June 26, 2003

More on the Naivete of Milton Friedman

Senor Edward Hugh of Barcelona joins those arguing for the "naivete" of Milton Friedman, playing Aramis to Paul Krugman's Athos and Daniel Davies's Porthos. I'm beginning to feel a little like M. Jussac...

His point is a definite "touche": Milton Friedman's and Anna Schwartz's belief that Fed policy greatly expanding the monetary base would have stopped the Great Depression in its tracks in 1930 and 1931 hinges on a belief that the Fed's throwing more high-powered money at the economy would not have induced countervailing contractions in the money multiplier or in the velocity of money itself. In Hugh's view, they don't even ask the right question because their framework, naively, "...take[s] virtually no account of the asset side of the bank's balance sheets. Indeed it seems to be the case that their conceptual framework leaves little place for a consideration of the role of the banks as financial intermediaries between two types of client: depositors and borrowers. Nor do they seem to put great store by the fact that the banks as intermediaries operate in a world of uncertainty, that banks assessment of their clients' creditworthiness varies, and that in the short trem their lending determines the size of the money stock..."

This is not quite right: the asset side shows up implicitly as one of the determinants of the deposits/reserves ratio. But it is almost right: their argument for the power of Fed policy in the Great Depression hinges on their decision to model banks as having a target for the stock of outstanding loans rather than as having a target for the ratio of deposits to reserves. And they give no compelling argument for this particular modelling decision.

My parry is that enough high-powered money injected into the system soon enough means that deflation doesn't take hold and the asset quality problems that limit banks' desired stocks of outstanding loans simply do not appear. But I'm not sure my parry is effective. And I hope the Cardinal sends some reinforcements soon...

BONOBO LAND: ...What seems preoccupying in the Friedmand and Schwartz view is that they never seem to actively consider the possibility that banks may have been held back by factors other than their reserve position. This appears to be because they take virtually no account of the assett side of the bank's balance sheets. Indeed it seems to be the case that their conceptual framework leaves little place for a consideration of the role of the banks as financial intermediaries between two types of client: depositors and borrowers. Nor do they seem to put great store by the fact that the banks as intermediaries operate in a world of uncertainty, that banks assessment of their clients' creditworthiness varies, and that in the short trem their lending determines the size of the money stock. (And how do I know all this: because my brother used to be a banker, and he has spent years perforating my eardrums with this and other relevant information as to the realities of money stock fluctuations).

Now why is any of this of any real importance today, and why is the problem more than merely a semantic one: because right now, in Japan, there is a problem, and many economists once more failing to listen to what the bankers are telling them, imagine that there is a simple monetarist solution to the problem: dramatically expand the money stock. And why may the problem assume even more importance: because right now in Germany and the United States deflationary pressures may well be raising their ugly head, and because, once more the simple monetarist solutions are going the rounds without giving sufficient consideration to the question as to in which direction the causal chain may in fact be operating.

Another (non-trivial, and definitely non-semantic,) problem which to avoid argument I will relegate to the level of secondary non-mainstream dispute, would be to open an examination of what impact the US decision to effectively close the doors to mass immigration in 1922 might have had on the extent and duration on the depression...

Posted by DeLong at June 26, 2003 11:56 AM | TrackBack

Comments

Edward Hugh - Nicely argued.

I wonder if the closing of America to mass immigration was a factor leading to recession and depression, could the aging of Japanese society have had a similar though more subtle effect?

I have long thought the Japanese central bank began increasing liquidity too late in the slowdown, but the bank was most aggressive when the problem began to be recognized. Also, I do think Japanese fiscal policy was has been effective in preventing a far more serious problem for Japan.

Posted by: anne on June 26, 2003 12:47 PM


I'm sure closing America to immigration had to be a factor. I had never considered it about Japan, but I have seen a number of studies in Europe that point out that, absent more immigration, their current retirement benefit system is unsustainable. I don't know the specifics of Japan but I would not be at all surprised.

