August 26, 2012
U.S. monetary policy since the financial crisis
The Federal Reserve Bank of New York announced on Thursday that it had sold the last remaining securities from its Maiden Lane III portfolio, successfully closing the chapter on its assistance to insurance giant AIG. I thought this would be a good occasion to review the various measures that the Fed implemented over the last 5 years-- what they were attended to accomplish, what they did accomplish, and the significance of Thursday's announcement.
The first point to emphasize is that the Fed's strategies for dealing with the financial crunch in 2008 were very different from the tools it subsequently began to adopt in 2009. In 2008, the Fed implemented a series of emergency lending measures which are represented by the orange region in the graph below of the total assets held by the Federal Reserve.
The graph below displays the individual components within that lending category. The most important among these were currency swaps, the Commercial Paper Funding Facility, and the Term Auction Facility. Most of this lending had ended (with all loans repaid with interest) by March of 2010. There was a brief resumption of currency swaps (lending to foreign central banks) as concerns about the European financial situation heightened at the start of this year, though at the moment these are back down to $26 billion, compared to $570 B in November 2008. The Term Asset-Backed Securities Loan Facility (magenta in the graph below) lasted a little longer than most of the other lending, though today it is below $3 B.
A somewhat different class of assets that I've also included in the "lending" category of the first graph includes some questionable securities that the Fed acquired in the bailouts of Bear Stearns and insurance giant AIG. The Fed's holdings of these are broken out separately in the graph below.
The Fed had been following a strategy of gradually selling and writing these off, a process that now is essentially completed. On Thursday, the Federal Reserve Bank of New York issued this statement:
Today's announcement on ML III follows the successful wind-down of Maiden Lane II LLC (ML II) in February 2012, which resulted in a net gain of approximately $2.8 billion for the taxpayer. It also follows the January 2011 termination of the New York Fed’s extension of credit to AIG, which produced approximately $8.2 billion in interest and fees. When taken together, the total net profit to taxpayers from the New York Fed’s assistance to AIG and AIG-related facilities was $17.7 billion.
I was surprised to see that the Fed ended up making a profit on AIG-- my understanding had been that the Fed's strategy had been to mark these down at a loss over time. I was unable to discover the details of how this ended up favorably for the Fed. Thursday's statement indicates that more information will be provided on November 23.
But the fact that the Fed ended up making a profit from these transactions is an important detail. The key uncertainty for policy makers at the time (just as it is the key dilemma for the ECB at the moment) was determining whether the crisis is one of illiquidity or insolvency. If the problem is just that assets are temporarily undervalued as a result of the financial panic (i.e., the assets are temporarily illiquid), the central bank can solve the problem by stepping in as a lender of last resort. If instead the problem is that the assets are correctly valued (i.e., the borrowers are fundamentally insolvent), all the central bank can do is transfer these losses from existing creditors to the taxpayer (possibly in the form of an inflation tax). A key indication that the central bank did exactly the right thing is if, as a result of their stepping in, the long-run value of the asset is restored, in which case the Fed would end up making a profit out of the transaction.
Some have criticized the Fed's emergency lending on the grounds that the Fed took all these extraordinary actions and yet the economy still performed very badly in 2008:Q4 - 2009:Q2. I think this misses the point. I don't believe that it was ever within the Fed's (or anyone else's power) to bring the economy quickly back to full employment. Instead, the purpose of the Fed's emergency lending was to prevent a very bad situation from becoming even worse than it needed to be. The evidence we now have suggests that the Fed indeed accomplished exactly this. See for example the recent post-mortems by Adrian and Schaumburg on the CPFF and the PDCF.
But let me now return to the first graph to briefly discuss what I see as a very different strategy that the Fed has been following since winding down these emergency lending programs. The Fed replaced the emergency lending with significant growth in its holdings of U.S. Treasury securities, debt issued by Fannie Mae and Freddie Mac, and mortgage-backed securities guaranteed by Fannie and Freddie. These are fundamentally very different from the aggressive lending in the fall of 2008 in that they involved no new transfer of private risk to the taxpayers. The reason is that, before the Fed bought any agency debt or MBS, the U.S. Treasury had already assumed financial responsibility for these agency obligations. Rather than trying to serve as lender of last resort, these more recent measures (sometimes referred to as "QE1" and "QE2") were instead just intended to help keep long-term borrowing costs low and to make sure that the U.S. did not experience a Japanese-style deflation.
These measures, too, have been criticized on the grounds that, despite QE1 and QE2, the economy continues to disappoint. And here again, I think the critics have missed the point. I again maintain that it is not within the Fed's power today to bring the economy quickly back to full employment. I nevertheless also believe that deflation-- an outright decline in wages and prices-- would make our problems even worse. For this reason, I have been a supporter of the Fed now moving ahead with QE3, though my expectations for what this will actually accomplish are low.
Let me end with a look at the liabilities side of the Fed's balance sheet shown below. Note that the height in this graph is by construction identical at every date to that of the original assets graph. One key liability is the dark green region corresponding to currency held by the public-- the green money that you and I carry around. This has increased only modestly despite all the emergency lending, QE1, or QE2. I know some of you have heard again and again that the Fed did all this by "printing money", but as a physical statement, this simply is not true. Dollar bills with pictures of George Washington (or C-notes with Ben Franklin's portrait) have never been printed in anywhere near the amount of the Fed's various actions. In fact, it would be quite a challenge logistically to print them in the quantity necessary to match the surge in Fed assets over the last 4 years.
