Lord (Robert) Skidelsky is the biographer of JM Keynes. Keynes is, as regulars here know, a man generally regarded as the “dark knight” of economics, a man who made intellectually respectable notions that had been often regarded as little more than the ploys of quacks and charlatans. Books by Henry Hazlitt and William Hutt, for example, have in my view pretty much demolished his central idea: that the way to get out of a recession is for governments to print money in large amounts and hopefully, when the sun comes out from behind the clouds, to turn on the monetary and fiscal brakes later on. It is an approach that was destroyed by the stagflation of the 1970s, when a combination of high unemployment, out-of-control trade union power, low growth and skyrocketing prices forced policymakers to seek alternative sources of wisdom, in the forms of Friedman, Hayek and the rest. However, the attempts by governments to revive their economies in the past few years have given what I consider to be a spurious impression that Keynes’ ideas are still appropriate to our time. I disagree.
Skidelsky argues that the current Tory/LibDem coaltion government is making a fearful error in trying to reduce debt and spending. He also argues that what the world needs right now is a new sort of Bretton Woods agreement, moving on from the original deal as signed in the 1940s at the end of WW2. That agreement achieved, among other things, strict controls on capital flows between nations. It is hard for younger people to realise that it was not all that long ago that it was illegal, for example, for Britons travelling abroad to take more than a small amount of money out of the country without explicit consent. This is serfdom: if people are banned from taking money from place A to B even if they have earned it, then what is the difference between that and a serf seeking the consent of his lord before moving to another village down the road?
And in any event, as Lord Skidelsky knows only too well, the BW agreement eventually failed because of a combination of forces: rising government deficits, rigid, unionised labour markets and inflation (caused by things such as Vietnam War, the Great Society welfare policies in the US and UK); the oil crisis of the early 1970s, and developments such as the offshore Eurodollar market, which encouraged a relatively unregulated, vibrant financial market that made BW increasingly hard to operate. The stresses proved too great; the US finally severed any link between the dollar and gold during the Nixon presidency, and Bretton Woods was dead. A good summary of how it all went wrong can be seen in this recent book by Deepak Lal.
Keynes was not completely wrong on all the topics of the day, and to his great credit, the post-war settlement did include attempts to foster free trade and reduce protectionism, which policymakers realised had been such a disaster in the 1930s. But the idea of governments spending vast sums of central bank funny money as a way to deal with the results of previous monetary excess looks less and less wise with every day that passes. Keynes still has his devotees, such as Paul Krugman, but his ideas are not, by and large, what are needed to get us out of our current predicament.
Since putting into words the question “where has the money gone?” a few days ago, having thought it very often but never overtly framed it as a question, I think it’s a very interesting one and so far as I know neither Keynesians nor Austrians have addressed it directly- though I may be in error and if anyone has some Austrian economist who has addressed it directly, I’d like a pointer please.
Maybe it’s just me. I think it’s a very interesting question. if there isn’t enough money after the crash, but there was before, where is it? The crash hasn’t destroyed any money. To simplify matters, strip out fiat and central banks. Use a gold standard or gold pieces economy. You can still have a crash if too many people bought tulips or railway shares or south sea bubbles. So, the day after the crash, where is the money? Who’s got it?
I think I have a basic answer but I’d like to read what our economics gurus here have to say if anyone’s interested in addressing it; and there is not enough room in this margin to write my wonderful proof anyway.
IanB, it is an interesting question but for Keynesians, as far as I understand it, what this is all about is confidence; by printing money, or whatever, the idea, so they say, is to create an upsurge of confidence in people to start spending again, which encourages investment. This is all about the so-called “multiplier effect”. And the Keynesian argues that the ME will pay for itself, so that the temporary deficit caused by the fiscal expansion will be countered by a surplus on the public accounts when the economy improves.
That is the theory. It sounds great – for a few minutes. The trouble is, of course, that most Western governments – with a few gaps – now have been running big deficits even during periods of supposedly strong economic growth; they no longer have the ability to turn on the fiscal taps. Another problem is that with so many pensioners, a lot of any additional liquidity just gets saved, and the money goes “under the mattress”, so to speak.
This is what has happened in Japan. The country has been in a stagant situation for about 20 years despite very low, or even zero, interest rates. It is an alarming situation that freaks the hell out of me.
I’m no economic guru and it’s 20 years since I did economics at school, but I think you’re asking about the the velocity of money(Link), which is part of the equation of exchange(Link). Basicly the money is still there, but people are evilly hoarding it for a rainy day instead of spending it as their masters’ command.
Governments really care about that as they get to tax the profit on each exchange, so if people save rather than spend the civil servants might suffer.
Ian B, into the pockets of people who sold before the bubble burst? Or is that too simple?
My house and my stock portfolio used to be worth a lot more two years ago than they are now. Who took the money? No one, it just vanished when valuations dropped.
IanB,
something particular like the tulip crash is not the same as everything crashing at the same time.
The money disappears because people rush to take their money out of the banks, thus reducing the banks’ reserves, forcing the banks to reduce the credit they have pyramided upon it. (?)
Do people mean “money” or “wealth”?
If it’s money they mean then AKM is correct, the velocity of money has fallen. Or, to put it another way, the demand for money to hold has risen.
If they mean capital or wealth then it’s a lot more complicated.
Couple of comments; bank balances aren’t money, stock portfolios aren’t money and houses aren’t money. They’re an aspiration to have some money later. They may be “wealth” but they are not money.
If the Keynesians are arguing that after the crash there is not enough money, where did the money go? I don’t believe this question can be answered by analysis of aggregate variables. I would also argue (well, I just thought of this in the bath so bear with me) that the only meaningful measure of the money supply is the sum of bank reserves+cash outside banks.
