Yet more on the floor with Paul Krugman

So, if you have been following this debate, you are a dork. To recap the dorkiness: I suggested that, from now on, the distinction between base money and short-term government debt will cease to matter in the US, because I think the Fed will operate under a “floor” system, under which the Fed no longer sets interest rates by altering the quantity of base money, but instead floods the world with base money while paying interest on reserves at the target rate. Paul Krugman objected, but I think he was misunderstanding me, so I tried to clarify. He’s responded again. Now I think that the points of miscommunication are very clear and remediable.


What Waldman is now saying is that in the future the Fed will manage monetary policy by varying the interest rate it pays on reserves rather than the size of the conventionally measured monetary base. That’s possible, although I don’t quite see why. But in his original post he argued that under such a regime “Cash and (short-term) government debt will continue to be near-perfect substitutes”.

Well, no — not if by “cash” you mean, or at least include, currency — which is the great bulk of the monetary base in normal times.

So, here’s one confusion. I agree with Krugman that zero-interest currency is inherently very different from interest-bearing paper, including both T-bills or interest-paying bank reserves. However, under a regime where cash can be redeemed at will for interest-bearing paper, that inherent difference disappears, and they trade as near-perfect substitutes.

Let’s try a more edible example. Plastic apples are inherently very different from organic apples. Only one of the two is yummy. But suppose there was an omnipotent orchard that, upon invocation of the phrase “apple-cadapplea”, converted plastic apples to fleshy ones and fleshy apples to plastic apples. Then choke-hazard-y, untasty, but easy-to-carry(!) plastic apples would suddenly trade as perfect substitutes for real apples. The two would still be inherently different. During periods when people travel a lot, they’ll drive up the quantity of plastic fruit as a fraction of the total, um, “apple base”. At everybody’s favorite snack time, the apple base will be nearly all flesh. But as an economic matter, at all times, they will trade as perfect substitutes. Because with a mere invocation of “apple-cadapplea” they are perfect substitutes, despite the fact that one is inherently tasty and the other a choke hazard.

Emitting plastic apples would then be equivalent to emitting real ones, and vice versa. Similarly, when cash is instantaneously interconvertible to interest-bearing debt at par, emitting cash is equivalent to emitting debt.

More Krugman, considering a “platinum coin” example:

what happens if and when the economy recovers, and market interest rates rise off the floor?

There are several possibilities:

  1. The Treasury redeems the coin, which it does by borrowing a trillion dollars.
  2. The coin stays at the Fed, but the Fed sterilizes any impact on the economy, either by (a) selling off assets or (b) raising the interest rate it pays on bank reserves
  3. The Fed simply expands the monetary base to match the value of the coin, an expansion that mainly ends up in the form of currency, without taking offsetting measures to sterilize the effect.

What Waldman is saying is that he believes that the actual outcome would be 2(b). And I think he’s implying that there’s really no difference between 2(b) and 3.

So, Waldman definitely is saying that he believes the actual outcome would be 2(b), and he agrees with Krugman’s analysis of what that implies. That expanding the base affects the Federal budget is part of how money and government debt are equivalent under a floor system.

But Waldman definitely does not at all believe that 2(b) and (3) are equivalent when the interest rate is positive. He’s not sure where he implied that, but he must have done, and is grateful for the opportunity to disimply it. An expansion of the currency unopposed either by offsetting asset sales or paying interest on reserves would have the simple effect of preventing the Fed from maintaining its target rate. That would mean the Fed could not use interest rate policy to manage inflation or NGDP.

But that is precisely why Krugman is a bit unhelpful when he concludes, “Short-term debt and currency are still not at all the same thing, and this is what matters.” It does not matter, once the Fed’s reaction function is taken into account. The Fed will do what it needs to do to retain control of its core macroeconomic lever. Its ability to pay interest on reserves means it has the power to offset a hypothetical issue of currency by the Treasury, regardless of its size. Krugman is right to argue that, above the zero bound, an “unsterilized” currency issue would be different from debt, that it would put downward pressure on interest rates and upward pressure on inflation. But that is precisely why it is inconceivable that the Fed would ever allow such a currency issue to go unsterilized! In a world where it is certain that the Fed will either pay IOR or sell assets in response, we can consider issuance of currency by the Treasury fully equivalent to issuing debt.