Instead, the Fed's assets have been acquired by creating reserves, which are simply credits that banks maintain in their accounts with the Fed. Although banks could, in principle, ask to convert these credits into green currency, for four years banks have instead been content to let the reserves just sit there. Those who insisted that all this "money creation" would lead to runaway inflation have so far at least proved to be spectacularly wrong.
My view is that the Fed never had the power, and lacks the power today, to solve our primary economic problems. However I believe it did have the power, and successfully exercised the power, to prevent our problems from becoming even worse.
Posted by James Hamilton at August 26, 2012 07:16 AMdigg this | reddit
Before declaring the Fed or any Central Bank as a glory in heaven, one may wish to look at their actions and achievements in the continuity. The great depression records a total outstanding loans and credit at 260 % of GDP, as of today the same components stand at 360%.
Those figures are keys,when studying the performances of the CBs and the comments on this post.One may share the appreciation of CBs achievments at a time and yet may disgard their performances in continuity.Those are public institutions and not association of persons.
Assets pricing and repricing are in the power of the Central Banks, the returns on those pricing is the true economy.The assets pricing has required the Fed to not only purchase large amounts of MBS but to provide, the liquidities to European Banks,such as Credit Suisse (Please see the related Econbrowser post on the subject)The troubles and Fed intervention may just stem from the potential sales of the same assets by European Banks.
Central may not print but they did and drove a mispricing of assets and returns.
Posted by: ppcm at August 26, 2012 08:43 AM
Prof. Hamilton, I credit what you write as perfectly reasonable. But you are ignoring half of the story.
You are ignoring the harm to the financially least sophisticated who are being robbed via CD's. And who will be even more severely losers in coming years now that they are fleeing into bond funds. (Isn't there irony that the govt justifies much of what it does as helping the poor: The Fed is actually doing the reverse for the benefit of rich & powerful bankster & the politically well-connected.)
You are ignoring the harm to pension funds and insurance companies who of necessity must deal significantly in bonds. Will you remember to thank the Fed in future years when pension funds & ins. companies reach crises?
You are ignoring that entrepreneurs are misled regarding the actual quantity of savings, which is key to their deciding the mix of products they offer to the public. For what is the real quantity of savings when the Fed may create it out of thin air?
You are ignoring the moral hazard the Fed is creating in luring the US govt closer to the Greek model. There is no way the US govt could borrow at the levels it is currently borrowing if we were in a world of free-market provision of money & banking. Savers would refuse to lend. But with loose fiat money, the alcoholic is enabled and encouraged to dig the hole deeper. Is it not obvious to you that the US cannot ever pay the present debt & unfunded liabilities--except by cheating creditors via future inflation?
Add to this that Fed money creation enables expansion the size of govt relative to the private economy, with predictable detriment to future GDP growth.
Posted by: Bryce at August 26, 2012 09:03 AM
There is a difference between quickly and never, and while it may indeed not be within their power, I would have to have evidence of that. The great tragedy here is one of missed opportunity to test that hypothesis.
Posted by: Lord at August 26, 2012 09:08 AM
The Fed is carrying ~2.9 T$ of assets on ~55 G$ of capital, an asset/capital ratio > 50:1.
I submit that this, by itself, is wildly risky, and that if a bank the Fed regulates submitted a balance sheet with that kind of ratio, the Fed would take immediate regulatory action to install new management and restructure the balance sheet.
But, I seem to be the only person int eh country who worries about this.
Posted by: Walter Sobchak at August 26, 2012 11:38 AM
Profitability of the Fed is hardly a great test to differentiate between insolvency and illiquidity. The Fed can create money out of thin air and charge interest on it, on top of being able to affect asset prices in a massive way.
Many banks were likely completely insolvent at the beginning of the crisis when their assets were priced to market. However, when the Fed rushed to provide below-market exclusive loans to select banks, and buy trillion dollars worth of impaired assets with newly created money, and when federal government nationalized financing of entire single-family housing industry, suspended mark-to-market, etc., etc., suddenly all these banks became both solvent and very profitable.
The crisis is still here, and many losses are likely being shifted to the future taxpayers. Let's see how profitable are 30yr 3.5% mortgages in the end.
Four years after the start of the crisis, can all emergency measures be reversed and money supply frozen? Will the Fed and Fannie/Freddie be still profitable?
As far as inflation, even 2-3% cumulative yearly inflation can hurt a lot if your income is stagnant or has dropped 10-20% or more, and your house is no longer tax free ATM machine.
Posted by: B Turnbull at August 26, 2012 11:55 AM
My view is that the Fed never had the power, and lacks the power today, to solve our primary economic problems. However I believe it did have the power, and successfully exercised the power, to prevent our problems from becoming even worse.