I also don’t believe in the velocity of money. It sounds plausible, but if you try to describe it in terms of actual economic activity, a meaningful definition becomes elusive.
If we drag out the hackneyed MV=PQ equation, I believe an analysis shows that V is just a fudge factor. The equation actually says something phenomenally trivial; “in a single round of transactions, the money spent (MV) will be the sum of all the moneys spent (PQ)”. Well, duh. The V factor is an attempt to introduce a time constant to an equation that should be differential. It is a strange equation; of all the terms only one can be measured (and there is much disagreement about how to measure it); M. V cannot be measured. P cannot be measured, and Q cannot be measured, though PQ can be crudely measured as GDP (in which at any instantaneous measure P=1). P (“aggregate price level”) is another sneaky differential term. The equation is actually M=Q. That’s it. I don’t think it really tells us much at all.
Anyway, I don’t believe there is any “velocity of money”.
Oops, P is crudely measurable as inflation.
Keynes’ idea was actually to engage in deficit spending in time of recession by increasing state expenditure and/or to stimulate demand by cutting taxes (again resulting in deficit). To pay for this, Keynes saw it would be necessary to increase taxes and reduce state spending in the positive part of the economic cycle, thus building up a reserve of cash for the inevitable bad times. This is counter-cyclical policy, which is really all that Keynesian economics is. It works, too, in exactly the same way and for exactly the same reasons as it works when the private individual saves money in good times so he has a cushion for the bad.
However, the hard part is getting governments to raise taxes and cut spending after recession. They don’t like to do this, because people find it inconvenient and thus the fear is they might not vote for the government. This is an argument against democracy, not against counter-cyclical economic policy. It also shows what’s wrong with the selfish and short-sighted individual, who finds it difficult, once started, to turn away from pissing cash up the wall on useless bling.
The velocity of money is the average number of times a unit of money is transacted during some period; it is the inverse of the demand for money. We might also conceive of other goods having velocities, such as cars, bonds, clothing or whatever, but it would normally be uninteresting to do so. But the velocity of money is interesting, because money is one half of every transaction. If the velocity of money falls while prices remain constant, then the average velocity of all other goods must have fallen too.
Personally, I prefer to use the phrase “demand for money”, because it connotes more familiar notions of supply and demand, but it is conceptually identical to the velocity of money. It seems to me quite impossible to understand monetary economics while “not believing” in the concept of money velocity. Keynesians may be wrong about many things, but this is not it.
Like I said, it’s just a fudge factor to introduce time into an equation that ought to be a differential but which doesn’t say anything much at all. I think it was Friedman who argued that “velocity” doesn’t change significantly and it seems clear to me that that is correct. Money clocks through the economy via regular wage payments, rents, etc etc and the idea that it would suddenly precipitously drop is pretty preposterous. That gets used as an explanation to try and provide meaning to a rather useless equation.
That’s what I keep saying: let’s reform that damn individual once and for all!
That’s what I keep saying: let’s reform that damn individual once and for all!
I get the sarcasm, but more realistically, let’s not assume individualism is a panacea for anything much.
EG
No such assumption on my part, Euan – I didn’t get that old by looking for a panacea in this world – and I don’t believe in the next one either. Oh, and welcome back:-)
In the video clip which claims to show Skidelsky advocating a Bretton Woods solution, he says nothing of the sort!!!!
As to the idea that money supply increases necessarily result in inflation, how come there was an astronomic and historically unprecedented increase in the U.S. monetary base a year ago (it went up around 250%), yet inflation is near non-existent there. Moreover, the big money is not betting on significant inflation any time soon because the yield on 10 year U.S. government debt is at a near record low.
There is chart produced by the Federal Reserve showing this monster money supply increase at:
http://research.stlouisfed.org/fred2/series/BASE
Ralph, I think the short answer there is that most of the stimulus money is circulating in the former bubble economy, holding up prices that had already inflated and further weakening the productive American economy, which is being parasitised both directly and indirectly to support unproductive “bubble industries”. To maintain this position the US government will be forced to keep printing money until it does break out and inflict a general further inflation, although it is hard to predict precisely when.
Already covered that, Ralph.
Euan talks about the supposed problems
in a democracy of making counter-cyclical
policy work. It is a real bummer when
there are no Platonic guardians around,
is it not? Seriously, though, the trick is surely not causing the boom and bust cycle in the first place via central bank
funny money.
O
N
Moreover, the big money is not betting on significant inflation any time soon because the yield on 10 year U.S. government debt is at a near record low.
Want to go ask George Soros or John Paulson what the big money is betting on? Here’s a clue: try googling NovaGold. Saying that the “big money” isn’t betting on inflation because the yield on the 10-year note isn’t high at the moment is a bit like someone, a few years ago, saying that no one is betting on a housing slump because prices have been going up for the last decade.
Price rises in America are accelerating. The US dollar is currently falling against pretty much every major currency — the Federal Reserve is “winning” the global currency war. Cost-push inflation is here to stay; have a look at what commodity prices have been doing recently.
You can’t create a ton of new money — “QE” — and not debase your currency.
Is there a “boom and bust cycle”? Is cycle the right word to apply to unpredictable economic crashes?
Is there a “war and peace cycle”, or is it just sometimes the case that we are at war?
Money and credit is not the same thing. Broad money includes credit as well as base money, i.e. Real money like the gold coins of old. As for where the money goes after a crash, if you invest your money in a project that fails the money is gone. Just like a crop failure. The explosion in the money suppy is due to central banks buying crap bonds from the financial sector in exchange for newly created cash. This sits in the banks accounts at the central bank. If and when it gets lent out it would be inflationary. This will not happen until demand picks up in the economy.
