Wednesday, January 4, 2012

Small and Large Footprints: Reserves and the Fed

As most economists are well aware, financial institutions in the United States currently hold a very large stock of reserves - deposit accounts with the Fed. The first chart shows the stock of reserves for the last five years. Before the financial crisis, the primary role of reserves was as a means of payment among large financial institutions. Commercial banks of course have to fulfill reserve requirements, but given financial innovation that allows banks to essentially bypass the requirements, it is most useful to think of reserve requirements as irrelevant in the United States. Pre-financial crisis, a stock of $5 billion to $20 billion in reserves was sufficient to support all intraday financial payments and settlement in the United States. It is important to note that this small quantity of reserves was funding a huge quantity of daily payments. Indeed, in 2008, the average daily value of transactions on Fedwire (using reserves) was $2.7 trillion, so the intraday velocity of reserves is immense. It is important to take account of intraday credit extended by the Fed as well, which is essentially outside money created within a day that goes away overnight. In 2008, average daylight overdrafts (as within-day Fed credit is called) were about $62 billion.

Since the financial crisis, as can be seen in the chart, reserves have grown to the neighborhood of $1.6 trillion - more than 100 times the typical stock of reserves in the pre-crisis period. What implications does this have? During the financial crisis and shortly after, it was common for economists and Fed officials to discuss "exit strategies." The typical view was that we were in the middle of unusual circumstances requiring unusual monetary policy interventions, but that these interventions would eventually be unwound. Here's a speech that Charles Plosser made in September 2010. Plosser says:
As I have argued in past speeches, the Fed will need to shrink the size of its balance sheet toward pre-crisis levels and return its composition to all Treasuries.
This necessarily involves shrinking reserves outstanding to pre-crisis levels. Further, Plosser has some comments on reserves specifically:
There are two proposed mechanisms for implementing IOR [interest on reserves], both of which can impinge on central bank independence. One IOR operating mechanism is the floor system, in which the central bank sets its policy rate equal to the IOR. Under this framework, the central bank supplies enough reserves so that the banking system faces a perfectly elastic supply schedule of reserves.16 Under such a floor system, the Fed’s balance sheet is divorced from interest rate policy because an unlimited amount of reserves are available at the IOR-policy rate. Some have described the floor system as the “big footprint” central bank because its balance sheet can be large without directly affecting the monetary policy instrument, the IOR. Some think that this approach has advantages because it would enable the central bank to provide liquidity in a financial crisis without necessarily altering the stance of monetary policy.

The other IOR operating mechanism is the corridor system, in which the central bank’s policy rate is a market rate that is always between the rate charged at the discount window and the IOR. The corridor system does impose constraints on the size of the balance sheet because the supply of reserves would be set at a level that achieves the targeted interest rate. Thus, this might be called the “small footprint” central bank.
Thus, the system the Fed currently operates under is a floor system, whereby there is a large stock of reserves outstanding overnight, and the interest rate on reserves essentially determines the overnight interest rate (with some slippage in the United States due to GSE reserve accounts). the alternative system, the corridor system, is what the Bank of Canada currently adheres to. In Canada, reserves essentially go to zero overnight, and intervention by the Bank determines the overnight rate, which is higher than the interest rate on reserves and lower than the rate at which the Bank lends to financial institutions.

Plosser has some reasons not to like the "big footprint" floor system. Something I could add is that, under a corridor system the Fed gets current information on the daily shocks hitting the payments system and financial markets more generally. If the demand for overnight reserves rises or falls, the Fed has to intervene in the overnight market in order to achieve its target for the fed funds rate. If the same things happen under a floor system, this would have to be reflected somehow in the quantity of reserves outstanding, but there are currently many other factors, such as movements in and out of Treasury accounts, that also affect reserves. Maybe the Fed can untangle all these things; maybe not. The key problem is that the reserves are an accident waiting to happen. The Fed can always counteract higher inflation by increasing the interest rate on reserves under a floor system, but if it does not tighten when the appropriate time comes, the danger is a self-fulfilling expectation of higher inflation.

In my opinion, since quantitative easing is irrelevant under current conditions, one could reverse it with no effect. That is, the Fed could sell $1.6 trillion in Treasury securities and mortgage backed securities, reduce overnight reserves to some small amount on the order of what existed pre-crisis, and nothing much would happen. Then we would transit from a floor system to a corridor system.

There is another argument being made, though, as to why a big-footprint floor system might be a good idea. Unfortunately I can't find a link to this paper, but here are some slides from a presentation by Jamie McAndrews at a recent Bank of Canada conference. People who concern themselves with the economics of payments systems (and there should actually be many more of such people), including Jamie's group at the New York Fed, focus on issues to do with the timing of payments during a given day among financial institutions, the Fed's policies toward daylight overdrafts, and how these things relate to general monetary policy issues. If reserve balances are too scarce during the day, then financial institutions might delay payments they need to make, and a type of coordination failure arises. One could always make a payment by taking out a loan (a daylight overdraft) from the Fed, but that is costly as the Fed charges interest on daylight overdrafts, and there are also credit limits. Why? The Fed is worried about systemic risk. If the Fed extends too much daylight credit, there may be a danger of systemic default where the Fed ends up holding the bag.