This makes sense to me. Can anyone point me to any studies or articles on the effects of the aging population on Japan's economy?

sz

Posted by: SZ on June 26, 2003 01:54 PM

It seems to me that the easiest refutation of Mr. Hugh's argument is that Friedman told us in 1954 that the "American Economy is Depression-Proof".
The major reasons Friedman gave for this were the establishment of the FDIC in 1934, and the loosening of the ties between gold and monetary policy.

With the FDIC being the most important, because it was an even more profound change than the establishment of the Federal Reserve system in 1913. He claimed that made multi- bank failures a thing of the past. He's been right for almost a half-century now.

Posted by: Patrick R. Sullivan on June 26, 2003 02:46 PM

Well, depression-proof is not right in the short run when prices are sticky. Anyway I posted a version of this message awhile ago, and I think it's applicable:

Think of the real interest rate (r). There is a real interest rate which is associated with the natural rate of unemployment. If r > the real interest rate associated with the natural rate of unemployment, then actual unemployment > the natural rate of unemployment. We have the nominal interest rate (i) and expected inflation which is (Pe/P)-1.

r = i - ((Pe/P)-1)

To decrease r you must decrease i or increase ((Pe/P)-1)

Suppose r > the real interest rate associated with the natural rate of unemployment and also that i is fixed at i=0 and hence we are in a liquidity trap. Then your only choice for monetary policy is to increase ((Pe/P)-1)

Therefore to get out of the liquidity trap with monetary policy, you must conduct monetary policy so that Pe must increase faster than P. This decreases the real interest rate, and if it does so enough, you will get to the real interest rate associated with the natural rate of unemployment, and you will be out of the trap.

Posted by: Bobby on June 26, 2003 04:04 PM

Well, depression-proof is not right in the short run when prices are sticky. Anyway I posted a version of this message awhile ago, and I think it's applicable:

Think of the real interest rate (r). There is a real interest rate which is associated with the natural rate of unemployment. If r > the real interest rate associated with the natural rate of unemployment, then actual unemployment > the natural rate of unemployment. We have the nominal interest rate (i) and expected inflation which is (Pe/P)-1.

r = i - ((Pe/P)-1)

To decrease r you must decrease i or increase ((Pe/P)-1)

Suppose r > the real interest rate associated with the natural rate of unemployment and also that i is fixed at i=0 and hence we are in a liquidity trap. Then your only choice for monetary policy is to increase ((Pe/P)-1)

Therefore to get out of the liquidity trap with monetary policy, you must conduct monetary policy so that Pe must increase faster than P. This decreases the real interest rate, and if it does so enough, you will get to the real interest rate associated with the natural rate of unemployment, and you will be out of the trap.

Posted by: Bobby on June 26, 2003 04:05 PM

Asset models suggest that decisions to supply money (bank deposits) and decisions to demand money and othter assets depend on expected returns versus risks. I can imagine situations where raising the monetary base (cash and reserves) does little to increase the money supply. But then the key point for the real economy is neither balance sheet ratios or the ratio known as velocity but how the impact on asset supplies translates into the cost of new capital (machines) relative to the demand for new capital. Bobby started us there by talking about the translation between nominal rates and real rates via expected inflation. But in a very depressed economy, we can't count on expected inflation to evade any alleged liquidity trap and even if we could, doesn't the depressed expected future cash flows mean that even low real rates might not trigger more investment demand?

Posted by: Hal McClure on June 26, 2003 04:10 PM

And so Bobby boldly puts himself in the place of that fabled French professor who is supposed to have said "It may work in practice, but will it work in theory?"

Posted by: Paul Zrimsek on June 26, 2003 04:56 PM

"But in a very depressed economy, we can't count on expected inflation to evade any alleged liquidity trap and even if we could, doesn't the depressed expected future cash flows mean that even low real rates might not trigger more investment demand?"

Within the context of what i said in my post, isn't this just one way of saying that the real interest rate associated with the natural rate of unemployment will be really really low. If you keep decreasing real interest rates eventually you reach a real interest rate that is small enough to increase output to the natural rate.