I think this gets it just about right, but I'm wondering who those folks are that supposedly believed the Fed had in its power the ability to solve today's economic problems. The MMT crowd? The mainstream view seemed to be that the Fed could act at the margins, but most of the heavy lifting would have to be done on the fiscal side.
The risk is that we let the Fed off the hook too easily by acknowledging the limits of what the Fed could actually accomplish. For one thing, the Fed's footdragging on QE3 gives politicians the kind of excuse they want for inaction: "Hey, if the Fed doesn't think conditions are urgent enough to merit action, why should we?" Bernanke's hair should be on fire right now, but he seems strangely uninterested or disengaged. Several weeks ago JDH laid out a very strong and convincing case as to why we should expect the Fed to announce QE3. And then the FOMC meeting came and went with nothing new, just more wait-and-see.
And then we get the nutjobs arguing for higher interest rates out of concern for savers and those dependent upon coupon clipping. And the nutjobs aren't just here...it appears that Romney's Veep pick belongs in that camp. High interest rates for savers plus a return to a gold standard with gold coinage. Ugh!
Posted by: 2slugbaits at August 26, 2012 01:36 PM
I could make my investments look pretty good too if I could control the money supply.
Posted by: maynardGkeynes at August 26, 2012 03:37 PM
Posted by: XS at August 26, 2012 04:38 PM
The thrust of these remarks is for the most part correct. In historic context, savvy financial observers and participants did not know whether the US financial system was going to collapse or not. All of the creative Fed facilities to backstop the various parts of the financial sector did their intended job. Moreover, the Fed stress tests of big banks was an important additional action that helped markets turn the corner. Perceptions were important. Announcement effects also played a role. All this will be vividly clear to economic historians from the voluminous news and commentary in the months surrounding the stock market’s 2009 bottom which demarks when confidence was restored. The financial system did not collapse because of Fed actions and TARP and to a lesser extent the Obama fiscal stimulus.
QE2 and beyond are a different matter entirely. With QE2 and Operation Twist the Fed has blown at least two new bubbles, the stock market and bond market. There’s also something of a bubble in commodities. For certain we should not be Pollyannaish. For one, the Fed has driven a dagger straight into the hearts of retirees and others who rely on fixed income earnings. This had a large effect on disposable income last year when interest rates plunged. Also there is no way of knowing how the bubbles are going to turn out when they bust – as they inevitably will. At some point in the future the 10-year yield must normalize at around 5½% from today’s 1¾%. Even higher if inflation has picked up by then. Watch what happens when the economy starts climbing that steep hill. Moreover, economic history and common sense say problems should be addressed early. Bubbles are problems. Financial markets are not free markets at present, not with the QEs. And society’s scarce capital priced artificially is distorting investment decisions which are committing funds to projects that would otherwise not be profitable, and will prove to have been just that (unprofitable) in coming years. QE2 and beyond are creating a smear of Solyndras across the landscape. Who is on the hook for home mortgages at 4% and below? Fannie and Freddie hold the assets, and taxpayers will pick up the tab on what goes underwater or belly up over the next decade. The Fed will once again be the culprit that has enabled Fannie and Freddie with today’s record low rates.
The spike of the monetary base is going to have unintended consequences. The creation of this much fiat base money is unprecedented. It is risible that anyone can believe this is going to turn out all right. All right that the financial system did not collapse … yes indeed. But in the words of Donald Rumsfeld there are unknown unknowns out there, as well as a lengthy list of knowns. Bryce gave a good short list of some of them. Let me add one more. Erosion of potential GDP growth going forward in an environment of distorted investment including but not limited to the non-earning asset of housing, funds that could be better directed elsewhere but are now locked up in housing for as long as 30 years. Moreover, there are socially unacceptable redistributional implications to nursing the most flagrant offenders, the big banks, back to health with risk free provision of 16 basis point funding. The revolving door between the Fed and Wall Street enters and exits the room with the bed they lie down in together and gives off more than a whiff of the stench of corruption. If only the broad public understood.
Hyperinflation is indeed overrated – for the moment of the next few years. But so is the deflationary threat. The financial system and aggregate demand are not collapsing as they were in the fall of 2008. And deflation like that at major stress points which can turn into Irving Fisher debt deflation is not in the cards. Probabilistically it’s not even in the deck. Mild deflation in fact, for much of America’s history, was a consequence of productivity growth and a sign of health. The greater risk by far is the never-before-been-tried exit from this unprecedented fiat base money. So let’s up the ante and make it even tougher to exit. The risk of what lies ahead will become far more apparent when the broken monetary transmission mechanism starts to heal. Excess reserves will then gain traction and there will be an inflationary impulse. It is to this broken mechanism (onerous bank capital requirements) that the Fed should be directing its efforts, not to more QEs. A few Fed district presidents understand this and are making the clarion call though to little avail.
AIG was at the center of an opaque spider’s web of multibillions of CDS. Its failure risked failure of the system; AIG epitomized systemic risk. For the sake of the system AIG had to be kept from collapsing. But what was the true cost of bailing out AIG and then convalescing them back to health? AIG gambled with other people’s money. It and Bear and Lehman and the other investment banks nearly brought the house down! From an adjusted price of $1000 per share in 2007, AIG stock is now selling at $34. This after being the beneficiary of the biggest corporate bailout in history and 4 years of government handholding? Excuse me about “the long-run value of the asset is restored.” Only in our corrupt pull-the-wool-over-the-eyes-of-the-public nation’s capital would the corpse not have been dismembered and sold off piecemeal.