But, as McAndrews and company point out in their paper, the large quantity of reserves that has existed in the financial system post-crisis appears to have speeded up clearing and settlement in the payments system, and reduced the quantity of daylight overdrafts. They don't come up with measure of the welfare benefits, but it seems there has to have been a dramatic reduction in payment delay costs.

Is this a serious argument, or just part of an attempt by the Fed to justify the existence of a very large quantity of reserves that now appears to be out there indefinitely? It's important to recognize that reserves held overnight, and daylight reserves are very different animals. Overnight reserves, which is what is measured in the above chart, just sit. They are not used in transactions. Currently, most of the reserves in existence during the day also sit, but some of them are used in clearing and settlement among financial institutions - a transactions role for reserves. If we wanted it, we could have a lot of reserves in daylight hours, and zero reserves overnight. There are different ways to do this: (i) The Fed could inject the outside money every day through daylight overdrafts. If there is some worry about default risk, the Fed could take collateral against the daylight overdrafts, as in other large-value payments systems in the world. (ii) The Fed could conduct an open market purchase each morning. (iii) The Fed could do a reverse-repo in the overnight market at the end of each day.

With regard to the last option, reverse repos have become a bigger deal recently. The Fed once proposed reverse repos (along with term deposits at the Fed) as a "reserve-draining" tool - part of an exit strategy. The second chart shows that the value of reverse repos on the Fed's balance sheet is currently about triple what it was before the financial crisis.

So, there seems a way to have our cake and eat it too. The Fed can have a small footprint, and also make reserves sufficiently plentiful during daylight hours to make large-value financial transactions occur efficiently.


  1. As we are seeing the financial crisis rates and ratios are having big and bigger gap .Firstly outsourcing must be controlled then only other can be controlled .

  2. Whether used as a corridor or floor is irrelevant. IOeRs alter the construction of a normal yield curve, they INVERT the short-end segment of the YIELD CURVE – known as the money market. Thus IOeRs induce dis-intermediation.

    IOeRs currently cause a contraction (shrinkage), in the non-banks (& shadow banks), - the most important lending sector in our economy — or pre-Great Recession, 82% of the lending market (Z.1 release, sectors, e.g., MMMFs, commercial paper, GSEs, etc.).

    IOeRs decrease the supply of loan-funds, increase long-term interest rates, increase the capitalization rate on earnings, and depress economic growth rates.

  3. Steve, Happy New Year.

    I tried to poke holes in this post but came up empty. Very thorough. Clearing and settlement systems are an esoteric subject but quite fascinating. I must admit I was surprised to learn that Fedwire daylight overdrafts did not require collateral. Is this not an accident waiting to happen?

    Keep up the good work, this continues to be one of the first blogs on my list.

  4. JP,

    Happy new year.

    "I must admit I was surprised to learn that Fedwire daylight overdrafts did not require collateral. Is this not an accident waiting to happen?"

    The Fed seems to think they are covered by charging interest on the daylight overdrafts to make them costly, and by putting caps on the the amount of credit they are willing to extend.

    I don't think people should think of this as esoteric. It's actually quite important, and macro people should pay more attention to it.

  5. "it is most useful to think of reserve requirements as irrelevant in the United States"

    There may be general agreement among economists that statutory reserve requirements are not binding. However that's a blatant error.

    To rely on the theory that the Central Bank acquires leverage over money & the bond markets simply because the commercial banks need to hold interbank demand deposits at their District Reserve banks for clearing checks and making payments will prove as fatal as Keynes' "liquidity preference curve" has.

  6. In an FFR targeting regime, the supply of reserves is perfectly elastic. Existing reserves can be converted by the system into currency, but so can borrowed reserves.

    ER's do reflect the extent of the fiscal transfer from Treasury (the recipient of Fed profits) to the private sector. This transfer is equal to the premium over the private-market price that the Fed paid for any assets on its balance sheet. ER's also reflect the transfer of term or credit/earnings risk from the private sector to the government. That is, if the Fed were to experience losses (due to credit or duration risk), those losses would accrue to the Treasury. Therefore, the implications of a large Fed footprint are fiscal, and not monetary. The exception is whatever monetary policy "signaling" effect is created by the Fed risking large losses from either duration or credit risk.

  7. anon1,

    I've heard this idea before that the interest on reserves is a transfer from the Treasury to the private sector. The way I think of it is that (as you recognize) the Fed is intermediating across maturities, issuing reserves as liabilities, and holding long maturity assets - T-bonds, MBS, and agency securities. This is essentially encroaching on banks' business. But there's no net transfer to the private sector involved. If the Fed were not holding all the reserves it is, it would be earning smaller profits, and the Treasury would have to make that up somehow. Of course if the interest rate on reserves were high enough, the Fed would start to earn negative profits on the deal.

  8. so banks have taken $1.6 trillions in customer cash and deposited such at the Fed were the sum is earning interest.

    and, our banks are earning profits by making the deposits because the interest being paid is higher than their cost of funds from depositors.

    such makes perfect sense when one understands that the Lesser Depression was caused by the collapse of the private debt bubble, which had zoomed to about 300% of GDP.

    If we have to work down to 100% of GDP, the Fed is going to have to hold that $1.6 trillion for a long long time.

