Joe Gagnon on what the Fed got wrong

Marcus Nunes sent me a post by the always excellent Joe Gagnon.  I’m not sure I fully agree with Gagnon’s view of the situation, but his post does a beautiful job of explaining the issues faced by the Fed in December 2008, and how they evaluated their various policy options:

The FOMC did not discuss the possibility of a negative interest rate on bank reserves, but it is widely agreed that a significantly negative interest is not feasible because banks would convert their reserve balances to paper currency. A lingering puzzle is why the Fed never lowered interest on reserves to zero in subsequent years, when financial strains had diminished and depositors and market participants had gotten used to the low rate environment, but standard macroeconomic models imply that the benefits of such a small decline would have been correspondingly small.

This paragraph shows that the Fed had two serious misconceptions.  Vault cash is a part of bank reserves, and hence there is no reason that the negative IOR could not also be applied to vault cash. (There may be legal barriers, but laws can be changed.) In earlier posts I’ve recommended that banks be exempt from negative IOR on a “normal” level of bank reserves, perhaps required reserves plus X%. The key is to make excess reserve holding costly at the margin, so that new injections of base money go out into circulation as cash. Because cash is very costly to store, this would depress market interest below zero, if the policy failed.  More likely it would succeed and dramatically boost AD, and therefore the mere threat of negative IOR would make the actual implementation of negative IOR unnecessary.

Update: Mark Sadowski clarifies the legal status of vault cash

The second misconception is the assumption that the benefits from a further small reduction in interest rates are minor.  That comes from flawed Keynesian models of monetary economics, which ignore the role of money as a medium of account.  If you set IOR at a rate slightly above the T-bill yield, then the demand for base money rises dramatically, which is highly deflationary.  To be sure, a lower rate might decrease T-bill yields by a roughly similar amount, in which case the spread is preserved, but that assumption raises all sorts of further questions, such as what impact does lower interest rates have on the expected future path of monetary policy.  There are numerous cases where over a trillion dollars in global stock market wealth has been created or destroyed within minutes by a decision over a 25 basis point change in the fed funds target. In other cases that sort of change has little impact. There is no basis for simply assuming that a small change in the fed funds target would be unimportant when the economy is poised on the knife edge of a depression.

There was some discussion, both within the meeting and in the background memos, about the possible benefits of committing to hold the policy rate low for so long that the economy would be likely to overshoot the long-run desired levels of employment and inflation temporarily. Some participants questioned the credibility of such a commitment, given the likelihood that the Fed would come to regret it later. More generally, FOMC participants seemed to have little appetite for tying their hands in such a dramatic fashion. Although they were all for getting back to their economic goals quickly, they had no desire to speed up the recovery at the expense of overshooting their goals.

Not willing “to speed up the recovery at the expense of overshooting?”  Sorry Fed officials, but that is against the law.  You have a dual mandate.  A decision that you are unwilling to overshoot 2% inflation by even a tiny bit, even when unemployment is 10%, is tantamount to admitting that only inflation matters.  A policy of never trying to overshoot 2% inflation is basically a single mandate policy, inflation targeting pure and simple.  That which has no practical implications, has no policy mandate implications.  If your policy is indistinguishable for a single mandate IT regime, then it is a single mandate IT regime.

There was widespread approval of the Fed’s generous provision of liquidity during the crisis, with some participants noting that measures of financial stress were beginning to ease a bit. Both the discussion and one of the background memos agreed that the liquidity facilities had a macroeconomically important effect to the extent that they were preventing cutbacks in consumption and investment that would otherwise have occurred. Some noted that these facilities were less effective at providing additional stimulus than they were at offsetting negative shocks because market participants could not be coerced into using these facilities.

God help us all if 80 years after the Great Depression Fed officials were still worried about pushing on strings and leading horses to water.

The FOMC discussion shows that there was little appetite for a dramatic push to increase inflation expectations, with some participants expressing doubt that the Fed could raise expectations substantially through statements about its intentions without any additional actions. But there was also an acknowledgment that the Fed had not been as clear as it could have been about what inflation rate it aimed to achieve. Speeches and other published materials seemed to show a comfort zone for inflation with a lower end around 1 to 1.5 percent and an upper end at 2 percent. One of the background memos assumed an inflation goal of 1.75 percent. Participants did not agree on a common inflation goal at this meeting.

The first sentence might be translated as: “There was little appetite for pushing inflation expectations up to a level where the policy was expected to succeed, and in any case in order to actually raise inflation expectations we might have to actually do something.”  Not quite sure what “little appetite” has to do with optimal monetary policy.  Perhaps it just means the FOMC members were not as hungry as the 15 million unemployed.

On the plus side, the actual adoption of a 2% inflation target in January 2012 might be viewed as a limited victory for Ben Bernanke, given that the implicit target was a bit lower.  Keep in mind that a 2% PCE inflation rate implies a 2.4% CPI inflation rate.  Very few people understand that the current 5 years TIPS spread of 2.16% means that markets expect the Fed to fall short of their PCE inflation target. And since unemployment is also elevated, there is an overwhelming case for easier money (if you accept the Fed’s announced policy goals–perhaps not if you favor a lower target.)

PS.  Just to be clear, I’m not recommending negative IOR in the current situation, the Fed has far better options.

PPS.  Note that the excerpts I quoted here aren’t necessarily Gagnon’s views.  He occasionally recommended a more aggressive Fed stance. They are his view of what the Fed was thinking.

PPPS.  My second link was to a recent Charles Evans speech which contained this gem:

Although all central banks face these strategy and communications issues, and they implement them somewhat differently, my view is that 90 percent of the communications challenge is met by expressing policy intentions clearly so that the public can understand the Federal Reserve’s goals and how the Fed is committed to achieving these goals in a timely fashion.A clear expression of policy intentions requires stating the Fed’s policy goals clearly and explicitly. These messages need to be repeated – over and over again. It is also necessary to clearly demonstrate our commitment to achieving these goals in a timely fashion with policy actions.

That’s what the Fed did not do in 2008-09.

Update:  Mark Sadowski also has some comments on Gagnon’s post.


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108 Responses to “Joe Gagnon on what the Fed got wrong”

  1. Gravatar of foosion foosion
    5. April 2014 at 08:50

    Inflation and employment both indicate we should ease. Gee, I wonder what we should do?

  2. Gravatar of Garrett M Garrett M
    5. April 2014 at 09:59

    Professor,

    You cite TIPS spreads frequently as your go-to source for market-implied inflation expectations, but the specific spread that the Fed follows is the five year five years forward TIPS breakeven.

    You wrote a post about the problem with the 5×5 breakeven back on March 5th (link:/?p=26296), which makes sense to me, but if the implication is that the 5×5 is inferior to the straight 5 year breakeven as an indicator of the current stance of monetary policy and we don’t have a NGDP futures market, then I think there’s value to dedicating a portion of your blogging capacity to focusing more on the two indicators and why the Fed should switch to focusing on the 5 year (or whichever breakeven is most useful).

    Doing so is a far cry from NGDP futures targeting, but seems to be a valid short-term goal.

  3. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. April 2014 at 10:42

    Scott,
    Off Topic.

    Among endogenous money enthusiasts Ramanan often writes things which I find interesting and non-objectionable. However, in this particular instance I have to pick on him.

    http://www.concertedaction.com/2014/03/31/the-phrase-money-multiplier-itself-is-inaccurate-and-misleading/

    March 31, 2014

    The Phrase Money Multiplier Itself Is Inaccurate And Misleading
    By Ramanan

    “Some people

    https://www.themoneyillusion.com/?p=26479

    point out that the critique “there is no money multiplier” is wrong because it is a ratio whatever said. No! The phrase “money multiplier” itself is wrong because the phrase itself captures a wrong causal story. A phrase is a small group of words standing together as a conceptual unit and hence the phrase “money multiplier” is inaccurate and misleading.

    So take the textbook Keynesian multiplier first. It suggests that a rise in government expenditure leads to a rise in output more than the increase in the expenditure. The ratio of rise in output to the rise in expenditure is the multiplier.

    But this is not the case with the “money multiplier”. There is no direction of causality from a rise in bank settlement balances to the rise in the money stock. This is true even if the central bank is doing QE/LSAP, i.e., purchasing assets on a large scale. So if the central bank purchases government bonds in the open market, it leads to a rise in banks’ settlement balances at the central bank and also a rise in the money stock. But the rise in the settlement balances could not have been said to have caused the rise in broad monetary aggregates such as M1, M2 etc. It is the act of the central bank purchase which leads to a rise in the stock of both narrow and broad monetary aggregates…”

    The first problem I have with this is the implicit assumption that the statement “a rise in government expenditure leads to a rise in output more than the increase in the expenditure” is obviously correct. In fact one of the most notable facts about the Keynesian multiplier is that empirical research has had great difficulty in detecting nonzero Keynesian multipliers, never mind multipliers greater than one, perhaps due to problems of endogeneity, but more likely due to the fact that monetary policy should routinely offset fiscal policy, unless the central bank is incompetent or lazy.

    The second problem I have with this statement is the absurdity of claiming that the rise in reserve balances cannot be said to have caused the rise in deposits since it was the “act of the central bank purchase” that caused both. QE literally means a targeted increase in the monetary base (or its reserve balance component in the case of Japan) so how can its effect on deposits be disentangled from its effect on reserve balances?

    In fact, provided QE consists of purchases of assets held by a non-banks (as has been effectively true, as of today, in the case of 100% of all QE done in the US and the UK), it creates a simultaneous entry on the liability and asset side of commercial bank balance sheets in the form of a commercial bank deposit-reserve balance deposit pair. How can one say that the the central bank’s intent of creating a reserve balance deposit did not cause the commercial bank deposit, since, as QE has been practiced, one could not come into existence without the other?

    Moreover, using similar techniques to Post Keynesian economists such as Basil Moore, Thomas Palley, Robert Pollin etc. in empirical endogenous money research, I find that the US monetary base has Granger caused commercial bank loans and leases during the period of QE. So if “loans create deposits”, as the endogenous money enthusiasts keep chanting, this implies that QE, by encouraging loan creation, has catylized the creation of even more deposits.

    Ramanan continues:

    “…Now to the case of no QE.

    Same story: the rise in banks’ settlement balances could not have been said to have caused a rise in broad monetary aggregates. The more appropriate phrase is “credit divisor”. Here’s Marc Lavoie from his 1984 paper The Endogenous Flow Of Credit And The Post Keynesian Theory Of Money…”

    This reminds me of the several things I have read on how the “Keynesian multiplier” should really be called the “Keynesian divisor” by Kevin Hassett, Charles Gave, and so on:

    http://muhlenkamp.com/upload/pdf/keynsianDivisor.pdf

    none of which I give much credence to either.

    Something tells me that economics textbooks are not going to replace the word “multiplier” with “divisor”, in the case of either the monetary or Keynesian multiplier, in the near future.

