The smiling assassin

Picture a crime movie where the killer is arrested.  After hours of being grilled under a hot incandescent bulb, he breaks down and confesses, sobbing as he describes how he murdered his wife so he could get the insurance money and run off with a another woman.  It would be very odd if the killer calmly confessed to that crime, with the demeanor of someone describing a walk in the park, or taking the kids out to fly a kite. You expect remorse. Indeed a calm demeanor might be taken as evidence of insanity; maybe the killer didn’t even understand what he had done.

Let’s set the stage.  It’s early October 2008.  It’s been three weeks since Lehman failed, and the global economy is starting to fall apart.  There are scary stories about trade plunging all over the world.  The stock market is crashing, falling continuously during the first 10 days of October, often by large amounts.  TIPS spreads are plunging. Commodity prices are plunging.  Commercial real estate is beginning to fall sharply, after surviving the initial subprime crisis.  Unemployment is rising sharply.  What does the Fed decide to do?  Commenter Beefcake sent me to the San Francisco Fed, for its explanation.

Before the crisis, Congress passed the Financial Services Regulatory Relief Act of 2006 authorizing the Federal Reserve to begin paying interest on reserves held against certain types of deposit liabilities. The legislation was supposed to go into effect beginning October 1, 2011. However, during the financial crisis, the effective date was moved up by three years through the Emergency Economic Stabilization Act of 2008.4 This was important for monetary policy because the Federal Reserve’s various liquidity facilities5 initiated during the financial crisis caused upward pressure on excess reserves and placed downward pressure on the Federal funds rate. To counteract these pressures, on October 6, 2008, the Federal Reserve Board announced that it would begin paying interest on depository institutions’ reserve balances.

Well there you are, what could be more sensible?  I’m impressed at the audacity of the Fed, if nothing else.  This is the explanation they provide in their “education” department.  I suppose the average man on the street would nod his head, thinking, “It sure looks like the Fed knew what they were doing.”

There’s just one problem, the Fed is describing a murder, the killing of the economy. Don’t be fooled by the calm tone of this explanation.  They are describing a policy that they themselves indicate was rushed into service three years early in order to prevent interest rates from falling.  Its entire purpose was to prevent monetary stimulus, to make money tighter.

Their explanation is that the money that was being put into the banking system to rescue Wall Street threatened to also reduce interest rates thus easing monetary policy. But that could have the side effect of also rescuing Main Street!  The Fed was so horrified by the thought of a cut in interest rates at the time the economy was falling off a cliff that they begged Congress to let them move earlier on IOR.

You might wonder why the Fed simply didn’t wave its magic wand, and set rates where they wanted them.  Actually, before they had the legal option of doing IOR, the Fed had no magic wand. It only seemed like they could directly control interest rates.  In fact, they controlled the monetary base, and used changes in the base to influence interest rates.  When they sharply boosted the base to rescue the banks in September 2008, they had no way of stopping interest rates from falling all the way to zero.

The week this happened I went absolutely ballistic, and essentially became a different person.  (After not have a strong opinion on monetary policy for the previous 25 years) I went down to Harvard to ask the top macroeconomists what the hell the Fed was doing, something I never would have done before 2008.

Now inevitably someone will cite Paul Krugman, who likes to point out that central banks are quite capable of driving the economy into a zero rate trap without IOR. The Japanese did it in the 1990s, and the Fed did it in the 1930s. That’s true but irrelevant. The fact that people can also be murdered with knives does not prove that a man standing over a dead body with a smoking revolver in his hand is not guilty of murder.

Others will say that one decision is no big deal; it’s the future path of policy that matters.  That’s also true, but decisions can tell us a lot about the Fed’s mindset, and hence the likely future path of policy.  As Tim Duy recently pointed out, the reason the markets care so much about the measly quarter point increase is not the direct effects on the economy, but rather what it tells us about the Fed’s reaction function.

The October 8, 2008 rise in IOR was neither a necessary nor sufficient condition to produce the Great Recession.  But it was one important part of the story, which began in 2008 and still has not ended.  Believe it or not a rate rise in September 2015 would help cause the recession of 2008, as the severity of that recession was partly caused by the perception that the Fed would raise rates before we got back to the previous NGDP trend line.  (An idea Krugman developed back in 1998.) And now the Fed is about to confirm that perception.

PS.  Now reread the final sentence of the opening paragraph.

PPS.  I have a new post at Econlog on a related issue.


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71 Responses to “The smiling assassin”

  1. Gravatar of foosion foosion
    12. September 2015 at 04:35

    >> I went down to Harvard to ask the top macroeconomists what the hell the Fed was doing>>

    What did they say?

    BTW, my favorite current “analysis” – they should raise rates to eliminate the market’s anxiety about raising rates. Probably written with a calm demeanor.

  2. Gravatar of ssumner ssumner
    12. September 2015 at 06:11

    Foosion, The comment that really struck me was something like “Oh they know AD is falling too fast, they just don’t know what to do about it.” ((Not exact words.)) That shocked me, but later it became obvious that that was correct. Everything I’d been teaching my students for 25 years out of the Mishkin textbook that said “Monetary policy is still highly effective even when interest rates are near zero” was just my view, not the profession’s view, as I had assumed. Bernanke’s critique of Japan in 2003, was Bernanke’s view then, not Bernanke’s view in 2008. Friedman’s claim that very low interest rates usually mean money has been tight is something Friedman and I believed, but almost no one else. When I was in grad school the idea of a liquidity trap was treated as a joke–“look how stupid Keynes was!” Finding out the profession was in a very different place is what radicalized me. And I’m not the only one, Svensson went through the same disillusionment in Sweden, for instance. DeLong said he had always assumed the Fed wanted to prevent big collapses in NGDP, and was shocked to discover otherwise. Krugman comes off best, having always had doubts that central banks would do what it takes.

  3. Gravatar of JP Koning JP Koning
    12. September 2015 at 06:14

    Look on the bright side. With IOR in place, at least the Fed can now set negative interest rates.

  4. Gravatar of Mike Rulle Mike Rulle
    12. September 2015 at 06:25

    The most persuasive aspect of your narrative is that the murderer is insane. It has always been plausible to me that decision makers somehow can step outside the logical framework within which they have been trained. One bit of narrative of late is the Fed should raise rates to demonstrate they are not afraid to raise rates. I believe a Fed official made this point. My impression is the Fed is tired of zero interest rates. It does not feel “right” to them. It feels like a permanent state of crisis. What if this is their actual thought process? But there is no theory that supports this concept. So they are willing to toss out any idea to justify getting on the path to non zero rates. But this is just another version of the murderer is insane narrative. I really think they want to “fake tighten”. They don’t believe tightening is really called for. But they cannot pyschologically bear many more years of zero rates. Maybe that is their true reaction function. I certainly do not claim this makes sense. But is it any more insane than to think we should REALLY tighten? After all, they have already demonstrated an ability to think outside their discipline to justify policy decisions.