    Flow5 has it backward when he writes, "IOeRs decrease the supply of loan-funds, increase long-term interest rates, increase the capitalization rate on earnings, and depress economic growth rates."

    Until the causes and damage of the private debt bubble are corrected, what sane person would borrow? Banks loans are still dropping.

  9. The IOR is not itself a fiscal transfer. Rather, the Treasury (via the Fed) is absorbing duration risk formerly held by the private sector. This duration risk is essentially a contingent tax liability issued to taxpayers. It has a fiscal impact, but it is not, directly, a transfer.

    What is a fiscal transfer is the premium the Fed paid to purchase term assets from the private sector.

    The Fed "footprint" reflects both the potential amount of premium (fiscal subsidy) paid for risk assets; and the amount of the contingent tax liability created for taxpayers. Other than signaling, this fiscal impact is the only net effect of Fed asset purchases.

  10. Stephen: Will you be attending the ASSA annual meeting?

  11. It is time Market Monetarists define the debate.

    What the Fed and other monetarists are practicing is "theo-monetarism."

    Theo-monetarism, as practiced, is resulting in recessionary deflations in Europe and the USA, and a Japan-like economy.

    Japan has an extremely strong yen. Japan has had 15 percent deflation in the last 20 years. Japan's manufacturing output has fallen 20 percent in that time period, while stock and equity markets cratered by 80 percent. Banks suffer continual losses on real estate and loans in nominal yen.

    You call that "theo-monetarism." A faith that an undefined, oblique, ad hoc "tight money" policy works, despite abundant empirical evidence to the contrary.

    Theo-Monetarism is a faith-based monetarism, for those who genuflect to gold and worship the idea of a stagnant paper currency.

  12. anon1,

    Yes, I think I agree with that, more or less.


    Yes, I'm here. Mostly stuck in a hotel room interviewing.

  13. I often wonder, how many economists have actually read and understand the legal issues in 12 USC § 225A, which charges that the Fed:

    …shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

    before taking any other step, the Fed is required to calculate the "long run potential to increase production," for until that is done the law does not permit "growth of the monetary and credit aggregates."

    That makes the Fed's job one protecting and increasing production (manufacturing).

    Where is our promised currency war?

    Second, use of the word "prices," instead of "price," implies a duty on the part of the Fed to remedy past policy mistakes which permited an asset bubble to develop in one part of the economy, by means or methods that do not deflate the bubble, for two wrongs don't make a right (it just punishes people, like first time and young home buyers, twice, who are caught in a bubble).

    In sum, when the Fed let the private debt bubble expand to 300% of GDP, instead of tightening in 2007, it should have started printing money in quantities sufficient to reduce private debt to below 100% of GDP and maintain private asset (principally real estate) prices.

  14. John D.

    It is true that with QE governments are taken off the market and this would decrease the demand for loan funds & therefore interest rates other things being equal. But I do not have it backwards. IOeRs induce dis-intermediation within the shadow banking system just like REG Q ceiling hikes did in 1966. This reduces the supply of loan funds in the money market. And the volume of non-bank assets that has been erased vastly exceeds the volume of excess reserves held by the commercial banks.

  15. I have concluded there are two kinds of monetarists. There are Market Monetarists and Theo-Monetarists.

    Market Monetarists believe in transparency and clarity in central bank policies and actions. The central bank will public identify a NGDP target, and say what tools it will keep in place or employ until the NGDP targets are met. In brief, the central bank bluntly identifies goal and methods, and indicates iron resolve.

    Theo-Monetarists believe in an oblique central bank, that identifies no targets, or perhaps only squishy inflation targets. Methods are not discussed, and resolve is lost amid murk and mysticism. There may be genuflecting to gold, and worship of paper currency as a store of value.

    All monetarists who are not Market Monetarists are essentially Theo-Monetarists, whatever branch of Theo-Monetarsm they belong to.

  16. "I don't think people should think of this as esoteric. It's actually quite important, and macro people should pay more attention to it."

    Preaching to the choir.

    I've been reading George Selgin's paper "Wholesale payments: questioning the market-failure hypothesis".

    I noticed he brought it up in one of your posts. (

    Anyways, it's very good.

  17. Flow5

    Sorry, but I am unable to make sense of what you are writing.

    Let's begin in the beginning. Bank's now have $1.7 trillion (according to Williamson) in customer cash (deposits) on deposit with the Federal Reserve. Banks are being paid interest on these deposits above the amounts they are paying their customers, making a small profit which they are offsetting against loan loss reserves as they are booked each quarter (what many are calling pretend and extend).

    These deposits, according to my understanding, meet the requirements for being counted as reserves (or equity) for regulatory purposes so that the deposits vastly increase the capacity of banks to make loans, by creating money, under what Ron Paul likes to call fractional reserve banking (as if this was per se evil).

    Banks are not making loans now because there is no demand for loans (private debt is still working down from about 300% of GDP to 100% (or perhaps even lower). And, there is no collateral for loans (the simple preferred 2nd mortgage or DT being a thing of the past, since the Fed crashed home values 35%, wiping out $7.5 trillions in home owner equity (+/-).

    Now are we in agreement on the facts so far?

