To end a drought, have everyone carry umbrellas

Michael Darda sent me the following email:

Ronald McKinnon in the WSJ today offers a good (sad?) example of how economists mix up cause and effect and give disastrous policy advise as a consequence. Yes, low rates are associated with weak growth, but it doesn’t stand to reason that they therefore are the cause of it. Moreover, if equilibrium rates are low, raising rates prematurely is quite unlikely to “spur faster growth” and would simply serve to depress the business cycle. Assuming the Fed both raised the IOER/Fed funds and kept QE going at its current pace, we would likely have a step up in money/safe asset demand relative to current and expected money supply (thus a further decline in velocity) and slower NGDP. Apparently McKinnon isn’t familiar with the ECB’s two rate hikes in 2011, which produced a two year double dip recession. Or Japan’s premature attempt to exit the ZLB in 2000 and 2006, which slowed NGDP and thus failed. Or the Fed’s error in 1937, which also precipitated recession and thus necessitated an even longer period of near zero short rates. On an A to F scale, this was an F.

Here is the WSJ story that Michael was commenting on:

Yet there is no doubt that the U.S. needs to break out of its near-zero interest-rate trap in order to avoid perpetual stagnation, where real returns on new investments are also driven toward zero. But is there an efficient way out of the trap that the Fed has set for itself? I believe there is.

The Fed can start by raising short-term interest rates, currently near zero, while leaving QE3 on hold.

Update:  Yikes, I had a nagging feeling I was plagiarizing someone.  (Andy Harless)



12 Responses to “To end a drought, have everyone carry umbrellas”

  1. Gravatar of Yichuan Wang Yichuan Wang
    28. October 2013 at 07:01

    I personally do like thinking about monetary policy in terms of interest rates, but this article really shows by thinking in terms of M can leave you making fewer fallacies. Just think how ludicrous MacKinnon’s article sounds if you say “to expand bank lending, the Fed should contract the money supply”

  2. Gravatar of Andy Harless Andy Harless
    28. October 2013 at 07:07


  3. Gravatar of ssumner ssumner
    28. October 2013 at 07:18

    Yichuan, Yes, and he also assumes the balance sheet stays large, so he’s really talking about higher IOR, which increases the demand for base money. He’s saying we should do what the Fed did in 1937 when they raised reserve requirements. Not clear how higher IOR encourages banks to lend more.

    PS. IOR is the only interest rate that can fairly be called “monetary policy.”

    Andy, Thanks I added an update.

  4. Gravatar of Nick Nick
    28. October 2013 at 07:23

    Putting aside the questionable timing of the tightening recommended in the op ed piece, would raising rates before/instead of dumping securities be a better way to tighten when the need arises?

  5. Gravatar of flow5 flow5
    28. October 2013 at 07:40

    QE in conjunction with the payment of interest on excess reserve balances is a misnomer. QE has backfired. QE doesn’t stand for quantitative easing, QE stands for quantitative excuses.

    Bankrupt you Bernanke doesn’t know the difference between money & liquid assets.

    QE has destroyed the non-banks (shadow banks). Whereas always prior to the payment of interest on reserve balances (between 1942 & 2008 when the CBs were fully lent up), the CBs bought “specials” from non-banks (the non-bank public includes every institution, the U.S. Treasury, the U.S. Government, State, & other governmental jurisdictions, & every person, except the commercial & the Reserve banks). In the past this resulted in the creation of new money & credit.

    After the payment of interest on reserves (& with a remuneration rate that exceeds the short-end segment of the wholesale funding market, i.e., an inverted yield curve), the banks are now paid not to lend.

    I.e., QE proceeded pari passu with the growth of excess reserves & not the money stock. Prior to paying interest on reserves, the CBs minimized their non-earning assets. But now the CBs are paid to hold idle & unused balances (but are remunerated by the public’s purse to do so).

    Open market operations should be divided into 2 separate classes (#1) purchases from & sales to, the commercial banks; & (#2) purchases from, & sales to, others than banks:

    (#1) Transactions between the Reserve banks & the commercial banks directly affect the volume of bank reserves without bringing about any change in the money supply. The “trading desk” “credits the account of the clearing bank used by the primary dealer from whom the security is purchased”. This alteration in the assets of the commercial banks (the banks’ IOeRs), increases – by exactly the amount the PD’s government securities portfolio was decreased.