  4. Gravatar of Vaidas Urba Vaidas Urba
    5. April 2014 at 11:27

    Fact 1: ECB pays zero IOR, is threatening negative IOR, Bundesbank says negative rate decision is the first choice for the next ECB easing step
    Fact 2: BoE pays 50bps IOR

    Conclusion 1: the exact position of ZLB is not very important
    Conclusion 2: every little bit helps, especially in December 2008

  5. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. April 2014 at 11:48

    Scott,
    “Vault cash is a part of bank reserves, and hence there is no reason that the negative IOR could not also be applied to vault cash. (There may be legal barriers, but laws can be changed.)”

    To clarify, prior to November 1959 vault cash was not permitted to be used to satisfy reserve requirements. And, on average, only about 73% of vault cash has been used that way since:

    https://research.stlouisfed.org/fred2/graph/?graph_id=123515&category_id=

    The red line is all vault cash, the green line is vault cash used to satisfy reserve requirements, and the blue line is vault cash not used to satisfy reserve requirements.

    Evidently IOR already applies to that portion of vault cash used to satisfy reserve requirements, as the legal code does not make special provisions for vault cash used to satisfy reserve requirements:

    http://www.law.cornell.edu/cfr/text/12/204.10

    So negative IOR might encourage banks to convert reserves (including vault cash used to satisfy reserve requirements) into vault cash not used to satisfy reserve requirements.

    But as you imply, this is a mere legal technicality that could easily be solved by making all vault cash count as reserves (and exempting a “normal” level of bank reserves).

  6. Gravatar of Major_Freedom Major_Freedom
    5. April 2014 at 12:27

    Sumner:

    “The key is to make excess reserve holding costly at the margin, so that new injections of base money go out into circulation as cash.”

    Taxing bank capital isn’t going to increase bank fiduciary credit lending ability. More cash held by the public doesn’t mean more spending. Negative IOR is likely deflationary.

  7. Gravatar of Major_Freedom Major_Freedom
    5. April 2014 at 12:48

    foosion:

    “Inflation and employment both indicate we should ease. Gee, I wonder what we should do?”

    That term “indicate” is entirely a product of your a priori theory that holds more money and spending raises employment and output. The data isn’t saying this to you. You are.

    For it just so happens that another priori theory is also something the data “indicates.” This theory is that employment and output are low because of inflation being too high, not too low. Thus, low employment and output would “indicate” that money is too loose.

    If you want to show either theory to be right or wrong, you can’t claim that the data “indicates” one or the other is true or false. You have to go deeper.

    If you critique and analyse each a priori theory using a priori techniques, then it will become clear to you that inflation can only “work” to the degree that it deceives and exploits.

    Imagine that every individual in society was perfectly aware and understanding of every detail of inflation, every detail of the transmission mechanism, then monetary inflation would have zero real effect on the economy. It could not result in more labor being purchased because sellers of labor would immediately raise their asking to their specific relative degrees, with the result being that the exact same amount and type of surplus labor would go unsold as what presently exists prior to the inflation.

    Same thing for capital and real resources. Sellers of capital and real resources would immediately raise their prices to their specific relative degrees, with the result being that the exact same amount and type of goods will be purchased, meaning the exact same quantity of surplus goods would go unsold, as what presently exists prior to the inflation.

    The only way that inflation can be a part of the process of sellers of labor and capital NOT raising their prices to degrees that would keep unsold labor and capital intact, would be if people were not fully informed of inflation, not fully understanding of it, and not fully knowledgeable of what is going on with the monetary system.

    This is an accurate description of the present day world. Most people have no clue how inflation affects them, other than that they believe that there will be continuous rise in prices over time for most of the goods they buy, just like it was since the day they were born. Those who know more about how inflation works, will gain at their expense, but the gain will not be full, since those who know the most, still don’t know every detail.

    This difference between what most people know and understand of inflation, and the nature of inflation itself, is actually the impetus for the theory of “sticky prices”. Prices are sticky relative to inflation and spending, because of a lack of full knowledge of inflation in most people. Prices and wage rates are in fact perfectly flexible…relative to individual preferences. If preferences change, prices are changing. They mean the same thing.

    Inflation only “works” because most people don’t know how to immediately adjust their prices in a way that would be beneficial to them, when the Fed acts. They don’t raise their prices with full information, and that allows their buyers to take more goods off the shelves than they otherwise could with the same nominal quantity of buyer dollars. In other words, those who don’t know the full nature of inflation, will lose real wealth as a result.

    This resulting “movement” of goods, is the “stimulating” effect of inflation. Deceit turns into turning over more goods. Sumner et al believe this is “the market communicating that it wants more money and spending.” Ha!

    Imagine that your income rose by a nominal 5%. Now imagine that immediately after you receive that additional income, everyone in society knows about it, and they all raise their prices in the perfect relative manner such that now you have to spend exactly that much more for the goods you will buy from them.

    Now imagine the same thing is true for the sellers as well. Imagine they receive more income from your spending, but everyone else immediately knows about it, and so they raise their prices on those sellers. And so on. In other words, everyone raises their prices in the exact way that nobody can buy any additional goods or services than before.

    In this scenario, if there are any unsold (surplus) labor or goods, then more inflation cannot reduce these statistics. Only if people are deceived about inflation, does inflation “work”. The less deceived people are, the less inflation will “work” on them. Full absence of deceit would collapse the notion of “monetary stimulus” in full.

    Not even monetary economists who study the Fed for a living know exactly how much of their own income is due to the marginal utility of their productivity relative to their peers, and how much is due to inflation deceit. They would probably like to believe the deceit is minimal, for affirmation purposes, but I doubt that their employer and their paying customers have more knowledge than the average Joe.

  8. Gravatar of Tom Brown Tom Brown
    5. April 2014 at 13:52

    Mark, that’s interesting. I didn’t think that IOR currently applied to vault cash at all. Thanks for clearing that up.

  9. Gravatar of TravisV TravisV
    5. April 2014 at 15:15

    Not sure how significant this is but…..

    “The Exit Of Two ‘Goldilocks’ FOMC Members Means The Fed Could Become More Hawkish”

    http://www.businessinsider.com/fomc-losing-neutral-members-2014-4

  10. Gravatar of Kevin Erdmann Kevin Erdmann
    5. April 2014 at 16:02

    Wouldn’t negative IOR have an adverse effect on bank balance sheets at this point? Aren’t banks capital constrained? So, negative IOR might lead to inflation. But, wouldn’t this process involve an increase in bank assets? And, to accomplish that, wouldn’t banks have to replace a lot of credit risk with capital that they can leverage up, like treasuries and MBS? So, you might get some inflation, but wouldn’t you also end up with banks defunding a lot of productive activity? Do we really want to incentivize banks away from credit risk at this point in the cycle?

  11. Gravatar of BC BC
    5. April 2014 at 16:23

    Scott’s PPPS mentions his second link (“PCE Inflation Target”), to a speech by Charles Evans. There’s a pretty interesting “bullseye” chart there that shows, if I understand correctly, the Fed’s projected path to achieve its dual inflation and unemployment objectives. The chart is titled “Balanced Approach to the Dual Mandate Is Consistent with Mainstream Macroeconomics”. Apparently, the Fed does not expect to meet its goal of full employment until 2016 (Dec?) and projects to approach 2% inflation from below. I’m curious as to what others think: is a three year “glide path” to reduce unemployment by 1% much slower than what most people would consider consistent with a dual mandate?

    If so, I guess this would be evidence supporting what Scott and others have said about the Fed deliberately accepting unemployment to avoid overshooting the 2% inflation target, i.e., treating 2% as a ceiling. I know that the contours in the chart suggest that the Fed would allow overshooting, but the path seems to be a very slow one. For example, the circle that the 2014 point sits on is supposed to represent an equal-loss circle. That would mean that the Fed considers the likelihood of overshooting the 2014 point to the other side of the circle is about as likely as undershooting that point by even a small amount. Does that much of an asymmetry between overshooting vs undershooting seem reasonable?

  12. Gravatar of Major_Freedom Major_Freedom
    5. April 2014 at 16:29

    There has never been a hawkish FOMC in US history.

    What people mean by “hawkish” is “dovish”, as opposed to to “über-dovish”.

  13. Gravatar of TravisV TravisV
    5. April 2014 at 17:04

    “the Fed was not flying blind” – Joe Gagnon

    Wrong! They WERE flying blind!

    When QE3 was announced, an insightful analyst observed: “The Fed has implicitly acknowledged that they should have paid more attention to market monetarists and Woodfordians back in 2008-09.”

    https://www.themoneyillusion.com/?p=16230

    Either that or they thought steep asset price crashes and skyrocketing unemployment were hunky-dory.

  14. Gravatar of dannyb2b dannyb2b
    5. April 2014 at 17:11

    “The key is to make excess reserve holding costly at the margin, so that new injections of base money go out into circulation as cash.”

    Why not just make reserves similar to cash by allowing anyone to hold them electronically like depository banks and place new created reserves evenly in people’s account. Wouldn’t that be even better because most transactions are electronic anyway?

    Off topic. If sticky prices exist wouldn’t the price level be sticky at 0 inflation? When ngdp contracted shouldnt the inflation measure have been stuck around 0? 1% inflation is a movement in price.

  15. Gravatar of Benjamin Cole Benjamin Cole
    5. April 2014 at 20:01

    Excellent blogging.

    This statement of Scott Sumners’ (or is a quote, hard to tell) is a hyperbole, but captures an important idea.

    “Perhaps (feeble Fed policy) just means the FOMC members were not as hungry as the 15 million unemployed.”

    No, we do not have starving people in America.

    But yes, does anyone think we would have the same Fed policy if the FOMC board included real estate developers, small business owners, construction industry people, labor and manufacturing reps?

    Do Fed staffers take pay cuts and lose their jobs when the Fed suffocates the economy (in fact, they benefit from lower inflation while having sinecures).

    And Evans’ point about clarity—how can you have “clarity” when a Richard Fisher is racing around in sweat-drenched hysterics about inflation, or a Charles Plosser is rhapsodizing about deflation?

    The FOMC is an active menace to American prosperity.

  16. Gravatar of Major_Freedom Major_Freedom
    5. April 2014 at 20:53

    “The FOMC is an active menace to American prosperity.”

    Milton Friedman seemed to agree:

    http://www.youtube.com/watch?v=DUDaev3gKW8#t=0m12s

  17. Gravatar of ssumner ssumner
    6. April 2014 at 05:39

    Garrett, Yes, I should talk more about that. The 5 years TIPS spread tells you about the stance of current policy, the 5 year, 5 year forward tells you about the credibility of future policy, to be done by future Fed officials.

    Mark. Thanks, I added an update about vault cash to the post.

    Vaidas, That sounds reasonable–as always the impact depends on context, and implications for future policy.