  5. Gravatar of Dustin Dustin
    12. September 2015 at 06:28

    This 2009 piece from the Atlanta Fed a la Gerald Dwyer seems much more your speed. I particularly like that it is from 2009 pretty much nails what has transpired since.

    https://www.frbatlanta.org/cenfis/publications/notesfromthevault/0910.aspx

    A few of select quotes:
    – “Payment of interest on reserves accounts for much, though probably not all, of the increase in excess reserves.”
    – “… banks hold excess reserves rather than count on borrowing reserves from other banks. The net result is little or no borrowing between banks and a greater demand for excess reserves than previously.”
    – “As long as the interest rates on reserves and risk-free assets are similar and banks’ demand for risk-free assets does not decline, there is no obvious reason why excess reserves will decline.”

  6. Gravatar of John Hall John Hall
    12. September 2015 at 06:39

    @foosion I’m with you. How does that even make sense. Or that the Fed should raise rates now so that sometime later it can lower rates.

  7. Gravatar of Ray Lopez Ray Lopez
    12. September 2015 at 06:57

    Another brilliant Sumner post, describing how he became an easy money radical! Priceless. A free (market) radical.

    But this sentence sounds like time travel: “Believe it or not a rate rise in September 2015 would help cause the recession of 2008, … (An idea Krugman developed back in 1998.)” -?? No, I don’t believe it! The future influencing the past? Only in Hollywood SciFi.

    Also keep in mind that credit default swap risk peaked in Feb 2009, about the time the stock market tanked, showing that the crisis was not ‘over’ in Fall 2008. On my blog I have the chart, copied from Forbes magazine. This point goes to Sumner’s comment: “Others will say that one decision is no big deal; it’s the future path of policy that matters. That’s also true,…”

  8. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    12. September 2015 at 06:59

    ‘In fact, they controlled the monetary base, and used changes in the base to influence interest rates. ‘

    I love it when you talk like that.

  9. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    12. September 2015 at 07:01

    Btw, at the time, Bernanke said, in congressional testimony, that The Fed was doing IOR deliberately to ‘sterilize’ the increase in reserves.

  10. Gravatar of Ray Lopez Ray Lopez
    12. September 2015 at 07:18

    Off-topic: T or F? http://www.hussmanfunds.com/wmc/wmc150330.htm

    “The true Phillips Curve is a relationship between unemployment and real wage inflation, it cannot be usefully exploited by monetary policy, and it is the only version of the Phillips Curve that actually exists in empirical data. Pursuing general price inflation does not somehow “buy” more jobs. It also does not raise real wages. It lowers them.”

    I had assumed the Phillips Curve is dead, whether real or nominal.

  11. Gravatar of Peter K. Peter K.
    12. September 2015 at 07:36

    I thought of the IoR as a way – along with TARP – for the Fed to recapitalize the banks, quell the panic and ease conditions in that manner. Basically the IoR is just giving money to the banks so that anybody who feared the banks were insolvent would have their fears eased.

    I never realized that the Fed wanted to counteract the following pressures:

    “This was important for monetary policy because the Federal Reserve’s various liquidity facilities5 initiated during the financial crisis caused upward pressure on excess reserves and placed downward pressure on the Federal funds rate.”

    ” To counteract these pressures, on October 6, 2008, the Federal Reserve Board announced that it would begin paying interest on depository institutions’ reserve balances.”

  12. Gravatar of Becky Hargrove Becky Hargrove
    12. September 2015 at 08:00

    The problem of course is that getting to the truth, i.e. heart of the matter, does not always solve the problem, even if the heart of the matter is painfully obvious.

  13. Gravatar of David de los Ángeles David de los Ángeles
    12. September 2015 at 08:03

    Dr. Sumner,

    I certainly agree that Federal Reserve Bank (FRB) cannot stop interest rates from from falling when the market drives them down. For example on June 29, 2006 the FRB raised the Target FFR (TFFR) from 5% to 5.25%. The Effective Federal Funds Rate (EFFR) was indeed 5.25+/-0.1% from July 2006 to July 2007. However the EFFR began to fall in August of 2007 and by September it was 4.94%, all without any FRB action. On September 18, 2007 the FRB lowered the TFFR to 4.75% which it was by October but it continued to fall and the FRB kept lowering the TFFR [1]but the EFFR kept falling faster[2]. The FRB was trailing the market, not leading it.

    However what is clear is the FRB was not trying to stop the fall in the EFFR, it was desperately trying to keep up with it. Finally in December of 2008 the FRB the Quantitative Easing Policy (QEP), including the Zero Interest Rate Policy (ZIRP) was adopted, which simply acknowledged reality.

    If the FRB was trying to murder the economy in 2008, it was wasting it’s time, it was already dead (think Gosford Park).

    [1] http://1.usa.gov/1BWmAuc

    [2] http://bit.ly/1BWmBy5

  14. Gravatar of David de los Ángeles David de los Ángeles
    12. September 2015 at 08:09

    Hello Peter K,

    The Federal Reserve Bank (FRB) began the effort to be allowed to offer interest on reserves (IOR) long before 2008. IOR was first proposed by Dr. Milton Friedman almost exactly fifty years ago in “A Program for Monetary Stability” [1]. Dr. Friedman’s goal was to reduce the degree of control that the Federal Reserve Bank over commercial banks (“The Chicago Plan”) to make a 100% reserve system. Dr. Friedman wrote:”[The Chicago Plan] would be necessary to go in the radical direction of eliminating controls over individual banks, in the direction of 100% reserve banking. This move would tend to eliminate all control over the lending and investing activities of banks and would separate out the two functions of banking….On the one hand, we would have banks as depository institutions, safe-keeping money and arranging for the services of transferring liabilities by check. They would be 100% reserve banks, pure depository institutions… our present banks would be sliced off into other branches operating like small – scale investment trusts. They would be lending and investment agencies in which private individuals would invest funds as they now do in investment trusts and other firms, and these funds would be used to make loans. Such organizations could be completely exempt from the kind of detailed control over financial activities that banks now are subject to.”

    Dr. Friedman believed that paying interest on reserves would for the half of the new banking system that was strictly savings oriented would create greater price stability. So the idea is an old one that does not have its roots in the Crash of 2008 or the Great Recession.

    2) The FRB has been working for nearly 20 years to make Dr. Friedman’s proposal for IOR a reality. Their current authority was introduced into legislation in 2001 in what later became the Financial Services Regulatory Relief Act of 2006 [2]. The FRB did not have authority to offer IOR under the Federal Reserve Act. IOR was not supposed to go into effect until 2001 but with the Crash of 2008, the FRB was able get emergency legislation through congress to allow them to offer IOR immediately [3].

    3) The FRB did not really have the sort of emergency response to an economic melt down in mind when it adopted Dr. Friedman’s idea of IOR and proposed it to Congress. The only connection to the Crash of 2008 was that the date of implementation was moved forward.

    [1] http://bit.ly/1AAHb6v

    [2] http://bit.ly/1F2KLO7

    [3] http://bit.ly/17SIG0G

  15. Gravatar of Beefcake the Mighty Beefcake the Mighty
    12. September 2015 at 08:11

    This is a very significant post, because Scott implicitly acknowledges that the standard monetarist line, that IOER are an opportunity cost to lending, is a myth. The issue concerns the lack of demand for these reserves by the banks (clearly evidenced BEFORE the IOER policy was implemented), and the Fed’s concern about losing control over interest rates. Hence Scott’s silly murder mystery metaphor.