Economies with a high discretionary component are prone to ‘stalling’, where consumers in an otherwise healthy economy get spooked and reduce consumption, bringing about the very recession they were afraid of. A Keynesian stimulus is a treatment for this quite specific ailment.
The UK does not have a healthy economy that has stalled, and a Keynesian stimulus is not appropriate. Furthermore, the UK economy is not receiving a Keynesian stimulus anyway, which would require lower taxes and easier credit, the exact opposite of what is actually happening.
Ian B and others,
There are certainly problems with the monetarist equation MV=PQ. But, the thinking behind it is useful. In my view it’s best not to pay much attention to the equation behind it, but to pay more to the concepts behind it.
The discussion in Mises book “The Theory of Money and Credit” is very good on this topic. Mises begins by dividing money into two broad types. “Money in the narrower sense” is coins and notes. These can be gold coins in a commodity standard or fiat notes and coins in the sort of system we have at present. The second type is “Money in the broader sense”, that includes money-in-the-narrower sense and also adds bank balances and banknotes issued by commercial banks. Bank balances fulfill the tasks of money since they provide means of payment, that makes them what Mises calls a money substitute. Since I can do everything I can do with cash with my debit card my debit card is a very close substitute for cash. A similar sort of division is used by every school of economics, though some use different terms. In what follows I use money to mean “money in the broader sense”.
Now, all money is owned by one particular agent at a time. There is no time at which money is not owned. There is a “demand for money to hold”, that is each of us want to hold a particular amount of our total assets in money. We are prepared to forgo certain things in order to do that. For example, I’m prepared to forgo the interest I could get by putting £200 into a bond in order to have £200 in my pocket for discretionary purchases.
Let’s suppose that the economy is in a sort of equilibrium, prices have been roughly the same for a reasonable time. The total amount of money has remained the same. The demand for money by each agent has remained the same. In this case the real volume of transactions would remain the same.
Now, we can imagine changes to each of these aggregate variables, in a simplistic and approximated way. If the amount of money rises then spending power rises without any other change then the purchasing power of money will fall. If the demand for money rises then the purchasing power of money will fall. If the real amount of goods rises without any other changes then prices will fall.
The problem with what I’ve written in the above paragraph is that it is simplistic, it is “cartoon monetarism”. The various schools of economics have many more precise theories about what happens in each of these cases. In the book “The Theory of Money and Credit” by Mises I referred to earlier he sets out what he thinks happens in each cases, and outlines the nuances that separate it from the simplistic situation.
Going back to the subject of this thread. At present there is increased holding (or “hoarding” as Keynes called it) of money. The demand for holdings of money has risen because of uncertainty about the future. In particular the demand from banks for holdings of reserves has risen. Hayek called this “perverse liquidity”. This has been exacerbated by the central bank policy of paying interest on reserves. That is why the amount of base money in the US especially has risen dramatically without a corresponding rise in prices.
This doesn’t mean, contra Toby Baxendale, that creating money cannot create real wealth. To put things simply, a fall in prices comes with an adjustment cost, just as a rise in prices does. That cost can be removed by altering the money supply as the demand for it alters. The situation is essentially similar to that in other markets.
The problem with central banking is not that they believe in fluctuating money supply but supply should be fixed. Supply should *not* be fixed, just as it should not be fixed in any other market. The problem is that central banks have no way to understand demand, because their existence has destroyed the competitive market in money. As a result they rely on poor estimates.
This leads to our current problem in this recession (which is quite different than the problems that got us into recession). The central banks have created vast amounts of reserves to meet the demand for reserves from commercial banks. By doing so they have mostly headed off major price deflation and it’s associated adjustment costs such as mass unemployment. But, nobody believes that they will reduce that quantity of reserves quickly enough once the demand for money falls again. Political pressure will likely mean that they will keep the amount of reserves high and allow prices to rise rapidly. And that is why people are reluctant to invest now.
Call me naive but…
I always thought that Keynsianism’s reductio ad absurdam was to pay half the population to drop litter and the other half to pick it up with both group’s wages paid by borrowing.
Well, that’s this economic illiterate’s take on it.
PS: Google Chrome spell check suggests for “Keynsianism” these: Lesbianism, Equestrianism, Sectarianism & Vegetarianism. Perhaps we would all benefit from government spending on such core areas of the economy. Sectarianism does, after all, break a few windows.
This is a reply to Midwesterner (Oct 8th, 10:09). I looked at your 3rd June post. You assume, as do most people, that because banks get interest on reserves (it’s only 0.25% anyway), that that induces them not to lend because those reserves somehow or other compete with money that banks can or do lend.
The flaw in this argument is that banks do not need reserves in order to lend. Banks just create the money they lend out of thin air. You’ll find loads of material on this subject if you Google the phrase “banks do not lend out reserves”. You’ll find more material by Googling “banks are capital constrained, not reserve constrained”.
Ralph,
I’m a supporter of fractional-reserve free banking, a “monetary equilibrium austrian”. I understand that you are a post-Keynesian. There is one place where our views are quite similar, and that’s the idea that banks are capital constrained.
The main problem that a commercial bank faces is that it’s balance sheet must be positive. It must get sufficiently high quality loans to ensure that a string of bad debts cannot affect it’s stability. Similarly, it must encourage account holders to use it’s bank account service, but it must not spend too much money supplying them with services and paying interest. The problem of paying sufficient reserves is a minor details.