    Travis, So in a couple months there will be 4 empty Board seats.

    Kevin, Negative IOR need not have any negative effect on bank balance sheets. It can be made revenue neutral by having positive IOR on required reserves exactly offset by negative IOR on ERs.

    BC, Good point in your first paragraph. But in the second, unless I misunderstood they are saying that undershooting in 2014 is far more likely than overshooting.

    Danny, Stickiness in prices does not imply zero inflation. It simply means that individual prices are slow to change away from where they were set. They may have been set based on expectations of 2% inflation.

  18. Gravatar of Kevin Erdmann Kevin Erdmann
    6. April 2014 at 08:33

    Scott, I’m not saying that bank balance sheets will suffer because of the interest expense. I’m saying they will become less optimal for economic growth because bank assets will increase as a reaction to negative IOR. If banks are capital constrained, in order to increase gross assets, they will have to buy treasuries and MBS and reduce the quantity of credit they hold that has credit risk.

  19. Gravatar of TravisV TravisV
    6. April 2014 at 09:58

    “The Current Hangover In China’s Stock Market Is Worse Than 1929”

    http://www.businessinsider.com/hangover-in-china-stocks-worse-than-1929-2014-4#ixzz2xelO5YIt

  20. Gravatar of TravisV TravisV
    6. April 2014 at 09:59

    “These 2 Charts Will Make You See The Stock Market In Totally Different Ways”

    http://www.businessinsider.com/two-stock-market-charts-2014-4

  21. Gravatar of TravisV TravisV
    6. April 2014 at 12:34

    New post by Brad DeLong on Paul Krugman:

    “Oligarchy and Monetary Policy: I Confess That I Do Not Understand”

    http://bit.ly/1jmJfs2

  22. Gravatar of Vaidas Urba Vaidas Urba
    6. April 2014 at 12:48

    Scott,
    Negative rates are supported by those who think IT is optimal, or those who want to preserve status quo (Bundesbank). Guidance is the solution if you support NGDPLT. British experience with guidance at the 50bpsLB is a good natural experiment that shows us NGDPLT would be a better policy.

  23. Gravatar of ssumner ssumner
    6. April 2014 at 13:14

    Kevin, I still don’t see. With negative IOR wouldn’t bank balance sheets (assets) look something like what they did pre-2008? I.e. very few ERs. Mostly bonds and loans.

    Travis, Interesting links.

    Vaidas, Yes, NGDPLT is far better.

  24. Gravatar of Kevin Erdmann Kevin Erdmann
    6. April 2014 at 13:44

    Scott,

    With no IOR, banks would tend to maximize their assets based on the income they can generate from each type of asset, relative to the regulatory limits on how much leverage they can use.

    In a very simple framework, imagine industrial credit pays a spread of 6%, and can be levered up 10 to 1 and treasuries pay a spread of 2%, and can be levered up 30 to 1. So, banks would be indifferent to these assets. Let’s say banks in this simple world hold 500% of capital in industrial credit and 1500% of capital in treasuries. And, let’s say they have 100% in capital in excess reserves.

    So, for $1 of capital, they have $5 of industrial credit, $15 of treasuries, and $1 of reserves, when they really only need 10 cents of reserves.

    If you add a penalty to these excess reserves, especially when the excess reserves are this extensive, it seems to me that there would be two extremes of outcomes in this simple model.

    If the Fed sterilized the policy by trading the banks treasuries for reserves, the banks would end up with $15.90 of treasuries and 10 cents of reserves. And, capital constraints would require them to reduce industrial credit to $4.7.

    If the Fed didn’t trade any treasuries for reserves, then the banks in this simple model would be incentivized to sell all their industrial credit, hold $30 in treasuries, and hope that reserves were reduced somewhat by the propensity for the public to hold more currency.

    Since the penalty for holding excess reserves would be reduced by increasing assets, regardless of the type of asset (assuming credit markets were in equilibrium, with banks indifferent about their asset holdings in regard to leveraged income) then banks would want to increase assets with the assets they could leverage the most.

  25. Gravatar of Kevin Erdmann Kevin Erdmann
    6. April 2014 at 14:13

    More realistically, they would still hold some industrial credit, but spreads would increase to compensate the banks for holding assets that were less effective at reducing the reserves penalty.

  26. Gravatar of ssumner ssumner
    6. April 2014 at 14:31

    Kevin, I don’t know enough about banking to comment on your specific model, but will ask my question in a different way:

    I’m assuming that the mere threat of negative IOR would prevent banks from actually paying any IOR. They would hold small ERs, as in 2007. So I’ll ask my question again. Do you agree that balance sheets would look like they did in 2007? And if so, is that bad? If so, why?

  27. Gravatar of Frances Coppola Frances Coppola
    6. April 2014 at 15:31

    Scott, Kevin,

    Sorry to jump in, but I would like to add to Kevin’s remarks.

    Firstly – Scott, it is not possible for ALL banks to hold small ERs. Some bank, somewhere, has to hold much larger ERs, just because it is in the system. It’s like a massive game of Pass the Parcel. When the music stops, whichever bank is caught with the excess reserves has to pay the negative IOR. The banking system AS A WHOLE cannot avoid it. Negative IOR is in effect a tax which can be avoided by individual banks only to the extent that they are able to unload ERs. So it would increase reserve velocity, but not necessarily productive investment.

    Secondly – Kevin is correct that banks can only substitute riskier assets for ERs to the extent that they have the capital to do so. As banks are capital constrained, they would be likely to substitute assets on which the capital requirement is as low as possible – so T-bills would seem the obvious choice. Therefore, Scott, if IOR were cut to below zero, T-bill yields would follow, as would all short rates. The exception would be retail deposit rates (since retail customers can substitute physical cash), but banks would be likely to increase fees on these accounts to achieve the same effect as a deposit rate cut.

    I really don’t think you can assume that banks would necessarily leverage their balance sheets to offset the IOR charge, or substitute risky assets for ERs. But if they did, then I would expect them to raise interest rates to borrowers to compensate them for the increased balance sheet risk and higher cost of capital. That would of course be contractionary.

    If they did not raise rates to borrowers and fees to depositors, then banks that could not avoid the negative IOR would face a profit squeeze. If this continued for any length of time, this would have negative implications for their shareholders and employees.

    In a capital-constrained banking system, I am therefore unconvinced that IOR would be expansionary.

  28. Gravatar of ssumner ssumner
    6. April 2014 at 16:11

    Frances, No, banks as a whole do not have to hold the ERs. They can lower interest rates on deposits into negative territory and get rid of ERs that they do not want to hold. Even a monopoly bank could do that, which disproves your argument. You are confusing bank reserves with the base (which really is a hot potato.)

    I don’t much care how banks responded to negative IOR, if I did the policy it would be to reduce the demand for the MOA, not to change bank behavior. Of course negative IOR is not a policy I would recommend, except as a last resort.

  29. Gravatar of Frances Coppola Frances Coppola
    6. April 2014 at 16:22

    Scott,

    I’m afraid you are simply wrong. You really do need to know more about how the banking system works, Scott. And no, I am not confusing bank reserves with the base. I’m well aware of the distinction – that’s why I said negative IOR would increase reserve velocity, not base velocity.

    The only way the banking system as a whole can diminish its holdings of ERs is by converting them to physical cash. The only other way of diminishing ERs is for the Fed to drain them. Negative rates on deposits make absolutely no difference to the reserve holdings of the banking system as a whole.

  30. Gravatar of Frances Coppola Frances Coppola
    6. April 2014 at 16:43

    To clarify:

    A monopoly bank would have no means of getting rid of ERs except by frightening off its retail depositors. But a banking SYSTEM made up of multiple banks wouldn’t do that. Each bank would try to keep its retail depositors (because they are stable funding) but try to lend ERs to other banks in the system, or – more likely – pass reserves on to other banks by increasing transactions. I could see that leading to all manner of stupid investments.

  31. Gravatar of Philippe Philippe
    6. April 2014 at 16:52

    I think he means people would withdraw their money as cash, rather than pay interest on their bank deposits. This would remove reserves from the banking system.

  32. Gravatar of Frances Coppola Frances Coppola
    6. April 2014 at 17:03

    Philippe,

    Yes, I realize that. But this is the fallacy of composition. A single monopoly bank could indeed force depositors to withdraw cash, but the banking SYSTEM can’t. Individual banks within the system are not going to frighten away stable funding. They will instead try to pass on the ERs to other banks. And believe me they would find ways of doing this – hence my observation about increased reserve velocity. Never underestimate the deviousness of bankers.

  33. Gravatar of ssumner ssumner
    6. April 2014 at 17:06

    Frances, I am afraid that I know a bit more about banking than you assume (although admittedly not very much). In the previous comment you said banks cannot get rid of reserves, in aggregate. Now you say they can get rid of them by converting them into cash held by the public. That was exactly my point in my reply to you. Yet you respond to your previous error as if it was I who made the mistake, not you.

    This is very simple stuff: The base equals cash plus reserves. No great knowledge of banking is required to understand this.

  34. Gravatar of TravisV TravisV
    6. April 2014 at 17:13

    Yglesias is back!!!!

    http://www.vox.com/authors/matthew-yglesias

    http://marginalrevolution.com/marginalrevolution/2014/04/vox-is-up.html

  35. Gravatar of Frances Coppola Frances Coppola
    6. April 2014 at 17:33

    Scott,

    Of course individual banks can get rid of reserves by cutting deposit rates into negative territory, thereby frightening off their retail depositors. I did not say they could not. My point was about the banking system as a whole.

    You cannot assume that the banking system AS A WHOLE will behave as an individual (monopoly) bank would. That, as I said in my reply to Philippe, is the fallacy of composition.
    Multiple interconnected banks have the alternative of trying to pass on reserves to each other in some way: an individual monopoly bank does not have that alternative.

    Banks like retail deposits as funding because of their stability – they are less likely to “run” than wholesale funding. And banks are under regulatory pressure to improve their stable funding. Therefore I do not think banks would use negative deposit rates in the way that you suggest. It is far more likely that they would keep deposit rates above zero and attempt to unload the ERs on to other banks. Even if some banks within the system chose to cut deposit rates, others might not – in which case depositors would simply move funds to other banks.

    I know what the composition of the base is, thanks.

  36. Gravatar of ssumner ssumner
    6. April 2014 at 17:55

    Frances, Suppose the negative IOR is minus 100000000000%. Will banks still hold ERs and pay the tax? Base money is either reserves or cash, there is no third option called “higher velocity”. I say banks will not pay the IOR, it would bankrupt them. Instead the base will be converted (mostly) to cash. Individual banks can and would do that. It would merely return us to the type of system we had in 2007, I’m not saying anything controversial.