    This is probably why Scott has adopted his current deus ex machina, about the Wicksellian “natural” rate being below 1/4%, and hence that current policy is restrictive. He somehow (magically?) knows what this rate is, but that’s the next thing to be explained away, I suppose.

  16. Gravatar of Vaidas Urba Vaidas Urba
    12. September 2015 at 08:13

    Scott,

    guns don’t kill people, people kill people. Did you become scared when Bank of England started paying interest on reserves in 2006?

    ” They are describing a policy that they themselves indicate was rushed into service three years early in order to prevent interest rates from falling. ”

    Other Fed sources say that interest rates were rising at the time. For example, see: http://www.voxeu.org/article/what-happened-us-interbank-lending-financial-crisis
    “The daily fed funds rate was relatively stable after the Bear Stearns’ episode until Lehman Brothers’ bankruptcy. The weighted average rate then jumped, with substantially more widening of the distribution”

  17. Gravatar of Vaidas Urba Vaidas Urba
    12. September 2015 at 08:21

    Scott,
    you say the Fed announced a new gun on October 8 2008 which scared the markets. Here is Econbrowser on October 7 describing the previous gun – transfer of reserves to Treasury supplementary financing account:
    http://econbrowser.com/archives/2008/10/balance_sheet_o

    Here is Treasury announcing the previous gun which was as powerful as IOR on September 17 2008:
    https://web.archive.org/web/20090201001535/http://treasury.gov/press/releases/hp1144.htm

    The power of IOR gun and power of Treasury supplementary financing account gun is equal. IOR announcement did not murder the economy.

  18. Gravatar of ssumner ssumner
    12. September 2015 at 08:33

    Just time for one response now, I’ll address the others later.

    Vaidas, we’ve been through this before. The problem is not the IOR per se, it’s that it was set at a positive level. It should have been zero or negative. In 2006 the UK probably set IOR at an appropriate level. Guns don’t kill people, guns fired at people kill people.

  19. Gravatar of Beefcake the Mighty Beefcake the Mighty
    12. September 2015 at 08:40

    “In 2006 the UK probably set IOR at an appropriate level.”

    Talk about begging the question.

  20. Gravatar of E. Harding E. Harding
    12. September 2015 at 09:34

    “Believe it or not a rate rise in September 2015 would help cause the recession of 2008”

    -Not possible; didn’t you say in late 2010 practically nobody believes the U.S. would still be at the ZLB in late 2014?

  21. Gravatar of marcus nunes marcus nunes
    12. September 2015 at 09:40

    And there´s the “neutron bomb” analogy:
    “it appears Bernanke tried to avoid “a little inflation” from rising demand when avoiding the collapse of a financial institution by “shooting a neutron bomb” i.e., keeping financial “houses” intact, only “killing” demand.
    https://thefaintofheart.wordpress.com/2011/11/03/william-niskanen-a-proponent-of-ngdp-targeting/

  22. Gravatar of Benoit Essiambre Benoit Essiambre
    12. September 2015 at 10:11

    I started following this blog and other economic blogs around 2009 when I had an idea for a mobile game project, a kind of SIM game for which I wanted to have a realistic macroeconomic and monetary model. I though it would be an on-topic game given the then recent financial crisis. I thought with Wikipedia and other online resources, I could understand enough for a basic simulation.

    I never imagined how deep the rabbit whole would go when I started going down. I never thought there would be so much debate around even basic mechanisms.

    I certainly did not think that blogs like this one, Nick Rowe’s and David Beckworth’s which seemed to give me the insight that made the different parts of the economy be sufficiently specified and logically fit for a simulation would also reveal that, central banks, through what seems like mathematical confusion, were destroying billions even maybe trillions of dollars worth of wealth and welfare (with all the suffering and death this implies, from making things like jobs and healthcare out of reach for many). I was astonished that they had the power to basically resolve the situation by just saying a few words that would set expectations correctly and push inflation high enough to unjam the labor and investment markets but were not even willing to try.

    For years, I have been in constant stupor and shock that this keeps going on in vast parts of the world. This post about oblivious murder really drives home this economic angst of mine.

  23. Gravatar of Kevin Erdmann Kevin Erdmann
    12. September 2015 at 11:43

    The cynicism in this country these days is oppressive. Scott’s reaction here makes perfect sense to me. I would not call it cynicism. Acknowledging empirical reality is not cynicism. Among 99% of the rest of the country, there appears to be a consensus that the Fed is the lapdog of the banks and Wall Street. All other facts are negotiable. Some say the Fed is enforcing low inflation because banks love low inflation and Wall Street loves low wage growth. Others say the Fed has been extremely accommodative because Wall Street loves asset inflation and the Fed is unconcerned with the rising true cost of living for workers. And interest on reserves is a Fed payoff to Wall Street, of course. Everyone agrees on that. You just need to ignore the fact that it’s implementation coincided with a collapse in corporate asset values that support bank balance sheets and that it followed a 2 year period where the Fed let housing stock values, the other main asset under bank balance sheets, decline by 25% with an explicit lack of support.
    It reminds me of Mencken’s comment that the people get what they want, and they get it good and hard. I just wish I wasn’t along for the ride.

  24. Gravatar of Major.Freedom Major.Freedom
    12. September 2015 at 11:46

    “Picture a crime movie where the killer is arrested. After hours of being grilled under a hot incandescent bulb, he breaks down and confesses, sobbing as he describes how he murdered his wife so he could get the insurance money and run off with a another woman. It would be very odd if the killer calmly confessed to that crime, with the demeanor of someone describing a walk in the park, or taking the kids out to fly a kite. You expect remorse. Indeed a calm demeanor might be taken as evidence of insanity; maybe the killer didn’t even understand what he had done.”

    This has a theoretical analogue in “market” monetarism.

    Except Sumner occasionally has intellectual meltdowns, indicating his insanity might be curable.

  25. Gravatar of John Thacker John Thacker
    12. September 2015 at 12:49

    And now the Fed is set to raise interest on reserves as part of raising rates. If this article is correct, from 0.25% to 1.00%, yet people keep talking about the quarter-point increase in the lending rate expected. Hmm.

  26. Gravatar of ssumner ssumner
    12. September 2015 at 12:58

    Peter, Actually, they could have gotten the same amount of money to the banks w/o IOR.

    David, I don’t agree, they were clearly trying to stop the fall in interest rates.

    Beefcake, I have no idea what you mean by the monetarist view of IOR. The natural rate of interest is a concept Keynesians like to use. I don’t like it, and just use it when people insist on talking about interest rates. I translate my views into interest rate language for those who insist. I’d prefer not to talk about market interest rates at all.

    E. Harding, You said:

    “Not possible; didn’t you say in late 2010 practically nobody believes the U.S. would still be at the ZLB in late 2014?”

    Don’t recall, but even if I did it doesn’t matter. The issue is not when the Fed raises rates, it’s where NGDP is relative to trend when the Fed raises rates.

    Marcus, Good analogy.