Update: I should clarify, in Krugman’s 3(b) 2(b) above, a central bank operating under a floor system needn’t actually raise the interest rate it pays on reserves to “sterilize” the new currency issue. It need only continue to pay its target rate on reserves, including the reserves generated from deposit of the new currency at the Fed. The total quantity of interest the Fed pays must rise (unless, unlikely, the private sector wants to hold all the new currency). But that is because of an expansion of the principle on which interest will be paid, rather than an increase in the rate itself.

Update History:

  • 16-Jan-2012, 5:00 a.m. PST: Added bold update clarifying that interest-paid must increase, but not the interest rate, to sterilize a new currency issue. Changed an “it’s” to “its” and “Krugman’s” to “Krugman” because, grammar.
  • 16-Jan-2012, 8:55 a.m. PST: Modified bold update to properly refer to “2(b)” rather than 3(b). Many thanks to commenter wh10!

37 Responses to “Yet more on the floor with Paul Krugman”

  1. Ramanan writes:

    I am a bit uncertain about what these discussions are.

    I am not sure why you think the floor system is permanent. The Federal Reserve has communicated that it will ultimately exit.

    “The authority to pay interest on reserves is likely to be an important component of the future operating framework for monetary policy. For example, one approach is for the Federal Reserve to bracket its target for the federal funds rate with the discount rate above and the interest rate on excess reserves below. Under this so-called corridor system, the ability of banks to borrow at the discount rate would tend to limit upward spikes in the federal funds rate, and the ability of banks to earn interest at the excess reserves rate would tend to contain downward movements. Other approaches are also possible. Given the very high level of reserve balances currently in the banking system, the Federal Reserve has ample time to consider the best long-run framework for policy implementation. The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system”

  2. Ramanan,

    Unless I’m missing something here, the Fed has not communicated anything of the kind. The paragraph you quote simply says that the Fed believes it can eliminate minimum reserve requirements for banks. That’s not the same as saying that it will drain reserves. Since 2009 the UK has had no minimum reserve requirement (it had a flexible one prior to that), but the banking system is awash with excess reserves on which the BoE pays interest.

  3. K writes:


    “it is inconceivable that the Fed would ever allow such a currency issue to go unsterilized”

    They *can’t* sterilize any quantity of coins! The limit occurs, as I discussed in your previous post, somewhere around the sum of currency and required reserves. At the end of 2007 (last time we weren’t at the ZLB), total currency was around $760Bn, required reserves at $41Bn, and excess reserves around $1.8Bn. Total $800Bn. So with rates above zero, the equilibrium size of the Fed’s balance sheet is not big enough for them to have enough assets to sterilize a $1Tn coin.

    *If* Treasury mints a $1Tn coin and the Fed buys it, that’s $200Bn more reserves than the system desires at an equilibrium nominal rate of about 4%. Since the public wont hold the extra base, it will get deposited at the banks. But the banks don’t hold anything like that quantity of excess reserves *unless* IOR=Fed Funds. You can’t keep an excess of $200Bn of reserves in the banking system while maintaining Fed Funds above IOR. The banks will dump their excess reserves in the Fed Funds market thus depressing the Fed Funds rate to IOR.

    So if you want to raise the Fed funds rate above zero to stop inflation, you also must raise IOR. And if you raise IOR the Fed loses money at a rate equal to IOR on the portion of coin financed by reserves rather than currency. This will drive the Fed into “insolvency” (for what it’s worth – see comments in previous post). So the Fed must choose between low rates causing inflation and insolvency, also (maybe?) causing inflation.