  37. Gravatar of Kevin Erdmann Kevin Erdmann
    6. April 2014 at 19:42

    Boy, I started a bit of a tussle, didn’t I? And I probably know less about banking than all of you.
    The idea of negative interest on deposits does allow for a reduction in reserves, but I can’t imagine ever having a policy that depended on that.
    I wonder if there could be a mechanism where the dollar is bid down in forex markets and all the reserves are bought up at a discount and parked abroad, outside the taxing jurisdiction.
    In general, isn’t negative IOR a whole different animal when it would require currency in circulation to triple, compared to pre-2008, when most fed liabilities were already in the form of currency?

  38. Gravatar of ssumner ssumner
    7. April 2014 at 05:11

    Kevin, You need to distinguish between “ceteris paribus” thought experiments that produce hyperinflation, and policies that might actually be contemplated. If the Fed was serious about a strongly negative IOR, applying to vault cash as well, then clearly they would reduce the base to prevent hyperinflation.

  39. Gravatar of Kevin Erdmann Kevin Erdmann
    7. April 2014 at 05:25

    My comment wasn’t about hyperinflation. It was that, whatever the outcome, banks would have to reduce the quantity of assets exposed to credit risk.

  40. Gravatar of Scott Sumner Scott Sumner
    7. April 2014 at 11:20

    Kevin, I was repsonding to your remark about the quantity of currency in circulation tripling.

    Regarding banking, I’m still having trouble seeing how it would be different from 2007.

  41. Gravatar of Kevin Erdmann Kevin Erdmann
    7. April 2014 at 13:28

    I’m sorry. I wasn’t clear. I agree that the Fed can sell securities to pull back inflation in that scenario. My point wasn’t about inflation. My point throughout this thread has been that if the banks are capital constrained, then any increase in assets will have to entail reducing credit risk and replacing it with government securities. So, regardless of what would happen with inflation, there might be a negative side effect that would hamper real economic activity because corporate funding from the banks might dry up in their quest to rid themselves of reserves. The more currency the Fed would allow to remain in circulation, the more banks would want to get rid of assets with credit risk that can’t be leveraged as high as govt. securities.

  42. Gravatar of ssumner ssumner
    8. April 2014 at 05:13

    Kevin, Would you agree that a low ER environment would put us back to the amount of risk taking that we saw in 2007, the last time we had that environment? That doesn’t seem to me to be a particularly low risk taking environment? Nor do I see any market failure here. If the Fed targets NGDP, shouldn’t markets determine the optimal amount of risk taking, without interference from monetary policy?

  43. Gravatar of Kevin Erdmann Kevin Erdmann
    8. April 2014 at 06:46

    In a context with extremely high excess reserves and a penalty for holding them, the banks wouldn’t be adjusting their balance sheets because of a market assessment of risk. They would be adjusting their balance sheets because it would be the only way for them to avoid the penalty. It would be a reaction to the level of reserves, the rate of negative IOR, and regulatory limits on bank leverage and capital – all of which are novel policy issues that don’t have anything to do with market determinations.

    I had only just thought of this possible side-effect. Even if the Fed could somehow just swap treasuries and MBS with the banks, in exchange for excess reserve cash, the banks would have to remove some assets from their balance sheets in order to stay within their capital constraints. That’s because holding excess reserves and their associated deposits is a completely neutral position for the banks. It doesn’t effect their capital position. But holding treasuries and MBS does.

    I agree that there should be no problem with having banks back at where they were in 2007. But, I think the path from here to there might include this technical contractionary reaction from the banks. If, along with a negative IOR, the Fed left enough extra money in the economy to create some inflation, that would be fine, but I’m afraid that there would be this proportional contractionary side-effect of reducing at-risk credit, which I presume would cause a contraction in real economic activity.

    Maybe it’s not an issue if the banks would be able to simply issue more equity. But, I think they would have to do something in order to maintain their current level of at-risk credit in the face of declining ER.

  44. Gravatar of flow5 flow5
    9. April 2014 at 08:45

    Only excess balance accounts are remunerated. And currently, c. 85% of the CB’s required reserves are satisfied thru applied vault cash.

  45. Gravatar of flow5 flow5
    9. April 2014 at 08:50

    Since the early 60’s (start of interest rate deregulation), the CBs began to pay (interest to depositors), for what they already own (their deposit liabilities). I.e., the CBs began to buy their liquidity as opposed to storing their liquidity.

    The remuneration rate’s or policy target rate’s valuation (vis a vis the non-bank’s), inverted the short-end segment of the wholesale money market funding rates for the non-banks (intermediaries between savers & borrowers). I.e., dis-intermediation hasn’t applied to the CBs since the Great-Depression. The CBs could continue to lend even if the non-bank public ceased to save altogether.

    The wholesale funding market for the non-banks (which was formally a function of small saver’s indirect investment, before direct investment was made more profitable by Congress), was an accident waiting to happen as soon as liquidity dried up (or as soon as Bankrupt you Bernanke tightened credit in Feb 2006).

    The Fed’s policy to pay interest on excess reserve balances, prevented the rollover of the NB’s highly liquid wholesale funding, i.e., extremely short-term (day-to-day), funding, from e.g., commercial paper & repurchase agreements. Initially, this destroyed non-bank lending/investing. I.e., the Fed paid the commercial banks not to lend, and forced the supposedly TBTF banks to reliquify (to increase their liquidity & capital ratios).

    As AD rebalances between NB & CB credit extension, the BOG’s & FOMC’s credit control device (the remuneration rate), will have to be adjusted. This will perhaps again, change the weighting or equilibrium (or “crowding out”), of lending/investing from the macro-economic savings-investment model.

  46. Gravatar of flow5 flow5
    9. April 2014 at 09:18

    “Each bank would try to keep its retail depositors (because they are stable funding”

    Depositors don’t fund anything. Whenever a CB makes a loan to or buys securities from the non-bank public, it creates new money.

  47. Gravatar of Scott Sumner Scott Sumner
    9. April 2014 at 13:43

    Kevin, Now you seem to be worried about the impact on NGDP, not just risk. But surely the net effect on NGDP would be positive, as the Fed would be signalling a strong determination to boost NGDP. So that’s the least of my worries. What I find harder to address is the fear that even if NGDP was on target there would be a suboptimal amount of risk taking.

  48. Gravatar of flow5 flow5
    10. April 2014 at 06:41

    “The only way the banking system as a whole can diminish its holdings of ERs is by converting them to physical cash”

    IBDDs can be converted into Euros, Yen, Yuan, etc. Go fish Frances.

    And “Banks like retail deposits as funding because of their stability”.

    This is a pseudo-economic relationship (& a micro one at that). Pseudo-economists have long tried to relate the volume of deposit liabilities to the volume of a bank’s assets. But both assets & liabilities come into being simultaneously. Again, go fish.

  49. Gravatar of flow5 flow5
    10. April 2014 at 07:04

    “If you set IOR at a rate slightly above the T-bill yield, then the demand for base money rises dramatically, which is highly deflationary”

    No different than an “administered” price increase (like OPEC’s in the 70’s). But the money stock can never be managed by any attempt to control the cost of credit.

  50. Gravatar of flow5 flow5
    10. April 2014 at 07:27

    “What the Fed got wrong?” Go fish.

    Roc’s in MVt = roc’s in aggregate monetary purchasing power [AD] – (but AD is not equal to nominal-gDp).

    CB lending expands both M & Vt (creates new money). NB lending forces the turnover of existing money, or increases the transactions velocity of existing money – Vt. I.e., NB lending/investing is a utilization of existing savings. Otherwise, CB held monetary savings are impounded within the commercial banking system.

    The S&L crisis was a logic error (the Keynesian macro-economic persuasion that maintains a CB is also a financial intermediary – i.e., a conduit between savers & borrowers). NBs do not compete with the CBs for savings (the source of all time/savings deposits to the CB system are other bank deposits, directly or indirectly via the currency route (& only temporarily), or thru the CB’s undivided profits accounts (e.g., increased bank capital requirements).

    Never are the CBs intermediaries in the savings->investment process. Commercial bank held savings are a leakage in Keynesian National Income Accounting (monetary savings are impounded within the CB system). And savings flowing thru the NBs never leaves the CB system. I.e., the CBs pay interest to depositors for what they already own.

    Redirecting the flow of savings thru the NBs lowers the overall term-structure of interest rates. It increases the supply of loan-funds (which is accomplished without increasing the money stock as Keynes’s liquidity preference curve or demand for money is a false doctrine). And it increases both the CB’s & the NB’s profit margins. It increases real-output (reverses the tradeoff between inflation & employment in the Phillips Curve). This is the source of the pervasive error that characterizes the Keynesian economics (the Gurley-Shaw thesis).

    The CBs do not loan out existing deposits (saved or otherwise). Eliminating Reg. Q ceilings (& interest rate differentials), for both the CBs & NBs, & giving the NBs the right to issue new money via the DICMCA (issue ATS & NOW accounts, etc.), provided the legal framework for the creation of 38,000 new commercial money creating depository institutions to the 14,000 we already had in 1980 [i.e., the MSBs, S&Ls, CUs].

    So as the NBs shrank with the S&L crisis of the late 80’s & early 90’s, so did AD. The Fed became concerned about subpar economic growth & eliminated 1/3 of the CB’s required reserves in order to jump start the economy (but dis-intermediation was the problem, not CB lending/investing). I.e., the welfare of the CBs was dependent upon the welfare of the NBs.

    Then, once again, financial innovation, CDOs, etc., (or velocity), played a part in the boom/bust. The housing boom was unstoppable. The Fed eliminated the CB’s legal reserve constraints. And the CBs weren’t capital constrained either. And adding bank capital simply released more excess reserves. So Greenspan’s laissez faire economic policies became a “free-for-all”.

    And then the Fed’s math error was so big that only an imbecile could have made it. Roc’s in MVt were negative for 29 consecutive months (i.e., AD was allowed to contract for 29 consecutive months). Then as the trajectory for money flows in Dec. 2007, indicated that there would be a recession beginning in Oct 2008, the FOMC administered the coup de grace (death blow), i.e., introduced the payment of interest on excess reserve balances that decimated the NBs. The Great-Recession was the inevitable result.

  51. Gravatar of flow5 flow5
    10. April 2014 at 07:39

    The Fed’s errors that created the Great-Recession have to be one the biggest cover-up’s since Watergate. I.e., 300 highly competent Ph.Ds. economists on the Fed’s research staff have been utterly censored.