  27. Gravatar of Jon Jon
    12. September 2015 at 13:48

    I don’t think anyone knowingly jawboned us into the recession but unawares the left-wing intelligentsia did use the initial crisis to argue against the Washington consensus. I remember the commentary centering around needing to rip up the fabric of theoretical economics… Of course that included denying or forgetting woodford’s expectations driven approach to monetsry policy…

    The economics community is small, particularly if you slice it further to the professors at elite schools. Trouble with a small group is group think sets in easily from social pressure. Small group != wisdom of the crowd.

    The pressure on this point was strong. You just couldn’t engage in social conversation from a point of view other than the corrupt bankers destroyed everything.

  28. Gravatar of E. Harding E. Harding
    12. September 2015 at 13:58

    @ssumner
    -I still don’t believe that “a rate rise in September 2015 would help cause the recession of 2008”. Maybe the next recession, but not the last one. The 2008 recession already happened; if the Fed holds off raising rates, there’s no way it could change the past to make it milder.

  29. Gravatar of Rick Rick
    12. September 2015 at 15:02

    I don’t understand how we can be near full employment or the natural rate when the labor force participation rate is so low. I know the calculation but the fact that there are many in the +50 crowd that would like a job, have good skills and can’t find employment seems not to matter w/r/t the Fed? Somebody show me the math, please. Does it have to do with the # of jobs available -vs- the number of available workers and thus wage pressure?

    Or must the Fed take into consideration the parity risk derivatives outstanding and what a .25 rise would do to those trades on the banking sector?

  30. Gravatar of E. Harding E. Harding
    12. September 2015 at 15:21

    @Rick
    Evan Soltas explained that half of the LFPR issue was due to demographics, and half to the recession. Like it or not, there are many people out there who are either very much unemployable (though they’re becoming rarer by the hour) or just don’t want to work. The unemployment rate is 5.1%. Over-27 week unemployment is back to historical norms. Job openings are strong. Things are getting better. The natural rate of unemployment is probably just over 4% or 4%, so I’d still wait a year or two before raising rates.

  31. Gravatar of benjamin cole benjamin cole
    12. September 2015 at 16:18

    BTW—the Fed also shrank its balance sheet going into 2008. So maybe they murdered with a gun…after administering poison.

  32. Gravatar of David de los Angeles Buendia David de los Angeles Buendia
    12. September 2015 at 16:47

    Dr. Sumner and other commentersm,

    If it was the goal of the Federal Reserve Bank (FRB) to use interest on reserves (IOR) to,prop up Effective Federal Funds Rate (EFFR), they most certainly tried to achieve that goal in a very odd way and was quite ineffective. In October of 2008 the EFFR was 0.98% and in very next month it was 0.38% and in December it was 0.18%[1]. December as marked the first round of the Large Scale Asset Purchase (LSAP) programme wherein the FRB began open market operation to double the size of it’s holdings[2]. The LSAP of course necessarily had the impact of lowering the EFFR. Making a virtue of necessity, the FRB created the Zero Interest Rate Policy (ZIRP).

    Now, if the murder of economy of the United States was the intent (mens rea) of the FRB by maintaining a higher EFFR through IOR, it could never be convicted because it achieved the exact opposite through LSAP and ZIRP (there was no factus reus).

    [1] https://research.stlouisfed.org/fred2/series/FEDFUNDS

    [2] http://www.tandfonline.com/doi/full/10.1080/00036846.2015.1061646

  33. Gravatar of TravisV TravisV
    12. September 2015 at 17:17

    Will Eric Rauchway’s new book The Money Makers be worth reading?

  34. Gravatar of TravisV TravisV
    12. September 2015 at 17:18

    Has anyone else had issues with TheMoneyIllusion site crashing with Safari on the iPad?

  35. Gravatar of Ray Lopez Ray Lopez
    12. September 2015 at 18:13

    @ David who lives on Buendia street in LA:

    “The FRB was trailing the market, not leading it.” – this is almost always the case. Money is neutral, the Ben S. Bernanke, 2003 FAVAR paper proves at least this. Dr. Sumner makes the claim that it’s very significant when the Fed does not trail the market, and this forms a sort of ignition or catalyst. There’s no data for his views however, it’s all based on metaphysical “expectations” language popular in the 1980s with the ratex crowd. Hence it’s basically unscientific. The troll Beefcake hits upon this and Sumner dodges the bullet.

    But Dr. Sumner is brilliant!

    @Benoit Essiambre – I code for fun, using Visual Studio (hence no Android mobile phone stuff though VS15 now does support it). If you are looking to simulate the economy by reading econ blogs you are wasting your time. The way simulations are done in practice (whether economics, as in SimCity, or physics, as in numerous games) is via a look-up table and a random number generator. It would have been worth your time to simply hire competent or decent but below-average (i.e. Indian) programmers and written your game. About $25k USD would have done it using India, $100k using US programmers, and then you have to hope the market likes your product, which is not a guarantee. The market is fickle; why they latched onto a silly game like “Angry Birds” is not clear. But that’s like the real economy anyway: it’s often random.

  36. Gravatar of Benoit Essiambre Benoit Essiambre
    12. September 2015 at 19:05

    Ray,

    You clearly haven’t hired Indian programmers as those that do low paid contract work for clients they never see in person could not pull off a realistic economic simulation in a million years.

    Yes simulations use random number generators, my ideas for this game included using a monte carlo algorithm to simulate probabilistic functions of agent behaviors.

    Anyways, since I engaged with you I might as well try once again to convince you that high inflation is important sometimes to prevent people from accumulating too much idle excess money which adds no value to an aggregate economy.

    Let me try this simplified agrarian economic metaphors which seems to have helped others understand:

    Say you had an isolated farming village where people wanted to save to be able to eat in the winter. Because there is some spoilage, crops stored for the winter are only worth 90% of the initial investment required to produce them, that is they have a real return of -10%.

    It is important that in the fall people in this village invest into excess production to have something to eat in the winter, even if, the real returns on these investments are -10%.

    Instead, this village could mandates its government to create a currency that always keeps 98% of its real value (2% inflation) even when private market stores of value can’t retain this much. The government would put money into circulation by buying part of farmer’s crop during the summer (politicians have to eat).

    In this situation, most farmers are going to produce enough food for the summer, sell some of their crop and keep their money to be able to buy something to eat in the winter. They will not produce a crop to store for the winter since it would only return -10% on their initial investment and their central bank promised to keep money at at least -2%.

    However, when comes winter, all farmers have cash but few have anything to sell because they didn’t reinvest their cash in the production of a crop to be stored!

    It’s going to be difficult for their government to control inflation in such conditions because there will be too few goods for the amount of money people will want to spend.

    If the government does manage to control inflation, it will be by depressing the nominal value of the crops of the few farmers who did invest in a crop for the winter. The central bank might do this by giving high enough interests payment on cash to prevent people from wanting to spend it immediately. In any case, people won’t eat much during the winter.

    This dire situation could have been prevented if the central bank had kept money devaluating sufficiently (in this extreme case, inflation above 10%) and farmers would not have kept their savings as idle fiat but would have reinvested them into an extra crop for the winter and have continued to trade during the winter.

