would go down first. Paulson clearly wanted to assume bank liabilities outright by overpaying for toxic assets. Having the Fed lend taxpayer money seemed like a better deal than letting Paulson give it away. The cost of paying interest on reserves, when I had written about it previously, was about only $11B in present value terms, insignificant in the grand scheme of things. (By the end of September, when I flipped, reserves had already grown to $100B… but I missed that.) Now we have the worst of all worlds: Not only has our corrupt, dysfunctional banking system won the small subsidy it has long lobbied for, but the size of that subsidy has grown by almost 8000%. The Fed is no longer lending only to financial institutions that would have to go under before taxpayers eat their losses. Under TALF, the Fed will lend to anyone who owns the kind of securities whose prices the Fed wants support. The borrowers will take the upside, while taxpayers eat the downside. (Does anybody know what kind of leverage the Fed will support under TALF? I’ve looked, but haven’t found.) The non-recourse lending that was extraordinary and barely legal when Bear went down is now the new normal, except that the Fed no longer bothers to ensure an upside for taxpayers. By institutionalizing non-recourse lending, the Fed has arrogated the power to do everything the original TARP would have done, except without the opportunity for people like me to write Congress in anger.

Despite all this, I am becoming rather Zen about the Federal Reserve lately. I have some sympathy: They are dancing to a tune that they no longer call, struggling to keep pace with an accelerating beat. The Bernanke Fed is clever and inventive, delightful as spectator sport. So many trillions of dollars have been spent or committed or guaranteed, that the amounts have gone meaningless. I think that the current financial system and the Fed itself are quite doomed, and I’m less inclined to get bent out of shape by the particular ordering of the death throes. There will be a great crisis. Hopefully it will only be a financial crisis. I’d prefer it to be an inflationary rather than a sharp deflationary crisis, both because I think that a great inflation would be less destructive, and because that’s the way my own portfolio tilts. So really, I should root for the Fed. Let the printing presses turn and the helicopters fly, but please don’t confiscate my gold.

Since the current Fed loves bold and unorthodox action, I thought I’d end this with a (sort of) constructive suggestion. As the composition of the monetary base changes from mostly currency in circulation to largely electronic reserves, the zero-bound on nominal interest rates can be made to disappear. How? Simple: Rather than paying interest on reserves, the Fed can tax them. If banks were taxed daily on their reserves, banks would compete to minimize their holdings, and interbank lending rates would go negative. With a high enough tax, banks could be made desperate to lend, even though in aggregate the banking system has no choice but to hold the reserves. Presumably, banks would pass costs to depositors by eliminating interest on deposits, increasing fees, and ceasing to offer term CDs. Money in the bank would go from what everyone wants to something nobody can afford to hold. People would strive to minimize transactional balances, and invest any savings in money markets or stocks or bonds, anything not subject to the tax. (This is similar in spirit to a suggestion by Arnold Kling.)

Of course there would be tricky consequences: Gresham’s law would kick in, as people would hoard physical cash to avoid the tax. Coins and bills would cease to be used for exchange, but would be held as stores of value. That would introduce some friction into small transactions: we’d end up using debit cards to buy candy bars, accelerating our transition to a cashless economy. But electronic money would be legal tender, and the appreciation of paper money would be no more relevant to the overall price level than the fact that older “wheat pennies” are worth much more than 1¢. With a sufficiently large electronic monetary base, there need be no zero-bound on nominal interest rates, and we can use “conventional” monetary policy to fight deflation by letting nominal rates go negative. I laugh in the maw of your liquidity trap.

FD: Long precious metals, short 30-yr Treasuries (youch!).


47 Responses to “Fedthink”

  1. PEJ writes:

    Long precious metals and 30-year treasuries too (ouch ouch!!) but short USD, which should be able to compensate the losses on the short treasury on the mid term?

  2. I wish I really could short 30 year treasurys, borrowing at 2.56% for 30 years!! That’s almost surely less than what the 30 year inflation rate will be, as those in charge of the Fed are, and in general will be, good, well trained economists (except for the Greenspan choice of the extremist, anti-thinking Republicans), who know that keeping inflation less than 3% over the long run hurts economic growth substantially by slowing real price, wage, and interest rate adjustment. .

    A 2.56% return rate on bonds for a term of 30 years — way, way beyond how long this crisis will last, is evidence of substantial inefficiency in the financial assets market. This is going to go down as one of the worst major low risk investments in modern American history.

  3. By the way, by comparison a TIPS that matures in 2032 currently pays 1.93% plus the inflation rate. So the market for 30 year government bonds thinks the inflation rate over the next 30 years — not 30 weeks, not 30 months, but 30 years — will be about 1/2 of 1%. This grossly misunderstands the power and training of the Fed’s economists.

  4. Steve, you write:

    The Fed has the authority to lend to whomever it pleases under “unusual and exigent” circumstances, but it is not empowered to spend outright what are in the end US taxpayer dollars…In my view, it is not quite legal for the Fed to extend non-recourse loans, and the practice should be curtailed.

    But Martin Wolf writes in the Financial Times:

    Once the interest rate hits zero, the Fed can perform much further easing. Indeed, it can create money without limit…Curing deflation is child’s play in a “fiat money” – a man-made money – system. So what might central banks do? They might lower longer-term interest rates by buying as many long-term government bonds as they wish or by promising to keep short rates low for a lengthy period. They might lend directly to the private sector. Indeed, they might buy any private asset, at any price and in any quantity they choose. They might also buy foreign currency assets. And they might finance the government on any scale they think necessary

    Note the, “Indeed, they might buy any private asset, at any price and in any quantity they choose.”. Please tell us why Wolf is wrong and this is illegal.

  5. Serlin:

    There is an EFT that holds long-term Treasuries. You can short it. I’ll get the ticker symbol for you.


    Repeal the Federal Reserve Act. You may have learned something from the last year. What? Ignore the “wonkish” stuff, 28-day this, 84-day that. When push comes to shove, we have no law and the Fed will do whatever it wants to protect the banks. Peasants, ready your pitchforks!

  6. Despite all this, I am becoming rather Zen about the Federal Reserve lately. I have some sympathy: They are dancing to a tune that they no longer call, struggling to keep pace with an accelerating beat. The Bernanke Fed is clever and inventive, delightful as spectator sport. So many trillions of dollars have been spent or committed or guaranteed, that the amounts have gone meaningless…So really, I should root for the Fed. Let the printing presses turn and the helicopters fly, but please don’t confiscate my gold.