  52. Gravatar of John Carney John Carney
    10. April 2014 at 13:28

    Related:

    http://online.wsj.com/news/articles/SB10001424052702303873604579493910198886306?mg=reno64-wsj

    J.P. Morgan’s Dimon Would Like Corporate Cash to Find a New Home

  53. Gravatar of Tom Brown Tom Brown
    10. April 2014 at 14:20

    John Carney, a long time ago you looked at a post I put up modeled after an example you gave describing how banks meet their capital requirements in a CNBC article you wrote. You more or less blessed my post. Later I put one up exploring the difference between bank equity and capital and different kinds of bank capital. That one I had some help with from an accountant commentator who worded as a bank auditor (at least that’s what he said he was). But he never saw the final product. The post is designed for a layman such as myself, so I try to keep it simple but give a flavor of what those concepts mean. Apparently the link I just tried to post from tinyurl didn’t make it through the spam filter, but if you simply Google the following:

    Banking Example #7

    It should be the 1st hit. If you have time, it’d be great if you could take a quick look. Thanks!

  54. Gravatar of Tom Brown Tom Brown
    11. April 2014 at 04:25

    Mark A. Sadowski, regarding IOR paid on vault cash. I never read your link till now, and that’s only because I showed it to JKH, who’s still skeptical:

    http://monetaryrealism.com/thomas-palley-on-steve-keens-model-of-aggregate-demand/#comment-109311

    And he’s right, the opening sentence doesn’t sound like vault cash:

    “The Federal Reserve Banks shall pay interest on balances maintained at Federal Reserve Banks…”

    Also vault cash, cash, and currency are not mentioned.

    Is it possible to calculate whether or not the Fed pays IOR on vault cash by figuring out how much IOR they pay and comparing that to electronic reserves vs electronic reserves + vault cash reserves?

  55. Gravatar of Tom Brown Tom Brown
    11. April 2014 at 04:34

    Sentences like the following:

    “Note. Required reserves must be held in the form of vault cash and, if vault cash is insufficient, also in the form of a deposit maintained with a Federal Reserve Bank.”

    Make it sound like deposits at Federal Reserve Banks excludes vault cash.

    http://www.federalreserve.gov/monetarypolicy/reservereq.htm

  56. Gravatar of Philippe Philippe
    11. April 2014 at 04:46

    vault cash and deposits at the Fed (reserve balances) are different. To my knowledge all cash held at the Federal Reserve Banks belongs to the Fed, i.e. commercial banks hold their vault cash reserves in their own vaults. I don’t know how the Fed would go about paying interest on cash held in commercial bank vaults.

  57. Gravatar of Tom Brown Tom Brown
    11. April 2014 at 05:10

    Philippe,

    “I don’t know how the Fed would go about paying interest on cash held in commercial bank vaults.”

    I always assumed they didn’t… in fact I looked into it once, but I couldn’t figure it out so I asked someone… maybe it was you or JKH, I don’t recall. Whomever I asked thought “no” so that’s what I’ve assumed ever since until I saw Mark’s comment above. Mark’s comment surprised me.

    I just used the Fed’s “contact us” email form to ask them directly. If I get a response I’ll let you know.

  58. Gravatar of flow5 flow5
    11. April 2014 at 07:31

    IBDDs are the only type of bank asset the Fed’s in a position to constantly monitor & absolutely control. This was the original definition of legal reserves – and it is still the only viable definition.

  59. Gravatar of flow5 flow5
    11. April 2014 at 07:52

    John Carney:

    Wholesale funding profitability (e.g., measures like net interest rate margins), depend on many regulatory and operating factors. Nevertheless, the fact is, that unless you hoard currency, or convert domestic currency to foreign currency, you simply cannot take money out of our payment & settlement (CB), system. This is by design, & the “Black Market” is no substitute. The Federal Gov’t has already taken measures to ensure that it is the only data pathway used, e.g., social security checks are no longer mailed. Big Brother is watching you ever more closely.

  60. Gravatar of flow5 flow5
    11. April 2014 at 08:03

    Dr. Leland Pritchard (Ph.D., economics, Chicago 1933) predicted the Great-Recession in June 1980:

    “Under this Act, the means-of-payment money supply (then designated as M1A by the Board of Governors) will come to approximate M3”

    “The nonmember banks can hold a part of their legal reserves in the form of interbank demand deposits (IBDDs) in correspondent member banks; the S&Ls, as IBDDs in the Federal Home Loan Banks; and the Credit Unions, as IBDDs in the National Credit Union Administration Central Liquidity Facility. Presumably in order to prevent the pyramiding of reserves, the Act requires all institutions holding these particular IBDDs to redeposit the funds in Federal Reserve Banks. Unfortunately, pyramiding will not be eliminated unless the Fed imposes a 100 per cent reserve ratio on these accounts. But the Act specifically exempts all except correspondent member banks from any reserve requirements”

    So as the thrifts (non-banks), stopped encountering negative cash flows, the growth of the money stock became uncontrollable and unabated.

  61. Gravatar of flow5 flow5
    13. April 2014 at 11:22

    “J.P. Morgan’s Dimon Would Like Corporate Cash to Find a New Home”

    Try: “Profit or Loss from Time Deposit Banking” — Banking & Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.

  62. Gravatar of Tom Brown Tom Brown
    20. April 2014 at 20:26

    Mark A. Sadowski,

    You write:

    “Evidently IOR already applies to that portion of vault cash used to satisfy reserve requirements, as the legal code does not make special provisions for vault cash used to satisfy reserve requirements:”

    Commentator pliu412 at pragcap.com found this:

    “Check question 11 in Fed document:”

    http://www.federalreserve.gov/newsevents/press/monetary/monetary20081006a2.pdf

    “11. Will the Federal Reserve pay interest on vault cash?
    No. The Federal Reserve is not authorized to pay interest on vault cash.”

  63. Gravatar of Mark A. Sadowski Mark A. Sadowski
    20. April 2014 at 23:33

    Tom Brown,
    That’s useful, although it would be even more useful to know specifically *why* the Fed is not authorized to pay interest on vault cash.

    Incidentally I googled that link and turned up a paper which cites that document:

    http://www.newyorkfed.org/research/staff_reports/sr642.pdf

    On first inspection there isn’t anything in that paper that’s really new, but there may be other documents cited there which could be useful.

    (Is it just me, or is it extremely odd that a Federal Reserve staff paper is citing press conference FAQ sheets as primary information? If we look more closely, will we also find citations of cocktail knapkins?)

    The most interesting thing about your document is that it mentions interest on excess reserves is set at a different rate than required reserves. That is no longer true, so I wonder how long there were two separate rates.

    Also, I didn’t notice your previous comment until now.

    “And he’s right, the opening sentence doesn’t sound like vault cash:”

    Yes, I agree, the wording suggests interest on reserves only applies to deposits held at the FRBs. Now of course we know that’s true.

    “Is it possible to calculate whether or not the Fed pays IOR on vault cash by figuring out how much IOR they pay and comparing that to electronic reserves vs electronic reserves + vault cash reserves?”

    Interestingly, I was thinking that myself. Release H.3 has some of the information that would have been needed to do that.

    http://www.federalreserve.gov/releases/h3/current/

  64. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 00:06

    Mark, thanks.

    “Is it just me, or is it extremely odd that a Federal Reserve staff paper is citing press conference FAQ sheets as primary information? If we look more closely, will we also find citations of cocktail knapkins?)”

    Yes, that’s strange. Lol. Also I never did get an answer from their “contact us” email form. No surprise I guess.

  65. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 00:18

    Mark, #10 in the Fed Q&A sheet mentions this:

    “Clearing balances will continue to receive earnings credits”

    Clearing balances are bank held Fed deposits, and the banks sound like they can chose how much of their Fed deposits in excess of requirements are clearing balances.

    1. Are clearing balances considered to be reserves?

    2. What are “earnings credits?”

  66. Gravatar of Mark A. Sadowski Mark A. Sadowski
    21. April 2014 at 08:39

    Tom Brown,
    Thanks to your question I think I finally understand what the main discrepancy is between the “monetary base” and the “adjusted monetary base”.

    “Clearing balances” were balances in excess of required reserves which banks anticipated would be needed for settlement (clearing) purposes. These balances were held as deposits at regional Federal Reserve Banks under a voluntary contractual agreement. The contracted amount of balances was referred to as the “clearing balance requirement” and the actual amount of balances was referred to as the “clearing balance”.

    The “Contractual Clearing Balance Program” was created by the “Depository Institutions Deregulation and Monetary Control Act” of March 1980 and seems to have been first implemented in 1981. The program is no longer considered necessary because of the implementation of interest on reserves. Consequently it was eliminated on July 12, 2012, to simplify reserve balances and monetary policy.

    https://www.frbservices.org/help/contractual_clearing_balance.html

    Let’s deal with these other questions in reverse order.

    1) “What are “earnings credits?””

    “Earnings credits” were a return on clearing balances used to offset charges that institutions incured through their use of Federal Reserve services. The interest rate that was used to calculate earnings credits was 80 percent of the rolling 13-week average of the three-month Treasury bill rate.

    And now for the icing on the cake…

    2. “Are clearing balances considered to be reserves?”

    For that question I’m going to turn the microphone over to Edward J. Stevens of the Cleveland Fed (page 8).

    http://www.clevelandfed.org/research/review/1993/93-q4-stevens.pdf

    “Required clearing balances are excluded from all measures of reserves, by definition, and from the adjusted monetary base, but are included in the unadjusted monetary base. This treatment is consistent with the differing purposes of the two measures of the monetary base.

    The adjusted series emphasizes the role of base money as actual or potential reserve assets. These are the high powered “tickets” that banks must hold when issuing reservable deposits, with the amount issued per ticket constrained by a reserve requirement. The adjusted monetary base includes the reserve assets held both by banks (adjusted total reserves plus vault cash not being used to meet reserve requirements) and by the nonbank public (currency in Ml). A historically consistent measure of adjusted total reserves has been derived by adding the actual historical quantity of excess reserves to adjusted required reserves. Similarly, because banks’ balances held to meet a clearing balance requirement cannot be used to satisfy reserve requirements, the adjusted monetary base excludes required clearing balances.

    The unadjusted monetary base emphasizes the federal government’s role in providing monetary assets directly to users in the private sector, rather than distinguishing between the quantities of private and public issues of money. The monetary base consists of all federally issued currency held by banks and the public (applied vault cash plus other vault cash plus currency in Ml), plus all deposit liabilities of Federal Reserve Banks to private banks (Fed balances, including required clearing balances). The associated measure of total reserves adds applied vault cash to Fed balances and then subtracts required clearing balances (because they are not reserves). Excess reserves is the difference between this measure of total reserves and required reserves.

    Measuring total or excess reserves thus involves distributing aggregate account balances between reserve balances and clearing balances. The current method does so by measuring reserve balances as all current balances other than required clearing balances.11 Any excess of maintained balances above the required clearing balance level, even within the penalty free band (for example, point A in figure 2), thus augments aggregate total and excess reserves. Similarly, any deficiency of maintained balances from the required clearing balance level, both within and below the penalty-free band (for example, point B in figure 2), reduces aggregate total and excess reserves, even though the bank may have satisfied its reserve requirement.”