  18. "quantitative easing is irrelevant under current conditions" Read your post on QE2. Assets = liabilities. There would be no new funds to remit to the Treasury because reserve balances are extinguished as any Treasurys are sold... both sides of the balance sheet contract together...And purchases and sales between the Reserve banks & non-bank investors directly affect both bank reserves and the money supply. Reversing QE2 by lowering the remuneration rate would be inflationary.

    "the Fed is intermediating across maturities"

    Never are the Reserve & commercial banks intermediaries in the lending process. Lending by the CBs is inflationary. Lending by the non-banks is not inflationary. Reserve banks operate on the same basic principles as commercial banks. They accept, create, and destroy deposits. As central banks creating & destroying credit in their lending activities, they create "basic" money - the money which constitutes the reserves of the member banks.

    Contrary to Milton Friedman legal reserves are not a tax. The Federal Reserve Banks acquire earning assets by creating new inter-bank demand deposits. The U.S. Treasury recaptures about 97% of the net income from these assets. The commercial banks acquire “free” legal reserves, yet the bankers complain that they are not earning any interest.

    On the basis of these newly acquired free reserves, the commercial banks can, and do, create a multiple volume of credit and money and acquire a multiple volume of additional earnings assets (thanks to fractional reserve banking).

    The 5 1/2 percent increase in REG Q ceilings on December 6, 1965 (applicable only to the commercial banking system), is analogous to the .25% remuneration rate on excess reserves today (i.e., the remuneration rate @ .25% is higher than the daily Treasury yield curve 2 years out - .25% on 1/6/2012). This induces disintermediation like in 1966.

    This unnecessary competition decreases the supply of loan funds (available savings). The CBs are forcing a contraction in the size of the non-banks (the customers of the CBs), and create liquidity problems in the process, by outbidding the non-banks for the public’s savings.

  19. What a farce:

    I followed a link, above, to an earlier post on this site where you claimed the ability to discern "quack," economists.

    Yes or No, is Alan Greenspan a "quack?" His ideas, being Ayn Rand follower, are quackier than those of DiLorenzo.

    Then you wrote:

    My advice would be to ditch DiLorenzo and company and talk to some of these people (I'm assuming Bernanke is the only Fed person who can speak directly to Congress):

    Mike Woodford, Columbia University
    John Cochrane, University of Chicago
    Mark Gertler, NYU
    Gary Gorton, Yale
    Arthur Rolnick, formerly Minneapolis Fed
    Robert Lucas, University of Chicago

    Inviting these people to speak to the subcommittee would at least capture the important ideas on monetary policy that are taken seriously

    Given the Blog War that has just taken place and been resoundingly won by Krugman/Delong over those whom you push forward (Cochrane is a wacko Catoist who predicted crushing inflation would happen, this afternoon, more than two years ago), in which the later have been openly exposed as intellectual frauds, whose ideas are not taken seriously, would you at least have the decency to retract your earlier counsel to Ron Paul, noting that he too is a quack.

  20. "Now are we in agreement on the facts so far?"


    But when CBs grant loans to, OR purchase securities from, the non-bank public, they acquire title to earning assets by initially, the creation of an equal volume of new money- (transaction deposits) -- somewhere in the banking system. I.e., while the bankers are short credit-worthy customers, they can buy governments (because of risk factors: inflation, supply, demand, etc., they are not "perfect substitutes").

    From a systems viewpoint, commercial banks (DFIs), as contrasted to financial intermediaries: never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits, or time deposits, or the owner’s equity, or any liability item. I.e., monetary savings are impounded within the CB system.

    That is to say CB time/savings deposits, unlike savings-investment accounts in the “thrifts”, bear a direct, one-to-one relationship, to transactions accounts. As TDs grow, TRs shrink, pari passu, and vice versa. The fact that currency may supply an intermediary step (i.e., TRs to currency to TDs, and vice versa) does not invalidate the above statement.

    The source of all time/savings deposits within the commercial banking system, are other bank demand/transaction deposits - directly or indirectly via the currency route or the bank’s undivided profits accounts.

    Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries, for the funds never leave the commercial banking system.

    At the current remuneration rate, IOeRs are a credit control device. IOeRs function is to absorb bank deposits. They have attracted and continue to attract available savings from the shadow banks (i.e., they induce dis-intermediation - an outflow of funds), where the intermediaries shrink in size, but the size of the CBs remains the same.

  21. "What implications does this have?"

    Under the current procedures: “End-of-day balances held to meet a clearing balance requirement (up to a specified maximum amount) generate earnings credits that may be used to offset charges resulting from the institution’s use of eligible Federal Reserve services. A Reserve Bank may impose a clearing balance requirement if an institution has a history of frequent daylight or overnight overdrafts”

    Under the proposed rules to simplify the administration of reserve requirements and reduce administrative burden:

    “The implicit interest rate that is paid on contractual clearing balances is below the remuneration rate paid on excess reserves. As a result, institutions could earn a greater return, and use the earnings for any purpose, by canceling their contractual clearing balance arrangement with their Reserve Bank and ” “redesignating its clearing balances as excess balances, and receiving explicit interest on those balances at a higher rates."

    Because of the payment of interest on excess and required reserves, the banks don't need a segregated balance receiving earings credits.

    "redesignating its clearing balances as EXCESS balances, and receiving explicit interest on those balances at a higher rate."