Posted by: JBH at August 26, 2012 07:47 PM
However, I took issue with this statement: "My view is that the Fed never had the power, and lacks the power today, to solve our primary economic problems."
Funny thing is, just the other day the market rallied when the Fed minutes were released, hinting at more QE. Imagine instead if the Fed announced they would do more QE until we hit 5 percent nominal GDP growth.
I think the thing that really stands out about the Fed's balance sheet is that they shrunk it in 2009 when the economy was still doing poorly. Second thing you notice is that the balance sheet was flat for much of 2010 while the economy was doing poorly. Third thing you notice is that the balance sheet has been flat since the middle of 2011 while the economy has done poorly. Typically, prior to 2008, when the economy was doing poorly, the Fed would loosen monetary policy. Now it's changed it's mind. That's the strange part...
Posted by: Thorstein Veblen at August 26, 2012 08:32 PM
As a Physicist that has taken an interest in macroeconomics since 2007, I am perplexed. Starting with only an assumption the macro economy is a natural system, cycles are a given as equilibrium is constantly sought. Consider this hypothetical and consequence: a FDIC that guarantees only 75% of a deposit, and a Fed that seeks to cause bank runs. What is the consequence of this? I argue a very, very strong banking system. Think of the US Forest Service and how they adjusted their fire prevention policy; controlled burns do improve the health of the forest, and lessen the risk of wide spread fires.
Also, I find a universal abhorrence of deflation. If deflation is so bad, I have bad news. QE(x) apparently always raises subsistence commodity prices faster than aggregate wages paid. QE(x) necessitates QE(x+1), i.e., a deeper hole is created while 401K holders take temporary comfort at the elevation of indices..
I fear we are past the point of avoiding a massive dose of deflation. It is well beyond my calling, but the more enterprising among you will understand this, and seek to 1) lessen the fear of deflation, and 2) design a healthy way to deal with it. Find the benefits, gentleman, because it is a cycle that your grandfathers remember.
Posted by: Kimo at August 26, 2012 11:17 PM
I think the thrust of this post is generally on target, but I do have a couple of points.
1. When people criticize the Fed for "printing money", I believe most of them are quite aware that most of that money has not been in the form of physical currency, but has instead been in the form of bank reserve balances. These balances themselves are a component of MB, and if the Fed creates them it is therefore creating additional money. The critics have been wrong to object to this process so strenuously, but "printing" is just being used here as a synonym for "creating".
2. Speaking of Fed purchases transferring risk to "the taxpayer" is highly misleading. The central bank, though an agency of government, is not the taxpayer. It doesn't require tax revenues to support it's balance sheet. There is no economically meaningful sense in which it can become insolvent. If its so-called liabilities exceed its assets, that does not mean what it does for an entity whose spending is revenue constrained. The central bank uses its balance sheet and capital ratio just as price level stability management tools, and as a way of representing its operations to the public in a manner they are familiar with: the asset/liability language of financial accounting.
If the Fed buys a financial asset that is effectively worthless, and pays a million dollars for it, that just means it has created a million dollars and given it to the previous owner of that asset in exchange for virtually nothing. The taxpayer has not "lost money" in this transaction, because the Fed creates the money in the process of spending it.
Has the taxpayer been exposed to a "risk" as a result? Possibly. But not a budget or solvency risk. Only a potential inflation risk. That hasn't been an issue in an environment in which the Fed has been fighting off deflation, but it could be a concern under other circumstances.
Are there other reasons to be concerned about the purchase of worthless assets? Of course. There is the moral hazard concern. There is the concern that the purchase by the Fed represents ill-gotten gains for reckless financial players. But I don't think that viewing the Fed on the standard model of a financial institution.
I think this latter point is important, because much of the public continues to be under the impression that financial institutions were bailed out from "taxpayer revenues".
Posted by: Dan Kervick at August 27, 2012 05:12 AM
Yes, the Federal Reserve and the U.S. Treasury Department prevented a serious meltdown of the existing financial system in 2008.
I am not sure that was a good result. Kevin Phillips makes a persuasive case that the existing financial system in the U.S. in 2008 had more faults than merits (BAD MONEY, 2008).
Saving the existing system prevented drastic change of that system.
Posted by: ReformerRay at August 27, 2012 07:31 AM
Thanks for a good post. Some comments.
Regarding your last paragraph. Although I agree with your view about central banking and monetary policy, I extend it to almost all economic problems, not just primary ones (anyway, a line that we could discuss forever). This is why I disagree with you about the paragraph's second sentence. There is no evidence that whatever the Fed did in the past five years helped to prevent an aggravation of the 2008 problems. You can claim that there is no evidence that it aggravated the problems, but I assume you don't want to be booed. Also, to claim success you should have some evidence of benefits and costs of whatever the Fed did. I don't think you have any reliable evidence. It's too early to assess the consequences of what the Fed did --we are still discussing the consequences of whatever FDR did! I know you only wrote "I believe" and you may change your belief as evidence accumulates, but we are talking about policy making not science and therefore first impressions define positions that are difficult to change with evidence.