  4. Fed Up writes:

    “In a world where it is certain that the Fed will either pay IOR or sell assets in response, we can consider issuance of currency by the Treasury fully equivalent to issuing debt.”

    What about raising the (central bank) reserve requirement?

  5. Detroit Dan writes:

    K– I haven’t seen any arguments that Fed “insolvency” will mean a damn thing, much less inflation. Real world effects would be zero…

  6. […] Krugman and Steve Randy Waldman both have a gift for writing. But when they write about base money their prose becomes fuzzy and […]

  7. Peter K. writes:

    I’m a dork who doesn’t even have a clear grasp on the terms of debate.

    Steve Williamson and Sumner have posts up about the “floor system.” I distrust the MMers and the MMTers. Basically I’m skeptical of any school which has a “M” in their acronym.

  8. Lord writes:

    I think the argument is, or should be, simpler than this, it is that the Fed will prevent interest rates from ever climbing above zero. At any glimmer of the possibility it will turn BoJ and prevent any strengthening that would lead to higher interest rates. (Also, the Fed has the third lever, the reserve ratio, which it can raise eliminating the need raise reserve rates.)

  9. What a lot of fuss about nothing! Americans might save themselves much confusion if they paid more attention to practices in other countries. Well before the financial crisis and QE, the Bank of England switched to paying interest on reserves to make the demand for reserves more elastic and hence make moneymarket interest rates, through which the BoE regulated its monetary stance, less volatile. Provided that the interest rate paid on reserves is a bit less than low credit risk private sector debt, the banks will still hold reserves primarily as a settlement asset, but simply hold more reserves. On May 18 2006, the day the new regime was introduced, reserves held by British banks rose about twenty fold, a demand met by the BoE, without any disturbance to inflation, sterling exchange rates or government debt markets. I explain the reasoning in more detail in this old post of mine: (especially paragraphs 20-24). I suspect that the Fed always wanted to introduce such a system themselves, but found it difficult to get past populist congressmen whining about giving money away to banks, and now they have it, they are going to hang onto it for operational reasons long after they cease paying interest on reserves for QE purposes!

  10. EmmaZahn writes:

    This is all very interesting but possibly a little premature. I am curious to find out how the expiration of the FDIC’s Transaction Account Guarantee on 12/31/12 will affect the amount of excess reserves at the Fed. Was it just coincidence that the deposits TAG insured and excess reserves were almost the same amount? Was the interest on reserves a sly way to pay the FDIC TAG premium? If so, it was a really good way to quell the all-round panic in 2008. But now that TAG has expired, will the Fed stop paying interest? So looking forward to January reports.

  11. Fed Up writes:

    “If “the crisis ends” (whatever that means) and the Fed reverts to its traditional approach to targeting interest rates, Krugman will be right and I will be wrong, the monetary base will revert to something very different than short-term debt.”

    By “the crisis ends”, do you mean the economy going back to being aggregate supply constrained instead of aggregate demand constrained (with aggregate demand constrained being CONTRARY to the definition of economics, UNLIMITED wants/needs and limited resources)?

  12. Dan Kervick writes:

    Krugman lost me when he said “What Waldman is now saying is that in the future the Fed will manage monetary policy by varying the interest rate it pays on reserves rather than the size of the conventionally measured monetary base.”

    Is he still thinking that absent a liquidity trap, the Fed manages the size of the monetary base? The Fed can’t target the size of the monetary base and target the overnight rate at the same time, right? So which is it?

  13. Tom Hickey writes:

    I think that it is unlikely that the Fed will continue the setting floor rate by paying IOR for political reasons similar to the reason that the platinum coin was smothered in the crib. It gives the game away and threatens the illusion that government finance is like firm or household finance under the current monetary regime. This is not an operational requirement since there is no operational reason for government not to fund itself directly. The illusion that government needs to be funded from revenue or borrowing from the private sector is created by political means, that is legislation, regulation, and interpretation. There is serious speculation that the central bankers’ club nixed the platinum coin gambit for this reason, and I would not be surprised to see TPTB nix payment of IOR when it no longer suits their purposes.