    The proposed rules to simplify the administration of reserve requirements and "reduce the administrative burden" will commingle the banking system's liquidity reserves (contractual clearing balances) with the system's credit control device (required reserves).

    The sine qua non of monetary management is total current control by a central monetary authority over the volume of legal reserves held by all money creating institutions, and over the reserve ratios applicable to their deposits.

    Rather than discipline the member commercial banks the reserve authorities have become increasingly lenient resulting in many undesirable forms, including allowing member banks to count vault cash in 1959 as a part of their legal reserves (as well as the payment of interest on IBDDs in Oct 2008), thus confusing liquidity (liquid assets used to meet seasonal and other “extra” demands on their clearing balances) and legal reserves, and making the Fed’s job of monitoring the volume of legal reserves more difficult to predict. Obfuscating the distinction between District Reserve interbank balances makes it harder for the Federal Reserve to determine the appropriate daily quantity of reserves to supply to the market.

    Contrary to the Financial Services Regulatory Relief Act of 2006, 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. But this act provides the legal authority to reduce or even eliminate reserve requirements (to as low as zero percent, from their previous minimum top marginal requirement ratio of eight percent), thereby "reducing a regulatory burden for all depository institutions".

    Unfortunately the Federal Reserve doesn’t gauge the volume and timing of its open market operations in terms of the amount and desired rate of increase of member commercial banks COSTLESS (contrary to Milton Friedman), legal reserves, but rather in terms of the levels of the federal funds rates (the interest rates banks charge other banks on excess balances with the Federal Reserve). That includes the FED's new tool, the remuneration rate.

    By using the wrong criteria (the manipulation of interest rates, rather than member bank reserves) in formulating and executing monetary policy (along with the commingling of IBDDs held by the member banks in their District Reserve Banks), the Federal Reserve inevitably becomes inflation's engine.

  22. Flow5 writes:

    From a systems viewpoint, commercial banks (DFIs), as contrasted to financial intermediaries: never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits, or time deposits, or the owner’s equity, or any liability item. I.e., monetary savings are impounded within the CB system.

    Sorry Flow5, but you are here just wrong. If my bank lends me $100k and puts it into an account, I can just walk into a local branch, take it out in cash, put it in by billfold and walk out the door, never to deposit the funds again in any bank. My doing such has no impacton the deposits of any other customer. My next door neighbor can do the same, tomorrow, and between us we have increased cash in circulation by $200k, without reduction of any other customer's deposits. With fractional reserve banking, banks can create money. The fed can close the bank, before I make the withdrawal, but short of that, banks can expand the money supply by making loans and giving customers cash.

  23. Time to congratulate Krugman and DeLong

    Others have commented on how keen Krugman has been in following the reactionary right of macroeconomics.

    It has become very clear that this blog, Bullard, and lots of others have been aiming to use the AEA meeting in Chicago in a major effort to future attack the Administration and to try to influence both Congress and the upcoming election.

    For example, Bullard gave a speech yesterday, no doubt prepared by Williamson or Andolfatto (or both) in which he tried to rehabilate Barro, Lucas, and Cochrane by claiming, this is laughable, that monetary policy has been up to the challenges of the Lesser Depression (which is why it is only going to go on for another 9 years, per Barrons). Here is the powerpoint.

    Williamson says he can discern an economic quack when he see one. He must have honed that skill by first hand observation.

    Here is my first take on Bullard's speech.

    It was especially fun to hoist Bullard on his own chart--a little 18th month gap in "effectiveness"

    Kahenman and Munger are right about this crowd.

    I especially like Munger's comment in his speech on Adademic Economists

    The reader my pick his or her poison but I like the general observation that economists do not understand second and third order effects.

  24. John D.

    Then there's no such thing as fractional reserve banking. The individual commercial banker performs an intermediary role between savers & borrowers. By attracting an inflow of funds (time or demand deposits or currency), he enlarges his legal reserves and clearing balances plus his legal and economic capacity to expand loans and investments. From the standpoint of the banker, he has simply loaned out the funds acquired; however from the system standpoint the added earning assets have been acquired though the creation of NEW money.

  25. Flow5

    To the contrary, mostly what bankers do is loan money they have not "acquired," and then chase reserves.

    Flow5. Learn a little. Try Keen at this link, first paragraph, top of page 3:

    Keen writes, "The endogenous money approach instead begins with a bank making a loan $L to a firm, and that loan simultaneously creates an equivalent deposit (any need to meet reserve
    requirements is fulfilled later: Moore (1983, p. 539); Holmes (1969, p. 73)).2 The endogenously created credit money then fuels economic activity. In this model, “loans
    create deposits (instantaneously)”.

    In another paper Keen explains:

    During normal times with an expanding economy, growth in credit fuels economic activity, while during a ‘credit-crunch’, the level of endogenously-generated money in the economy falls, and this alone is sufficient to cause economic activity to contract.


    Bailing out the Titanic with a Thimble

    You should also view Keen's interview by INET:

  26. We're at odds:

    Our monetary mis-management since 1965 has been the assumption that the money supply can be managed through interest rates.