Of course if you can shift out the IS curve, you increase the real interest rate associated with the natural rate of unemployment and therefore make it easier to reach from whatever the actual real interest rate is currently and hence easier to get out of the liquidity trap.

Posted by: Bobby on June 26, 2003 05:05 PM

As to the asset side of bank balance sheets it certainly is an issue in Japan -- even for the Bank of Japan itself, it seems.

The current Economist reports that the BoJ is concerned that a return to "normal" interest rates and inflation would so drive down the value of the bonds it has purchased as to impair its balance sheet. As I've noted before, just the end of deflation with 0% inflation implies a drop in the value of long Japanese bonds by as much as 50%.

As for the rest of the banking system, it is reputed to have a trillion dollars of bad debts in it. Whatever the real number, it's hardly surprsing that with bad debts on that scale doing in the balance sheets, pumping up base money isn't doing much for the higher M#s.

OTOH regarding the US in the early 1930s I'm not aware of any corresponding big systemic problem in the banking system. If there wasn't one, then I don't see why normal monetary expansion like Ben Strong favored and practiced in 1921 wouldn't have kept the money supply from falling, thus averting the deflation. Instead we got the reverse -- the Fed increased rates in 1928 in the midst of a recession and mild deflation to being with, and we were off to the deflationary races.

If someone wants to argue that US banks had a systemic balance sheet problem before the deflation that is fine and interesting, but I think they should give some indication of just what that problem was.

Posted by: Jim Glass on June 26, 2003 10:35 PM

That's interesting - why should a central bank worry about it's "balance sheet"? In fact, what is a "balance sheet" in the context of central banking, where one side of the sheet by definition doesn't balance?

Posted by: jimbo on June 27, 2003 06:38 AM

The balance sheet of a central bank does balance, and in the gold standard era it was important that it do so. But I've been pondering the significance of this in our fiat money era myself.

In any event the proposed remedy for the BoJ is a legal change to make all the bonds held by it adjustable rate, so the interest rate on them would move with the market. That's one way to mitigate the effects of a bond bubble, I guess, at least for selected bonds. Things are getting a little bizarre over there.

Posted by: Jim Glass on June 27, 2003 07:23 AM

"In fact, what is a "balance sheet" in the context of central banking, where one side of the sheet by definition doesn't balance?"

Interesting question....

Posted by: anne on June 27, 2003 08:46 AM

"OTOH regarding the US in the early 1930s I'm not aware of any corresponding big systemic problem in the banking system."

To which I must respond, huh? I am truly confused here, because are you discounting the huge number of bank failures that took place in the early 1930s? Banks failed because their assets sides were hit by the market crash. This lead to a series of bank runs. The Fed not stepping in to offer loans made the situation worse.

In response banks began holding more excess reserves to limit the effect of runs, changing the money multplier in the economy and adding to the deflation.

Posted by: Rob on June 27, 2003 10:35 AM

" Well, depression-proof is not right in the short run when prices are sticky."

Following up on Paul's point that was ignored, Bobby, when was the last depression in the U.S.?

Posted by: Patrick R. Sullivan on June 27, 2003 01:43 PM

"To which I must respond, huh? I am truly confused here, because are you discounting the huge number of bank failures that took place in the early 1930s?"

Of course I am aware of the bank failures that occurred *after* the 25% deflation started while the great collapse in production and business was in progress. Do you imagine many perviously sound banks wouldn't fold under such pressures? Just like so many, many other previously sound businesses did.

Bank failures in 1932 don't indicate any particular problem within the banking system other than that in a collapsing economy banks fail just like all other kinds of businesses do. (Although they may well indicate that the Fed failed in its job to act as the lender of last resort that it was created to be -- and that it contributed to the downturn in that way too.)

The question is, *before* the deflation occurred was there any systemic problem in the banking system that would have kept the money transmission process from functioning normally, so that if the Fed had lowered rates in 1928 through 1929 (instead of raising them as it did) it couldn't have averted the deflation to begin with.