  14. Peter K. writes:

    @9 RebelEconomist

    I’ve been wondering about international and historical analogues to the hypotheticals being discussed. AFAIK, Krugman had the original post of this thread. Greg Ip had an interesting response where he relayed:

    “How could any Federal Reserve chairman justify cooperating in such a scheme, in particular since the Fed would be taking the White House’s side in a fight with Congress over a matter of dubious legality?

    Yes, the Fed has sacrificed its independence for the sake of the national interest before, such as maintaining a ceiling on Treasury yields between 1942 and 1951; but that was (initially) in wartime, and it eventually led to inflation. [A good thing!] Would avoiding the debt ceiling be important enough to compromise the Fed’s independence? Perhaps not in this one case; but it would set a precedent future presidents will happily exploit and feed the perception that America’s economic institutions are in terminal decline.” Ip has partaken of the Kool-Aid I believe.

  15. Ramanan writes:


    Yes the one I quote can be open to interpretation.

    I also understand that zero reserve requirement is not the same thing as a corridor system. A zero reserve requirement can co-exist with a floor system.

    My point being – the Fed will ultimately exit but this could take years although won’t happen suddenly even when started. So it will smoothly move from a floor system to a corridor system as mentioned in the quote.

    From the note to which Comment #1 quoted the footnote:

    “The Federal Reserve anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy”

  16. If I’m going to be a dork, it’s nice to know I’ve got company.

    As for the debate about the future of Fed policy, I continue to remain on SRW’s side that the Fed will maintain excess reserves and use IOR to control interest rates for the indefinite future. This is not to suggest that the Fed will not permit its balance sheet to shrink at varying points. However, I believe future recessions will be met with further CB balance sheet expansion (similar to Japan). Its important to note that this type of monetary policy permits the CB to use QE in lieu of lowering interest rates if a crisis warrants.

    One question I have that has yet to be addressed, is what happens when the Fed’s capital is entirely drained? As the Fed raises the IOR rate, its profits are likely to decline due to the increasing interest payments. If the desired rate were high enough (~5%), its conceivable the Fed’s profits would turn negative. I imagine that Congress/Treasury would recapitalize the Fed, but would a vote be required or how would that process work? (The odds of this seem outcome seem minute.)

  17. Krugman – “3. The Fed simply expands the monetary base to match the value of the coin, an expansion that mainly ends up in the form of currency, without taking offsetting measures to sterilize the effect.”

    Why/when does the Fed expand the monetary base?

    Quick clarification assuming the platinum coin was used…
    When the Treasury deposits the coin at the Fed, the Fed credits the Treasury’s account with $1 trillion in reserves (not included in the monetary base). As these funds are spent by the govt, reserves enter the private banking system and the monetary base increases.

    If the funds are not spent by govt, would the Fed need to increase the monetary base to the value of the coin? If this is correct, than it would seem that the platinum coin is only inflationary (regardless of the monetary system in place) to the degree the govt actually spends the funds.

  18. […] Yet more on the floor with Paul Krugman – interfluidity […]

  19. Neil Wilson writes:

    It’s so much easier to see what is going on if you consolidate the balance sheets of the Fed and the Treasury.

    Then you can see what actually affects the rest of the economt vs what is essentially nothing more than internal government politics.

  20. JKH writes:


    From your first post in the series:

    “In the relevant sense, we will always be at the zero lower bound. Yes, there will remain an opportunity cost to holding literally printed money — bank notes, platinum coins, whatever — but holders of currency have the right to convert into Fed reserves at will (albeit with the unnecessary intermediation of the quasiprivate banking system), and will only bear that cost when the transactional convenience of dirty paper offsets it. In this brave new world, there is no Fed-created “hot potato”, no commodity the quantity of which is determined by the Fed that private holders seek to shed in order to escape an opportunity cost. It is incoherent to speak, as the market monetarists often do, of “demand for base money” as distinct from “demand for short-term government debt”. What used to be “monetary policy” is necessarily a joint venture of the central bank and the treasury.”