    Note that there are parallels with farmers saving for the winter and a baby boom saving in preparation for retiring and stopping to work.

  37. Gravatar of TallDave TallDave
    12. September 2015 at 19:29

    Increasingly aghast at the distressingly prevalent notion that a return to “normal” interest is a legitimate, even paramount policy goal.

    The vulgarity of the normative. Sigh.

  38. Gravatar of Rod Everson Rod Everson
    12. September 2015 at 20:56

    John Thacker, you wrote: “And now the Fed is set to raise interest on reserves as part of raising rates. If this article is correct, from 0.25% to 1.00%, yet people keep talking about the quarter-point increase in the lending rate expected.

    If you check the article again, you’ll find that the 1% figure arose by way of an example, as in “say the Fed wanted to raise the funds rate to 1%…” It wasn’t a statement of intent.

    There seems to be some confusion about the purpose of paying Interest on Reserves (IOR), by the way. As someone else pointed out, Bernanke claimed in testimony that IOR was needed to “sterilize” the excess reserves. That’s correct, although I prefer to say “neutralize the excess reserves.”

    Without IOR, the Fed could not have done the three Quantitative Easings (QE’s) because the banking system would not just sit on the resulting surge in excess reserves. That’s the precise purpose of the IOR, i.e., to neutralize, or sterilize, the $2.5 trillion of excess reserves now in the banking system. Without it, banks would hit any bid in the fed funds market above the frictional transaction cost. It’s the existence of IOR that is allowing the Fed to manage the funds rate between 1/8 and 1/4 of a percent. And raising the IOR is the only way to raise the rate at which funds will trade.

    And each 1/4% increase in the IOR will cost the Fed about $6.25 billion per year, incidentally, which just might be the real reason for the Fed’s reluctance to “normalize” rates over the past few years. Attaining even a 3% fed funds rate would about absorb their entire income stream from their portfolio of long paper, a portfolio that would likely be trading well under water if they had decided to allow short rates to trade again at a reasonable level of, say, 3%.

  39. Gravatar of Rod Everson Rod Everson
    12. September 2015 at 21:16

    JP Koning: You wrote “Look on the bright side. With IOR in place, at least the Fed can now set negative interest rates.

    Would you care to elaborate? Does the legislation enabling payment of interest on reserves also authorize the Fed to charge a fee on reserves held at the Fed (instead of paying interest), for example?

  40. Gravatar of David de los Angeles Buendia David de los Angeles Buendia
    12. September 2015 at 21:54

    Mr. Lopez,

    Why do you suppose that I am from the capital city of Bío Bío provence in Chile? There is no Buendia Street in that city and I doubt any Chilean city would bear the name of that Peruvian General. Perhaps you are thinking of Calle General Baquedano?

    It is neither here nor there one might suppose. Thank you for the note, it was enlightening. I was struck by Dr. Sumner’ comment that the Bank of England. I believe that Bank of England set the the Interest Rate on Reserves at 25 basis points above the overnight rate for bank reserves, just as the Federal Rerserve did[1] or did I read that incorrectly?

    [1] http://www.bankofengland.co.uk/markets/Documents/money/publications/redbook0506.pdf

  41. Gravatar of Rod Everson Rod Everson
    12. September 2015 at 21:54

    Dustin, there’s an interesting paragraph in the article by Gerald Dwyer that you linked to:

    The Federal Reserve currently is paying interest on excess reserves at 25 basis points. The Fed initially set interest rates for reserves at the average federal funds rate minus 10 basis points for required reserves and at the lowest fed funds rate minus 75 basis points for excess reserves. After a couple of intermediate adjustments, the rates on both required and excess reserves are now set to equal the upper end of the range of the intended fed funds rate announced by the Federal Open Market Committee.

    They initially set the IOR at 75 basis points below the level fed funds were trading at. But when the excess ballooned, banks would hit any bid greater than zero with their excess so this combination of Fed actions (setting the IOR below the level fed funds traded plus creating the massive amount of excess reserves) doomed fed funds to trade at zero. Hence the mid-course correction that resulted in the IOR being set at 25 basis point on all reserves.

    So, now, with $2.5 trillion in excess reserves in the system, raising the IOR is the only effective way for the Fed to raise interest rates. It will cost them, but they should do so anyway, in my opinion, and not stop until they have restored some sanity to the rates being paid to savers. That, and not some unsupportable fear that a modest rate increase will grind the economy to a halt, should be the reason to raise rates. The world won’t end, and the U.S. economy won’t crash, if fed funds trade at 2% by the end of this year. However, the Fed’s portfolio of long paper could take a significant beating, but that’s often how positive carry trades work out, particularly ones of this magnitude.

    More on that here: http://ontrackeconomics.blogspot.com/2015/08/positive-carry-trades-often-end-badly.html

  42. Gravatar of ssumner ssumner
    13. September 2015 at 04:33

    Jon, That’s right, and what made it even harder is that monetary policy works in counterintuitive ways, so it really did look like the financial crisis caused the recession.

    E. Harding. Obviously there is a bit of hyperbole there, but suppose markets had perfect foresight—then in 2008 they would have seen the Fed’s foolish decision in 2015. Now of course they don’t really have perfect foresight (hence the hyperbole) but the markets did expect this.

    Rick, You should read Kevin Erdmann’s post on this.

    David, You are looking at the wrong data. The key is the monetary base, which rose sharply in September. Those base injections occurred even before the IOR program. Another mistake is to focus on the fed funds rate, which was distorted by non-banks like GSE lending fed funds. They did not earn the IOR. But most of the ERs were held by banks, and that increased the demand for base money. Also note that real interest rates (TIPS) rose sharply in late 2008.

    I agree that rates were low by December, when they cut the IOR to 0.25%. The near zero rates were delayed 3 months, and even the 0.25% IOR was a mistake.

    Talldave, Yes, it’s sad. And also stupid, because raising rates will reduce the Wicksellian equilibrium rate–so they won’t even achieve their objective.

    Rod, I doubt the legislation gives them that right, but Congressional lapdogs give the Fed whatever power they demand. Even without that right they can do negative IOR by setting the rate at zero and raising the FDIC fee on reserves.

    And actually I think the US economy probably would crash if the Fed raised rates to 2% by yearend (obviously unless they did so with an easier money policy.)

  43. Gravatar of Vaidas Urba Vaidas Urba
    13. September 2015 at 04:49

    Scott,
    the problem was not IOR, it was the fed funds rate target. The problem was that the Fed did not cut fed funds target on September 16, 2008 and the problem was that the Fed did not cut the fed funds target to zero on October 6, 2008 etc.

    What did switch to IOR tell us about Fed’s policy? All the negative news were already in the fed funds rate announcements and IOR was positive news as IOR allows the Fed to do more QE as the exit from QE is less problematic when you have IOR tool.

    “When they sharply boosted the base to rescue the banks in September 2008, they had no way of stopping interest rates from falling all the way to zero.”
    This is wrong as the Treasury was helping the Fed to control the rates which on important occasions were much higher than the fed funds rate target in late September – early October.