I.e., any problem comparable to the bad debt problem in the Japanses banking system since the 1990s, which has kept the money transmission process from working there.

If there was any systemic problem in the banking system of the era that would have prevented the Fed from heading off the deflation by increasing the money supply had it tried to do so, I would be interested in learning what that particular problem was.

Posted by: Jim Glass on June 27, 2003 01:49 PM

Patrick. I didn't know that that was what Paul was getting at. My post describes the threat of the liquidity trap and how to get out of it. Saying that it hasn't happened *within the U.S.* since the Great depression is not a rebuttal. The point was that the liquidity trap is possible, and hence we're not depression-proof. The liquidity trap is not only theoretically possible but has of course played itself out in Japan and now Germany -- if the American economy's IS curve shifts inwards enough, r associated with the natural rate of unemployment can decrease below minus expected inflation. Therefore we're within the liquidity trap since the actual r will be greater than the r associated with the natural rate of unemployment even at a zero nominal rate (though the fed can really only go to .75% nominal fed funds rate so the threshold r below which we are within the trap really = .75% - expected inflation). Krugman says we are near or at that point now right now. We will stay there if our policy makers fail to do their job or fail to take the threat seriously.

Posted by: Bobby on June 27, 2003 02:36 PM

Edited

Patrick. I didn't know that that was what Paul was getting at. My post describes the threat of the liquidity trap and how to get out of it. Saying that it hasn't happened *within the U.S.* since the Great depression is not a rebuttal. The point was that the liquidity trap is possible, and hence we're not depression-proof. The liquidity trap is not only theoretically possible but has of course played itself out in Japan and now Germany -- if the American economy's IS curve shifts inwards enough, r associated with the natural rate of unemployment can decrease below minus expected inflation. Therefore we're within the liquidity trap since the actual r will be greater than the r associated with the natural rate of unemployment even at a zero nominal rate (though the fed can really only go to .75% nominal fed funds rate so the threshold r associated with the natural rate of unemployment below which we are within the trap really = .75% - expected inflation). Krugman says we are near or at that point now right now. We will stay there if our policy makers fail to do their job or fail to take the threat seriously.

Posted by: Bobby on June 27, 2003 02:39 PM

Just to be clear the liquidity trap does not *have* to happen. It can prevented beforehand through appropriate expansionary policy by fiscal or monetary authority, and after it occurs, you can get out of it with expansionary fiscal policy or unconventional monetary policy if they are large enough to do the job. The economy can go into the liqudity trap on its own. The point is that the country can slip into the liquidity trap on its own, if IS shifts inwards enough, and if expected inflation is low enough, and we stay if the aforementioned inaction occurs.

Posted by: Bobby on June 27, 2003 02:56 PM

"The balance sheet of a central bank does balance, and in the gold standard era it was important that it do so."

But even in the gold standard era, the central bank monetized gold by issuing money that came from nowhere, no? How do you figure the "assets" of an entity that waves a magic wand over pieces of paper and says "this now is money"? It's true that CBs hold government "debt" on which they are paid "interest", but it's all just accounting fictions - why should anyone take them seriously?

(actually, my theory on this is that the truth about money - that it is purely a social phenomenon, with no other reality than in people's heads - is so overwhelming to the modern mind (which spends most of it's time thinking about money) that it needs institutions to create a "veil of ignorance". This is why you have this elaborate facade of central banking in the first place - it hides the truth from people just enough to get them to sleep at night...)

Posted by: jimbo on June 27, 2003 03:07 PM

The point is that the country can slip into the liquidity trap on its own, if IS shifts inwards enough, and if expected inflation is low enough. Unless there is monetary or fiscal action to prevent this, we go into the trap, and we stay in the trap if the aforementioned inaction to get out of it occurs.

