Waldman Thinks Bernanke Will Go for (Flawed) Exit #1
Way back in March 2011, I had an article at Mises.org critiquing three “exit strategies” people had discussed for the Fed. The first was paying higher interest on excess reserves. Here was my analysis:
The option that Bernanke himself frequently mentions is the Fed’s ability to offer higher interest rates on excess reserves. Currently, if a commercial bank keeps its excess reserves parked at the Fed, the balance grows at an annual percentage rate (APR) of 0.25 percent, or what is called 25 “basis points.”
Now suppose (either because of rising price inflation or because of a healthy recovery) that the prime rate — what commercial banks charge their best clients — rises from its current level (3.25 percent) to, say, 10 percent. (This isn’t farfetched; the prime rate was higher than 10 percent in the late 1980s.)
Faced with earning a completely safe 0.25 percent by keeping their money parked at the Fed, versus earning a very (but not perfectly) safe 10 percent by lending to their most stable customers, many banks would begin drawing down their excess reserves, thus starting the inflationary spiral. To check this, the Fed could also bump up the yield it pays, to (say) 7.25 percent. By maintaining the spread between the two rates, the Fed could bribe the bankers to keep their money locked up at the Fed.
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In any event, Bernanke’s favored “tool” of raising the interest rate on excess reserves is the epitome of kicking the can down the road. In the beginning, the higher payments would simply reduce the Fed’s net earnings, meaning that it would remit less money to the Treasury. Thus, the federal deficit would grow larger, meaning that taxpayers would ultimately be the ones paying bankers to not give them loans.But at some point, if the process continued, the Fed would have exhausted its income from other sources. For example, on a balance of $1.2 trillion, if the Fed had to pay 7.5 percent interest, that would translate into $90 billion in annual payments to the banks. (The Fed earned about $81 billion in net income in 2010, of which it remitted $78 billion to the Treasury.)
To be sure, nothing would stop Bernanke from making such payments. He isn’t constrained by income statements; Bernanke laughs at the shackles holding back lesser men. He could simply bump up the numbers in the Fed’s computers in order to reflect the growing reserves balances of the commercial banks if they kept their funds with the Fed.
But this would hardly “solve” the problem of excess reserves. Rather than facing a $1.2 trillion problem, the next year the Fed would face a $1.21 trillion problem, and so on. The excess reserves would grow exponentially.
In a running argument with Paul Krugman, Interfluidity’s Steve Waldman recently wrote:
Cash and (short-term) government debt will continue to be near-perfect substitutes because, I expect, the Fed will continue to pay interest on reserves very close to the Federal Funds rate…This represents a huge change from past practice — prior to 2008, the rate of interest paid on reserves was precisely zero, and the spread between the Federal Funds rate and zero was usually several hundred basis points. I believe that the Fed has moved permanently to a “floor” system…under which there will always be substantial excess reserves in the banking system, on which interest will always be paid (while the Federal Funds target rate is positive).
Ruh roh.
Since you mention the “prime rate” I wonder if you’ve read this:
Is the Prime Rate a Scam?
http://www.interfluidity.com/posts/1160447599.shtml
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The Fed only buys bonds, so even if it never sells anything its balance sheet will automatically shrink as the bonds mature. Yes, the Fed will sooner or later lose money if it keeps betting on falling interest rates. A deeper question is, why do so many people believe that the central bank betting on falling interest rates – effectively wagering against the economy – is a “monetary stimulus” (because it increases bank reserves which monetarists just *know* is inflationary, never mind the mixed message)? That’s a mystery to me.
Let’s use your numbers.
The prime interest rate rises to 10% and for banks to demand 1.5 trillion in reserves, the Fed must pay 7.5% in interest on reserves. To keep reserves constant, they must sell 7.5% of their assets each year. That is about 112 billion.
Now, let us suppose that if the Fed kept on paying .25%, that the demand for reserves would fall back to $50 billion. That would require that the Fed sell 1.45 trillion in assets at the the same rate that the demand for reserves fell, perhaps a year or less.
By paying perhaps high interest on reserves, the Fed can greatly slow the rate at which it must sell off assets.
If the demand for currency rises 5% each year, this would reduce the amount of assets the Fed must sell to keep reserves constant much less–$37 billion. After about 20 years of currency growth, current base money would take the form of currency. Each year, the amount of reserves, and the interest cost of them would be falling.