You explain in detail the assets the Fed has shown in its financial statements, but then quickly dismiss the liability side saying that it created reserves. You accept the accounting of Fed's borrowing from banks as "reserves". I think it's wrong to accept it. I don't know details (I live much closer to the South Pole than to DC and I don't have the resources to do a detailed review of everything the Fed has been doing in the past 5 years) but from my experience with fiscal and financial crises, my reading of your graphs of assets and liabilities tells me a different story. Most likely initially the increase in lending (asset) was creative accounting --meaning that there was no transaction and the purpose of accounting an asset and a liability was to facilitate banks' compliance with regulatory capital rules (hope you can construct a detailed, consolidated balance sheet of the Fed and all relevant "banks" to know better what assets and liability increased). But then the increase in the three types of securities (assets) that you identify was financed with standard borrowing from banks, with the Fed as the borrower, paying interest to banks as any debtor and in this case with the additional purpose of ensuring compliance with capital rules. An important consequence of my view of what happened is that what the Fed did should have been accounted not as reserve (and therefore as part of the monetary base) but as Fed's debt with the banks. In other countries, similar borrowing was accounted as debt to avoid the mistake of thinking that the central bank was creating "money" and that there would be inflation (to understand the point I'm making I suggest to compare what happened in Argentina and Chile for a few years after July 1982 --in Argentina the bailout of debtors was financed with a 'hyper'-inflation tax whereas in Chile a much larger bailout was financed with Central Bank's borrowing from banks).
[BTW, in China, the mistake of accounting PBC's accumulation of international reserves as if it were the reserves that economists discuss when talking about monetary and exchange-rate policies has been a source of serious misunderstandings about the causes and consequences of PBC's accumulation of foreign assets.]
It's amazing how little attention most (macro)economists pay to the data that they use in their policy statements and even in their research. You are right to point that economists that argued that the Fed's large increase in reserves would lead to high inflation were spectacularly wrong. But they were wrong because they didn't pay attention to what the Fed has been actually doing and how it was reporting it, and for this we should blame Bernanke and the Fed economists that has systematically misled both their principals in Congress and their peers --although the latter should have known better.
Posted by: E. Barandiaran at August 27, 2012 07:33 AM
Suppose AIG had been treated like Lehman Brothers? Many important financial institutions throughout the world would have been forced to recognize that the private sector was unable to guarantee payment of private contracts under existing conditions. This would have led to the realization that removing derivatives from regulation by the public sector (in a 2000 law) had allowed the development of a unsustainable financial system. A different financial system would have been created by law.
Posted by: ReformerR at August 27, 2012 08:12 AM
Bryce claims that the Fed's actions harmed the poor.
That is very, very difficult to agree with.
If the Fed had not acted, the value of the securities held by the people Bryce is concerned about, surely would have collapsed. Bryce is imagining a scenario where the Fed did not stop the economy from falling, but the value of these assets rose. In my book that does not compute.
Posted by: spencer at August 27, 2012 08:17 AM
I nevertheless also believe that deflation-- an outright decline in wages and prices-- would make our problems even worse. For this reason, I have been a supporter of the Fed now moving ahead with QE3, though my expectations for what this will actually accomplish are low.
...Instead, the Fed's assets have been acquired by creating reserves, which are simply credits that banks maintain in their accounts with the Fed. Although banks could, in principle, ask to convert these credits into green currency, for four years banks have instead been content to let the reserves just sit there. Those who insisted that all this "money creation" would lead to runaway inflation have so far at least proved to be spectacularly wrong.
My view is that the Fed never had the power, and lacks the power today, to solve our primary economic problems. However I believe it did have the power, and successfully exercised the power, to prevent our problems from becoming even worse.
Your are right to be skeptical about QE3. Monetary expansion did not work during the Great Depression and it is not working now. QE during the Great Depression actually did the same thing that is it doing today, increased excess bank reserves and impacted gold.
There is a good paper Did Doubling Reserve Requirements Cause the Recession of 1937-1938? by Charles Calomiris, Joseph Mason, and David Wheelock that was published by the St. Louis FED in January 2011. Below is an excerpt:
The Banking Act of 1935 expanded the Federal Reserve’s authority to set the reserve requirements imposed on the System’s member banks. The Fed subsequently doubled requirements to their legal maximum rates in three steps in August 1936, March 1937, and May 1937 (see Table 1). The Fed took this action primarily in response to a rapid and large increase in reserve balances in excess of legal requirements, which Fed officials viewed as posing a potential inflation threat that could derail the economic recovery. A second consideration was a desire by Fed officials to regain control of monetary 3 policy from the Treasury and to make the Fed’s traditional policy tools—the discount rate and open-market operations—relevant and effective. The Fed viewed the significant slack in excess reserves as undermining the effectiveness of its other tools (See Friedman and Schwartz, 1963, pp. 520-22; Meltzer, 2003, pp. 495-500). Finally, the use of the reserve requirement as a policy tool reflected the loss of control by the Fed over the monetary base after 1935. The newly created monetary powers of the Treasury (the Exchange Stabilization Fund and the power to set the price of gold and thereby determine the size of gold inflows, established in 1934 and 1933, respectively) gave the Treasury effective control over the supply of high-powered money. The capacity of the Treasury to increase the monetary base was greater than the capacity of the Fed to reduce it, and Secretary Morgenthau recognized and used that strategic advantage to exert control over the Fed’s monetary policy (Calomiris and Wheelock 1998; Meltzer 2003; Calomiris 2010). The Fed engaged in almost no open-market operations over the period 1935-1941. The power to set reserve requirements, and thereby potentially to influence the money multiplier, however, remained with the Fed.