However, it doesn’t follow from that that the interest being paid on excessive reserves has no effect. The problem is that when excess reserve pay interest they compete with other assets. Ignore the liabilities side of the balance sheet for now, it isn’t relevant to this problem. The issue is that currently loans pay a low interest rate and there is significant chance of borrowers defaulting. Normally, once loans are made they cannot be unmade or bought back. In comparison reserves pay less interest, but they come with no risk of default and can easily be traded. Once a bank finds a loan that is pays sufficiently more than excess reserves do it can immediately invest in that loan and sell it’s excess reserves. So, reserves have more intangible benefits as assets than their interest rate indicates.
Keynes supposed that a “liquidity trap” could occur between commercial banks and the rest of the market. I don’t know if it ever could. But, central bank actions have created a similar sort of trap between the commercial banks and the central bank.
AFAIK Randall Wray thinks something very similar to what I’ve written here about this.
> The problem of paying sufficient reserves is a minor details.
I meant to write “The problem of holding sufficient reserves is a minor detail”.
Ralph,
I don’t know how they do things in the UK, but I don’t think you understand the US banking system at all.
In the US, there are two kinds of reserves. Required reserves, which are set at 10% of certain deposit account categories, and excess reserves, which are reserves that are available for lending but are not lent. This chart describes funds available for lending but not lent. There is one trillion dollars of money sitting in reserve accounts that could be lent but is not being lent.
Midwesterner,
Ralph is promoting the post-Keynesian view of banking. Though I don’t agree with that view it does make a lot of accurate criticisms of textbook Monetarism.
Bank planners don’t sit around thinking to themselves “if I had more reserves than that could support more current account liabilities and then I’d be able to make more loans”. The real problem is “how do I make a profit between the current account liabilities and loan assets and keep enough spare capital for emergencies”.
If a bank wants to make a loan it can always borrow reserves from the central bank and pay them back later. The problem for the bank is how to make doing that profitable. It’s for these reasons that the central bank can’t really control the quantity of money substitutes (aka bank balances) or the quantity of money in the broader sense, though they can control the interest rate in normal circumstances.
Current,
Presumably you are referring to the discount window? Barring another major change in Fed System rate setting philosophy, deliberately borrowing to relend those funds is not something that a bank planner would do. Borrowing there is a recourse that is imposed by banking regulations. If you compare the negative in bank reserves with the discount window borrowings, you will see a strong correlation.
Those excess reserve funds are the same funds that could be lent at the FF rate or serve as reserve base for consumer lending. The ratio between FF and ER rates to a very strong extent controls whether excess reserves are sent to commercial lending (inflationary) or to excess reserves (deflationary). Which one is a decision that bank planners make after looking at the incentives for each choice. In other words, when bank planners ask “how do I make a profit between the current account liabilities and loan assets and keep enough spare capital for emergencies”, those reserves are part of the calculation of the current account liabilities (to the depositors) and loan assets (to excess reserves or for interbank) they are trying to make a profit with.
Another factor is one you’ve mentioned partially. That is liquidity and the incentives for it. I suspect commercial bank planners are hedging against a surprise inflation ambush and doing everything they can to keep their commitments as short as possible. This alone is probably worth more than a few basis points.
RE Post-Keynesianism, I don’t know much about it but while the rest of it looked pretty command economy oriented I don’t see an obvious conflict on its claim that the central bank can either target money supply or interest rates but not both. This is true so long as one recognizes Milton Friedman’s point that once you preload inflation into the system by increasing base, ultimately you will achieve that inflation. If everything were to get rosy tomorrow, in other words the regulatory uncertainty in the business environment would magically vanish, I suspect the bank planners would look at the 0.25% on excess reserves, then look at the borrowers lined up at the door and decide to write commercial loans instead. If so, the consequences for the economy will be hellish inflation. Just that preloaded inflation is a sword of Damocles hanging over the economy and discouraging banks from exposing themselves to longer term lending. The best thing we could do right now is try to stuff the TARPulus back into the bottle.
I think the case can be made (and I tried to make it in the article I linked above) that the Fed has figured out how to simultaneously inflate the base, routing the new money to favored factions, while (temporarily) sucking an amount equivalent to that inflation out of commercial lending leaving the higher measures (M1, M2) quite stable. “Never let a crisis go to waste.” An insurance agent friend of mine (a Democrat) a couple of weeks ago greeted me lamenting the loss of two clients who were unable to renew their mortgages. Then he pointed out the window at how the stimulus funds had built a new street for the city. “At least someone is working.” D’oh! The Fed/Treas has figured out a way to borrow the funds of the commercial lending market. At some point they will come due with a hell of a balloon payment (pun intended). There is no even remotely benign failure mode. We are at the point where Wile E. Coyote is suspended over the canyon waving ‘bye bye’.
Midwesterner,
I agree with a lot of what you’ve written.
My point was to oppose simplistic monetarism. Over on the Cobden centre blog lots of folks seem to think that the money multiplier is uncontroversial and a natural part of commercial bank operations. But, that isn’t really the case.
I think you understand that commercial banks may be limited by other factors than the amount of reserves. That means that the central bank doesn’t really have control over the quantity of money. In fact, given current monetary institutions it would be impossible for the central bank to really control the quantity of money. At present the commercial banks don’t have to request reserves when they need them, rather they are automatically granted reserves. So, on the one hand in some cases when the central bank want to decrease the quantity of money the commercial banks may continue lending money into existence and on the other hand in some cases when central banks want to increase the quantity of money the commercial banks may not be able to find enough loans. So, what the central bank really control closely is only the interest rate. In my opinion these facts don’t lead to the consequences that post-Keynesians believe they do.