What happens on the Fed’s balance sheet depends on the earnings on its asset portfolio. Since the Fed is holding longer term government bonds and mortgage backed securities, it will only be able togradually replace these with higher earning government bonds (and who knows what else.) Because currency is about $1 trillion and the Fed pays no interest on that, the Fed has a long way to go before it suffers losses, even if it pays higher interest on reserves than it earns on the share of its asset portfolio matching reserves.
Of course, your analysis of the consolidated government balance sheet is correct, any reduction in income from the Fed is a reduction transfers to the Treasury, which requires more borrowing from everyone other than the Fed, and in the long run, less government spending or higher taxes than otherwise would be necessary.
What I would advocate, however, would be to raise interest on reserves and sell off securities nearing maturity (or not replace them) at a rate that reduces the quantity of reserves. (Rather than simply offset the impact of crediting reserve balances with interest.) I see no “problem” with reducing transfers to the Treasury to zero. If there is any net income, it should be used to cover realized capital losses from more rapid sales of assets.
In fact, I would like the Fed to ask Congress for a bailout. That the Fed doesn’t always provide money and sometimes imposes a cost is a good lesson for Congress and the voters. Asking Congress to cover the losses on the mortgage backed securities would be a good thing.
(By the way, I don’t think 10% for the prime interest rate is likely if the Fed follows any of these exist strategies. If instead, you assume that it’s exit strategy will be to keep interest on reserves low and base money constant and allow a higher growth path for path, then a 10% (or higher) prime rate is quite possible during the transition. ) If you assume they continue to increase base money as before, then a higher than 10% prime rate is likely.
I think you have a fundamental framing of fiat money being something that is printed up and spent by the government. Just like gold miners pan for gold and spend what they find, government prints up paper money and spends it on what it wants.
I have a fundamental framing of credit money being something that represents borrowing and that it _should_ adjust according to the demand to hold it. I always hold out the hope that its quantity will be reduced when there is lower demand to hold it. And I aways advocate that the quantity should be reduced when there is lower demand to hold it. Just as I advocate that the quantity should increase when there is an increase in the demand to hold it. Those parts of money that can pay interest, in my view, should pay interest at rates that shift with saving supply and investment demand. If the economy recovers and investment demand rises and saving supply falls, then the interest rate the Fed pays on reserves should rise. But the quantity should be reduced to match the demand to hold it.
Bill,
Nice analysis.
As an NGDPT advocate do you see this raising any particular challenges ?
It seems to me that the fed could hit an NGDPT target either by paying higher IOR on reserves as bank lending increases or just using the old mechanism of the fed fund rates and maintaining this at a sufficiently high level (via OMO) to prevent the lending of excess reserves becoming inflationary.
The question of how fed policy affects govt income is an interesting one. and one guesses that for political reasons higher IOR will NOT be the preferred approach.
Bill Woolsey wrote:
What I would advocate, however, would be to raise interest on reserves and sell off securities nearing maturity (or not replace them) at a rate that reduces the quantity of reserves. (Rather than simply offset the impact of crediting reserve balances with interest.)
Bill, this is very interesting. I have never seen anyone spell that part out before. Is this so obvious that no one bothers mentioning (except in the comments of my blog), or is this a novel idea on your part?
I want to highlight this for the world. Do you / could you have a post on it, or should I just quote from your lengthy comment above?
That’s a call for the government to print fiat money, directly, in case anyone missed that.
It’s what the Greenbackers want.
Why the Greenbackers Are Wrong
http://www.tomwoods.com/blog/why-the-greenbackers-are-wrong/
The Case for a Free Market in Money
http://www.libertyclassroom.com/free-market-money/
I disagree on that one, but a true free-market in money would require at least two or more types of fiat money in parallel circulation, in order to have some sort of competition and market forces.
Under a situation with multiple fiat currencies in parallel, you do have balancing forces at work: it is profitable to print more (obviously) but you want to encourage confidence so that people keep using your currency instead of switching to something else. The point is that under current conditions they can’t switch, and that’s why the market mechanism cant’ work — no free choice, no free market.
You disagree that it is always profitable to produce fiat paper money?
There is no limit to the amount of fiat paper denominations that can be created.
What you’re describing is based on the idea of “perfect competition”, which is not a free market concept.
Competition doesn’t require multiple producers; Rather, it requires the freedom to ATTEMPT to compete with other producers.
An industry is no less competitive where there is only one producer, than where there are many, so long as government isn’t granting privileges.
When government bases policies on “perfect competition” it actually restricts competition by artificially restraining some producers for the benefit of others.