    Ben’s big problem is that until the brain dead Republicans leave town in January he’s being put in a position where he has to do more than he should. Most of the key remedies are not monetary. See my current post for more details.

  7. JKH writes:

    SRW –

    I respectively disagree in part.

    The Fed is forcing excess reserves into the banking system as a way of funding its balance sheet expansion.

    Excess non-interesting bearing reserves are a tax to banks. They don’t require them. In fact they dilute bank interest margins. The payment of interest merely rebates that tax. Yes indeed the reserves aren’t “their money”. And the system as a whole can’t get rid of the opportunity cost of being forced to hold that money at a zero rate of return.

    As an alternative, the Fed could request Treasury drain excess reserves by issuing debt and depositing the funds with the Fed indefinitely. The net consolidated cost to the Treasury/Fed of this arrangement is the cost of treasury debt instead of the cost of paying interest on reserves.

    The payment of interest on reserves roughly preserves the risk spread between the return on risky Fed assets and the cost of public funding. The reserve based spread is now in effect in respect of balance sheet expansion. It is in the same order of risk/return as the spread between the same risky asset returns on the pre-expansion balance sheet and the cost of originally held treasury debt sold into the market, on which interest must now be paid net by Treasury/Fed.

    Taxing reserves sounds like a form of a synthetic negative Fed funds rate. That could be counterproductive if the banking system can’t pass through synthetic negative rates to their deposit liabilities as well.

  8. guest writes:

    bernanke has to go. this is a disgrace. he either outright lied that everything is fine for 2 years ( which i think he did), or he’s incompetent.

    NYT has an article on India’s sound banking system and what a decent central banker needs to do. the case is not singular around the world.

  9. Richard — so long as Fed reserves are legal tender, the Fed “can” declare the Bernanke Family Christmas Shopping Spree to be an essential economic stimulus, and pay of his credit card bill with a check from the Fed. Mechanically, it’s doable. But it’s quite illegal, as the Fed is not authorized to purchase toys for Ben’s nephews. The question of what the Fed may and may not legally do when conjuring US taxpayer obligations is defined by statute, and constrained pretty narrowly. See the Bernanke’s famous deflation speech: “Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly.”

    Generally speaking, the Fed may lend to whomever it wishes under “unusual and exigent circumstances”, which apparently are our circumstances for the indeterminate future. (If that fact fact doesn’t trouble you from a rule-of-law, limited-democracy perspective you’ve not read much history.) But the menu of assets it is authorized to purchase outright with taxpayer obligations is limited. The Fed is explicitly permitted to lend to the depository institutions it regulates, so it may buy their short-term loans. But the Fed is nowhere authorized to purchase asset-backed securities and money-market funds. This needn’t be a serious constraint, provided that the Fed lend to banks, and banks purchase the assets, bearing the credit risk (and thereby retaining an incentive to do due diligence). But when the Fed lends nonrecourse, it is effectively purchasing the downside of assets. Who, then does due diligence? Does the Fed have sufficient expertise in credit analysis to make good investments for taxapayers? Should it rely on dangerously flawed ratings agencies? Should it expect private partners — the people who keep the upside to evaluate the risk? That depends on leverage ratios, as if the nonrecourse lending permits private partners to be highly levered, then optionality of incentives means those partners will seek risk. All of these are reasons why the Fed is just not allowed to do this stuff. It should not be a taxpayer-funded hedge fund that assumes risk and privatizes return. Volcker made that quite clear in March, damned near accusing Bernanke of a serious breach of law and the norms of central banking. (All of a sudden Volcker’s quiet, but then people tend to become that way when they’re attached to a Presidential administration.)

  10. JKH — Please don’t disagree respectfully. I merit about as much respect as a slug on the sidewalk after a rainstorm. Best to bring along a salt-shaker.

    There is no genuine opportunity cost for banks holding non-interest-bearing excess reserved. What opportunity are they foregoing? Precisely the opportunity on earn interest on funds they would not hold if the Fed did not manufacture them from thin air. If I’m wrong please explain why, but I don’t see what opportunity banks would have absent Fed action that they do not have in a world where they are forced to hold reserves without interest. So where is the opportunity cost.

    Forcing banks to hold reserves without interest does harm banks’ accounting profitability ratios, but does not harm their actual economic profitability. Zero-interest reserves show up as an asset on bank balance sheets, reducing reported return-on-assets. In an alternative reality where leverage ratios are seriously enforced, equity must rise with assets, so banks’ reported return-on-capital is harmed by zero-interest reserves.

    But these are artifacts of accounting and regulatory convention, and not actual economic costs. The right way to deal with this is modify GAAP, to exclude excess reserves from ROE and leverage ratio calculations. Giving an $800B subsidy is just not a reasonable or proportionate means of eliminate a economically meaningless drag on bank accounting ratios.

    Do you still disagree? Please explain why. And don’t be all respectful about it! Remember that salt-shaker!

  11. JKH — Eliminating the zero-bound, creating a synthetic negative FF rate, is exactly the motivation for taxing reserves. It’s suggested to be provocative — I’m playing with the idea, but not nearly comfortable enough with it to call it good policy. I’d be eager to hear the ways in which you think it would be counterproductive. I’m trying to think through what would happen if we did something like this. Obviously, banks would fight not to receive deposits, but being regulated depository institutions, we could constrain their ability to refuse. We could permit banks to pass the cost on to depositors in the form of a fee. The deposits would still come, because people cannot hold more cash than the Fed has issued. People would begin to seek other stores of value, “good stores” like investment assets, and “bad stores”, like commodity hoards. Is that the main counterproductivity, that rather than encouraging investment spending or consumption, it might encourage hoarding or a flight to alternative value stores? But don’t those critiques hold for ZIRP and quantitative easing as well? Is it a matter of blatancy, the obviousness with which bank money would seem “debauched” compared to physical currency that would make a tax on holding electric cash counterproductive? I’m just trying to think this through, I don’t have a strong position. Do say what you think would be the bad consequences of a negative FF rate that can’t, in the aggregate, be avoided by holding cash.