    So, in short, *required clearing balances* were not counted as reserve balances. If *clearing balances* exceeded required clearing balances the excess was counted as part of reserve balances. If clearing balances were less than required clearing balances the deficiency was subtracted from reserve balances.

    On the other hand, *required clearing balances* were counted as part of the monetary base but were excluded from the adjusted monetary base. This means required clearing balances were a kind of third category of the unadjusted monetary base. They were not physical notes and coins, and neither were they reserve balances. Neat, huh?

    FRED has a series called “Service-Related Balances and Adjustments” which is equal to required clearing balances plus “adjustments to compensate for float.” The float reflects mismatches in check-clearing operations. It’s not clear to me what the relationship is between the float and clearing balances.

    FRED also has a float series. The service related balance series goes back to 1984 and the float series only goes back to 2003. (However the float series can also be found on Federal Reserve Release 4.1 going back to 1996.)

    https://research.stlouisfed.org/fred2/graph/?graph_id=173554

    The float was never more than about a billion dollars, and simple subtraction reveals that the monthly average of required clearing balances peaked at $11.8 billion in December 2003.

  67. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 09:15

    Mark, thanks! I was going to post over here what pliu412 found about the “Contractual Clearing Balance Program”… well, shoot, I still will:

    http://pragcap.com/did-market-monetarists-accurately-predict-low-inflation/comment-page-1#comment-173505

    But it looks like you’ve got that already and more.

    “Neat, huh?”

    Yes… and more complex than I ever imagined. Ha!… we’ll this one I’m definitely saving a link to. Thanks again!

  68. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 09:17

    I posted the wrong link, I meant to post this one:
    http://pragcap.com/did-market-monetarists-accurately-predict-low-inflation/comment-page-1#comment-173554

  69. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 09:28

    Mark, you write:

    “This means required clearing balances were a kind of third category of the unadjusted monetary base.”

    What about vault cash not counted as required reserves? Is it still considered to be reserves? This statement from your reference makes it seem like the answer might be “no”:

    “adjusted total reserves plus vault cash not being used to meet reserve requirements”

    So if some vault cash is being added to “adjusted total reserves” it sounds like it might be outside the category of “adjusted total reserves” whatever “adjusted total reserves” are.

  70. Gravatar of Mark A. Sadowski Mark A. Sadowski
    21. April 2014 at 13:06

    Tom Brown,
    Let me review some basics, just so we’re on the same page. Here’s the unadjusted components of the monetary base during the Great Contraction (except for currency held by public which is seasonally adjusted):

    https://research.stlouisfed.org/fred2/graph/?graph_id=123170&category_id=

    You can slide the time period control to the left and right and verify that the monetary base was *exactly* equal to currency in circulation plus reserves held at Federal Reserve banks from July 1917 through November 1959.

    Here’s the unadjusted components of the monetary base from 1950 to present:

    https://research.stlouisfed.org/fred2/graph/?graph_id=173589

    Again, except for infinitesimal discrepancies, the monetary base is exactly equal to currency in circulation plus reserve balances until 1959. Of course, in 1959 the Federal Reserve allowed commercial banks to use vault cash to satisfy reserve requirements.

    Nevertheless the discrepancies remain less than $100 million until 1970 and never exceed $400 million until December 1980, which is of course about the time the “Contractual Clearing Balance Program” was implemented.

    If you add in “service related balances” which of course includes required clearing balances, the discrepancies after 1980 are largely accounted for. Other than February 1987 and December 1990 and January 1991 difference between the monetary base and the sum of these three components is never more than a billion dollars until 2008.

    In October and November 2008 there are discrepancies of (-$24.4) billion and $16.8 billion respectively, and from September 2008 onward the discrepancies are frequently a few billion dollars and oscillate from positive to negative.

    So the bottom line is, prior to 1980 the monetary base had two major components with essentially zero discrepancies from 1917 to 1959. After 1980 it has three major components with minor discrepancies until September 2008 when the “stuff” hit the fan.

    Next, I’ll get to your questions on vault cash.

  71. Gravatar of Mark A. Sadowski Mark A. Sadowski
    21. April 2014 at 13:46

    Tom Brown,
    I found a Total Vault Cash and Surplus Vault Cash series in FRED that pointed me to some errors I had made about vault cash previously. So here’s my corrected vault cash series:

    https://research.stlouisfed.org/fred2/graph/?graph_id=123515&updated=2386

    Note that 100% of vault cash was used to satisfy reserve requirements from December 1960 through October 1980. I recall you pointing to some change in reserve requirements that may have led to the change in 1960. The change in 1980 was no doubt related to the “Depository Institutions Deregulation and Monetary Control Act”.

    According to these corrected figures, on average 87% of vault cash has been used to satisfy reserve requirements since November 1959.

    The point of my previous comment was to demonstrate beyond a shadow of a doubt that vault cash is a component of currency in circulation and not counted as a part of reserve balances. In fact if you look at the gap between currency in circulation and the currency component of M1 (which is what Friedman and Schwartz called “currency held by the public”) it is almost exactly equal to vault cash:

    https://research.stlouisfed.org/fred2/graph/?graph_id=173642

    There’s a slight discrepancy that I have not been able to account for yet.

    The bottom line is the portion of vault cash used to satisfy reserve requirements is itself a component of currency in circulation and is not a component of reserve balances.

    P.S. “Adjusted reserves” is a whole other topic. There are two major adjustments done to reserve balances. One is called reserve adjustment magnitude (RAM). The other is the seasonal adjustment.

  72. Gravatar of Mark A. Sadowski Mark A. Sadowski
    21. April 2014 at 13:49

    Here’s a paper I found on vault cash which I haven’t read yet:

    https://research.stlouisfed.org/publications/review/98/07/9807da.pdf

    Here’s one on RAM that I haven’t read yet either:

    https://research.stlouisfed.org/publications/review/03/09/Anderson.pdf

  73. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 14:13

    Mark, wow, that’s a lot of good information. Much thanks. I never knew this:

    “The bottom line is the portion of vault cash used to satisfy reserve requirements is itself a component of currency in circulation and is not a component of reserve balances.”

    So if reserve requirements are 10% for a bank and it has $10 in demand deposit-liabilities and $1 in its vault and no Fed deposit, it has $0 in reserves, but it still can be satisfying its reserve requirements?

    I’ll read more when I get a chance.

  74. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 15:19

    Mark, you write:

    “vault cash is a component of currency in circulation and not counted as a part of reserve balances”

    So do you know off hand if there is any kind of cash a bank might own which is not considered “vault cash?” If so, what is it’s status (reserves? “currency in circulation?” … something else?)

    Recall Sumner’s old article with the picture of the $100,000 bill?:

    https://www.themoneyillusion.com/?p=17357

    “But prior to 1914 the base was 100% currency, and we could easily return to that system and still run monetary policy essentially the same way. The only difference would be that the Fed would give banks ten $100,000 bills for a $1 million T-bond, not credit their Fed account for $1,000,000. That’s a trivial difference.”

    I first imagined such a note might be used as a bank’s reserve balance (I couldn’t imagine what else it’d be used for), but that doesn’t appear to be the case (if we trust Wikipedia):

    http://en.wikipedia.org/wiki/Large_denominations_of_United_States_currency

    “These Series 1934 gold certificates (of denominations $100, $1,000, $10,000, and $100,000) were issued after the gold standard was repealed and gold was compulsorily confiscated by order of President Franklin Roosevelt on March 9, 1933 (see United States Executive Order 6102), and thus were used only for intra-government transactions and not issued to the public. Of these, the $100,000 is an odd bill in that it was printed only as this Series 1934 gold certificate. This series was discontinued in 1940.”

    BTW, when they say “gold was compulsorily confiscated” does that mean grandma had to give up her gold jewelry?

  75. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 15:21

    Also, do you use “cash” and “currency” as synonyms?

  76. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 15:23

    Strike one of my questions off the list above: I didn’t see the link at first:

    “Executive Order 6102 required all persons to deliver on or before May 1, 1933, all but a small amount of gold coin, gold bullion, and gold certificates owned by them to the Federal Reserve, in exchange for $20.67 (equivalent to $376.58 today[3]) per troy ounce.”

  77. Gravatar of Mark A. Sadowski Mark A. Sadowski
    21. April 2014 at 16:10

    Tom Brown,
    One more thing while it’s fresh on my mind.

    From 1959 through 1980 vault cash averaged 70.2% of the difference between currency in circulation and currency held by the public. From 1981 to present it has averaged 96.2%.

    Essentially what happened was that vault cash held by depository institutions that were not members of the Federal Reserve system was not counted as “vault cash” from 1959 to 1980. That’s because it was ineligible to be used to satisfy reserve requirements because they weren’t Federal Reserve system members. But in 1981 that all changed.

    So once you take that into account, the discrepancy between vault cash and the gap between currency in circulation and currency held by the public is actually quite small (e.g. $3.5 billion in March), and probably it has almost always been so.

    Interestingly, vault cash as a percent of the gap fell from 96.8% in August 1999 to 76.8% in December 1999 and then rose to 132.2% in February 2000, before falling back down to 93.8% in June 2000. The gap was equal to $18.4 billion in December and (-$15.5) billion in February. This was obviously related to the preparations for the Y2K crisis that never occured.

    The question still remains, what accounts for the gap?

    By process of elimination I think it must be the Treasury and/or the Federal Reserve itself.

  78. Gravatar of Mark A. Sadowski Mark A. Sadowski
    21. April 2014 at 16:25

    Tom Brown,
    “So do you know off hand if there is any kind of cash a bank might own which is not considered “vault cash?” If so, what is it’s status (reserves? “currency in circulation?” … something else?)”

    Not to my knowledge. If you read my previous comment I think the discrepancy between actual vault cash and the gap between currency in circulation and currency held by the public has probably almost always been quite small. It’s probably all accounted for by the Treasury and/or the Federal Reserve.

    “Also, do you use “cash” and “currency” as synonyms?”

    In Fedspeak, “currency” refers to notes and coins, and “vault cash” to notes and coins held by depository institutions.

  79. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 17:14

    Mark, Great, thanks!

    When you write:

    “By process of elimination I think it must be the Treasury and/or the Federal Reserve itself.”

    So you’re talking there about the part that averaged 100-96.2 = 3.8% from 1981 to the present, right? The small gap remainder gap after vault cash fills most of the original gap.

    Are you saying that this 3.8% small gap was currency held by Treasury for example? I wouldn’t have thought that counted as “in circulation.” And if the Fed holds paper reserve notes, I thought they no longer had any face value (since they represent liabilities no longer in existence)

    Maybe coins held by the Fed? They should retain their face value while at the Fed… but again, they should not be counted as “in circulation” I’d think, should they?

    What is it that you mean there?

    I suppose the approximately $239 million in “United States Notes” still on the Treasury’s balance sheet as a liability counts as “currency in circulation?”