However, it’s also worth noting that the level of existing reserves can’t be used to accurately predict what the amount of money will be in the future. For example, today the US banks have enormous amounts of excess reserves. As recovery occurs the Fed may withdraw excess reserves from the market. So, the quantity of money may never rise to amount indicated by the money multiplier multiplied by the amount of base money. If the Fed do allow the money supply to rise that sharply it will be because of political considerations, not because they can’t do anything about it.
Yes. But with only comparatively minor changes a central bank could control money supply except for the part about governments using control of the monetary system to print their own spending money. I discussed it farther down in this thread. Basically it involves the elimination of taxpayer/central bank funded deposit insurance and requiring it to be purchased on the open market. With that stipulation, then money supply is controlled by varying the rate on borrowing central bank base funds. Since this money would be borrowed, not added permanently to the money supply, it could be recovered.
I don’t see at the moment how this can happen. I can see the sale of Fed assets (MBSs, etc) on the open market to reduce base, but I don’t understand how the Fed can act against reserves. They are the property of the depositors. There is the small amount of money borrowed at the discount window, but that is currently around 50 billion, a rounding error in today’s banking system. But expanding the discount window volume to replace money lost by eliminating compulsory fractional reserve of demand deposit lending is what I laid out in “A shot … ” comment thread.
Just FTR, my goal is to see a return to an open market in banking and monetary services and I am only suggesting this as a possible way to bring market forces back to bear on banking activities.
Something to keep in mind is that at all times, the upper limit of inflation is base x multiplier. At no time is it possible for inflation to exceed that amount. Unreserved lending must be restricted to time deposits or deposits capable of losing value.
Midwesterner,
Bank reserves are not the property of depositors. Depositors own a financial asset, a bank IOU that promises to pay the holder up to some quantity of base money on demand. The bank owns the base money it uses to create loans and satisfy reserve needs.
The Fed can easily prevent the currently large supply of base money from creating severe inflation. Besides ordinary open market operations, it now has the power to pay interest on reserves. Further, let us not forget that in an emergency the Fed can change reserve requirements. If the Fed wants to lock up base money in the banking system (so that it does not circulate and drive inflation), then it has plenty of tools at its disposal.
If there is a severe inflation, then it will not be for lack of ability on the part of the Fed, but rather its political will.
None of those things allow the Fed to remove base money from circulation. Let’s go down the list.
Paying interest on reserves: I’ve discussed this at some length and did an entire article on it. It does not permanently remove base money from circulation. It temporarily rents it from the banks. If the banks get better offers from depositors then the Fed’s only option is raise the interest it pays banks for reserves and where do you suppose money to pay that comes from?
Change reserve requirements: I’ve discussed this at some length also. Any raising of reserve requirements puts banks underwater unless they already have excess reserves. The reserves would need to be raised before a recovery (when reserves are high), not during or after a recovery. I don’t see that happening, so this plan is a bullet to the head of any incipient recovery.
All that is left is the open market operations (selling MBSs etc) and the plenty of tools you suggest without naming. What are they? They only tool I see for controlling downward the supply of base money is to rent the base to the banks, not rent it back from them. Paying interest on excess reserves leaves the Fed in a bidding war against a bull market and unable to increase money supply in a contracted monetary base. Charging interest for base money allows the Fed to make money available at very little cost to counteract monetary contractions but also allows the Fed to raise the rates on that base to bid down an inflating economy. Instead of the stimulus they could have lowered rates at the discount window and achieved them same result. But of course, all deposit insurance must, MUST, be moved to the private sector. FDIC is just a ‘too big to fail’ incentive for banks to not put sufficient weight on the quality of assets.
RE your statement:
Perhaps in a legal sense you are correct. The depositor owns an IOU, but reserves are collateral for that IOU so they are de facto, if not de jure, the property of the depositors. If you are suggesting that the Fed raise reserve rates cold turkey and require banks to make up the difference at the discount window (as it is presently operated) then I think you are making much trauma were there doesn’t need to be. This attacks the soundest assets in the portfolios while not addressing the quality of the other assets.
A good first step would be a phased transition from public sector to private sector deposit insurance. Do it slowly enough so that banks can adjust the risk on the balance sheets to better reflect reality (as perceived by private sector underwriters).
I agree with you about the lack of political will. This is why we need to move bank regulation from Dodd, Frank, Bernanke, et al, to private sector insurance companies who have skin in the game.
D’oh. Dyslexia strikes.
That would of course be “borrowers”.
Bit late, but:
The “boom and bust” cycle is not caused by central bank “funny money” – it is the correction mechanism in a capitalist economy whereby gross mispricing is corrected. It is unavoidable. All that can be done is to mitigate its impact, which is what Keynes was concerned with. Counter-cyclical taxation and expenditure does this.
Consider the stock market collapse in 1987 – a greater loss than in 1929, but quietly fixed through entirely Keynesian methods.
EG
Midwesterner,
Base money only circulates are currency. When held by banks as reserves, base money does not circulate as money. The Fed has ample tools to lock base money up in bank reserves, and thereby suppress the multiplier and inflation. It doesn’t really matter whether the Fed permanently reduces the supply of base money, though I presume they wish to eventually.
In any case, raising reserve requirements would be able to head off such inflation. Your objection is peculiarly irrelevant. Isn’t this discussion premised on the fact that banks are currently holding excess reserves? One could simply raise reserve requirements to whatever banks are currently holding, and so prevent the supply of base money from driving inflation.
Lee Kelly has done most of my arguing for me.
To go back to an earlier point. I certainly think that deposit insurance is destructive. However, I don’t think that removing it would allow the central bank to control the quantity of money. If it is removed then the problem reappears “at the other end” as it were. In a situation where the banks cannot make good, new loans, the quantity of money can’t be raised. Now, I don’t think it should be raised in that situation anyway, my point is that it can’t be raised. Keynes made this point somewhere.