    Between 1965 and June of 1989, the operation of the NY Fed’s “trading desk” was dictated by the federal funds “bracket racket”. Even when the level of non-borrowed reserves was used as the operating objective, the federal funds brackets were widened, not eliminated.

    Ever since 1989 this monetary policy procedure has been executed by setting a series of creeping, or cascading, interest rate pegs.

    This has assured the bankers that no matter what lines of credit they extend, they can always honor them, since the Fed assures the banks access to costless legal reserves, whenever the banks need to cover their expanding loans – deposits.

    We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about.

    The effect of tying open market policy to a fed Funds rate is to supply additional (and excessive, & costless legal reserves) to the banking system when loan demand increases.

    The effect of Fed operations on interest rates is INDIRECT, and varies WIDELY over time, and in MAGNITUDE.

    The money supply can never be managed by any attempt to control the cost of credit (i.e., thru interest rates pegging governments; or thru "floors", "ceilings", "corridors", "brackets", etc). IORs simply exacerbate this operating problem. I.e., Keynes's liquidity preference curve is a false doctrine.

    With the use of this device the Fed has pursued a policy of automatic accommodation. That is, additional costless reserves, & excess reserves, were made available to the banking system whenever the bankers and their customers saw an advantage in expanding loans. The member banks, lacking excess reserves, would just bid up the federal funds rate to the top of the bracket thus triggering open market purchases, free-gratis bank reserves, more money creation, larger monetary flows (MVt), higher rates of inflation – and higher federal funds rates, more open market purchases, etc.

  27. Flow5

    You write that we are at odds, then you write several paragraphs, attempting to sound like an economist, rather than communicating.

    Then, at the end, agree with me when you write, "The member banks [commercial banks] … triggering … "more money creation."

    It would help your thinking if you would stop calling deposits by member Banks with the Fed "reserves." They are not reserves, they are deposits, which earn interest.

    These deposits may also qualify as "reserves," for regulatory capital purposes, but they are first, and in an economic sense, entirely deposits.

    My POV has been throughout that commercial banks create money when they make loans to customers. You now agree.

    A lot naturally follows, including that there is no such animal as the Ricardian Equivalence.

    Could we now get on with it, and your agreement that Williamson doesn't know what he is writing about also?

  28. “loans create deposits (instantaneously)

    I agree. But Keen has some problems understanding money & central banking. And it would help if he simplified his points.

    Economic prognosticasions are actually infallible because contrary to economic theory, & Nobel laureate, Dr. Milton Friedman, monetary lags are not “long and variable”. The lags for monetary flows (MVt), i.e. the proxies for (1) real-growth, and for (2) inflation indices, are historically (for the last 97 years), always, fixed in length.

    I didn't see the great-recession coming like Keen, but the course of nominal gDp was easy to forecast.

  29. Today's USA today had a well written article on the continuation of the Lesser Depression, re-enforcing the view that we have four years down into a lost 15 to 20 years, or maybe even forever (Japan), due to the Fed's failure to maintain price stability of real estate (mostly).

    I am going to move fast here, much faster than Williamson is capable of understanding, but the reason were are in this boat is that Williamson and most other economists have forgotten second and higher order effects (Munger 1993)

    Williamson looks at $1.7 trillion of deposits and doesn't see what I see: a stack of loan apps from here to the Moon and back.

    Lets assume that he is right, that the Fed should take some action to remove these liabilities from its balance sheet. Has Williamson ever sat down and calculated how long it will take commercial banks to loan $1.7 trillion? Banks don't have the policies, procedures, and people in place for such a task, especially when the private demand for loans is falling and is going to continue to fall until we restore sanity to our economy (ending imports and increasing R&D and investment spending to historic trends as a percent of GDP).

    IOW, Williamson's approach is madness, doubled down.

  30. With respect to this:

    "One could always make a payment by taking out a loan (a daylight overdraft) from the Fed, but that is costly as the Fed charges interest on daylight overdrafts, and there are also credit limits."

    I recommend you visit this web sites:

    Also, you might want to review this (pre-crisis) article ( which is known for making the point that a floor system with large quantities of reserves could reduce the use of Fed provided daylight credit by banks.

  31. "Could we now get on with it"

    Thanks for the clarification. I like the way you phrased it. Williamson's departure is alarming.

  32. Flow5

    Williamson is in Chicago,engaged in the mother of all conspiracies within the profession.

    His chief, Bullard, head of the St. Louis Fed, wants America to die on a cross of gold. With Lucas, Cochrane, Barro, et al, he is part of an organized effort to push the country radically to the right, crushing the 99% with austerity.

    They all had their little Cato like moves (and papers) planned, but Krugman beat them to the punch with his attack on Lucas and the RE.

    Williamson is just pathetic.

    He claims not to have noticed when private debt zoomed to 300% of GDP in a bubble promoted by Greenspan but he does notice when the Fed's liabilities zoom because of the opposite: the collapse of private debt.

    If you have been to What About St. Louis you will see where I use Bullard's and Williamson's own charts to show that the Fed was 18 months late in moving interest rates to zero.

    Frankly, I do not think we will ever get out of this mess. You have 98% of the economics profession, like Williamson and his side kick, trying to save their own skins instead of admitting they were wrong and either coming on board or just retiring from the field and getting out of the way.