Posted by: Bobby on June 27, 2003 04:31 PM

Edit:

The point is that the country can slip into the liquidity trap on its own, if IS shifts inwards enough, and if expected inflation is low enough. Unless there is monetary or fiscal action to prevent this, we go into the trap, and we stay in the trap if the aforementioned inaction to get out of it occurs.

Posted by: Bobby on June 27, 2003 04:31 PM

Jim--

The deflation was a result of the Fed inaction, not due to Fed action. The initial Bank failures in 1930 were due to the market crash causing bank asset holdings to fall as well as drought in 1930 causing default on agriculture loans. As banks started to fail, runs started and other banks startd to fail. From Friedman and Scwartz: 256 banks in November of 1930 with deposits of $180 milion and 532 in December with depositis of over $370 million.

The Fed did not provide discount loans to failing banks. This is important for two reasons: 1) People still did not have trust in the banking system leading to more holding of cashand 2) Banks began to hold more vault cash since they could no longer trust the Fed to offer them loans. This meant that all banks were selling off assets further decreasing the value of assets bank's held causing more problems.

The increase in currency holding and bank's excess reserves decreases the the money multiplier for the economy. This is what really is responsible for the deflation. The Fed did not recognize the change in the multiplier, so even though the Fed increased the monetary base, the money supply still fell.

So to the question about the Fed changing rate: The rate change is not was casued the deflation, unless you hold that increased rate was what caused the bubble to finally burst. But assuming that it was going to burst in time anyway and combined with the shocks to the agricultural sector for the past few years, banks would be holding a great deal of bad assets.

So to the meat of the question: Could the Fed increase the money supply? I'd agree with Brad that increasing the monetary base enough would sooner or later cause the money supply to go up. Given the information the Fed was working with at the time and information availale, is it realistic for them to have done so? This is a more difficul t question. Since they actually thought they were increaseing the money suply by lowering their nominal interst rate target (following the policy the Fed used in the 1920s) it is unlikely the knowledge to do so was there.

Of course the best thing the Fed could have done was to try to keep the banking system from collapsing.

Posted by: Rob on June 27, 2003 05:16 PM

"The balance sheet of a central bank does balance, and in the gold standard era it was important that it do so."