Regarding reserves… I think Lee Kelly is basically correct. Though, I don’t see why the Fed couldn’t remove reserves by performing OMOs. If the Fed sells a bond then a bank has to transfer reserves to the Fed.
> Consider the stock market collapse in 1987 – a greater
> loss than in 1929, but quietly fixed through entirely
> Keynesian methods.
No it wasn’t. The central banks lowered the interest rates, but that’s a monetarist method.
The “boom and bust” cycle is not caused by central bank “funny money” – it is the correction mechanism in a capitalist economy whereby gross mispricing is corrected. It is unavoidable. All that can be done is to mitigate its impact, which is what Keynes was concerned with. Counter-cyclical taxation and expenditure does this.
Nonsense. Highs and lows are a natural correction mechanism of a capitalist economy, but booms and busts are not necessarily so. When they do occur, absent central bank intervention they have historically been short and sharp, then a new equilibrium is established and life goes on. The existence (and manipulation) of central banks is the primary cause of booms and busts, and also exacerbates their magnitude and duration. The application of Keynian nostrums in the 30’s caused the Great Depression (by turning what would otherwise have been an ordinary recession into a full-blown depression), and today are the reason we now have a “jobless recovery” and the prospect of a stagnant economy lingering as far as the eye can see.
And no, “Keynian methods” didn’t “fix” the market collapse of 1987. Reagan was no Keynsian. The market recovered because Reagan didn’t fall into the Keynsian trap, but rather permitted the economy to right itself with a mimimum of government intervention. (Also, please note that the stock market recovered all of its 2008 losses in less than 2 years; today we’re nowhere close to recovering the losses since the high in 2008, notwithstanding all the neo-Keynsian stimulus of the Obama administration.) Keynes was a quack, and his prescriptions (a hodge-podge of warmed-over and internally inconsistent ideas which had been thoroughly discredited decades earlier) only have continuing relevance because they have a superficial appeal to the ignorant and fit nicely with the desires of politicians (most of whom also fall into the first category).
Euan Gray – “consider the stock market crash of 1987” certainly Sir.
Rather than accepting the correction (the correction of artificial stock market values inflated by their own policies) the Federal Reserve in the United States and the Bank of England in the United Kingdom increased the money supply – leading to a classic boom-bust.
Yes the economic slump of the early 1990’s was caused by the “Keynesian methods” pushed by Alan Greenspan (and Nigel Lawson) in 1987.
In Britain, in a classic example of missing the point, the boom-bust was blamed on Lawson’s cuts in tax rates – not on his expansionist monetary policy.
Of course Lawson also had the excuse that he was “shadowing the D. Mark” – i.e. trying to rig the exchange rate.
“Control exchange rates”, “control capital flows” – ancient fallacies that political economy was developed to refute. Sadly people who denied basic economic reasoning (in the sense that they ignored it) took control of the subject.
If you have different rates of monetary expansion of course exchange rates will change over time – attempts to prevent this create “black markets” and distortortions in the basic economic structure. Captial controls – I see so investors think that a particular country (for example the United States) is a really crap place for investment right now (because it is) so they try and get their money to a place where they may not lose it all (for example New Zealand). But this “capital drain” can be prevented by men with guns (which is what “capital movement controls” actually mean). Errr oh no it can not – not over time it can not be.
In the case of Keynes it was open – he wrote in praise of John Law (the 18th century monetary crank – responsible for the crack up boom under the French Regency)) and even of people like John Hales (16th century government apologist – employed to argue that the rise in prices was caused by the greed of merchents, or be enclosure, or by ANYTHING, rather than the governement debasement of the coinage that actually caused it).
“But at least Keynes was in favour of free trade” – no he was not (not all the time) I changed his opinions as other men change their shirts. “The facts changed” – no they did not, only the facts of what was to his advantage changed.
The man was not an economist (he could not do even basic economic reasoning) and neither are his followers – they just cover their lack of knowledge or skill with techical langauge and lots of mathematics (as if econometrics was actually any less of an absudity now than it was in the days of Sir William Petty).
“Individualism” – actually an economy is based upon voluntary cooperation (civil society) not “atomistic indivduals” it is state intervention that tends to break down civil society into the atomistic indivudalist position.
“Free market fractional reserve banking” – I must confess I do not like the theory (because it violates a basic rule of logical reasoning – i.e. that borrowing can not be larger than real savings) however there is also another problem.
The practical problem that as soon as these “free market fractional reseve banks” run into trouble (as they tend to do – so often) they start to quietly ask for sweetheart loans from the Central Bank (this corporate welfare is treated as a matter of course – but it is, of course, utterly corrupt) and if the problem gets worse they scream like stuck pigs – demanding “suspention of payments” (i.e. a refusal to pay people their property) and even open bailouts.
To be fair there are some counter examples – the one that springs to mind is Canada in the early 1930’s.
None of Canadian banks went bankrupt (in the face of the Greatr Depression in the United States that hit Canada like a club over the head) and yet none had help from the Candadian Central Bank – because there was no such beast.
However, far from being greatful to the banks, many Canadians started to demand more credit money – a whole political movement grow to demand (the Social Credit party – although it was based on old fallacies) and a Central Bank was created later on the 1930’s.
That is the way of politics, if people observe a policy that fails (with terrible consequences) such as the failure of government intervention in banking in the United States – they are fairly likely to COPY the mistake.
How to get out of the present mess.
Which one? The credit bubble economy or the entitlement nightmare?