(By the way, this is also how Crony Capitalism gets started. The artificial restrictions required to pursue “perfect competition” actually end up pricing people out of the market. This is inevitable. Notice the irony that such policies are socialistic in intent; It is SOCIALISM that gives rise to Corporatism and Fascism, NOT the free market.)
Moreover, though, the concept of “perfect competition” is logically incoherent; It’s not competition if I’m not drawing away patrons from someone else with better products or lower prices. Producers compete with other producers FOR patrons.
Here’s Ron Paul talking about these issues:
Anti-Trust and Monopoly (with Ron Paul)
http://www.youtube.com/watch?v=8C4gRRk2i-M
Yes I’m disagreeing… in a competitive environment there will be a balance because printing more currency undermines confidence in that currency.
Correct, but there is a limit in what people will accept, especially if they have a choice to select something else instead.
Sorry, but where did I say “perfect competition” ? I just said that some competition has to exist. Enough to give people a choice, that’s all. I dunno where this “perfect competition” concept popped out from, but not me.
That just sounds like making excuses for a monopolist. I recognize that government’s anti-monopoly efforts have been ineffective (after all, they split up Bell but the whole thing has pretty much rejoined itself) but the fact that government is incompetent at achieving its ends, doesn’t make those ends not worth achieving.
I disagree with that as well, Crony Capitalism reliably offers advantages to the largest incumbents at the expense of the small upstarts, rather than the other way around. It’s mostly just about a privileged elite defending the status quo (which any elite group will do if they can). Very difficult for Joe’s corner store to offer enough campaign donations to buy any favours, but much easier for the supermarket chain to buy those favours.
I was referring to an “all else being equal” situation.
To be sure, competition for a lower rate of inflation would result in less inflation than a single fiat currency.
But note that fiat currencies would still inflate; This exemplifies my point, rather than disproves it.
As well, fiat money competition creates enemies where none exist; One fiat currency creator is accused of currency manipulation because the other believes that the one that isn’t inflating as much is stealing jobs that are thought to belong to those using the more inflated currency.
Cheap imports are good for everyone; The trade deficit doesn’t really matter.
It only SEEMS to matter when you have multiple fiat currencies:
Classic Ron Paul – 1988 Campaign Interview (part 2)
http://www.youtube.com/watch?v=Tpp5XOJPGlM
(It’s the first thing Ron Paul talks about in that particular video.)
Austrians WANT to select something else: commodity money. But we are accused of wanting to crash the economy, or of stealing from the state, when we try to escape fiat money.
The limit in what people will accept has been forcefully extended by government threats.
If you’re for government interventions to stop “monopolies”, but you’re not advocating “perfect competition”, then your proposal necessarily results in Crony Capitalism, which you claim to be against.
At any rate, the idea that a necessary component of “competition” is the presense of multiple producers is logically incoherent.
Competition IS the pursuit to do something better than someone else. That’s what it means.
Further, it’s the patrons who decide which producer is better, in a free market, not the producers. Producers work to fulfill the desires of patrons – that’s the only way they can acquire wealth in a free market.
So, if patrons decide that a single producer shall get most (or all) of the market share, then that single producer is the best competitor.
There is zero lack of competition in this scenario. People are free to compete, and free to fail at doing so.
Not only is the government incompetent at achieving it’s ends, but there is no benefit in government granting privileges to one party just so they can have their profits protected from a superior competitor.
On the matter of incompetence, anti-trust laws are arbitrary:
If a producer is charging high prices, he’s accused of stealing from the public;
If he is charging low prices, he is accused of trying to monopolize market share;
If he is charging the same as other producers, he is accused of collusion and attempting to form a trust.
Any price, then can be considered monopolistic (or oligopolistic) depending on which company is disfavored at the moment.
Cronyism is inevitable under anti-trust laws.
On the matter of the benefits of government pursuing “perfect competition”:
Since you are willing to accept an incompetent pursuit of ending what you consider to be “monopolies”, it should interest you to learn that the free market results in far less of them than what you are proposing.
This is the discovery of Dominick Armentano, who once used to teach against monopolies.
He discovered that, in fact, government is the source of monopolies in the sense you describe, and that the agitation in favor of anti-trust laws came primarily from those who wished to have government protections:
Dominick Armentano: The Case for Repealing Antitrust Laws
http://www.youtube.com/watch?v=xBT-fnJsfo0
Monopolies were never the problem people who hold your position thought they were.
More directly, though:
No one is entitled to any product, and it is profit which leads producers to produce;
Artificially restricting the market share or profits of the superior competitor is a violation of his right to mutually beneficial exchange with patrons.
It also creates artificial shortages since there is a government imposed limit on the amount of profit which can be made.