    Holders of currency always have the right to convert to the same type of bank liabilities as they would in the case of quantitative easing and IOR. QE is not required to produce these kinds of bank liabilities – they are always available on request.

    So, in that respect, it doesn’t take QE to illustrate the incoherence of the market monetarists on this aspect. Your point is a fundamentally important one, but it always holds – it doesn’t require “a brave new world”. The “hot potato” can always be absorbed by financial intermediation according to this line of thinking – rather than by the real economy.

    So in that sense, specifically according to your general paradigm of “substitutability”, we’ve always been at the zero bound by implication. It doesn’t require excess reserves and IOR at positive rates to demonstrate this point.

  21. JKH writes:


    Re the previous post, Krugman uses the word “leak” to describe the process of currency expansion. It appears to me that he is characterizing currency demand as a compound function – an endogenous function (currency) of an exogenous function (deposit creation). He’s wrong on the exo function but right on the endo function, IMO. In fact, they’re both endo.

    In his worldview, the monetary authority manages the size of the monetary base through the dominance of the core exo function of deposits, with some sort of predictive currency leakage.

  22. Dan Kervick writes:

    Are checking accounts near perfect substitutes for savings accounts?

  23. Tony writes:

    On the floor with Paul Krugman? hmhmhmhm Was it worth?

  24. Carter writes:

    Having paid a lot of attention to speeches by Dudley, Brian Sacks, etc, I suspect that there is a “middle path” that the Fed may take once growth warrants higher rates. Consistent with a “risk management” philosophy, the Fed will not want to surprise markets by raising rates much more quickly thatn the forwards. They played that game in the 1990s, and the result was Orange County and LTCM and BT’s clients.

    One might consider that the Fed will raise the short rates “in an orderly fashion” and perhaps use interest on reserves (a tool they are now enamored of) to “tail-the-hedge”. This means they may raise IOER faster than nominal fed funds

  25. A. Wells writes:

    It is hard to take seriously the remainder of a post after reading “a regime where cash can be redeemed at will for interest-bearing paper, …”.

    In fact, the paper can be redeemed for cash. You can not pay your utility bill with the interest bearing paper, nor any other kind of bill. You can not buy groceries, with it, you can not even pay taxes with the government’s own interest bearing paper. You have to redeem it for cash first.

    So, how about keeping to a set of believable premises before arguing for, whatever; I really did not read the rest of the post.

  26. Fedwatch writes:

    Not sure if it’s been noted yet in these comments, but the April 2011 minutes are telling

    Normalization steps were discussed, and “Most participants saw changes in the target for the federal funds rate as the preferred active tool for tightening monetary policy when appropriate.” And work how? “Most of these participants indicated that they preferred that monetary policy eventually operate through a corridor-type system in which the federal funds rate trades in the middle of a range, with the IOER rate as the floor and the discount rate as the ceiling of the range, as opposed to a floor-type system in which a relatively high level of reserve balances keeps the federal funds rate near the IOER rate.”

  27. Fedwatch – If the Fed prefers a corridor system, why would it continue paying IOER? For the corridor system to be applicable, wouldn’t excess reserves have to decline to the minimal level that existed before the crisis?

  28. @Joshua, that is how the BoE (and the ECB I think) do it in normal times. No IOER, but an uncompetitive standing deposit facility to provide a floor. If the cb sets IOER at the rate it targets for the inter-bank market (and therefore must be willing to lend at least close to in its OMOs), there is a danger that the inter-bank market gets conducted via the central bank as a central counterparty.

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

  30. wh10 writes:

    Steve, you wrote “3(b)” in your update. I don’t think Krugman had a 3(b). Did you mean 2(b) or 3?