Fed officials did not view the increases in reserve requirement in 1936 and 1937 as a tightening of monetary policy. Rather, they viewed excess reserves as “superfluous” balances, and expected that the increases in reserve requirements would have little or no impact on interest rates or credit supply (Meltzer, 2003, pp. 495-96). Their goal was not to tighten monetary conditions, but to put the Fed into a position to either tighten or ease policy later using open-market operations and changes in the discount rate. By contrast, Friedman and Schwartz (1963) contend that the increases in reserve requirements substantially reduced money stock growth and were a main cause of the recession of 1937-38, and their view has remained widely accepted.
A reveiw of Table 2 in the paper shows that the excess reserves increased all during the Great Depression and contrary to the claims of Friedman and Schwartz the excess reserves actually fell slightly after the official reserves were imposed only to resume their increease as the economy shifted back into contraction.
While I agree that the FED's actions did little to harm the economy, most of the harm was done fiscally and legally by the legislative and the executive branches, but as you acknowledge the crony capitalism on which the FED's QE was based did harm the economy by propping up companies that should have been allowed to fail. Fiscal policy wasted productive resources. During the Great Depression hogs were destroyed and potatoes were plowed under and putting people on the government payroll to do virtually nothing. Today we and bulldozing housing developments and demolishing public building in insanely wasteful make-work projects as well as funding bloated state and local government employment.
An unbiased review of the situation during the Great Depression demonstrates just how similar governemnt reactions have been to the two contractions with similar results.
Posted by: Ricardo at August 27, 2012 08:38 AM
"My view is that the Fed never had the power, and lacks the power today, to solve our primary economic problems. However I believe it did have the power, and successfully exercised the power, to prevent our problems from becoming even worse."
Well now, if I were a Keynsian, I might draw my sword on this one.
Posted by: Steven Kopits at August 27, 2012 09:06 AM
"Instead, the Fed's assets have been acquired by creating reserves, which are simply credits that banks maintain in their accounts with the Fed. Although banks could, in principle, ask to convert these credits into green currency, for four years banks have instead been content to let the reserves just sit there. Those who insisted that all this "money creation" would lead to runaway inflation have so far at least proved to be spectacularly wrong."
Obviously, those who were predicting inflation were focused on the ability to convert the reserves into currency. Why do you think the banks have not done so?
Posted by: Anonymous at August 27, 2012 12:03 PM
Great question. I am dying to answer but I really want to read the professor's answer.
Posted by: Ricardo at August 27, 2012 01:59 PM
Ricardo Your are right to be skeptical about QE3
Maybe you and I read a different post by JDH. I certainly didn't get the impression that JDH is "skeptical" about QE3. I think JDH has been quite clear in his support...almost unqualified support for QE3. JDH is simply realistic about what can be expected. It is not in the Fed's power to manage a recovery; but it is in the Fed's power to stave off deflation. I suspect you are simply projecting your view onto what you would like to believe JDH said.
Posted by: 2slugbaits at August 27, 2012 05:02 PM
Still making some simple mistakes.
Reserves never "just sit there". They circulate among banks, as a results of payments and lending.
The impression that excess reserves "just sit there" comes from the notion that if banks used reserves to lend, that would increase demand for banknotes and absorb excess reserves. But in the contemporary economy increased lending is only weakly related to demand for banknotes. The act of lending in and of itself does not absorb reserves, it merely transfers them from one bank to another.
Posted by: Tom at August 27, 2012 05:39 PM
The assets held by the poor were FDIC-insured.
Permit me to quote Jeremy Granthem:
“If we had let all the reckless bankers go out of business, we would not have blown up our houses or our factories, or carted off our machine tools to Russia, nor would we have machine gunned any of our educated workforce, even our bankers! When the smoke had cleared, those with money would have bought up the bankrupt assets at cents on the dollar and we would have had a sharp recovery in the economy. Moral hazard would have been crushed, lessons learned for a generation or two, and assets would be in stronger, more efficient hands. Debt is accounting, not reality. Real economies are much more resilient than they are given credit for. We allow ourselves to be terrified by the “financial-industrial complex” as Eisenhower might have said, much to their advantage.”
The real capital of the economy isn’t destroyed. What would be destroyed has to do with the expansion & collapse of credit without regard to real savings—facilitated by faith-based fiat money.
Posted by: Bryce at August 27, 2012 06:11 PM
Tom: If you want a discussion of the circulation of reserves, see this.
If you will read the rest of the sentence to which you object, you will see that it is talking about whether or not banks "ask to convert these credits into green currency."