If no one wished to meet consumers’ desire for a particular product, then consumers would be worse off than if the producer charged high prices, since the product wouldn’t exist at all.
Artificially protecting market share or profits for an inferior competitor lets that competitor socialize its costs onto the citizens, reducing their standard of living (and raising everyone else’s costs of production).
It also creates artificial surpluses, leading to moral hazard since people are under the mistaken impression that wealth has been created, when in fact it has simply been redistributed to the politically connected.
It’s not cronyism to produce and price your goods in such a way that you gain 100% market share (that’s rare and difficult, by the way, without government protections).
Someone who is an inferior competitor on the free market has been done no wrong.
And again, it’s the consumers, themselves, who decide who gets what amount of market share on the free market.
No producer is entitled to any amount of patronage. Either people want someone’s product at the quality and price that is offered, or they don’t.
A free market makes producers accountable to consumers, since profits will only be made when consumers’ preferences are met. Anti-trust laws puts cronies in charge since profits are partially made when producers are politically connected.
That’s all very well in theory.
Back in the 1980’s and 1990’s Microsoft had a system where every manufacturer of PC hardware was forced to pay for a copy of MSDOS on every unit they sold, regardless of whether they actually sold a copy, and regardless of whether MSDOS was ever going to be used on that hardware.
It became known as the “Microsoft Tax” because, regardless of who you were, if you wanted to buy hardware you were compelled to pay Microsoft for their software. This was all done through contracts that were written such that they were “all of business” contracts. Thus creating an artificial barrier of entry into the marketplace.
All that people wanted at the time, was such exclusionary contracts to be struck down. Now, when you think about it, all contracts are enforced by state power anyhow, so this went through courts and eventually those contracts were deemed illegal, but it never got enforced, and so the practice continued.
Later on, Microsoft did it again when they sold both operating system software, and the application layer software that ran on the operating system. You would say, well there’s nothing wrong with selling two products, but they made sure their applications had access to special operating system features that other applications couldn’t use… thus giving themselves an advantage by leveraging part of their business to block competition in other markets.
I’ve personally seen the case where Microsoft took over the WINSOCK.DLL and rejigged the API to suit themselves (this particular library started out as a third-party library, called the Trumpet Winsock, but Microsoft dumped their library over the top), this caused the Netscape of the day to magically stop working, until Netscape caught up with a new version.
There’s a quick outline here:
http://www-cs-faculty.stanford.edu/~eroberts/cs201/projects/corporate-monopolies/dangers_msn.html
Again, all people wanted was a clean separation of products, which is only what you expect in any industry. Imagine how you would feel if you buy a car, but somehow they force you to only refuel that car at a particular station? Or you could only buy tyres from the original manufacturer? Sure, the auto industry tried this on with their service — the electronic engine management systems were locked so that only the approved service guys were allowed access to the computer. This locked out third party mechanics, but government stepped in on that one and forced them to use openly accessible interfaces.
Then the printer manufacturers tried to do the same by using electronic locks to force the purchase of ink from only one supplier. That’s been going through the court system.
All of these mechanisms are designed to lock in a monopoly position and take choices away from the consumer. No real free market libertarian should support this. We could argue about which mechanisms are effective ways to stop it happening, maybe with the Internet just bad publicity would be enough, but the point is that taking away individual choice is always bad.
http://www.theregister.co.uk/1999/11/05/how_ms_played_the_incompatibility/
There’s some documentation of the tricks they did to prevent people using DR-DOS, which came out during the Caldera trial.
Note that people reported that if you installed MSDOS first, and then installed Win-3.1 and then went back and replaced MSDOS with DR-DOS then you could use Win-3.1 quite successfully. However the Win-3.1 installer was specifically designed to prevent this, even though there was no technical reason to do so. Emails from the time showed that this was a policy thing, not an accident.
That’s not an artificial barrier. It’s a peaceful agreement.
(I’m against Copyright and Patent laws, by the way.)
No one was entitled to Microsoft’s software to begin with, so it’s within Microsoft’s right to put any conditions it wants on the sale of the information it has.
Now, Microsoft can’t justly punish someone, who is not under contract, for copying that information since you can’t own the thoughts of another person or what he produces with those thoughts.
The problem here is not with the free market, but with government interventions in the form of copyright laws.
If people didn’t want to sign a contract, then they would not be entitled to Microsoft’s information. There’s nothing wrong with that.
And there’s nothing wrong with people contracting to receive information which, when used, will prevent third party programs from operating.