  12. JIMB writes:

    Deflation would be far, far better, because inflation specifically rewards those that got us into this mess (they can borrow with high leverage while the savings and real income of workers is trashed). That would massively increase capital destruction and lower real wages far more than deflation. Deflation would stop the continuous theft (you work while I print the money) of capital and labor.

  13. JKH writes:

    SRW –

    Having just returned from two weeks in the sun, and given the alluring but mind-wracking density of your excellent post, your come back compounds an awfully tough brain starter!

    The Fed is in the business of dual money manufacturing – when it creates new reserves, it also creates broader money supply. Intervention occurs first via the liability side of commercial bank balance sheets, resulting in the creation of new deposits plus a monetary base “dual”. Bank deposit liabilities thus increase along with bank assets.

    I think that if you believe no opportunity costs are associated with zero interest excess reserve creation, then you should also believe that there are no variable costs associated with additional deposit banking. This suggests a contradiction to me, because I don’t believe this to be true. I suspect considerable empirical evidence to the contrary exists.

    If the deposits pay interest, bank interest margins will shrink. Whether they do or don’t, bank gross margins will also shrink due to the additional variable costs associated with new deposit maintenance.

    Reserves are in fact excluded from risk weighted assets, so capital adequacy measured on this basis wouldn’t necessarily be affected from this source. But gross balance sheet capital ratios would be.

    But in any event marginal profitability would be affected as described, which adversely affects the cost of bank capital.

    The bottom line is that excess reserves are fundamentally useless as assets to the banking system. But they introduce the additional external costs of carrying a larger deposit base without being able to deploy it. It’s a problem of reverse causation and the inversion of normal deposit loan economics.

    I’m suspicious of your $ 800 billion value methodology, but may need to put some more thought into it. You’re suggesting that the payment of interest on $ 800 billion results in a cost of $ 800 billion because the PV of the interest equals the value of the liability. But on that basis, the value of a liability that paid no interest would be $ 0. I don’t like it, but I’m muddled on this, and need to spend more time on it.

    In general, I’m suspicious of over-extending NPV approaches as applied to future income. E.g. Buiter’s NPV of seigniorage approach to the calculation of central bank true capital, and the US current account deficit “dark matter” theory.

  14. JKH writes:

    SRW –

    I think that the base case for the type of counter-productivity I suggested is a Fed monetary policy that inadvertently squeezes bank interest margins due to asymmetric asset pricing risks around the 0 bound. If the Fed wants to induce negative interest rates on bank assets, it should be prepared for the system consequences of banks not having the facility to do this on the liability side. Otherwise the Fed has introduced a new and fundamental bank asset-liability mismatch risk. This is a particularly lethal risk in an environment where the Fed and Treasury have already committed at least in part to the recapitalization of a broken financial system. Negative interest margins are not a way of allowing banks to contribute to their own recapitalizations via longer term franchise profitability.

    That said, perhaps there are ways to introduce effective negative interest rates on the liability side, as you have indicated via fees etc.

    Frail mind-warp:

    Why not make life direct and simple by introducing negative interest rates directly and more broadly? The Fed makes the funds rate negative and banks make their deposit rates negative. Banks just require that liability rates be more negative than asset rates. They can preserve margins and be sustainable on that basis. The result should prod activation of consumer bank balances and more general risk taking activity at some point. If there’s a legal problem in doing all this, I’m not sure why the law shouldn’t be changed to allow for deflationary environments.

    Negative deposit rates will automatically cause the quantity of money to shrink at the margin as an offset to the increase in its value due to deflation. At the same time, the Fed is currently trying to monetize as much as it can to avoid the shrinkage in the money supply and credit that is already occurring due to deleveraging. Is it desirable that the banking system stop shrinking due to dysfunctional credit seizing, while at the same time being desirable that it continue to shrink in part due to negative interest rates? Is this a contradiction?

  15. Serlin:

    The ticker symbol is EDV. Extended Duration Fund by Vanguard.

  16. Steve,

    Here’s another statement like Wolf’s from the guy you cited at the start of your post, James Hamilton!

    In a general deflation, the purchasing power of a dollar bill goes higher and higher, and as Greg notes, this can produce big economic problems, as it did for the U.S. in the 1930s or Japan in the 1990s. But it is absolutely a problem that the Federal Reserve can fix…If the U.S. were ever to arrive at such a situation, here’s what I’d recommend. First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities. No need to worry about those burdens on future taxpayers now! Then buy up all the commercial paper anybody cares to issue. Bye-bye credit crunch! In fact, you might as well buy up all the equities on the Tokyo Stock Exchange. Fix that nasty trade deficit while we’re at it! Print an arbitrarily large quantity of money with which you’re allowed to buy whatever you like at fixed nominal prices, and the sky’s the limit on what you might set out to do. Of course, the reason I don’t advocate such policies is that they would cause a wee bit of inflation.

    Hamilton I know because he wrote the biggest Ph.D. time series econometrics book. He’s a top econometrician. But a look at his vita shows he’s also done a lot of publishing in the areas of monetary and macro economics, so it’s interesting he’d say the Fed could, “buy up all the equities on the Tokyo Stock Exchange”. Why do you think he said this?

  17. Sorry, the Hamilton quote is from an October 29th Econbrowser post.

  18. Benign Brodwicz writes:

    Truly painfully mind-bending….

    What happens to the monetary base when all the crap the Fed has taken in starts to default? Do they just not tell us about it? And don’t the *banks* (not the Fed) earn rents (“seigniorage”) from fractional reserve banking that more than offset any loss of interest on reserves?

    What kills me is that the Fed seems to think that extension of more credit to an already over-indebted nation is somehow the way out. I know, I know, they’re just recapitalizing the banking system to get interbank lending going again…. I question (with Tim Duy) whether adding a load of Federal debt makes a lot of sense right now, either.

    We’re not going back to the old level of consumption, because it was financed by the home equity ATM out of bubble-values. The quickest way to bolster consumption is still to provide *immediately* a livable dole, food stamps, free access to health care, retraining and job search assistance to those ten million plus Americans who are taking the fall for the financial tricksters who got us into this mess.

  19. Independent Accountant,

    Some problems with shorting a fund of 30 year treasuries are:

    1) You can usually do it for only a short period like a year. That may not be long enough. A year from now treasury yields may be even worse than they are today, resulting in a loss.