  44. Gravatar of Beefcake the Mighty Beefcake the Mighty
    13. September 2015 at 05:21

    @Benoit

    Butt-plug say what?

  45. Gravatar of Shayne Cook Shayne Cook
    13. September 2015 at 05:22

    A question for Rod Everson …

    In your “positive carry trades often end badly” post, you state …

    “In other words, should interest rates now rise the Fed will see it’s financing costs rise, its portfolio likely fall in value, perhaps significantly, and will be subject to losing on both ends of a $4.5 trillion portfolio.”

    My question is, since when does the Fed have “financing costs”?
    If I remember correctly, the U.S. Federal Reserve Bank has statutory authority to “print money” at any time, so why would it ever be in a situation of having to assume debt (short-term or long-term) to support its mandates, its activities or the relative merits of its balance sheet?

  46. Gravatar of Major.Freedom Major.Freedom
    13. September 2015 at 06:09

    Ray,

    “Money is neutral, the Ben S. Bernanke, 2003 FAVAR paper proves at least this.

    You keep repeating that falsehood.

    A percent that averages between 3.2% and 13.2% is not zero, which is what would be required if money were in fact neutral.

    If Bernanke found the rate to be between say -5% and +5%, then an argument can be made that money might be neutral, because zero is between -5% and +5%.

    You are a liar at this point, give how many times this has been pointed out to you and given the fact that you keep repeating the falsehood anyway.

  47. Gravatar of bill bill
    13. September 2015 at 06:27

    I’m confused. Paying IOR is contractionary. QE is expansionary. Why do both?

  48. Gravatar of David de los Angeles Buendia David de los Angeles Buendia
    13. September 2015 at 06:38

    Dr. Sumner,

    The monetary base did indeed increase by 9% between August and September 2008

    Date MB[1] EFFR[2]
    BUSD %
    2008-08-13 875
    2008-08-27 877 2.00
    2008-09-10 875
    2008-09-24 950 1.81

    but that would have the effect of driving down interest rates, not propping them up.

    [1] https://research.stlouisfed.org/fred2/data/BASE.txt
    [2] https://research.stlouisfed.org/fred2/data/FEDFUNDS.txt

  49. Gravatar of David de los Angeles Buendia David de los Angeles Buendia
    13. September 2015 at 06:48

    Hello bill,

    Paying interest on reserves is not contractionary or expansionary, it merely encourages banks to move their excess reserves from their own vaults to the vaults of the Federal Reserve Bank. There are a variety of policy reasons for this that have nothing to do the Crash of 2008 and the subsequent Great Recession[1].

    [1] http://www.newyorkfed.org/research/epr/02v08n1/0205good.pdf

  50. Gravatar of Beefcake the Mighty Beefcake the Mighty
    13. September 2015 at 06:56

    @bill

    Uh, who says that QE is expansionary? Someone’s in need of checking their premises, and it’s not just Scott.

    BTW, MF is the intellectual equivalent of a dirty sanchez.

  51. Gravatar of ssumner ssumner
    13. September 2015 at 07:29

    Vaidas, That’s like saying “Guns don’t kill, it’s the intention to murder that kills.” Yes, the Fed’s desire to push rates higher was the real problem, but IOR was the tool to make it happen. Their only tool, given that they were committed to QE for other reasons.

    Bill, The QE in 2008 was done to rescue the banking system from a liquidity crisis. The IOR was to prevent that action from easing monetary policy.

    David, You said:

    “but that would have the effect of driving down interest rates, not propping them up.”

    Which is exactly my point.

  52. Gravatar of Ray Lopez Ray Lopez
    13. September 2015 at 07:37

    Benoit Essiambre – your farming analogy is wrong on so many levels I don’t know where to start: “Say you had an isolated farming village where people wanted to save to be able to eat in the winter. Because there is some spoilage, crops stored for the winter are only worth 90% of the initial investment required to produce them, that is they have a real return of -10%” – wow. You are saying that essentially the farming is not profitable and should not be done (though that’s not what you mean to say). FYI, crop losses even in western, modern countries are about 33% (from farm to table) and in the communist countries collectives ran as high as 90%. But always the ‘worth’ of the crops that made it to the market were always greater than the initial investment, otherwise nobody would grow them (unless they were slave laborers forced to grow).

    If your analogy is taken literally, what you should do is take the depreciated (98%) money and buy crops imported from another country, and not try to raise crops where you are going to lose -10%/yr (though that’s not what you mean I know).

    @ David de los Angeles Buendia – lol, now I know there’s a Los Angeles in Chile, thanks. BTW I just found out that Chile did not privatize their copper mines even when Pinochet took power–thanks to Tyler Cowen’s post today–amazing fact. You’d have thought the Chicago Boys would have pushed privitization. Your point about the Bank of England is good. The BofE often ‘goes against the market’ as George Soros found and profited from. But it cannot ‘lean against the wind’ for long (as China and Japan also find). While these central banks manipulate Fx and/or interest rates, the net effect (says Bernanke et al 2003 FAVAR paper) is about 3.2% to 95% confidence. That’s close enough to “money neutrality” for me. In short, the Fed / central banks largely follow the market, and when they try and steer the market or fight the market they often lose. Even and especially when a ‘peg’ is involved, like with Argentina or China or Switzerland or UK in 1992, eventually the peg is broken.

    Long story short: all evidence points to money neutrality. Even in Brazil with high-teens inflation, the drag on the economy was negligible say most experts (Calomiris book estimates it at 5%/yr, nominal, and yet Brazil grew robustly, see: http://www.tradingeconomics.com/brazil/gdp) The converse is also true: inflation is non-existent in Switzerland, yet it also grew robustly since time immemorial. Money is neutral. That’s one reason I no longer fight Sumner, as I’ve concluded: (1) nobody will adopt NGDPLT anytime soon, and, (2) short of hyperinflation, targeting NGDP is not much different than targeting interest rates and/or a basket of commodities, and is largely moot, ineffective, and irrelevant. Waste of time to even discuss.

    @MF – 3.2% is nearly trivial, most reasonable people would agree, you excepted.

  53. Gravatar of Rod Everson Rod Everson
    13. September 2015 at 08:10

    Shaye Cooke, you asked:

    My question is, since when does the Fed have “financing costs”?

    If I remember correctly, the U.S. Federal Reserve Bank has statutory authority to “print money” at any time, so why would it ever be in a situation of having to assume debt (short-term or long-term) to support its mandates, its activities or the relative merits of its balance sheet?

    Shayne, you’re right about the Fed’s statutory authority to print money. In my blog post I described that under the heading “The Fed’s Perfect Carry Trade, Established by Law”. The problem is that the Fed’s experimentation with Quantitative Easing (QE) has created those $2.5 trillion of excess reserves in the banking system. It will be impossible for the Fed to raise the federal funds rate unless those reserves are somehow neutralized. Otherwise, as soon as the funds rate sticks its bid a bit above the Interest Rate On Reserves (IROR), a funds trader loaded down with excess reserves will hit it.