The credit bubble economy is easy to deal with – let the prices and wages fall. What was allowed in 1921 and NOT allowed in 1929 (contrary to the establishment history books). Herbert “The Forgotten Progressive” Hoover certainly did NOT, in 1929, follow the policy Warren Harding did in 1921.
In 1921 real wages were allowed to fall – not in 1929 when Hoover did everything he could to PREVENT the market clearing.
In 1921 taxes and government SPENDING were dramatically cut – again this did NOT really happen in 1929. Indeed Hoover (over the next couple of years) set up the basic schemes that were expanded (under new names) by F.D.R. and co.
In fact in 1932 the Democrats promised to cut government spending by 25% and Jack Nance Garner (F.D.R.s running mate) made speech after speech denouncing the “socialist” Hoover.
All this has gone down the memory hole – now the Progressive Hoover is a free market man. Wild government spending solved the depression (untrue).
The United States prospered during World War II and went into decline in 1946 (this is what you have to believe if you follow the official statistics – Robert Higgs exposes the fallacies in his “Depression, War and Cold War”) and so on.
In short establishment history is almost as bad as establishment economics.
“But what about the entitlement program nightmare Paul”.
Solveing that one is hardly so straightforward – if, indeed, it can be solved at all.
Ah, of course, we’re stupid so we can’t see the wisdom you lot can.
Now I recall why I stopped posting here.
EG
Who was that said boom-busts were NOT created by credit money expansion ?
Was it Mr Gray?
If it was then I seem to remember asking him to read Ludwig Von Mises’ “Human Action” (when he was last here).
There is no sign of a refutation of Mises – but Mr Gray still turns up. Why?
I could ask him to read shorter works such as Thomas Woods “Meltdown” or Hunter Lewis “Where Keynes Went Wrong” (both 2009).
However, I very much doubt he will – even though I (like many others here) have read many Keynesian works (by God I wish I had not – as a child and then a young man I kept searching for some sort of reason in them, wasteing my time just as much as I did reading Marxist works).
So Mr Gray’s is not here for any real debate – he is not here to seriously consider ideas that do not fit with his political opinions.
The words of the late W.H. Hutt spring to mind.
When asked how the Keynesians “won the debate” in the universities, he replied…..
“There was no debate – they did not want any real debate. They just gained control of appointments and of the setting and marking of examinations – and that was that”.
Who is “we” Mr Gray?
By the way you stopped posting here because you exposed yourself as being ignorant (both in the sense of knowing very little – and also in the sense of having contempt for knowledge and reasoning).
You have exposed yourself again. Perhaps the police should be informed of a “flasher” like yourself.
Current,
Some people claim that open market operations may be problematic. If the Fed buys high and sells low, then a net increase in the supply of base money occurs. Supposing the mortgage backed securities the Fed is currently holding on its balance sheet cannot be sold for what the Fed bought them for, it might have difficulty reining in inflation. In principle, this makes sense. However, I suspect the Fed has ample assets to “mop up” the excess reserves when necessary. Any permanent inflation created by the MBSs could be gradually leaked into the economy without much trouble.
Since reserves not circulating seems obvious, I think I am missing your point here. Reserves provide base for loans aka commercial bank money.
I would like to know what some of those tools are. If they reduce base by paying interest on excess reserves, then you need to address who foots the cost of that interest when the economy recovers and borrowers bid up the value of those reserves. That is a potentially not small revenue stream.
Well, one could, but raising reserves locks in a ‘shrunken’ money supply. Doing this during a contraction is almost certainly politically impossible. That puts it back at a time when banks are lending the base out. I doubt the political process has the reflexes to split that point. Also remember that every TARPulus spewed out of the Fed ‘printing presses’ requires yet more to be locked up in increased reserves to keep it from feeding the multiplier. There is an ongoing campaign for yet more stimulus. If the purpose is to eliminate FRB, can we find a way to do it that isn’t just ‘printing’ the multiplier and giving it to favored political factions as ‘stimulus’? That is a serious question, not a sarcastic one.
By itself, it won’t. But FDIC deposit bailouts paid with new base (either directly or via T-bills) expands money base, private sector deposit bailouts paid for with insurance company assets has a net neutral effect on base. So in addition to being a perverse incentive problem, where the deposit insurance comes from is a money supply factor. Combine this with lending a substantial share of base at something resembling the discount window would allow changes in that rate to incentivise lending in either direction.
Midwesterner,
You wrote in response to my earlier suggestions:
I responded saying that base money only circulates as currency. Now you write:
In any case, the Fed could pay interest on reserves quite easily, because it holds many interest bearing assets. Once ordinary operating costs are covered, the Fed can use the “profits” to pay interest on reserves. I suppose it could be very competitive with potential borrowers, and could even sustain short-term losses in case of emergency.
However, I do not think it will come to that, since I believe the Fed has ample assets to contract the monetary base without such measures; my purpose here is merely to argue how they could achieve that end even if open market operations were ineffective.
Further, increasing reserve requirements need not lower the money supply. The money supply could be allowed to increase a small amount by setting reserve requirements slightly less than current excess reserves. This is not a particularly difficult technical problem!
And while I oppose central banking, I do not oppose fractional reserve banking. Quite the opposite, in fact. I believe the economy would suffer greatly without fractional reserve banking, though I sympathise with those who oppose its current form.
That’s true. I hadn’t thought of that. I’m not sure that FDIC bailouts are paid out with new base though, if they are you’re certainly right.
However, I don’t think that this means that if the FDIC were replaced with private insurance then the Fed would be able to fully control the base. I still think that they can’t really do that under existing arrangements.
I think Lee Kelly is right though that they can reduce the amount of reserves currently outstanding. I think that as far as practical politics is concerned, if the Fed were to be at risk of running out of treasuries to do OMOs then the treasury would step in to assist it. But, I don’t think the Fed is in that position.