    2) Transactions costs are relatively high

    It may still be a good idea for some people skilled enough to do it right for their particular financial situation, but it’s certainly not as good as just being able to borrow at 2.56% for 30 years.

    It is common in asset markets for shorting, especially very long-term shorting to be difficult, expensive, illiquid, or impossible, and it’s an important source of inefficiency and bubbles. For example, you can’t practically short the vast majority of residential homes.

  20. BSG writes:

    Steve – re. the “bring it on” comment, I’m not sure how much is tongue-in-cheek and/or portfolio driven preference, but I think it does highlight the danger in having academics run policy (I happen to have an advanced degree and I’m not into self-loathing, so I don’t think this is bias speaking.)

    It sort of reminds me of the wisdom, born of experience long ago, of having juries, rather than only professional judges in our legal system.

    Setting aside clever schemes to manipulate and fine tune anything and everything, I dare say it’s all but self-evident that counterfeiting is destructive to an economy (notwithstanding all of the massive propaganda and influence peddling over the centuries to the contrary.)

    If I’m right, then there is no way deflation (however destructive temporarily) can be more destructive than inflation. Besides, deflation will no doubt run its course and end its destruction, whereas inflation can be made to continue destroying indefinitely. It has repeatedly done so for extended periods many times and many places. Deflation not so much.

    Still, I’m with you about your apt observations about the larger forces at play and the “entertainment” value of it all (in a freak-show kind of way, unfortunately.) Thanks for yet another thought-provoking and highly informative post!

  21. JKH — I think you’re overstating the costs to the banking system of excess reserves. Empirical work is likely to guide you astray, because it will capture cross-sectional effects rather than aggregate effects. It is certainly true, that for a given level of aggregate reserves, high levels of zero-interest reserves and poor performance are likely to correlate. Good banks (used to) strive to keep excess reserves to a minimum, as in normal times, the opportunity cost to holding excess is foregone lending on the Federal Funds market, and good banks manage to minimize. Well-run banks will be reserve-efficient, and performance may well correlate with low excess reserves. But that says nothing about the costs of a change in the aggregate reserve level. If no interest were paid, banks in general would carry much higher reserve levels than previously, but they would still compete among themselves to be reserve efficient. The cross-sectional correlation would remain the same (at least when there’s a functioning, interest-paying Federal Funds market), but everything would scale up.

    I’d respond with a similar argument to your suggestion of variable costs in dealing with deposits. A change in the magnitude of the numbers that have to be entered into the computer system is not associated with significant variable costs. It is the activity of depositors, the fact that a bank has to deal with its customers, that creates variable costs. That activity is not really a function of the aggregate level of reserves. One could argue that bank activity (and this kind of variable cost) has been falling precisely when aggregate reserve levels have been ballooning. Again, in ordinary times, when aggregate reserves are stable, you might find a correlation between the magnitude of deposits and variable costs, as variable costs and customer activity go together. But when the Fed changes the baseline, the magnitude of deposits is quite certain to rise, but it’s not at all clear that variable costs would rise commensurably.

    Finally, even if we stipulate, wrongly I think, that a change in the overall level of reserves significantly increases banks’ variable costs, there is no connection between those variable costs and the short-term interest rate. If we believe this is real, and the banks, the poor dears, oughtn’t face an unfunded mandate, then any subsidy to the banks should be a fixed function of the quantity of reserves, not a variable market interest rate. I think that by any reasonable estimate, a subsidy to cover the increased variable costs associated with a change in the level of aggregate reserves would never exceed a few basis points.

    Banks very misleadingly claim that they are “taxed” when interest is not paid on reserves because they have to finance their balance sheet at short-term rates, and therefore deserve compensation at short-term rates for deposits. But this is not really true. Suppose the regulated banking system could only lend deposits to the Fed for zero interest. Then no regulated banks would offer interest bearing deposits. In fact, banks do pay interest on some deposits, and one cannot distinguish between deposits that get lent profitably and those that get deposited at the Fed. But the market-clearing interest rate is set by non-Fed demand for lending, as well as the option value of holding uncommitted reserves. In the aggregate, banks bear a cost of funding that is arithmetically spread across their entire balance sheet. But Fed-created excess reserves don’t themselves contribute to banks cost of funding. If anything, they reduce the option value of holding uncommitted funds, and thereby reduce banks’ overall cost of funding.

  22. JKH2 — I’m with you on the “why not just outright have a neg FF rate?” That’s really the thought experiment here — calling it a tax is just because people are so unaccustomed to the idea of a negative interest rate. Again, I don’t have a strong view about this, but I think we should acknowledge that electronic money gives even more degrees of policy freedom, for better or for worse, than paper money, and if our problem really is a “liquidity trap” (I’m not at all persuaded of that, but arguendo), why shouldn’t we begin to use those degrees of freedom, since we are well on our way to replacing paper money with electronic reserves. (Interestingly, that sounds like a years-long project, but I am really talking about since September.)

  23. Richard — Really, I don’t think we’re disagreeing. I would have no problem loosely talking about what the central bank can or might buy, and think frequently about different strategies a central bank might use in selecting a menu of assets to purchase to meet this objective or that. There’s this kind of thought experiment, which I believe encompasses Wolf’s and Hamilton’s remarks, and a separate question of how such policies might be implemented, given the legal constraints on central bank action, or whether implementing such policies would in letter or spirit violate those constraints. My claim in that non-recourse loans, while well within the menu of plausible CB strategies in thought-experiment mode, violate the spirit if not the letter of the law governing the US central bank’s behavior. That’s an arguable claim, and the Fed has been very careful to structure its deals in such away that they are always colorably “loans”, even when the Fed has taken a controlling ownership stake (in the first Maiden Lane LLC). We’re in the realm of legal shades of gray. In thought experiment mode about what a CB might do, we usually ignore these constraints. But when somebody is unhappy about how a central bank is behaving (Steve sheepishly raises his hand), they might claim that putting certain strategies into practice would run afoul of legal constraints, and they might have a point. We can’t really know unless some legal process resolves what are inherently thorny and ambiguous questions.