    You will never get Williamson, Lucas, Cochrane, Barro, to talk about fundamentals: fiscal adjustment cost discounting, loosing wars, reduction of federal R & D by more than 100% of GDP, declining private investment every time we cut taxes, movement of business to China, etc.

    On the last point, I found any interesting metric yesterday on a forum called Economics Job Markets Rumors, at this link

    go take a look at the China Job Market Thread with has more views than any other thread by a factor of about 50

    I could call myself an economist and write 2 or 3 paragraphs saying this was the perfect measurement for talent moving to the action in China, but that would be like shooting fish in a barrel.

    Of course, we are talking about second and third order effect of really really stupid policies of thinking that free international trade leads to prosperity. Never has, never will. Only an economist looking a models, instead of the real world, would ever think such.

  33. At What About St. Louis we ask:

    1) Why does Williamson's crystal ball now see $1.6 trillion of bank deposits on the Fed's balance sheets as a problem, when that same crystal ball failed to see that private debt soaring to 300% of GDP was going to cause the Lesser Depression?

    Williamson writes, "The key problem is that the reserves are an accident waiting to happen." That is crystal balling.

    Before giving a 16 year old the keys, they have to be licensed and pass a driver's test. Let's not forget that 4 years ago Williamson flunked his exam and still and has no keys for the car.

    2. Why does Williamson now think it is timely to reduce the supply of money by $1.6 trillion, which is what a treasury sale by the Fed would do (raising interest rates and reducing both the money supply and credit)?

    The step proposed is madness, a guarantee for only enhancing the the length and depth of the Lesser Depression and a step no different than when the Fed tightened credit between 1929 and 1933

  34. Delong tells us what he really thinks of the state of macro, today:

    "It is interesting how strong belief that ranting, trash-talking emperors like Lucas, Fama, and Cochrane must have clothes is..."

    I anticipate strong praise for the restaint I have shown in my comments about this trio

  35. I see the crackpot lawyer now has a name -- John D. He remains completely out of his depth.

  36. Crazy, thy name is John D. We salute you for your dogged determination to crazy.

  37. Anonymous crackpot

    So the truth is starting to hurt so you come out to engage in character attacks on a very well informed taxpayer.

    We know you can't read, nor do the math, so why not try a little internet streaming video

    Here is a link to John Kay discussing the similarities between the denial of contemporary economists and the Church's refusal to look at the data and empirical experiments of Galileo.

    If the bandwidth is clogged, its because Williamson's students are doing most of the watching, for they are getting so little out of his course

  38. John D is perhaps a taxpayer, but well-informed he is not. I definitely can do the math, sad and angry little man, and read apparently much better than you because I can distinguish John Kay from a serious person. You apparently cannot.

  39. Anon.

    Get a life.

    Williamson is a public servant who has thrown his lot into the public arena. If he is so smart he should be able to easily correct observations made by others.

    Williamson has 40 sidekicks with Phds on the Fed dole to call upon to show where or why any poster here is wrong.

    The fact is that the state of macroeconomics is appalling. You have an entire cabal of Catoist (Lucas, Cochrane, et al) who simply lie so as to promote their own political agendas. Ambition, fame, and fortune cause people to do this kind of stuff.

    The debate the other night when Huntsman, a very decent man, was criticized because he worked for a Democratic President was telling.

    The Nation is bitterly divided. Academics ought to be providing leadership but instead you have Lucas, Cochrane, and their tag alongs being obstructionist, at best

  40. What hath the internet wrought ? 20 years ago, the state of macro was good. We had an intellectual monopoly. We knew what sensible macro theory was - it was the message preached by the AEA, and respectable macro was what was published in journals like AER, JPE. Now, any fool with an internet connection can just spout any old garbage all over the blogosphere and the discourse is polluted beyond repair. Nobody gives a damn any more what is in journals and the quality of macro has gone into a probably irreversible spiral. Anything goes now.

  41. "The fact is that the state of macroeconomics is appalling. You have an entire cabal of Catoist (Lucas, Cochrane, et al) who simply lie so as to promote their own political agendas. Ambition, fame, and fortune cause people to do this kind of stuff."

    Blah, blah, blah. Keep being paranoid and bitter, it makes you a better person. It also keeps you busy and prevents you from doing harm.

  42. AH-1, AH-2

    what a said little pity party that you won't even give your name--what do you fear? That your students will walk out of your class?

    What is really funny is that you blame the messenger, but the reason the discourse is polluted is not because what someone has written on this blog.

    The reason is the discourse is polluted is that Lucas publicly made very sexist and offensive comments about CR which were untrue, starting Blog War III.

    The truth is that both of you are nothing but lap dogs for the Catoist Cochrane.

    20 years ago no self respecting academic would have ever associated with Cato, which is nothing but a propaganda organization that would delight Gobbels.

    As for what is in the journals, I give a damn. I read them. Others hear read them and cite to journals. The problem is that all the "models" were wrong. They are useless.

    If you think not, show me one model that tells us what will happen when private debt reaches 300% of GDP? And, what to do about that condition?

    Show me one model that says what will happen when you have wide spread fiscal adjustment cost discounting (Drugger) caused by inappropriate tax cut?

    Show me one model that says what will happen when you cut taxes and fight two wars, running massive deficits?