When a bank does ask for currency from the Fed, what happens is aggregate, systemwide deposits with the Fed go down and vault cash goes up by the amount of the transfer.
Please permit me to suggest that next time you think someone has made a "simple mistake", consider the possibility that it probably wasn't me.
Posted by: JDH at August 27, 2012 06:19 PM
A political correct post, so to say.
James, you said in March 2011 ".. banks really don't see much better use for the funds than just holding on to them as reserves."
Jim, any ideas how its going on from nowadays ?
@Anonymous, @Ricardo : the banks do not know what to do with their reserves. As Greenspan has left, Krugman became politician, Obama is hopeless, and Romney is insane.
Posted by: Johannes at August 28, 2012 02:08 AM
Thanks for the clarification. Essentially, the reserves are not being converted into currency because they are earning interest and the volume of lending is such that there is no need for conversion. The situation could change, however, and the Fed has a plan to deal with it....
Posted by: Rich Berger at August 28, 2012 02:26 AM
To add to the professor's response, when all banks have excess reserves there is no need for reserves to transfer from bank to bank. You are thinking in the past. When banks have loaned up to their reserve level they sometimes have to borrow from other banks to satisfy the reserve requirement. Today banks have so much in excess there is virtually no borrowing between banks.
Posted by: Ricardo at August 28, 2012 05:52 AM
From your reply to Tom's comment and your reference to your earlier post on reserves, I assume that you still accept that all reported "excess reserves" have been created equal. Yes, money is fungible but even access to my bank accounts or to my safety boxes may differ for a number of reasons and what matters to assess the degree of substitutability of my accounts or boxes is how different access is.
To know more about excess reserves we need some detailed analysis of the demand for reserves by banks. I have not been able to find any study explaining this demand in the past few years --say, similar to disaggregated studies of what happened in the Great Depression. More important --and albeit ignored by the studies of the demand for reserves in the GD-- we must pay attention to whatever the Fed has been "negotiating" with banks at a time of a big bailout. Most economists like to talk about the capture of government agencies by private banks and firms but I talk about collusion between the two parties, and therefore in the study of the demand for reserves I suggest to assess what sort of collusive agreement may help to explain the accumulation of reserves since early 2008 (before game theory I used to rely on 'moral suasion' as an effective monetary policy instrument).
Posted by: E. Barandiaran at August 28, 2012 07:29 AM
@JDH - You're hiding behind a claim to technical correctness, when you're conceptually mistaken.
It's certainly true that base money exists only in two forms, reserve deposits or banknotes. So it's certainly true that the existence of reserve deposits in excess of reserve requirements means banks are not converting all their excess reserves to banknotes. That's a rather meaningless truism.
Your mistake is in stating that instead of converting excess reserves into banknotes, banks "are content to let the reserves just sit there". That's not true. You have made an incorrect statement. The banks are not letting their reserves "just sit there". Banks are using their reserves to buy assets and make loans, which results in the reserves moving around among banks. Also every time any bank depositor makes a payment from his deposit to a client of a different bank, that results in a payment of reserves from his bank to the recipient's bank.
Imagine that the volume of banknotes in circulation was stable for a period of a year. Could you say that those banknotes were "just sitting there"? Of course you couldn't. They're circulating, playing an important role in the economy. Reserve deposits are doing exactly the same thing, circulating. The fact that the total amount of reserve deposits does not change does not indicate that the reserve deposits are "just sitting there".
Posted by: Tom at August 28, 2012 08:33 AM
PS The amount of reserve deposits converted to banknotes is not mainly up to banks, it's up to non-financial sector users of banknotes. Lately it depends largely on demand among foreigners who don't trust their own banks or currencies and so keep dollar banknotes in safe deposit boxes.
Banks do keep some banknotes as vault cash, which is basically just a cushion of ready supply to meet demand from depositors who want to withdraw banknotes. The aggregate amount of vault cash held by banks is fairly stable.
Of course, reserve deposits are constantly being converted into banknotes and vice versa. A stable volume of reserve deposits merely indicates that roughly equal amounts are being converted in both directions.
Posted by: Tom at August 28, 2012 08:44 AM
It is not in the Fed's power to manage a recovery; but it is in the Fed's power to stave off deflation.
Actually, this is the faulty assumption. The FED can neither manage a recovery nor can it stave off deflation in our current environment. Read the Calomiris paper I linked.
Keynes was right in identifying a liquidity trap, but he didn't understand what it meant. He saw the liquidity trap as lowering interest rates to the zero bound and monetary expansion no longer having any impact.
Actually, when the money supply is either greater or lesser than the demand it hinders the economy. Too much money, the normal reaction of a central bank, displaces production and distorts the price signals so that bubbles develop. Too little money creates a condition where inefficiencies are introduced into exchange.
Too often in monetary systems the insights of Cantillon are forgotten and it is assumed that an increase in the money supply enters the economy evenly. Actually when the money supply is increased it enters the economy in very unevenly and that creates bubbles. When bubbles burst the transmission mechanism is broken and additional injections of money are hindered from entering the productive economy. The result is increased bank reserves and increases in purchases on investment goods, commodities and such.