But even in the gold standard era, the central bank monetized gold by issuing money that came from nowhere, no?
~~~

The currency was backed by gold -- the currency was a liability of the central bank in real terms, and the bank could be forced to pay off on it. The banks had to have real assets correspondingly. Thus all the gold still sitting in the basement of the NY Fed.

The regional Federal Reserve Banks (as opposed to the Board of Governors) legally are not part of the government but are private banks. They were set up to operate like "real" banks. They had to follow all the rules of real banks, and still mostly do. They have shareholders who contribute capital (albeit on terms compulsory by law), and the Federal Reserve Act provides for their liquidation with an obligation to indemnify the gov't if they become insolvent and the gov't has to assume their obligations. All of which was quiet meaningful in the early days of the Fed.

Today with fiat money the currency still is a liability of the bank, but as it's not redeemable for anything it's hard to see what that exactly means. The bank still has to maintain assets vis a vis its liabilities, but if its assets were impaired as per a BoJ scenario I don't see the big problem in practice. To keep the accountants happy the gov't presumably could nominally advance assets to it to boost the asset side of the balance sheet (maybe a national park or something) with the Fed repaying it with interest received on gov't obligations, which it pays to the Treasury anyway. Since the Fed is functionally part of the gov't it would be like maintaining accounting between your left pocket and right pocket. I dunno. With fiat money it's all theoretical and a bit of a puzzle to me.

Posted by: Jim Glass on June 27, 2003 11:00 PM

"The deflation was a result of the Fed inaction, not due to Fed action."

Well, I largely agree, but it is worth noting that the Fed started raising rates during a period of mild deflation in 1928 -- which would not be considered good policy for avoiding deflation today. What's Alan doing now?

Also, the big wave of bank failures didn't hit until 1933 -- it was a result of the collapse, not the cause. Post "Monetary History" studies on the early bank runs show they were localized in agrarian areas and didn't have a big effect on the money centers. Remember that there were 600 bank failures a year back then even in the good times.

"So to the meat of the question: Could the Fed increase the money supply?"

I still don't see any systemic problem inside the banking system that would have kept it from doing so had it tried. Sure, the banks held on to vault cash after the collapse started, people got scared, and they got scared that the Fed wouldn't help them if they got in trouble. But those were problems imposed on the banks from outside after the fall started.

The BofJ has been pumping base money up, up, up, for years now without being able to increase the larger money supply because of the huge bad debt problems *inside* the Japanese banking system. But I don't see any similar problem inside the US banking system of 1928-31 that would have prevented the Fed from countering the deflation with money expansion had it tried.

So I think Prof. DeLong's "parry" is sufficient, until somebody shows some systemic problem that existed in the banking system *before* the deflation took hold.


Posted by: Jim Glass on June 27, 2003 11:37 PM

Bobby, you're just repeating your theory. The question is, hasn't Friedman been demonstrated to be correct in practice?

Posted by: Patrick R. Sullivan on June 28, 2003 10:10 AM

"With fiat money it's all theoretical and a bit of a puzzle to me. "

Warren Mosler argues, convincingly, that fiat money changes everything, in ways that have not been absorbed by policymakers:

http://www.mosler.org/docs/docs/soft0004.htm

Posted by: jimbo on June 28, 2003 11:25 AM

That Mosler paper proves that the only thing more dangrous than complete ignorance is a little bit of knowledge combined with complete arrogance.

I made it through a third until the howling mistakes just stopped me from wasting any more time:

1) The Government Budget Constraint. He does not understand that governemnt debt is limited by the ability of a governemnt to actually pay the debt back.

2) He asserts that the Fed must provide reserves to the system if bank's demnd them, which is just not true. He talks about how the banking system is really liquid compared to the past, but then pretends that it is not liquid enough to allow banks to affect their reserve-deposit ratios by holding on to a greater percentage of money deposited.

3) He says that monetization of the debt is not going to happen. His reasoning? Once the Fed sets the Fed funds rate target, it can't monetize the debt because it must maintain the target. Well,...yeah. Thats basically saying that if the Fed doesn't want to monetize the debt the Fed won't monetize the debt. If the Fed wanted to monetize the debt, it would change its target because it would want to expand the money supply.

So after that I let it go...

Posted by: Rob on June 28, 2003 02:03 PM

1,) The "ability of a government to pay" under a floating exchange rate system is limited only by it's willingness to cash it's own checks. It not have to obtain gold, other currencies, or anything else before it spends it...