    Also, Krugman responds –

    I think there is still disagreement on raising vs paying more IOR. I think more clarification is needed. Krugman may be assuming rates have to go up to counteract the stimulus of govt spending, which is why he is saying rates have to go up. I think you’re wanting to hold that constant in this debate (or at least assume there is lots of spare capacity in the economy).

  31. Peter K. writes:

    Izabella Kaminska, Jan. 16

    “Forget about the $1 trillion coin debate.

    The most exciting wonky discussion being had right now is between Steve Randy Waldman and Paul Krugman over whether “base money” and short-term debt are perfectly substitutable or not, and what that may or may not mean for central bank policy.

    We confess that we have a bit of a vested interest here because for a long time we’ve been arguing much the same point as Waldman.

    That’s not to say that Krugman is necessarily wrong; he may just be taking Waldman slightly too literally.”

  32. […] I sympathize with Krugman’s view, albeit probably for slightly different reasons.  In his newest post Waldman says Krugman misinterpreted his argument.  So perhaps they aren’t that far apart. […]

  33. flow5 writes:

    “A zero reserve requirement can co-exist with a floor system”

    That’s “Russian roulette”. 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.

    Per William C. Dudley, the President of Federal Reserve Bank of New York, & Vice-Chairman of the Federal Open Market Committee: The policy formula used on the front-end of a positively sloped yield curve is periodically adjusted to “set an IOER rate consistent with the amount of required reserves, money supply & credit outstanding”.

    “whether “base money” & short-term debt are perfectly substitutable or not”

    That’s how the unregulated, prudential reserve, money & credit creating, Euro-dollar banking system has operated since the 1960’s. And when the E-D market collapsed in July 2008 it took the World with it.

    From the standpoint of the Euro-Dollar banking system, Uncle Sam’s debt is “lawful money” (but not “legal tender”). It represents a medium of exchange, a unit of account, and a standard of value, (though not a store of value). Fractional reserve banking is a function of the velocity of money, & not a function of its volume.

    I.e., the prudential reserves of the money creating E-D banks consist of various U.S. dollar-denominated liquid assets (U.S. Treasury bills, U.S. commercial bank CDs, Repurchase Agreements, etc.) & interbank demand deposits held in U.S. banks. These are liquid balances in the U.S., or any other major currency country. If a bank’s balance is inadequate to meet a specific payment in the E-D system, it borrows in the London money market at or near the LIBOR rate (the London Inter-bank Offering Rate).

    I’d also argue that the Shadow Banking System creates lawful (re-hypothecated) money & credit (albeit has a lower multiplier).

  34. flow5 writes:

    And currency held by the non-bank public is not now, nor has ever been a “base” for the expansion of new money & credit. Currency has no expansion coefficient. Currency has no common repository for pyramiding. Currency isn’t backstopped by FDIC insurance nor are its transactions facilitated thru a payment & settlement system with varied checks & balances.

    Currency has some of the same characteristics as bank deposits. With the member CBs there are “saved” dds & savings/time deposits (but all demand drafts from all financial institutions clear thru dds with few exceptions).

    “Currency in circulation” is a misnomer as most currency is hoarded (doesn’t turn over – just like bank deposits). The percentage of currency outside the banks used to “meet the needs of trade” turns over much less frequently than the fraction of transaction deposits to other bank deposit classifications.

    To say that the base comprises all currency held outside the banks is tantamount to saying all bank deposits also belong in the base.

    The volume of currency in circulation (held by the non-bank public), is impersonally determined by the public, & by the amount necessary to meet the needs of trade.

    The volume of currency is unregulated because it needs no specific regulation. It is impossible for the public to acquire more of a given type of currency without giving up other types of currency, or else bank deposits. In other words, it is impossible for the public to add to the total money supply consequent to increasing its holdings of currency.

  35. […] addthis_share = {"templates":{"twitter":"Lux et Veritas: {{title}} {{url}} (via @jessefrederik)"}};}Steve Randy Waldman en Paul Krugman zijn beide economen die gezegend zijn met de gave om helder en overtuigend te […]

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

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