We are currently in a very serious situation where very serious deleveraging of bubbles have broken the transmission mechanism of money. If the FED enters into QE3 we will see increased excess reserves and increased prices for investment goods and commodities, but the real economy will simply continue to limp along. This is one reason that the price of gold is a very good indicator of excessive money creation.
So I repeat that the professor is very wise to doubt that QE3 will have much impact on the economy. Beyond propping up some failing banks that should fail or lining the pockets of politically connected crony capitalists, monetary expansion will have virtually no affect including no inflation and no impact on deleveraging (what most see as deflation).
Posted by: Ricardo at August 28, 2012 08:48 AM
balance sheet, shmalance sheet...
Studying money and banking, undergrad and grad, not once did I ever hear of a central bank "balance sheet" in a fiat money system....only the money helicopter. It was meaningless to discuss then as it is now. The assets, for example, are not marked to market or model. In particular, the ECB marks its gold to market, but the Fed does not. The MBSs I would guess are at book or purchase value. Thus, in a corporate sense, the Fed has some "goodwill" in there...or perhaps some "badwill". Anyway they could tear up these assets, and nothing would change. In particular, interest on treasury securities is just laundered by the Fed..they receive it, then give it back. Treasury securities held by the Fed should not even be counted as Treasury debt, and certainly not an asset on the Fed's balance sheet, since they do not keep the interest.
Regarding money and inflation...there seems to be some confusion in the comments between the expansion of the "money supply" in the sense of M1 and the expansion of the monetary base. The fed absolutely controls the base, and can influence M1 somewhat. Paying banks to hold reserves sort of reduces M1, but not exactly. In the process of expansion, the reserves are constant, but the liabilities (demand deposits) grow. So, banks could easily lend out now, and still receive money on the reserves. They would not be depleting there reserves by creating demand deposits with loans (if they make good loans). No contradiction there. M1 would grow, we would get the inflation Krugman is demanding (again), more bubbles, another cycle...sigh.
Posted by: pete at August 28, 2012 09:13 AM
"These are fundamentally very different from the aggressive lending in the fall of 2008 in that they involved no new transfer of private risk to the taxpayers. The reason is that, before the Fed bought any agency debt or MBS, the U.S. Treasury had already assumed financial responsibility for these agency obligations."
I wonder whether the Treasury would have so blithely assumed the risk for that debt without hope of accommodation by the Fed. And what about the expiration of the Treasury guarantee? If the Fed still has the assets at that time, will they have assumed risk on behalf of taxpayers?
I wish the graph showing currency had been extended back further - it looks like, from very casual observation, that it has grown substantially in recent years.
Posted by: don at August 28, 2012 11:42 AM
The heart of this post is about the QEs going forward. Ought there be a further QE? I put QE1 in the emergency camp. It was necessary to keep the financial system from collapsing. Now the gears have shifted to proper policy going forward. There are two bodies of thought – to do or not do QE3. Each side has proponents. Each side operates out of a different constellation of theoretical economic beliefs. Some of these are ideologically blinkered. What beliefs of those calling for more easing might be wrong? Conversely what beliefs against further easing might be wrong? I am in the camp that thinks further easing will be counterproductive, a wrong policy move. It’s clear Dr. Hamilton is in the other camp. Specifically I believe deflation is no longer a risk, though a debt-deflation spiral was indeed a huge risk in 2008-9. Now the economy is in a very different place. Empirically, the risk today emanates from the eurozone. A breakup could precipitate another round of collapse here, but as the globe is on high alert and has taken preventative measures in this regard (like new regulatory powers because of Dodd-Frank) a problem of systemic proportions is highly unlikely. The financial world will not be blindsided again as it was in 2007. Far more important, there will be a myriad of unintended consequences because of the QEs. These effects are not and will not be apparent to some, just as belief in the theoretical underpinnings of the era of moderation precluded them from seeing the crisis coming. It is as predictable as night following day that the exit from QE will not go the way the Fed expects. For example, at the first hint of tightening, when it does come, longer-term yields will soar and the stock market will plunge. Piling on even more QE will make the exit that much more problematic, and the ongoing consequences of distorting the system by artificial rates just that much worse. Financial market variables today are artificial and far away from their norm. The faster the system moves toward normality the better. QE3 takes us in the opposite direction. And this doesn’t even address the third alternative that a growing number of observers believe the exit should already be starting.
Posted by: JBH at August 29, 2012 07:59 AM
I do agree that the actions taken by the FED since 2008 have helped to prevent a further meltdown of our financial system and a deeper recession. That’s the only thing it managed to accomplish. However, it’s sad to realize that our monetary and fiscal policies have become totally impotent in stimulating our economy.
Posted by: Cosmo10 at August 29, 2012 08:50 AM
Doesn't look like the reserves are doing much of anything. Just sitting there is about right:
Posted by: An Idiot at August 29, 2012 11:20 AM
A very disappointing results. I agree with Ed Butowsky statement,"this policy program that Obama chose hurts the middle class and single woman the most because they spend a higher percentage of their income on food and energy, which are rising the fastest due to his printing of money.", posted in Fox Business News.
Posted by: Jesica at September 12, 2012 11:14 PM