    With respect to shorting, I’m very much with you on the costs and hazards of the strategy, especially longish-term. FWIW, my short exposure is via the 30-year futures contract, which avoids some of the financing costs and the risk associated with borrowing securties, but which has hazards of its own. Again, taking anything I write as investment advice is a bad idea. I’ve just been pretty badly burned, although I do think that eventually my (early, as usual) short position will pay off.

  24. IA — I wish that you were wrong. I am more and more persuaded that the “extremist” view of the Fed as institutionally so connected to entrenched financial institutions that it is unable to serve the public interest. It’s an open question whether that is true to the same degree of the Congress and the incoming Treasury. I do want to avoid pitchforks, though. The great thing about financial capitalism, when it works, is that you punish people by taking their money rather than with physical force. I hope we maintain that feature, although if we keep preventing the money of miscreants from being taken, people may get restless.

  25. JIMB — I think the inflation/deflation question is more complicated than you say. Deflation favors creditors and inflation favors debtors. You seem to take the view that “savers” deserve their money, and devaluations are theft. But “savers” are really lenders, and they were mostly dumb lenders who paid no attention to how their resources were being invested, instead entrusting those resources to fools and swindlers. It takes bad borrowers and bad lenders both to make a credit bubble. And I see no moral reason to favor one group over the other (although honestly, I view the creditors — the savers — as more culpable than the borrowers). Instead I think we should worry less about whose claims get favored, and instead try to figure out how best to maximize the continuing value of our assets. There are trade-offs. With inflation, we fail to terminate some value-destroying investments, while with deflation we accidentally terminate value-creating investments. There is a judgment call. I’m usually wrong, but after we endure some deflation and bankruptcies of the most egregious, I’d rather we shift into inflation before we liquidate too much. That might be dead wrong — A great case can be made that “humpty dumpty” is not really so valuable, and that a general liquidation will be quickly followed by a productive recombination. But I’m still leaning the other way.

  26. Benign — I agree entirely. We oughtn’t be encouraging lending, adding to the existing tangle of claims. We are trying to undo an unsustainable skein, and an unsustainable distribution of income. I’d much rather see the government/Fed complex spend and/or transfer than lend, wither directly or via banks. Steve Roth and reason in the comments to the previous post are very close to my view: we should offer a “national dividend”, or a negative income tax, or non-means-tested foodstamps, for humanitarian reasons, to create labor bargaining power without all the awfulness of unions, to maintain broad-based aggregate demand, to push against wealth concentration. Plus, during times like these, such policies are nicely antideflationary.

    I know people like JIMB are gonna hate this, and I really have a lot of sympathy for their view. But it’s much too simple to say that people make their own wealth, and therefore redistribution is immoral. Very few people create great wealth by their own solitary exertions: the distribution of collaborative production is the outcome of a bargaining process in which it is not true that each receives her “own product”, marginal or otherwise. The idea is incoherent, outside of very stylized situations. If the outcomes of the borrowing process undermines the preconditions for collaborative production (and by that I mean voluntary collaborative production, not coercion masquerading as choice), there is nothing a priori immoral about altering the terms of the negotiation. We want to be careful, because state interference in people’s affairs is a per se harm. But sometimes that’s better than the alternative.

  27. BSG — I agree with a lot of what you say, but obviously not with all.

    You’re right that inflation has no certain end, where deflation has a floor. But I think that doesn’t help us very much in practical terms — it’s like pointing out that long positions have unlimited upside while short positions have a ceiling. Both infinity and the ceiling may be far enough away that they don’t much influence your decision. There have been prolonged, habitual inflations, but also brief sharp inflationary adjustments. There have been long, painful deflationary adjustments, and sharp, quickly liquidated panics.

    I think your point about counterfeiting cuts in the direction opposite than you intend. In my view, very much of the wealth that has been accumulated during this decade has been a result of counterfeiting — of manufacturing near-fraudulent financial claims and then selling them for the safety of money. Deflation now would ratify that past counterfeiting, privileging the wealth of cashed-out intermediaries while destroying the weak borrowers against whom claims were manufactured and gullible investors to whom claims were sold. I’d rather dilute the fruits of past counterfeiting rather than call it a day now that the counterfeiters have all the real money. Fighting counterfeiting with counterfeiting is obviously suspect, we have an unjust and unsustainable distribution of claims, and as disagreeable as it may be, I think inflation underwritten by very broad-based wealth transfers — helicopter money, but not to banks — is probably our least destructive path to undoing it.

    Ideally, we’d be selective, deflating the wealth of miscreants to minimize the degree of inflation the rest of us have to endure. But our collective inability to force those in the financial sector to internalize any reasonable fraction of the harms they have wrought suggests to me that the only plausible resolution is a general inflation.

    Obviously, the “bring it on” tone was tongue-in-cheek. And my disgruntlement with the Fed is pretty inconsistent with this view. I don’t like advocating inflation. But I don’t like the idea of a liquidation in which the people with the wherewithal to pick up the pieces are disproportionately the same people who blew it all apart, or even those who “prudently” kept their money in the banks that the rest of us were forced to bail out.

  28. Spec writes:

    Beautiful post.

    This weekend I found myself struggling to explain the disaster we face, and refute the conventional financial industry wisdom on how all these actions are for the best. Your post should convince anyone that pays attention.

  29. kp writes:

    Hey, if the banks are getting a “windfall”, shouldn’t we be buying bank stocks? we will be the bank owners then….

  30. JKH writes:

    SRW –

    I’m unconvinced by your argument. I think you’re overlooking the fundamental importance of the fact that excess reserve creation must also generate new commercial bank deposit money creation. It is this consequence that has to do with the costs to which I refer – not the creation of excess reserves per se or the distribution or disposition of those excess reserves among individual banks.

    Let me try again.

    In a fiat money system, all aggregate deposit monies are created at first by the extension of credit. And in this sense there is no fundamental distinction between the fiat money creation capabilities of the private and public sectors. The commercial banking system expands deposits in aggregate by creating credit in aggregate. The credit intervention of central banks in order to facilitate monetary base expansion extends this to central bank fiat money creation. As both sources generate new credit on a growth path that exceeds that of old repaid credit, deposits as a whole must expand. The banking system balance sheet expands. Commercial banks individually compete for share of this system balance sheet.

    The key questions I think are:

    a) What are the variable costs associated with commercial bank deposit gathering and maintenance activity as the level of system deposits increases?

    b) Is there a difference in these variable costs according to the ultimate source of system deposit increases?