    The Fed has created a situation, which I describe in the section headed “The Largest, Highest-Risk, Carry Trade of All Time”, where they can’t hold the fed funds rate above zero without employing the IROR. That’s why they set it at 25 basis points. Note that funds have not traded above .25% since that action was taken. And they will not trade near .50% until the IROR is raised another 25 bp either. So, effectively, the Fed has “borrowed” $2.5 trillion from the banking system which it is using to partially fund a $4.5 trillion long-bond/mortgage bond portfolio.

    Should we enter a time of rapidly escalating inflation the Fed, in trying to raise the funds rate, will find it necessary to rapidly raise the IOR rate. They will then be in the classic situation of a positive carry trade gone wrong, where both ends of the trade start losing money, and on a several trillion dollar trade, the numbers would be eye popping should that happen. It might not, but the Fed has relinquished all control over whether or not it does happen, in my opinion.

    Going to try creating a link here…might not work out as intended:

    Positive Carry Trades Often End Badly

  54. Gravatar of Benoit Essiambre Benoit Essiambre
    13. September 2015 at 08:34

    No no Ray. I said isolated village. There are no export or imports (or they are too far to be worth the cost of shipping).

    Farmers can keep their cash or invest in a crop for the winter but spoilage will make this crop be worth about 90% of the money used to produce it (if prices were to stay about constant).

    This is an unimportant detail but yes spoilage could be over 50%. Normally, a crop’s value would be significantly more than the cost of production. For example, at harvest time, maybe 180% of the initial investment (80% return on investment) but then spoilage eats into it over time and in the winter you loose 50% and you are left with something worth 90% your initial investment (-10% return).

    What should be done? Think about it.

  55. Gravatar of Rod Everson Rod Everson
    13. September 2015 at 08:36

    Bill wrote: “I’m confused. Paying IOR is contractionary. QE is expansionary. Why do both?

    Quantitative Easing was expansionary in two ways. First, it directly lowered rates on the long end of the yield curve and in doing so also drove other asset prices higher as investors cashed in their bonds and sought alternative places for their money.

    Second, in doing the QE the Fed directly injected $2.5 trillion into the U.S. economy, financing it by effectively “borrowing” that amount from the banking system in the form of newly-created excess reserves. This should have been far more effective than the traditional Keynesian approach of having the government itself borrow from taxpayers and spread around via the budget process because the Fed can actually create new money when it increases excess reserves.

    So, the QE’s were strictly intended to be expansionary, but they had a side effect, or rather running excess reserves over as little a even $1 billion had a side effect, that being that, left to themselves, the excess would drive the funds rate to zero, or even slightly below zero because a fed funds trader earning nothing on his excess position would hit any bid much above zero.

    At first the Fed set the Interest Rate on Reserves (IROR) at well below the trading level of fed funds. What they soon found is that the IOR rate on the excess portion quickly became the ceiling on the fed funds rate. That led to them setting it a a measly 25 basis points so that fed funds would trade in a slightly positive range, but always under .25%.

    To David: The banks don’t move excess reserves to the Fed when earn interest on them. Excess reserves are strictly a bookkeeping entity. The Fed, as a bank, has $2.5 trillion of them on deposit from the banking system, and the banking system in aggregate has a $2.5 trillion asset in the form of an excess reserve balance at the Fed. If the Fed does nothing, that excess will just move from bank to bank at the banks’ will as they trade funds from day to day and as customers move deposits from bank to bank while doing routine transactions.

    So, when the Fed decided to pay IOR of 25 basis points, it just pays it to the banks of record holding various amounts of the excess position. The reserve position varies among banks themselves, not between the Fed and the banking system, unless, of course, the Fed does an open market operation or another QE (which is effectively just an open market operation.)

  56. Gravatar of Rod Everson Rod Everson
    13. September 2015 at 08:52

    Scott, you wrote: “And actually I think the US economy probably would crash if the Fed raised rates to 2% by yearend (obviously unless they did so with an easier money policy.)”

    Actually I think that the economy would benefit because savers would start to earn a return on their savings once again. Granted, some asset markets would likely suffer in the bargain. I also think that action could possibly trigger the easier money policy implicit in the massive excess reserve position and that the Fed could have a very difficult time getting things back under control since they’ve essentially rendered their normal monetary tools useless with the QE’s.

    More on that here:

    Has the Fed Made Itself Irrelevant?

  57. Gravatar of Vaidas Urba Vaidas Urba
    13. September 2015 at 09:41

    Scott:
    “Yes, the Fed’s desire to push rates higher was the real problem, but IOR was the tool to make it happen. Their only tool, given that they were committed to QE for other reasons.”

    No, they had other tools to do the same – they could continue using Treasury supplementary financing account as they did before October 8, 2008, and they had an alternative of exiting QE much earlier and/or doing much less QE.

  58. Gravatar of Ray Lopez Ray Lopez
    13. September 2015 at 11:42

    @Benoit Essiambre – your farming example makes no sense. You are saying an activity is not profitable, yet vital for survival. This is like assuming a rock so heavy not even God who created it could lift it… 0/0 = nonsense.

    By definition, even with 99% spoilage, if food production was vital there would be a price at which it would become profitable, and the food would sell at this price. It’s impossible to have negative profitability ‘built into’ a vital activity.

    Analogy for you to consider: a closed lifeboat where some survivor has figured out how to coax fish to swim to their hands. Nobody else can do this feat and everybody is starving for food. Also this person can pee nearly pure water and has a very active bladder. Think about it: do you think this lifeboat passenger will be the first thrown off the lifeboat? No, even if they’re a ‘loser’ in social status. Their price would go up, just like the price of your spoiled food (no way would it sell for a loss).

    Hence, you cannot have -10% profitability (i.e., unprofitable returns) on a vital activity like food production in a closed economy.

    What you’re trying to say (I think) is this: suppose sticky prices, money illusion, money non-neutrality and incipient deflation. Should the central bank, which has a monopoly of fiat money production, inflate or deflate the money supply? Under these assumptions (sticky prices, money illusion, and, somewhat redundantly, money non-neutrality) then inflation of money supply is indeed better than money deflation. But that’s assuming the answer based on unproven priors. Goodnight, time for bed (3:40 AM PH time).

  59. Gravatar of Major.Freedom Major.Freedom
    13. September 2015 at 12:09

    Ray,

    “Under these assumptions (sticky prices, money illusion, and, somewhat redundantly, money non-neutrality) then inflation of money supply is indeed better than money deflation.”

    That is totally false, and is THE reason why you keep making the absurd claim that money is neutral.

    You have this false belief that money non-neutrality implies inflation is better than deflation.

    The truth is that money non-neutrality does not imply that inflation is better than deflation, nor does it imply that deflation is better than inflation.

    In a market guided by individual preferences, the truth is that both inflation and deflation are implied as consistent with optimal allocation of resources.

    The key is that only by market activity can anyone know whether inflation is better than deflation or whether deflation is better than inflation, or neither is better than the other, over a given period of time.

    Money non-neutrality is actually consistent with the possibility that inflation is worse, much worse, than deflation, depending on the circumstances, which again we can’t know in the absence of market activity and signals.

    Money changes in the abstract can actually adversely affect the real economy, if those changes are not market driven. That is why inflation is a bad thing. It is because the non-neutrality of money, which should be affecting the economy in a positive way, is not doing so because money is not market driven.