No one is ever entitled to the property of others. Therefore Microsoft’s restrictions written into the code – insofar as sales were based on contract and not copyright – were neighter artificial nor unjust.
If you can figure out how to make your computer do what Microsoft does, but without the restrictions, and as long as you don’t have a contract with Microsoft, then you could justly save a lot of money.
Not many people can, so they must sign a contract or go without. Nothing wrong with that.
How will Congress pay for its budget deficits if the Fed reduces its buying or, in the worst case for Congress, becomes a net seller? And what will that mean for interest rates?
There’s a bit of a rumour going round that the Fed’s asset portfolio is a bit lacklustre.
Yeah well if you buy government bonds at low interest rates, and then sell them when interest rates are higher, the rule of thumb is you are going to make a loss on that.
There should be a fairly easy way to discriminate between these ideas, based on where the control elements are. If the Federal Government finds itself needing to spend more than it has revenue, does the President:
[A] run to the Fed and ask what “money holding demand” looks like, with the idea in mind to cut spending if required; or
[B] just spend anyway and toss it over for the Fed to deal with, come what may?
Based on understanding which way the direction of control is applied, we can decide whether we are dealing with “print and spend” or “carefully adjust to suit money holding demand”. I’m willing to look at a case-by-case breakdown, but at first glance I’d be going for [B] every time.
Why has no one mentioned the change (increase) in reserve requirements by the Fed? I was told that had a lot to do with the fact that credit is tight.
konst, what increase in reserve requirements? Are you talking about capital requirements?
I don’t know the details but if I understood it correctly was told that some “assets” wouldn’t count toward reserve requirements. That’s like increasing the reserve requirements but in an indirect way. Someone needs to verify this. Maybe I’m wrong.
I’m pretty sure you are thinking of capital requirements, though, konst. “Reserves” were pretty narrowly defined even in 2007.
Maybe you’re right. If I remember correctly, the conversation at the time was about why banks why there was a credit crunch.
Whatever the exact changes, I was told the reason was the result a change in fed policy. This was about a multinational bank with sites in the US and Europe.
Forgot to add, the change wasn’t about interest being paid on reserves.
This guy maybe?
http://en.wikipedia.org/wiki/Basel_III
That may have something to do with it though I thought it was 3% not 4.5%.
There might be a phased implementation. Usually these things are done like that to prevent the sudden jump, so I’d be guessing that 3% is an intermediate stage towards the 4.5% figure.
Flawed “Exit” #4: Get the government to distract the country with war.
“See? WE didn’t crash the economy. Of course, since every government is insolvent, we will have to borrow money from the IMF, which will cost you even more liberty.”
The only way to win is not to play the game; We have to stop using fiat money. Barter if necessary.
There’s another way that’s so easy a caveman could do it.
Save up to 15% with Geico?
haha no. There’s one thing sociopaths hate, maybe more than anything, and that’s to be ignored by their victims.
So the more people you can get to just ignore them the better. Some might call it sucession, disengaging from the system,… but the action is the same and with similar results.
People that say they “woke up” or refer to people as “waking up” is the same. The result is that the sociopaths are deprived of their victims. If you can get large numbers of people to ignore them, i.e. ignore the sociopaths, and ignore their parasitic rules then that deprives the psychos of their power.
That also reconfigures the economy into a free market automatically, the reason being people will have to deal with each other rather than having their resources/wealth go through an intermediary.
That strategy would actually be impossible, since it is the fiat money which allows them to confiscate the wealth required to do what they are doing to us.
This video explains the futility of trying to ignore the sociopaths under a fiat currency:
War and the Fed | Lew Rockwell
http://www.youtube.com/watch?v=Tl9lS5k7H5M
When I say ignore I don’t mean let them do what they’re doing. I meant don’t participate in their system, don’t follow their rules,…
Of course on certain occasions if you try to ignore them you’ll realize that you are their slave and it’s likely to make visible the “chains” they use to keep people in servitude. At least it will show people around you the real situation and the cause of their problems.
“banks would begin drawing down their excess reserves, thus starting the inflationary spiral”
Banks can only “draw down” their excess reserves by withdrawing them as physical cash. Why would they want to do that?
“the Fed could bribe the bankers to keep their money locked up at the Fed”
Reserves can only be withdrawn from the Fed if they are withdrawn as cash. Again, why would banks want to do that?
Also, most of the “excess” reserves only “belong” to the banks in the sense that they hold them on behalf of their depositors. If banks receive interest on their reserves from the Fed, they will pass it on to depositors by crediting interest to their accounts, keeping a fraction for themselves.