    (#2) Purchases & sales between the Reserve banks & non-bank investors directly affect both bank reserves & the money supply.

    The CBs need at least a 3% net interest margin to make money. But Bankrupt you Bernanke has flattened the yield curve thru his QE operations, read: LSAPs (esp. with operation twists 1 & 2).


    The FED will fail mirserably. Unless money flows exceed the rate-of-change in real-output by 2-3 percentage points, output can’t be sold, production will be cut back, & jobs will be lost. Combine the lost output (potential gDp) with the need to constantly roll over Treasury debt implies an unmitigated disaster.

    The solution is to get the CBs out of the savings business.

    And the FED’s new repo facility has the potential to force a cumulative & reinforcing contraction in the money stock. Whereas in the past the primary dealers were all commercial banks, with the new counterparites (read GSEs), the FED’s new capacity to drain liquidity is unparalleled.

  6. Gravatar of flow5 flow5
    28. October 2013 at 07:45

    Interbank demand deposits (IBDDs’s) are now commercial bank earning assets – defined by economists to be outside-of-the properties normally assigned to the money aggregates. I.e., IBDD’s are not a medium of exchange. They do not circulate outside of the inter-bank market. They do not require Basel II regulatory capital. They are not subject to reserve requirements.

    However, a CB needs clearing balances to lend (e.g., excess reserves). And whereas an individual bank lends its excess reserve balances; from the standpoint of the entire system, lending & investing merely results in the endogenous shifting (redistribution) of IBDDs. I.e., money creation is a function of the circular velocity of deposits (not their volume).

    Money creation isn’t ex nihilo per se. An individual bank is limited in the volume of deposits it can create by an amount up to approximately equal to its excess reserve position (& of course, adequate bank capital ratios, which if insufficient, counteracts the increase in the money stock by the amount of bank capital required; note: an increase in bank capital destroys an equivalent amount of bank depoists, ceteris paribus), or for non-bound banks, their prudential reserve position (i.e., unused lending & investment capacity).

    When a CB buys bonds from the non-bank sector, reserves are either re-deposited or shifted/re-shuffled to other commercial banks within the commercial banking system, but in either case, both reserve velocity, & the transactions velocity of money – increase.

    Note, only if the individual CB is “e-bound”, then these transactions can be summarized by crediting excess reserves & debiting required reserves, leaving the total (system) reserve’s balances unchanged. Otherwise, with 85% of all reserves being satisfying using the CB’s vault cash, the system itself isn’t bound by reserve requirements.

  7. Gravatar of flow5 flow5
    28. October 2013 at 07:50

    The commercial banks (CBs) are credit creators. The non-banks (NBs), or shadow banks, are credit transmitters. Lending & investing by the CBs is inflationary. But lending & investing by the NBs is non-inflationary – ceteris paribus (matching voluntary monetary savings with real & financial investment). Viz., for those accounting aficionados, with respect to the commercial banking system, the whole is not the sum of its parts.

    Commercial bank lending/investing expands both the volume & the velocity of CB system bank deposits (where S does not equal I). Whereas lending/investing by the non-banks increases the velocity of CB system bank deposits (matching: S = I).

    Fractional reserve banking, the modus operandi of commercial banking (or the creation of new money & credit), is a function of the velocity of the banking system’s deposits (not the volume of their deposit liabilities).

    Never are the CBs intermediaries (conduits between savers & borrowers), in the savings-investment process. From the context of the system, CBs, as contrasted to financial intermediaries: never loan out, & can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits, or time/savings deposits, or the owner’s equity, or any liability item (the CBs collectively, simply pay for what they already own).

    The lending capacity of the CBs is determined by domestic monetary policy objectives, & not by the savings practices of the public. The CBs could continue to lend even if the non-bank public ceased to save altogether. I.e., with very minor exceptions, the source of all time/savings deposits to the CB system is other CB system held customer bank deposits (directly via the CB’s undivided profits accounts, or indirectly, albeit temporarily, via the currency route).

    Whether the non-bank public saves, dis-saves, or chooses to hold its voluntary savings in the CBs, or to invest them directly, or indirectly, through the NBs, etc., (viz., the use or non-use of savings), does not determine the lending capacity of the CBs.