    Show me one model that says what will happen when you cut federal R & D spending as a percent of GDP in half?

    Show em one model that says what will happen when investment as a % of GDP declines and GDP instead becomes maintained by borrowed consumer consumption?

    Show me one model that deals with second and third order effects of trade on terms with China, since it devalued? (Munger 1993, Drugger)?

    I could go on and on and on about the really big questions and the really small answers (if macroeconomics was a porn movie it would be a farcial comedy).

    In sum, FO

  43. Not me baby. Everyone from the pity party

    Brad DeLong, today:

    There are, it seems to us (or, rather, to me), two intellectual sides here. One consists of a lot of people trying to grapple with a confused, uncertain, and near-desperate situation (and advocating policies like housing finance reorganization, nominal GDP targeting, expansionary fiscal policy, etc.). The other consists of a bunch of rather lazy ideologues who haven't done and won't do their homework talking bullshit and trash.

  44. "There are, it seems to us (or, rather, to me), two intellectual sides here. One consists of a lot of people trying to grapple with a confused, uncertain, and near-desperate situation (and advocating policies like housing finance reorganization, nominal GDP targeting, expansionary fiscal policy, etc.). The other consists of a bunch of rather lazy ideologues who haven't done and won't do their homework talking bullshit and trash."

    Exactly. Except DeLong is wrong about which team he's on. And you're still a crackpot.

  45. I forgot -- John D. is not only a crackpot, but he's also a really big asshole. Steve should banhammer this nutbag.

  46. Being a genuine Catoist (Senior Fellow, 2008-, and proud of it), I think I'm perhaps uniquely qualified to say that John D. doesn't even know which economists actually have some connection to that organization, and which ones don't. Why the cad doesn't even have the decency to name me--the one truly deserving person--among the nuts!

    So yea, Steve: banhammer the lout.

    1. it is of no surprise that a catoist would jump on board for censorship

      beyond that, a brief story. A team of scientist went deep into the Arkansas Ozarks to study religion. Far up one hollow they found a one room cabin with a light in a window. They knocked and asked the old gent if they could ask a few questions? Well Yes. They progressed down the list, finally asking, "Do you believe in full immersion infant baptism? Believe in it, Hell, I've seen it."

      I am pretty confident that I am the only on here who has seen the start of a bank run. Boxes of endorsed loan docs, armored cars with cash, and scared people starting to form in lines. My Dad saw real runs. My Grandfather saw real runs. And, my Great Grandfather saw real runs.

      My point. Do we need deposit insurance to prevent bank runs and do business in the country? My answer, Believe in it, hell, I've seen it.

      Now, at the same time, I could give you chapter and verse about what is bad about how deposit insurance is structured, but catoists have no desire to improve, to make anything work, so the devil with you.

      no, they just want to end deposit insurance, because private is better than gov't

      if that is true, why are you reading this blog? the fed reserve is gov't. you should be with Ron Paul for banning it.

      Now, when I see someone is pushing "free banking," from an ideological extreme, who is a cad, you shows no understanding of people, of duty or public trust, of peoples hopes, doubts, and fears, someone who lacks personal knowledge or the reality of banking, what it can do for people or how it can go horribly astray, I really am not going to bother listing their name.

      At any date, time, and place, with anyone who has a balanced POV, I would be happy to talk about banking. I was personally complaining to the OCC and FED about mortgage loan quality in 2002.

      I know exactly how a single reg on appraisers (for nat'l banks, 13 CFR 34.45(b)(2)) was turned into a loop hole that permitted the trillions in bad loans to be written. Facts which will never appear in the Feds models.

      In sum, banking is a human activity will all its ups and downs. What bothers me mostly about this blog and catoist is that there is no genuine attempt that I can see to deal honestly with reality.

      Huntsman said it really well the other night, responding to catoists who were mad because he went to China for a democratic President. That's sick.

    2. Who is arguing to get rid of deposit insurance? Nobody I know of. This guy really needs a sedative.

  47. "Do we need deposit insurance to prevent bank runs and do business in the country? My answer, Believe in it, hell, I've seen it."

    No--you've seen a slice of US history. You evidently haven't seen the experience of many other nations that felt no need for such insurance until the idea started to spread, like a disease, to them from the US. In the 30s deposit insurance was a device to prop-up a unit banking system that clearly wasn't capable of standing on its own feet. It was small-bank corporate welfare, no worse than the large-bank version that prevails today. And that is why I am happy to respond to Anonymous (7:12 AM) by volunteering myself as an instance of someone who'd like to get rid of it.

    Having seen a bank run, in short, doesn't necessarily amount to seeing the big picture. You will no doubt wish to respond. But as this is Steve's blog, not mine, I don't feel at liberty to continue.

  48. Good for George Selgin. As a neutral UK citizen with no dog in this US fight, I have to say John D is an ideologically-driven ignoramus.

  49. Why are we screwing around, we just need to turn the lights out... For good. NNEMP generators can be carried as a payload of bombs and cruise missiles, electromagnetic bombs with diminished mechanical, thermal and ionizing radiation effects and without the political consequences of deploying nuclear weapons. A couple of these and the lights go out in Tripoli. It will leave them helpless. These are not something from a science fiction book, they do exist and they should be used immediately.

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