    My answers to these questions are based on a sort of “reductio ad absurdum” argument:

    Looking at the second question first, I see no reason for such a distinction. Money is homogenous. Whether it is created initially by private or public sector credit extension, the result filters out through the system and finds its way into individual bank deposits according to the same general process of transactional commerce and investment and bank competition for deposit share.

    So assume there is no distinction. Then assume variable costs are zero for deposit gathering of funds resulting from central bank intervention. Because there is no distinction in this sense from privately created money, variable costs for additional deposit gathering must be zero for all deposits. But if variable costs for all incremental deposit gathering are zero, then cumulative variable costs for banking system deposit gathering and maintenance must also be zero. They are zero whether the banking system has evolved to a size of $ 1 billion or $ 10 trillion. This is patently absurd. So the result contradicts the premise. There must be non-zero variable costs associated with deposit gathering resulting from the injection of new money by central bank intervention in order to create excess reserves.

    Thus, money that is added to the banking system via fiat creation finds its way through the banking system according to deposit gathering capabilities of banks collectively and individually without being distinguished by the private or public identity of the fiat creation source. There is no zero cost incremental deposit gathering function that identifies central bank originated money as such and then attaches zero variable costs only to that money. Cross-sectional competition for central bank originated money should be just as fierce as it is for commercial bank originated money. Variable costs must be greater than zero for all deposit gathering, regardless of the original source of fiat money creation.

  31. Steve,

    Basically, I think the same thing. Hamilton understood that the Fed could not legally buy huge chunks of the Japanese stock exchange without legislative approval, but he just literally wrote that because he put style ahead if non-misleadingness. He did not want to clunk up the “smoothness”, “compactness”, or cuteness of the writing by putting in, say, a parenthetical statement like (This would require congressional approval. The Fed generally can only make loans without such approval…).

    Putting style, smoothness, “brevity”, tightness, unnatural separation and compartmentalization, etc. ahead of clarity, accuracy, and non-misleadingness, is a huge source of ignorance, and misunderstanding. See my very first blog post for more on this.

  32. JIMB writes:

    Steve – I suppose if you bought stock in my corporation to find that I can print certificates at will for my gain at your expense that would not qualify as theft? Hard to know what to discuss if that isn’t bad. But I’ll give it a go. Deflation doesn’t favor creditors that are heavily indebted themselves (banks) and it doesn’t favor many of the rich, who get a great deal of their earnings from the debt expansion. It DOES favor those people that are careful with their money … hence the screams by institutions for “bailout” who are monumentally careless (as they know they have the “taxpayer” as a bailout in case the fraud threatens “systemic” collapse). That is the intent of the Federal Reserve (a cartel) – to pass the losses to the public. The entire nonsense should be sunsetted. Creating money from thin air is theft, categorically — just as printing fake ball game tickets is (neither represents real goods). Savers are not the lenders (in the majority of cases), the “lenders”, by operation of monetary expansion, dilute the money (and yields) of savers. Because the lender produces nothing of value to earn the new money they create (adding a few digits to a bank account and drawing up some docs isn’t productive at all, like the effort to say, build a house) there is never a genuine “swap” of value for value. That occurs only in the case where money is not created where a saver actually has refrained from consumption, so the money represents something real. The collateral of debt-creators is always inflated in value past the market level. Finally, I see no moral reason to allow the government to trash our money, earnings, liberty, livelihood, and future to “save the system”. If they do that, we’ve got no system, just a crazy free for all which will end in violence.

  33. Blissex writes:

    «Finally, I see no moral reason to allow the government to trash our money, earnings, liberty, livelihood, and future to “save the system”. If they do that, we’ve got no system, just a crazy free for all which will end in violence.»

    It is not a free-for-all. it is a free-for-RNC-sponsors. The top 1%, the WINNERS who are Real Americans.

    Anyhow as to long post, it still relies on the assumption that someone somewhere is looking out for the mythical “common interest”.

    As to what is really going one, we just need to read a very public manifesto for the salvation of the elites by Alan Greenspan:

    Greenspan’s essay

    «Though capital gains cannot finance physical investment, they can replenish balance-sheets. »

    «Obviously, higher global stock prices will enlarge the pool of equity that can facilitate the recapitalisation of financial institutions. Lower stock prices can impede the process. A higher level of equity, of course, makes it easier to issue debt. Another critical price for the return of global financial stability is that of American homes. Those prices are likely to stabilise next year and with them the levels of home equity—the ultimate collateral for global holdings of American mortgage-backed securities, some toxic.»

    «The eventual partial recovery of global equities, as fear inevitably dissipates, should do the rest. Temporary public capital injections into banks would facilitate this process and arguably provide far more benefit per dollar than conventional fiscal stimulus.»

    What Greenspan is advocating here is massive inflation (paper capital gains) and massive subsidies to keep as many financial executives as possible in their jobs in the commanding positions of the political and economic system.

    There is not even the remote notion that perhaps the financial system and its beneficiaries have become too big and too parasitical.

    When the free agents in the free market for financial services lose a lot of money through incompetence or crookedness, the recommended solution is just to give them a new round of chips, through massive inflation or subsidies. Aren’t they after all the best and brightest?

    The conclusion of the article is however the funniest part:

    «Even before the market linkages among banks, other financial institutions and non-financial businesses are fully re-established, we will need to start unwinding the massive sovereign credit and guarantees put in place during the crisis, now estimated at $7 trillion. The economics of such a course are fairly clear. The politics of draining off that much credit support in a timely way is quite another matter.»


  34. BSG writes:

    Steve – your point about possibly ratifying past malfeasance via deflation is an excellent one.

    Thinking about it some more it occurs to me that at least in the first phase of the crisis, the ones most at risk from deflation and the accompanying bankruptcies were in the financial sector, disproportionally hitting those who manufactured bogus claims that they had not yet had a chance to convert to cash.

    Instead of allowing that beneficial (IMHO) adjustment, the Fed essentially gave the crooks a lot of real money, thereby setting us up for great dilution of productive capital.

    Now that the financial sector has trillions in Fed money and guarantees and is all but shielded from deflation, we are indeed in a quandary.