    Market driven money positively affects the real economy because it punishes suboptimal allocations of resources, INCLUDING in money production itself. And any individual can take only so much punishment before they have to change their ways.

  60. Gravatar of Catherine Catherine
    13. September 2015 at 14:25

    Synchronicity: I looked up that exact passage **today,** without having seen this post.

  61. Gravatar of Benoit Essiambre Benoit Essiambre
    13. September 2015 at 16:10

    Ray what part of my example doesn’t make sense? It’s a pretty simple example. Read it again.

    The key thing to understand is that in the real world, storing value for later can have a cost. Even if producing a crop has a positive return initially, it doesn’t necessarily keep this worth forever.

    This just reflects the laws of thermodynamics that tell us that everything tends to decay without a constant supply of work and energy. In general, most things require maintenance to keep their worth.

    The 20th century was probably the most notable exception. Because of unprecedented demographic and technological growth, positive risk free real returns were easy to find. The recency effect probably explains some of the confusion people have about this. It is possible that under favorable conditions, wealth can have positive returns and even compound into very good long run returns but it is not a guarantee and there is nothing natural about it. It may not continue forever.

    A large cohort of people retiring can result in something like the farming example. It is a situation where there is a disconnect between when people can work and when they want to consume. This means higher demand for things that can safely carry value into the future, things that can be built now but are useful for a long time. But sometimes these things lose value with time.

    If the marginal safe store of value loses more than 2% a year but cash doesn’t, cash acts as a subsidy against producing these stores of value necessary to maintain future consumption. People, businesses and banks accumulate pieces of paper instead. Unfortunately, unless people want to eat paper when they retire, on the aggregate, this form of saving is an illusion. The only way idle excess cash can provide value in the future is from redistribution of value created by others. The value is either going to come out of other people’s investments, from devaluation of other assets through future tight money, or from higher taxes or it will simply evaporate through inflation.

    Savings have to be tied to an increase in future production or to storage of goods to be worth something. Idle excess fiat isn’t.

    Again, the only way to efficiently allow a large cohort to stop working and continue consumption is to invest in things that help to maintain production later with less labor. The risk adjusted real market rate of return for these things can sometimes be considerably negative over time.

  62. Gravatar of Ray Lopez Ray Lopez
    13. September 2015 at 20:04

    @Benoit – “The key thing to understand is that in the real world, storing value for later can have a cost. Even if producing a crop has a positive return initially, it doesn’t necessarily keep this worth forever.” – so what? The final value must exceed the initial cost minus all expenses, including storage, or the goods are worthless and will be scrapped. It has nothing to do with the money supply. Whether a society uses gold or fiat money makes no difference to this calculation. Get your head around this concept and the scales will fall from your eyes.

    “Savings have to be tied to an increase in future production or to storage of goods to be worth something. Idle excess fiat isn’t.” – there’s no such thing as “excess fiat”, which is the source of your confusion. You are essentially making the same mistake as Marx did, who thought that capital (money, among other things) had no value, only labor did.

    @MF – I doubt what you’re saying is true. In any event, I believe money is in fact largely neutral (and the evidence supports this) so it’s a moot point.

  63. Gravatar of Ray Lopez Ray Lopez
    13. September 2015 at 20:07

    @myself – of course I’m saying marginal revenue must be greater than or equal to marginal cost, or the goods are not worth producing and whatever goods are produced will be scrapped at the marginal cost value. That’s one reason expensive yachts are sunk / scrapped, as any seaman knows, once the monthly maintenance bill becomes greater than any utility (including enjoyment) the yachtsman gets from owning the yacht. Fiat money or gold coins don’t change this calculation.

  64. Gravatar of Christian List Christian List
    13. September 2015 at 20:14

    @Ray Lopez
    What do you even mean by saying “money is neutral”

    There are many defintions out there. Maybe you could explain what you actually mean by that then we can agree or disagree.

  65. Gravatar of Benoit Essiambre Benoit Essiambre
    14. September 2015 at 03:34

    Ray,
    “so what? The final value must exceed the initial cost minus all expenses, including storage, or the goods are worthless and will be scrapped. Get your head around this concept and the scales will fall from your eyes.”

    Why would you take that as an axiom when I showed you it can lead to situations where whole societies have cash but starve because there is no food to buy? You think that is an optimal outcome?!

    Well anyways I tried. I guess some people are just impervious to logic.

  66. Gravatar of E. Harding E. Harding
    14. September 2015 at 05:15

    @ssumner
    DeLong said he had always assumed the Fed wanted to prevent big collapses in NGDP, and was shocked to discover otherwise.

    -Didn’t DeLong think monetary policy was impotent in January 2009? His beliefs were close to those of Krugman.

  67. Gravatar of ssumner ssumner
    14. September 2015 at 05:19

    Rod, The only ways to raise rates to 2% would be to either get rid of the ERs, or sterilize them with higher IOR.

    Vaidas, I doubt those other methods would have worked. They Fed also seemed skeptical, which is why they asked for IOR. But it’s a moot point, as IOR is the actual contractionary policy tool they chose. Even if another policy option were available, it doesn’t change the fact that IOR was used. You don’t say gun shots don’t matter just because the killer could have used a knife. The bullet is what did the damage.

  68. Gravatar of ssumner ssumner
    14. September 2015 at 05:20

    E. Harding, Yes, but perhaps later he changed his mind.

  69. Gravatar of Rod Everson Rod Everson
    14. September 2015 at 06:35

    ssumner: “Rod, The only ways to raise rates to 2% would be to either get rid of the ERs (Excess Reserves), or sterilize them with higher IOR.

    Obviously. And given the bath they would take on their portfolio of long bonds if they decided to raise rates to 2% by year end, I think they would take the route of raising the Interest on Reserves (IOR). That move would cost them about $50 billion per year which I suspect is a consideration, especially since such an action would also probably do some severe damage to the value of their sizable portfolio of long maturity assets.

    The Fed’s Massive Conflict of Interest

    On the other hand, the positive effect it would have on the substantial savings of retirees might just be what it takes to get the economy out of the doldrums. We keep trying low interest rates, as do other countries, without much effect. Maybe it’s time to try a different approach? Do you really thing a 2% short rate would grind the economy to a halt on its own? For myself, I seriously doubt that it would. In fact, it could prove stimulative.

  70. Gravatar of Ray Lopez Ray Lopez
    14. September 2015 at 08:08

    @Benoit – “Why would you take that as an axiom when I showed you it can lead to situations where whole societies have cash but starve because there is no food to buy?” – lol. Not in recorded history has this happened, except in war with say a blockade (as in Athens, in WWII) but in your fantasy world it happens and you believe it’s a universal truth? Logic is not your forte my friend…

    @Christian List – please educate us by the different types of money neutrality. I generally see only one kind, that effecting real interest rates and involving either neutrality or super-neutrality.

  71. Gravatar of ssumner ssumner
    15. September 2015 at 17:00

    Rod, You can seriously argue that tighter money makes the economy grow faster? Didn’t the ECB try that in 2011?

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