  80. Gravatar of Mark A. Sadowski Mark A. Sadowski
    21. April 2014 at 19:01

    Tom Brown,
    “So you’re talking there about the part that averaged 100-96.2 = 3.8% from 1981 to the present, right? The small gap remainder gap after vault cash fills most of the original gap.”

    Yes.

    “I suppose the approximately $239 million in “United States Notes” still on the Treasury’s balance sheet as a liability counts as “currency in circulation?””

    I just checked. “Treasury cash holdings” are listed separately from “currency in circulation” in Federal Reserve Release H.4.1, so it’s definitely not part of currency in circulation.

    I also agree with you about the coin holdings of Federal Reserve Banks. It probably doesn’t satisfy the definition of “currency in circulation” and it would probably be too small in any case.

    But what’s left? Are there any depository institutions which are not part of the Federal Reserve system? And what about the Y2K surge? How is that explained?

  81. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 20:18

    Mark, thanks…

    “But what’s left? Are there any depository institutions which are not part of the Federal Reserve system? And what about the Y2K surge? How is that explained?”

    Shoot I don’t know!

    Also, by your response I’m not positive you got my meaning about “United States Notes”… I mean those odd-ball paper notes they stopped printing back in the early 1970s that look like Reserve Notes but that are direct liabilities of the Treasury rather than the Fed. I suppose there’s $239 million worth of those out there “in circulation” somewhere since they are still on the Treasury’s books. Of course there’s not enough of them to fill any gaps:

    http://en.wikipedia.org/wiki/United_States_Note

    I would think those would count as “cash in circulation” but perhaps not as “vault cash” if banks own them?

  82. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 20:23

    Page 13 here lists “United States Notes”
    http://www.treasurydirect.gov/govt/reports/pd/mspd/2013/opdm122013.pdf

  83. Gravatar of Mark A. Sadowski Mark A. Sadowski
    21. April 2014 at 22:57

    Tom Brown,
    I’m sorry, that slipped under my radar. US Notes would count as currency in circulation so that doesn’t help either.

  84. Gravatar of Tom Brown Tom Brown
    21. April 2014 at 23:39

    Mark,

    “US Notes would count as currency in circulation so that doesn’t help either.”

    Right, but what if it’s all held by banks and not part of “currency held by the public?” If it’s also not counted as vault cash, then it would explain part of the gap right?

  85. Gravatar of Mark A. Sadowski Mark A. Sadowski
    21. April 2014 at 23:45

    Tom Brown,
    What I mean to say is the issue isn’t what kind of note it is, but who holds it. Who’s got the missing $3.5 billion?

  86. Gravatar of Tom Brown Tom Brown
    22. April 2014 at 00:41

    OK, check this out:

    http://www.federalreserve.gov/faqs/currency_15197.htm

    “…up until 1913, the only currency issued by the United States that was legally recognized as “lawful money” was various issues of “demand notes” (subsequently known as “old demand notes”) and “United States notes” authorized by Congress during the Civil War.”

    “At the time, some currency was not considered legal tender, although it could be used by national banking associations as “lawful money reserves.” Thus, the term “lawful money” had a broader meaning than the term “legal tender.” ”

    So I wonder if that’s still the case: that “lawful money reserves” can be composed of “United States notes” (and maybe some other stuff, like silver/gold certificates?), but that these are not considered to be “vault cash” (I guess if they are considered “reserves” they can’t be “vault cash” right?

    If you Google “lawful money reserves” you get some old documents going back to 1908 and 1910, amongst others.

  87. Gravatar of Tom Brown Tom Brown
    22. April 2014 at 01:07

    Mark, check this one out:

    http://www.federalreserve.gov/pf/pdf/pf_appendixes.pdf

    Some interesting definitions in this glossary: [I’ll put my comments in square brackets]

    ———————————————————–
    cash
    U.S. paper currency plus coin

    currency
    Paper money that consists mainly of Federal Reserve Notes. Other types of currency that were once issued [but still used?] by the United States include [but are not limited to?] silver certificates, United States notes [which we know are still around], and national bank notes.

    [so this document draws a distinction between cash and currency! Cash being currency plus “coin”]

    M1
    Measure of the U.S. money stock that consists of currency [not cash! so excluding “coin?”] held by the public, traveler’s checks, demand deposits, and other checkable deposits.

    [I can’t cut and paste it for some reason, but also check out “money” which again seems to draw a distinction between “currency” and “coin”]

    required reserves
    Funds that a depository institution is required to maintain in vault cash, or… [again I can’t cut an paste so I’ll let you check out the rest: but this sure sounds like “reserves” includes “vault cash” here, doesn’t it?]

    [they also have “vault cash” but it’s not particularly interesting, and I can’t cut and paste it, so you can look it up]

  88. Gravatar of Tom Brown Tom Brown
    22. April 2014 at 02:25

    Also check this one out:

    http://www.fdic.gov/regulations/laws/rules/7500-500.html#fdic7500204.4

    Look at the parts above and below

    “(2) Vault cash must be either:”

    In transit to a Federal Reserve bank, and held at a remote location is OK *provided* it can be obtained in a day basically by ground transportation. And always it implies

    (vault) cash = currency + coin

    And in another FDIC document, we have this:

    “FORM OF RESERVES

    SEC. 19(c)(1) Reserves held by a depository institution to meet the requirements imposed pursuant to subsection (b) shall, subject to such rules and regulations as the Board shall prescribe, be in the form of–

    (A) balances maintained for such purposes by such depository institution in the Federal Reserve bank of which it is a member or at which it maintains an account, except that (i) the Board may, by regulation or order, permit depository institutions to maintain all or a portion of their required reserves in the form of vault cash…”

    http://www.fdic.gov/regulations/laws/rules/7500-200.html

    and here

    “Regulation D establishes requirements for depository institutions to hold reserves in the form of either vault cash or non-interest earning balances held at a Federal Reserve Bank against transaction accounts that are held by banks on behalf of their customers.”

    http://www.fdic.gov/regulations/laws/federal/04cSPARKSdepositDEF719.html

    Mark, that phrase “reserves in the form of vault cash” appears quite a bit on the FDIC site. Here’s another:

    “Could determine proportion of reserve
    to be in vault cash.”

    http://www.fdic.gov/bank/historical/brief/brhist.pdf

    I don’t see anything on the FDIC site indicating that vault cash is NOT reserves. It seems to indicate that they are reserves. But this isn’t consistent with what you found?

  89. Gravatar of Tom Brown Tom Brown
    22. April 2014 at 03:16

    Mark, I’ve got one in moderation (too many links maybe), but it has quotes from the FDIC like this:

    “”Regulation D establishes requirements for depository institutions to hold reserves in the form of either vault cash or non-interest earning balances held at a Federal Reserve Bank against transaction accounts that are held by banks on behalf of their customers.””

    Which seems at odds with what you found. The paragraph above seems to indicate that vault cash is a form of reserves. This is mentioned quite a bit on the FDIC site actually.

  90. Gravatar of Tom Brown Tom Brown
    22. April 2014 at 07:12

    Mark, I asked David Andolfatto who in turn asked Dan Thornton some questions and here’s what I got:

    http://andolfatto.blogspot.com/2014/03/employment-along-canada-us-border-part-2.html?showComment=1398166567624#c5980055562732625220

    My questions:

    1. Reserves: does the definition of reserves include “vault cash?” Mark seems to think that vault cash can count towards satisfying reserve requirements, but that it is not actually “reserves.”

    2. Cash vs currency: I found one Fed document and several FDIC ones that draw a distinction: cash = currency + coin, with currency = paper money. Is this correct?

    3. Interest of reserves? Does this apply to vault cash? It seems like it does not.

    4. If currency is not the same as “coin” then does M1 include coins?

    5. “currency in circulation”: does it include “vault cash?”

    The response:

    Here are the answers. 1. Vault cash is reserves and counts towards meeting reserve requirements. 2. Correct, that is the common distinction. 3. No, only to deposits at Fed banks. 4. Yes coins are included. 5. No

    (Hopefully Dan didn’t just look that up on Wikipedia! :D)

  91. Gravatar of Mark A. Sadowski Mark A. Sadowski
    22. April 2014 at 10:16

    Tom Brown,
    Other than interest on reserves, which is a relatively new policy, all of this is really elementary stuff. You really need to buy an undergraduate textbook on money (I recommend Mishkin) rather than harassing the Vice President of the St. Louis Federal Reserve about first year definitions.

    1. “Reserves” = “Reserve Balances” + “Vault Cash used to satisfy reserve requirements”.

    2. “Currency” = Notes + Coins

    3. “Currency in Circulation” includes “Currency held by the Public”/”Currency component of M1” and “Vault Cash”.

    I don’t see anything in the things you’ve posted that contradicts #1 so I’ll just assume you misunderstood what I was saying.

    So let’s take a look at #2.

    Footnote #1:
    “…As used In Federal Reserve statistics, the term currency in circulation” includes paper bills and subsidisry coin issued by the Treasury and the Federal Reserve Banks and held either by the public or in bank vaults, but excludes currency held by the Treasury or the Reserve Banks themselves…”

    New York Federal Reserve Monthly Review, 1964

    http://www.newyorkfed.org/research/monthly_review/1964_pdf/02_4_64.pdf

    Pages 352-353:
    “…The published figures for currency outside the Treasury and Federal Reserve Banks are themselves the difference between the amount of each kind of currency outstanding and the amount in the Treasury and, beginning November 1914, the amount in Federal Reserve Banks. The primary sources of those figures are the “Reports of the Treasurer” in the Secretary of the Treasury’s annual reports and the monthly Circulation Statement of United States Money. The kinds of currency included in the stock are:

    1. Gold coin, gold bullion, and gold certificates issued by the Secretary of the Treasury in return for the deposit of gold
    2. Standard silver dollars and silver certificates issued by the Secretary
    of the Treasury in return for the deposit of silver dollars
    3. Fractional or subsidiary silver coin…
    9. Minor coin….”

    Friedman and Schwartz, Monetary Statistics of the United States, 1970

    Footnote 1:
    “…Currency in circulation totaled S86.5 billion In December 1975 and consisted of the following denominations

    Coln . . . . . .$8.959 million…”

    Donald Kohn, Currency Movements in the United States, 1976

    http://www.kansascityfed.org/PUBLICAT/ECONREV/econrevarchive/1976/2q76kohn.pdf

    Now I assume that when Daniel Thornton says “common distinction” he’s referring to the general public.

    But from the standpoint of monetary economics, and monetary economists such as Friedman, Schwartz and Kohn, “currency” means notes plus coins.

    That’s the way I mean it, and that’s what it means when we talk about “currency in circulation”, “currency held by the public” or the “currency component of M1”.

  92. Gravatar of Mark A. Sadowski Mark A. Sadowski
    22. April 2014 at 10:33

    Here’s a bonus definition:

    Page 990:
    “As used here, the term “currency” includes coin and paper money issued by the Government and by banks.”