    If, as is highly likely, the Fed succeeds in generating inflation, it seems to me that given the distribution path of newly created fiat money, it will again be the financial sector that benefits most. At least historically they generally have. I don’t think it’s a coincidence that those that created fractional reserve lending/fiat money are the ones that benefit most from it.

    While sharp deflation is indeed quite destructive, I think it is more amenable to legislative and judicial intervention to ensure as just and beneficial an outcome as is possible in bad circumstances. With inflation, that seems highly unlikely to me, especially given the money distribution mechanisms we presently have. I am unaware of inflation ever having produced an overall socially beneficial outcome. Perhaps you or anyone else can enlighten me. Intuitively it seems silly that it should, given that it is in essence a fraudulent activity (I don’t mean to be merely provocative in using the term “fraud”. If it is reasonably accurate, it should help us think through the consequences.)

    Now, it is entirely possible that even though it is trivial for the Fed to create inflation, given its high preference to work through loans and financial intermediaries it may fail, or succeed only sporadically. It also seems to me more likely that if they get traction, the adjustment may be sudden and much larger than advocates anticipate, causing a variety of negative side effects about which everyone involved will declare, once again: “Hoocoodanode?”

  35. BSG writes:

    Steve – I should add that I realize you mentioned it shouldn’t be banks that receive the newly minted (inflationary) money. I just think that if we can muster the public will for the necessary changes (a very low probability to be sure, at least in the near and intermediate future) it would be far better to actively disentangle the morass created by the financial industry than to indiscriminately dilute productive capital along with what you so aptly describe as the recently created fraudulent claims. Besides there appear to still be a massive amount of such claims outstanding that have not been realized yet and that the Fed is on track to monetize, so careful what you wish for.

  36. UrbanDigs writes:

    To short 30 YR treasuries you can either short TLT or go long TBT, the inverse.

    PST is the short 7-10YR treasury index

  37. groucho writes:

    “FD: Long precious metals, short 30-yr Treasuries (youch!).”

    Steve, your book seems to be creating quite a FED(balance sheet) obsession!

    The FED is not a leader, though. It “follows” the market, the US Treasury and Foreign trade participants(CBs, geopolitical developments)

    With Volker working for Obama, Bernanke’s “illegal activity” days are surley numbered. Non-recourse will soon be replaced with cosigning by CB and treasury policymakers.

    They will have to personally cover losses to the taxpayer(hey we can dream can’t we)

    As a follower does the FED have the ABILITY to keep the canoe from tipping over? I think ONLY if foreign govts decide to “make it so”.

    Since the US(and Anglo) consumer is maxed out the mercantilist game has to change. What will the changes be and how will the FED follow these new developments?

    There’s talk of an infrastructure Marshall plan financed by Japan’s dollar reserves as a means of helping the lack of US savings and trying to ameliorate the likely dollar crisis that your bet points to as a likely outcome.

    China, the ME, Russia are playing their game for long term geo-political advantage and will play their cards as zero sum.

    China in particular will play “beggar thy neighbor” for all it’s worth, putting tremendous deflationary pressure on

    the US, which as a 70% consuming nation is a huge net positive. “Bad deflation” is only an economic problem for producers(and financiers) who can’t produce a profit.

    The current US debt deflation will yield a huge increase in standard of living through default on unsustainable debts and liquidation of useless consumables, freeing the workforce to move into new exciting endeavors.

    Don Patinkin was a proponent of deflation , believing that deflation should be allowed to run it’s course to create REAL WEALTH.

  38. zanon writes:


    Great discussion, as always. On the “inflation vs deflation” question, you say:

    “But “savers” are really lenders, and they were mostly dumb lenders who paid no attention to how their resources were being invested, instead entrusting those resources to fools and swindlers”

    This is not true. Savings are not needed for investment. Essentially, under FDIC, deposits in a bank sit there like gold in a vault. They are not lent out in any way. The bank borrows directly from the Fed at the Fed funds rate, at quantities determined by the bank, and at prices determined by the Fed + credit risk. The requirement of bank reserves is this weird anachronism which sits halfway between a gold standard model and a fiat model and makes zero sense in either. Why should a bank’s ability to attract deposits limit it’s ability to make good credit assessments and extend loans?

    Inflation hurts those who keep cash, those with “gold in the vault”. This credit mess was *not* their fault, savers are *not* dumb lenders. Savings does not drive investment.

    Unfortunately, it is also true that there is no good mechanism for savings on the planet. If you wish to defer consumption, your are SOL. The stock market cannot be considered savings in any way, cash in the bank gets inflated, and even TIPS (assuming you believe that the CPI has any value, I do not) does not protect you from the dilution of your old money by new money created through credit expansion.

  39. JIMB, BSG, groucho & zanon — My second to next headline post will be on savings and investment, inflation and deflation. This is stuff about which many of the people with whom I often agree often disagree. Oh well. But I’ll try to address some of your points, and put my view plainly, so that yawlz can disagree plainly…

    For today, something else is schemed.

  40. JIMB:

    I agree with you. The Fed is a fraud. It exists to redistribute wealth. Any notion the Fed exists to “regulate the economy” is nonsense. Marx favored the existence of a central bank, Plank Five of the Communist Manifesto. Why? To permit taxation to take place through inflation. By SW’s standards, I am a “super extremist” with regard to the Fed. Kill the monster! Dust off Andrew Jackson’s old speeches! Load your flintlocks and sharpen your swords!


    The peasants are getting very angry. They see Citigroup get $306 billion in the latest bailout and Washington balks at giving the UAW-Big Three more than $13 billion. It’s unalloyed class warfare. For the first time in I don’t know how long, I find myself siding with a union! If Uncle Sam can give AIG, how much, $150 billion, in a manner which I conclude is criminal under 18 USC 1341, 1343 and 152, why not bail out the Big Three? I’d rather see the autoworkers bailed out than some useless Wall Street trader get his $25 million bonus! What do these traders do anyway? How do they make money? The system is rigged. It’s a massive bankruptcy fraud. I’ll explain. The Wall Street houses pay out as much in compensation as they can. When they get in trouble, go to your friendly Fed, home of Zimbabwe Ben for a bailout. Get bailout, repeat process. This kind of criminal operation, where Joe Schmoe can’t earn a 2.5% per year real return on his money can only continue because of the Fed. As more and more Joe Schmoes figure out the system is rigged against them, the results will be unpleasant to say the least. I’ll say it again, “our current conditions look like those of 1780s France”. We know how that turned out.