2.)If there is a shortage of reserves in the banking system, one or more banks is going to come up short in it's reserves (and will thus fail). The Fed - monopoly issuer of reserves - cannot simultaneously require banks to hold it's money and then refuse to provide it to them. But even before that happened, a general shortage of funds would cause banks to bid up the Fed funds rate without limit. As long as the Fed is targeting a fed funds rate, it must provide as many reserves as are necessary to prevent the rate from rising above that target. Which brings us to...

3.) Banks only borrow reserves to fulfill their legal requirement. They lose money on them, since they draw no interest. Therefore there is a strict limit on the market for reserves - once every bank has enough to fulfill it's requirement, there is no market for any additional reserves. The Fed cannot "monetize the debt" because, if it injects more reserves into the system than demanded by banks, the price of those reserves (which the banks no longer need and will not bid upon) immediately goes to 0. If it wants to maintain ANY non-zero target (whether .5% or 15%), it MUST withdraw excess reserves from circulation.

Maybe you should read it again, looks like you wern't paying attention the first time...

Posted by: jimbo on June 28, 2003 03:32 PM

Repeating incorect assertions do not make them correct:

1) Governments are still limited on how much they spend. No one will lend to a government if they do not believe the government will be able to make good on its obligations. And so government debts are limited and hence governement spending is limited. Governments are only slightly less constrained than before when under a fixed system.

2) If the banks are short on reserves, they will sell off other assets to get the needed reserves. The selling of assets will lead to a shrinking in the money supply. Hence the Fed can chnage the money supply. And there is no requirement for the Fed to provide reserves to banks who want them.

3) No, just because the market clears doesn't mean it won't clear again if situations change. The Fed injects reserves by buying bonds. The banks that sells the bonds, can do what ever it wishes with the money. It isn't marked as "for reserves only." Only as the money supply expands does this injection bceome necessary for reserves. This is why there is always a market for reserves. Some banks wnat to lend on the reserve market for risk and liquidity reasons as well as some banks will want to borrow at the market for similar reasons.

Reserves are just one type of assets a bank can hold.

Posted by: Rob on June 28, 2003 04:32 PM

Repeating incorrect objections doesn't make them correct, either.

1.) Once again: the only reason the Federal government needs to "sell" bonds (aside from self-imposed requirement) is to prevent interest rates from falling to 0%. There will never be any shortage of "lenders" at a non-zero rate because that would require people to prefer to hold non-interest bearing cash rather than interest-bearing government treasuries, and most economic theories say that people and institutions generally prefer not to do that. Aha, you say, but they can invest it in other things besides treasuries. No, they can't. I mean, they can, but it doesn't change anything in the system as a whole. Investing in other financial instruments just moves the money around, it doesn't remove it from the system.

Say I buy a bond from IBM. I write a check to IBM, IBM deposits the check in thier bank, my bank transfers the money from my acount to IBM's bank. A new asset has been created for me, a new liability has been created for IBM, but the total amount of money in the banking system remains the same. In fact, the money never "leaves" the banking system, until it is "paid to" the Federal reserve. THe Fed then waves it's magic wand and declares it to no longer be money.

2.)Once again, you're not understanding the nature of the system. Reserves can neither be created nor destroyed by the banking system. If a bank sells an asset, it gets money for it. Where does the money come from? Another bank! Any money that is transfered into one bank MUST BE transfered out of another (with the exception of actual cash, but that's a relatively minor part of total reserves) Selling of assets between banks or from a bank to a private individual (who pays for it by a bank draft) DOES NOT create or destroy money - only the making and paying off of bank loans affects the amount of money in the system, with the caveat that a certain percentage of that new money must be held as reserves at the Fed (or vault cash). Which again leads us to...

3.)Yes, reserves are just one form of asset that banks can hold. They are, however, from a bank's perspective, the worst kind of asset, since they pay no interest. A profit-maximizing bank would prefer to hold none - but the Fed forces them to hold 10% (is that right? I can't remember the current number...) of assets as this dead weight. A bank is not going to hold 11% - it's losing money if it does. it's going to go onto the fed funds market and try to loan them to another bank that came up short. If there is a general excess in the system, at some point every bank will have their requirement , and there will be no market for a more reserves. The price - the fed funds rate - drops to zero.

Again, you're thinking in terms of one bank - its buying and selling of assets. You need to think of the system as a whole. Think of both sides of the transaction. As Deep Throat famously said, Follow the Money...

Posted by: jimbo on June 28, 2003 05:32 PM