    Bicentennial Edition: Historical Statistics of the United States, Colonial Times to 1970

    http://www2.census.gov/prod2/statcomp/documents/CT1970p2-11.pdf

  93. Gravatar of Mark A. Sadowski Mark A. Sadowski
    22. April 2014 at 11:13

    Tom Brown,
    Now let’s deal with #3.

    Footnote #1:
    “…In comparison, the term currency outside banks” represents currency in circulation less vault cash held by commercial banks…”

    New York Federal Reserve Monthly Review, 1964

    Page 352:
    “CURRENCY HELD by the public is the difference between currency in circulation (i.e., outside the Treasury and, beginning November 1914, also outside Federal Reserve Banks) and bank vault cash…”

    Friedman and Schwartz, Monetary Statistics of the United States, 1970

    Page 6:
    “…The currency component of the money supply is obtained
    by subtracting vault cash of all commercial
    banks from total currency in circulation.3…”

    BURGER and JORDAN, The Revised Money Stock: Explanation and Illustrations, 1971

    https://research.stlouisfed.org/publications/review/71/01/Stock_Jan1971.pdf

    Footnote #1:
    “The currency component of the money stock includes all currency outside the U. S. Treasury, the Federal Reserve Banks, and the vaults of commercial banks. A related concept, currency in circulation, also excludes currency held by the US Treasury and the Federal Reserve, but includes commercial bank vault cash…”

    Donald Kohn, Currency Movements in the United States, 1976

    Page 990:
    “…In the series in this section three types of currency figures are shown: (a) Total currency stock (series X 420); (b) currency in circulation (series X 423-437), defined as coin and paper money outside the Treasury and Federal Reserve banks; and (c) currency outside banks, that is currency in circulation less cash in the vaults of banks (series X 410).”

    Bicentennial Edition: Historical Statistics of the United States, Colonial Times to 1970

    “The currency component of M1, sometime called “money stock currency,” is defined as currency in circulation outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions. Data on total currency in circulation are obtained weekly from balance sheets of the Federal Reserve Banks and from the U.S. Treasury. Weekly currency in circulation data are published each week on the Federal Reserve Board’s H.4.1 statistical release “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.” Vault cash is reported on the FR 2900 and subtracted from total currency in circulation…”

    Federal Reserve, Performance Evaluation of the H.6 Statistical Release Money Stock Measures, 2009

    http://www.federalreserve.gov/releases/h6/perfeval2009.htm

    In my opinion Daniel Thornton has published some pretty questionable research papers in the past, so I already had a low opinion of him. But to not know that “Vault Cash” is part of “Currency in Circulation” is pretty inexcusable.

    I really don’t care if anybody thinks this is rude or not, but in my opinion anyone that doesn’t know that Vault Cash is part of Currency in Circulation has no business being within 100 yards of a Federal Reserve Bank, much less being one of the Vice Presidents of the St. Louis Federal Reserve.

  94. Gravatar of Tom Brown Tom Brown
    22. April 2014 at 11:19

    Mark,

    “You really need to buy an undergraduate textbook on money (I recommend Mishkin) rather than harassing the Vice President of the St. Louis Federal Reserve about first year definitions.”

    Yeah, I probably went too far there. I did find what appeared to be one online yesterday, but I didn’t save the link.

    “so I’ll just assume you misunderstood what I was saying.”

    Yes, probably, when you wrote this:

    “The bottom line is the portion of vault cash used to satisfy reserve requirements is itself a component of currency in circulation and is not a component of reserve balances.”

    I thought you were saying that vault cash was not reserves! (but that it somehow still satisfied reserve requirements: that’s what I was trying to clarify above with my simple example with $10 of deposits, etc):
    https://www.themoneyillusion.com/?p=26531#comment-333263
    … but what you meant is it’s not “reserve balances” … a different thing. Vault cash is definitely reserves then. Good to know.

    “Now I assume that when Daniel Thornton says “common distinction” he’s referring to the general public. ”

    Also the FDIC I think, they always write “currency and coin” in their documents, like they are different things, plus that’s how that one obscure Fed glossary I gave a link to defines it. I didn’t realize A) there was a distinction in the 1st place and B) that monetary economists have their own definition, which agrees with more substantial Fed documents and statistics. Interesting.

    Now how about #5 on my list? It sounds like Dan Thorton got that one wrong then?

  95. Gravatar of Tom Brown Tom Brown
    22. April 2014 at 11:23

    Mark by the time I pressed “submit” you’d already answered my last question there pretty definitively. 😀

  96. Gravatar of Tom Brown Tom Brown
    22. April 2014 at 11:30

    BTW, if there’s still several billion missing in the accounting, perhaps it’s time to call 60 minutes.

  97. Gravatar of Tom Brown Tom Brown
    22. April 2014 at 20:10

    While Googling for glossaries of terms yesterday I found an online version of what appears to be a macro text book by McConnell and Brue (my best guess given the chapter titles vs numbers). Ever hear of that one? It’s nearly 900 pages.

  98. Gravatar of Mark A. Sadowski Mark A. Sadowski
    22. April 2014 at 21:02

    Tom Brown,
    I have a copy of McConnell and Brue’s Principles of Economics (Micro and Macro). Do they also have a money textbook?

  99. Gravatar of Tom Brown Tom Brown
    22. April 2014 at 21:23

    I found the same thing in a large chunk (chapters 24 to the end) here (page 708):
    http://digilib.mercubuana.ac.id/manager/file_ebook/Isi5255073448113.pdf
    and it just so happens that Chapter 24 covers the money multiplier. I did see they had a section entitled “SOME IMPORTANT PROVISOS ABOUT THE DEMAND DEPOSIT MULTIPLIER” … and they stated in words those provisos, but not the (1+c)/(r+c) formula. Nor did they address this criticism from Nick Rowe, regarding the way the money multiplier is typically presented to students:

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/04/temporary-vs-permanent-money-multipliers.html

    But by far, my favorite part was this:

    “The Fed’s ability to conduct its policies in secret””and its independent status in general””is controversial. Some argue that secrecy and independence are needed so that the Fed can do what is best for the country””keeping the price level stable”” without undue pressure from Congress or the president. Others argue that there is something fundamentally undemocratic about an independent Federal Reserve, whose governors are not elected and who can, to some extent, ignore the popular will. In recent years, because the Fed has been so successful in guiding the economy, the controversy has largely subsided.”

    Yes, secrecy is very important! The Fed can’t let anyone know what they’re up to, else how can monetary policy be conducted properly?? Keep-em guessin’… that’s the Fed’s long time secret to success! Lol. 😀

  100. Gravatar of Tom Brown Tom Brown
    22. April 2014 at 21:46

    Mark, I hesitate to post the main directory I found because an unethical person might be tempted to rip them off for every textbook they appear to have (in subjects ranging from engineering to mathematics to economics). But it should be easy enough to locate given what I’ve already stated. Of course if I was unethical as well, you might say I was motivated to not let this library be identified and shut down by the publishers so I could continue to peruse it at my leisure without paying a dime, but we all know how ridiculous that idea is!

    But to answer your question, I only see the micro and macro books by McConnel, although they do have one entitled

    “Money, Banking and Financial Markets”… I’m bringing it up now to see who wrote it. It’s the 7th edition and it’s 850 pages.

  101. Gravatar of Tom Brown Tom Brown
    22. April 2014 at 21:47

    Frederic S. Mishkin

  102. Gravatar of Mark A. Sadowski Mark A. Sadowski
    22. April 2014 at 21:59

    That’s the one. It’s Scott’s and my favorite intermediate money textbook. Apparently Cullen has a copy but evidently he uses it as a door stop.

  103. Gravatar of Tom Brown Tom Brown
    23. April 2014 at 00:14

    Woodford discusses the CB secrecy idea here:
    http://www.nber.org/papers/w8674.pdf
    On pages 7 and 8 (and maybe more… I’m getting tired so that’s where I’m quitting for now)

    Have you read the paper? Your thoughts?

  104. Gravatar of Mark A. Sadowski Mark A. Sadowski
    23. April 2014 at 08:39

    Tom Brown,
    Like nearly all of Woodford’s papers its long so it’s difficult to summarize my opinions. Let’s divide it by sections.

    1) I think I agree 100% with the section on transparency in monetary policy. The Cukierman-Meltzer theory that monetary policy is more effective if kept a secret is ludicrous in light of the empirical evidence.
    2) The section on the monetary base is ironically both prescient and obsolete. Woodford clearly anticipated the future course of reserve balance management. But he didn’t forsee the passing from a Neo-Wicksellian to a Monetarist universe that occured when we hit the zero lower bound. Consequently I think he’s potentially very wrong about the unimportance of currency in an electronic age. Eventually there may be a “FedCoin” and I suspect it will be very important.
    3) The section on central bank control of short term interest rates thus poses some concerns that have already been addressed or are in the process of being addressed. With the implementation of the reverse repo facility the Fed will dramatically extend its power over short term interest rates throughout the economy. But in the final analysis interest rates are vastly overated, so my reaction is, so what?

    My take on all things Woodfordian is that he is brilliant…for a Neo-Wicksellian. He’s the authority on monetary policy from an interest rate perspective. Too bad interest rates don’t matter that much.

  105. Gravatar of Tom Brown Tom Brown
    23. April 2014 at 09:03

    FedCoin? meaning this:
    http://marginalrevolution.com/marginalrevolution/2014/02/what-would-fedcoin-look-like.html

    I thought of something like that the other day in a discussion with winterspeak (at JKH’s). I didn’t realize it had a name.

    Or did you mean something else?

    Thanks for the review. Has Woodford changed his mind on any of that since?

  106. Gravatar of Mark A. Sadowski Mark A. Sadowski
    23. April 2014 at 10:08

    Tom Brown,
    When I used the term “FedCoin” I meant electronic MOA, so apparently I’m not using the term in the same way that Cowen is. Recall that we’ve talked about the possibility of electronic currency before.

    “Has Woodford changed his mind on any of that since?”

    I don’t think so.

  107. Gravatar of Tom Brown Tom Brown
    23. April 2014 at 13:28

    Mark, you were quite critical of Dan for his reply on my #5, yet David passed that one along w/o comment.

  108. Gravatar of Mark A. Sadowski Mark A. Sadowski
    23. April 2014 at 14:57

    Tom Brown,
    I have a lot of respect for David Andolfatto’s thinking although we don’t always agree on everything.

    But in my opinion he is often too supportive of his colleagues (e.g. Stephen Williamson) when they are obviously wrong, even to him. In this case he was probably simply acting as an intermediary. I would not interpret that as meaning he necessarily agrees with Daniel Thornton. On the other hand the things that he does not know sometimes surprise me.

    There’s something in the freshwater of St. Louis which makes it a very strange place.

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