Although I am not really a monetarist, I do like their basic approach, especially the way they distinguish between money and credit. Changes in the price level are determined by changes in the supply and demand for the medium of account, i.e. money. Unfortunately, the Fed seems to have forgotten that, and increasingly seems to focus on credit. Here is Dave Altig of the Atlanta Fed:
Is the 25 basis point return paid by the central bank creating a significant incentive for banks to sit on reserves rather than lend them out to consumers or businesses? At least some observers are skeptical:
“Barclays Capital’s Joseph Abate…noted much of the money that constitutes this giant pile of reserves is ‘precautionary liquidity.’ If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum.”
This is one of those situations where I don’t know whether I should be criticizing Abate, for what he said, or Altig, for seeming to approve of it. But whoever is to blame, this quotation seems to get things exactly backward, and does so by focusing on credit, rather than money.
Let’s suppose banks reacted to a cut in the interest rate on reserves (IOR), by switching over to some sort of short term debt. Where would the reserves go? There is only one place unwanted bank reserves can go, out into circulation. That means a nearly instantaneous $1 trillion increase in currency in circulation, with banks instead holding more short term assets like T-bills.
[As an aside, I do understand that this probably wouldn’t happen, I’m just trying to work through Abate’s worst case. In practice, yields on T-bills might fall to zero, or even a few basis points below zero. Of course if there was a negative interest rate on ERs (including vault cash), then it really would happen.]
So what would this mean for the economy? First, it would be equivalent to a trillion dollars in quantitative easing (QE), which is quite a bit. But you might ask; “Why would an extra trillion in QE help, didn’t the last round of QE have relatively little effect?” One answer is that at least it had some effect, it was better than nothing. But more importantly, the previous QE had little effect because most of the new base money went into ERs. If the banks got rid of reserves and replaced them with short term debt, then all the extra base money would go into circulation. It would be like a trillion in QE, with 100% of the new base money becoming currency in circulation. Not just QE, but super-charged QE. Indeed this is the nightmare scenario that led to the IOR program in the first place. The Fed was doubling the monetary base in late 2008, and feared what would happen if all that extra cash went out into circulation. What Abate defines as failure, to me seems like a dream come true.
Of course a super-pessimist like Paul Krugman might talk about how sales of safes boomed in Japan once rate hits zero. And technically it is possible that even this super QE would have no effect—it might all be hoarded. But a trillion dollars is a lot of cash, and I think it more likely that the “hot potato” process would take over—people would try to spend some of the extra money, driving up AD.
The “hot potato” process is the central concept of monetary economics. If you put more cash into circulation than people want to hold, they’ll try to get rid of it. Individually they can, but collectively they cannot. The attempt to get rid of the cash will drive up AD. I think everyone understands this (excluding post-Keynesians of course) but many economists forget what monetary policy is all about; the supply and demand for money. Lowering the IOR will lower the demand for money, and tend to raise prices and NGDP. The effect may be small or large, it mostly depends what else the Fed does. But with the economy this weak it is certainly worth trying.
HT: Mark Thoma, JKH, JimP