Patrick read the *entire* post, which says that the answer to your question is (a) no for Japan and now Germany and (b) no because the U.S. might be in the liquidity trap right now (c) saying it "hasn't happened yet" is simply not sufficient to rule it out as a possibility in the U.S. (especially when the trap *did* happen in Japan and *did* begin in Germany and it looks like it's happening now) -- sometimes we repeat historical mistakes from which we should have learned precisely because the lesson has been lost with the passage of time (d) not only is it not sufficient, but I have provided a very plausible scenario of how it can happen when discussing the theory and failure of policy makers to address the liquidity trap (e) no one ever said that the liquidity trap is a frequent occurance or even common, and I think most of its supporters, including me (and I think that includes Paul Krugman too) would say it is rare, so a good track record does not rule out a rare occurrence (f) quite a few would argue that U.S. monetary and fiscal policy from the end of the Depression until Paul Volcker was mostly biased towards inflation and being expansionary, so, even if you put a through e aside, it is not appropriate to employ the entire post-Depression economic record as a standard by which to judge whether the trap can occur.

You can argue your point on other grounds, but the track record of the U.S. economy since the depression is not one of them.

Posted by: Bobby on June 28, 2003 09:08 PM

"Warren Mosler argues, convincingly, that fiat money changes everything, in ways that have not been absorbed by policymakers"

Yes, yes, not absorbed by the Fed nor by "numerous Nobel Prize winners" nor the textbooks, only by Mosler. ;-) I've been reading his papers for years, they're very entertaining. Just counting all the howlers is a challenge.

"If there is a shortage of reserves in the banking system, one or more banks is going to come up short in it's reserves (and will thus fail)."

Well, a less painful option is to reduce lending a tad, perhaps by letting a loan mature without making another one. That will get things back within the reserve requirement -- and the bank's shareholders will probably prefer that. ;-)

"The Fed - monopoly issuer of reserves - cannot simultaneously require banks to hold it's money and then refuse to provide it to them"

Although it doesn't require them to hold any particular amount of reserves. It only requires them to hold reserves in proportion to lending. So it certainly can refuse to provide reserves sufficient to support lending beyond a certain amount, and cause banks to restrict lending to that amount as a result.

"the only reason the Federal government needs to "sell" bonds (aside from self-imposed requirement) is to prevent interest rates from falling to 0%."

So what was the unique, limited-time-only condition that kept interest rates from falling to 0% while the gov't was buying hundreds of billions of dollars worth of bonds during the surplus years?

"There will never be any shortage of "lenders" at a non-zero rate because that would require people to prefer to hold non-interest bearing cash rather than interest-bearing government treasuries,"

What you mean is that there will never be any shortage of *borrowers* at a non-zero rate, because etc. But we borrowers do not set the interest rate by ourselves, alas. So this willingness on our part to borrow at 0.2%, which I would surely do, will hardly drive the interest rate to zero.

"Say I buy a bond from IBM. I write a check to IBM ... the money never "leaves" the banking system, until it is "paid to" the Federal reserve. THe Fed then waves it's magic wand and declares it to no longer be money."

Are you saying that when I buy a bond from IBM it reduces the money supply?

"Reserves can neither be created nor destroyed..."

Here's a tip I've found useful: When an amateur says he is about to use "pure force of logic" to refute the Federal Reserve, "numerous Nobel Prize winners", and all the textbooks in print .... beware.

Posted by: Jim Glass on June 28, 2003 09:57 PM

"He says that monetization of the debt is not going to happen. His reasoning? Once the Fed sets the Fed funds rate target, it can't monetize the debt because it must maintain the target ... So after that I let it go..."

You should. Mosler and the Moslerites (who exist in surprising number, I know a bunch of 'em) build their church on this rock (his emphasis):

** "As long as the Fed has a mandate to maintain a target fed funds rate, the size of its purchases and sales of government debt are not discretionary." **

Though, of course, this mandate is given to the Fed by the Fed.

So logically this is the same as saying if you give yourself a mandate to go to the refrigerator to get yourself a tall frosty, you have no discretion in whether or not you go to the refrigerator to get yourself a tall frosty. Even if you then decide you don't want one.

Of course in reality what the Fed *targets* is a level of desired economic activity, and it *adjusts* the Federal funds rate in order to achieve it, entirely according to its own discretion, according to its judgment in light of the best information available at the moment, which changes all the time -- causing the Fed to buy or sell securities at its best discretion in consequence. With us hoping that best discretion is correct.

And with that exercise of discretion, the rock crumbles....

Posted by: Jim Glass on June 28, 2003 10:21 PM

Whoops the previous posts only say a and b. I tacked on a few new ones in the latest one above. . . .

Posted by: Bobby on June 28, 2003 10:33 PM
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