    KILL THE FED. NOW! We don’t need assignats and mandats pouring out all over America. Historical note: assignats were supposedly backed up by church lands. Shades of CDOs. Oh yes, Merry Christmas.

  41. Sr Max Higgins writes:

    Bank of America and Mr. Higgins missing $millions, it can happen to you my, fellows Americans

    More info at: http://maxhiggins.com/blog/

  42. Anthony writes:

    “The deposits would still come, because people cannot hold more cash than the Fed has issued.”

    So what happens when people go to their bank and demand a cash withdrawal, but the bank doesn’t have the cash?

    No, if you’re going to do this, you’d have to make it illegal to hold cash. Interestingly, that’s exactly what Roosevelt did with gold in 1933.

    As for the moral argument between inflation and deflation, I think the US government has committed to a continuous low level of inflation, and that the only moral thing to do is to follow through with that commitment. Of course this raises the question as to how to measure the level of inflation or deflation, but any good faith attempt at this is better than simply giving up and allowing deflation or hyperinflation.

    In the mean time, let’s encourage the free market to come up with alternative currencies with their own inflation/deflation commitments and their own definition of the appropriate basket of goods. Imagine a mortgage priced not in dollars but in terms of a currency directly related to the average rent. Dollar inflation would cause mortgage payments in dollars to go up, dollar deflation would cause mortgage payments in dollars to go down. It’s probably doable today, but it’d be a lot easier if the government would explicitly endorse such contracts.

  43. gigi writes:


    Pardon me but you are off your rocker. I enjoy your posts and have much respect for you but this post and comments lack your usual brilliance.

    Lets consider one of your stupid savers who deferred consumption for whatever reason. Since (s)he now knows that savings will be inflated/taxed away whenever the government/bankers/economic elites (like our esteemed SRW) there are some lessons learned by the saver.

    Lets first look at what the presence of savings imply:

    – Deferred consumption is a sign of an ability to plan.

    – Deferred consumption is also a sign of overproduction, i.e. the saver has the ability (or luck) to produce more than consume.

    Given the above, the saver has a partially working brain. Realizing that savings is a losing game, this person will thus bring their production in line with their consumption. Either consumption will go up or production will go down. I suspect that it is production that will go down significantly along with a slight increase in consumption. Why produce for someone else to steal?

    Another interesting aspect is that our hypothetical saver is not an unchanging entity. It is not a plant unable to move, creating food for herbivores to eat. Neither is the saver a cow who feeds only to be eaten by predators. The saver might logically conclude that production is not a useful excercise whereas theft is quite beneficial. The saver might very well decide to change his colors and decide to live off the productivity of others.

    Oh, and if you think your gold will be safe in an inflationary environment, think again :-) The crooks who devalue money will also confiscate/tax gold. And will probaly tax corporate profits away as well while they are at it. And when the peasants scream, why not bring in full fledged socialism? Should be fun.

  44. gigi writes:

    JIMB, very well said. This is how socities unravel.

    Independent Accountant, the French revolution is a very apt comparison.

  45. Anthony writes:

    “Lets consider one of your stupid savers who deferred consumption for whatever reason.”

    To be a “saver”, defined as those negatively affected by inflation, requires more than deferring consumption. It requires deferring consumption *and* deferring investment. Someone who earns more than he spends and invests the surplus is not negatively affected by inflation (ignoring the capital gains tax, which is a whole ‘nother story).

    “Deferred consumption is a sign of an ability to plan.”

    Not any more than consuming is a sign of an ability to plan. The plan is just different. There’s nothing wrong with a 30 year old who plans to work for the next 35 years of his life, assuming he has disability insurance to protect against losing the ability to work. Are you really suggesting that a 30 year old who borrows money to buy a house is immoral? You do realize that he would be severely hurt by a massive deflation which brings down his wages, right?

    Ultimately, it’s as I said, the morally responsible action for government to take is to maintain a low but positive level of inflation (2-3% or so) just like they implicitly promised to do. This way both the “saver” and the “borrower” get exactly what they should have expected when they agreed to the loan in the first place. Sure, inflation will eat away at the savings of the saver, but that’s one of the reasons loans have interest rates.

  46. another gigi writes:

    A negative interest rate could wreck havok among various derivatives which assume that it can only go down to zero. It could lead to all kinds of unforseen blow-ups.

  47. Steve,

    Just got round to reading this as I catch up. Since you do not mind disrespectful disagreement, I shall say that I think that this post was misleading rubbish! I know JKH from various blogs, and his disagreement should raise a warning flag.

    The base money that the Fed uses to pay for the loans and securities it buys is just an asset with certain properties that give it value (primarily, in a fiat money system, that it is accepted by the government as tax payment and has its exchange value enforced by legal tender laws, and now, that it can be held as reserves that pay interest). Base money is not given to the banks as a grant; it is paid by the central bank in return for some debt (ie a reverse repo loan, securitised by some other asset owned by the commercial bank) purchased in an open, competitive market. It may be the case that, in the absence of other buyers, the central bank is paying more than that debt is worth, especially with the non-recourse feature, which I agree seems excessively generous, but it is not the interest paid on base money per se that makes it a good deal for the banks. The central bank could have equally overpaid for that loan with non-interest-bearing base money, but since the commercial banks would not willingly hold such an asset, the central bank would have to sell other assets to mop up that money if it wanted to avoid inflation. It is overpaying for otherwise unsaleable assets that helps the banks, not paying interest on base money. Actually, this is really fiscal policy in my opinion. It is TARP-lite (because the troubled assets are mobilised as repo collateral rather than being purchased outright).

    The less interest the central bank pays on base money, the harder the banks will work to do without it. If the central bank tried to charge for positive reserve balances, the banking system would probably set up their own settlement bank and only deal with the central bank to obtain the amount of banknotes drawn by their customers. If the central bank tried to resist this withdrawal, the banking system would probably revert to gold-based free-banking.

    In normal times, in its open market operations, the central bank is trying to control the interest rate on some reference asset (eg overnight treasury repo), and its control of interest rates may well be better if its own asset is a closer substitute by being interest-bearing too. For that reason, some central banks like the Bank of England have been paying interest on reserves for several years.