I said “circulation” when I should have said something more general like “use”. My bad.
I don’t think any of this is all that difficult of a technical problem. But all of it is a very difficult political problem. Just look at the corrupted politihacks running the system. Look at the corporatist campaign donors whispering in their ears. If I could only have one wish, it would be for deposit insurance to be put in the private sector where it belongs.
In your last paragraph, I assume you meant ‘legal tender laws’ because all currency systems, even private ones, will need something comparable to a ‘central bank’ to oversee them. With that understanding, I agree. I could easily see depositors distributing their money in several different kinds of accounts at the same time, fully reserved, insured FRB, and uninsured floating balance accounts depending on their financial plan.
To the point that FDIC relies on premiums for payouts, in can function as a pseudo-private sector activity. I do not believe it has the political will (or the legal means) to function in the discriminatory way that a true private sector insurer would any more than the pseudo-private Fannie and Freddie reflected market realities. For this reason I consider it to be functionally a ‘printing press’ funded agency when a crisis hits and it matters the most.
You are right. They can’t do that under present arrangements. The shift to private sector deposit insurance and the establishment of a fully reserved transaction account option for those who want to pay extra for it will result in a reduction of the available base for lending. At that point instead of increasing the base, the Fed should lend base to commercial banks at an interest rate adjusted to exert influence on the magnitude of lending/money supply.
I agree with Lee that fractional reserve lending in a free market is a useful tool for depositors that choose that option, but a currency with a significant lending component still will reasonably need to be maintained in approximate parity to a basket of commodities. Doing that requires the ability to both contract and expand base money. Ongoing central bank lending (at something like the discount window) would permit changes in the interest charged to influence commercial banks in either direction, not just one way.
The system has been operated so far in a single mode, full throttle. If you look at Fed history you will find most of the time it is against the fractional reserve governor. When it drops off of that governor, the mechanisms available to ‘goose’ it are not well suited to being retracted once the crisis passes. I have strong doubt that the Fed actions (buying MBSs, etc) can be fully undone. I think it is certain that some degree of stimulus monitization will occur. Maybe a lot.
Oops. I think there is another communication problem here. I don’t see the long term problem as being reducing reserves, that is a short term problem and paying interest on reserves suggests that they don’t really want to ‘fix’ it. The difficulty that I don’t think the Fed has the means to deal with is when demand for lending picks back up and those reserves start turning back into multiplied commercial bank money. Lee thinks the Fed will just crank up the interest payments on excess reserves. Maybe.
I didn’t understand what you were saying about “running out of treasuries to do OMOs then the treasury would step in to assist it”
Midwesterner,
I am an advocate of free banking. I do not believe we need a central bank, period. Naturally, I believe deposit insurance should be entirely private and optional. That said, I do not expect my preference to be realised, and so normally argue for policy on the assumption of central banking.
Euan Gray, rather than responding to Laird’s and Paul Marks’ devastating rebuttal of his extroardinary claim that Keynesian ideas somehow “solved” the 1987 stock market gyrations, merely comes out wth a sort of petulant outburst, the equivalent of putting out his tongue and making a rude gesture. Nice.
Oh well, Paul Krugman does the same to anyone who dares challenge his fatuous assertion that WW2 cured the Great Depression, so I guess EG is in exalted company.
Robert Higgs is well worth reading on the economic side of World War II.
Although, of course, it could have been worse – for example there was much less state control in America than there was in Britain or Nazi Germany.
Indeed the Federal government war on business (for example the war on the Ford Motor Company) was called off – no more backing for union activists.
Also wartime price rises (even if hidden by the absurd price controls and rationing) had one good effect – they utterly destroyed the “keep real wages up at any cost” policy of Hoover and, peacetime, F.D.R.
When lending picks up again why can’t the fed perform OMOs to soak up the excess base? They sell bonds on the open market in exchange for reserves, then they keep the reserves.
Which sounds to me like it has all of the downsides of chasing the market by paying higher interest on excess reserves but without the liquidity. Certainly it would be more costly. There will be a premium to pay for tying up money for bond terms. And selling bonds in the face of mounting inflation (which is when it would be necessary) could be, er, problematic. And pricey.
Midwesterner,
I think you are overestimating the problem. Markets, at least, are predicting very low inflation over the next couple of years, well below the Fed’s target.
🙂
Midwesterner,
This is the kind of thing central banks have always done.
The paradox of central banking occurs here. If they make it clear to the market that they will sell the bonds come hell or high water then that means there will be low inflation in the future. If the market realise that then they will not include an inflation premium. If they don’t make that clear then the markets will include an inflation premium.
In any case, the central banks balance sheet is essentially fiction. If there’s ever a time when they run out of bonds to sell the government are certain to give them more.
What if they do make it clear and the market responds “Yeah. Riiiight.” The market is beginning to understand that we are moving into the zone of Fed System eschatology. Most other money systems as well. Anybody who can still say “This is the kind of thing central banks have always done” is ignoring the last two years. What worked in the past doesn’t necessarily work any more. This failure very closely tracks the failure that was peaking during the Carter years. At that time Volker and Reagan put in place the system that soaks up extra money with National government debt. The subsequent fall in the price of gold offset the movement of money into US debt bonds, etc. Nobody believes that the National government will be able to continue servicing that debt. Time lines vary but no serious case is being made for the long term to be anything better than a sustained mire. And those are the optimists.
Having sold government debt to the limit, they are now borrowing and spending the multiplier. For a fractional reserve based economy, this is the equivalent to eating your seeds instead of planting them. We are on a very finite trajectory.