    Monetary savings are not put to work (do not change ownership,) until they are spent or invested. The non-banks (e.g., investment banks – but not bank holding companies), find investment outlets for the voluntary savings which are transferred thru them by their owners. With the non-banks, investment follows savings. Savings transferred thru these intermediaries activates (finds an outlet for), existing money or voluntary savings.

    I.e., monetary savings are impounded within the CBs (they are lost to any type of investment or expenditure), & unspent savings represent a leakage (non-use), in Keynesian National Income Accounting.

    If savings do not exchange hands (are a leakage), they exert a dampening, contractionary, or net deflationary impact on prices, production, employment, incomes, & in consumer & business confidence.

    Allowing the CBs to buy their liquidity (liability management), as opposed to following the old fashioned practice of storing their liquidity, redistributes the excess reserves (& the money stock), within the CB system (but does not alter their total volume – unless currency is hoarded).

    Net changes in Reserve Bank Credit since the Treasury-Reserve Accord of March 1951 are determined by monetary policy objectives. Paying interest to capture deposits (or giving away toasters), is virtually tantamount to redlining or redistricting (monopolistic price practices by the oligarchs). Laissez faire economics obviously does not apply (e.g., Greenspan’s signature TBTF endorsement).

    Bankrupt you Bernanke’s “IOeR policy” allows the CBs to out bid the NBs (the true intermediaries between savers & borrowers), for both loan-funds & collateral. I.e., virtually all the FRB-NY’s LSAPs purchases (QE operations), were transacted with the CBs (as evidenced by excess reserves growing pari passu with POMOs – & not the money stock – i.e, required reserves did not expand commensurately).

    With all the FRB-NY’s “trading desk” counterparties, or primary dealers (PDs), being CBs; this should come as no surprise. Thus, the CBs (because of the .25% remuneration rate exceeded all money market rates), forced a contraction in the size of the NBs, & created liquidity problems in the process, by outbidding the NBs for the non-bank public’s voluntary savings (wholesale money-market funding is differentiated by it’s position on the short-end segment of the yield curve), in the borrow-short to lend-long business-model. I.e., Bankrupt you Bernanke destroyed NB lending/investing (destroyed the financial intermediaries. I.e., the CBs are paid not to lend/invest by our Federal Gov’t (read: the public’s purse).

    This process is called “dis-intermediation” (an economist’s word for going broke). The reverse of this operation cannot exist. Transferring saved deposits through the NBs cannot reduce the size of the CB system. Deposits are simply transferred from the saver, to the NB, to the borrower, etc.

    I.e., CB liabilities are simultaneously monetarily liquid for its customers as a whole (principally because the liquidity of the CBs (esp. during the Great Recession) was backstopped by several credit & liquidity programs (specialized discount windows); & partly because of the circuit velocity of deposits within the commercial banking (payment & settlement), system.

    Bankrupt you Bernanke’s “IOeR policy” induced dis-intermediation within the NBs (where the size of the NBs have shrunk (c. -$6 billion), but the size of the commercial banking (CB) system remains unaffected (c. + $3.6 billion)). I.e., the FOMC must offset the decline in lending/investing by the NBs (follow an easier monetary policy), by forcing the CBs to invest in Treasury’s (as opposed to perhaps hedging with stop-loss credit default swap insurance).

    This is exactly the same paradigm as the 1966 S&L crisis where the CBs out bid the thrifts (i.e., where an increase in Reg Q ceilings exclusively for the benefit of the CBs was actually a tax on the CB system’s earnings – because the NBs had no ceilings whatsoever prior to 1966, i.e., the NBs were unregulated – not deregulated)).

    The CBs pay for what they already own (interest on their customer’s savings). All studies show that the lower the ratio of time (savings deposits) to demand deposits (within the member CB system), the higher the ratio of profits to the net worth of banks, irrespective of the size of the bank.

    Keynes’ perversion (“optical illusion), is that savings flowing through the NBs never leaves the CB system (as anybody who has applied double-entry bookkeeping on a national scale knows). The implicit & false idea is that the NBs compete with the CBs for savings. The NBs are the CB’s customers.

    To wit: (1) “These measures should help the banking sector attract liquid funds in competition with non-bank institutions & direct market investments by businesses” [sic] – Testimony of Treasury in response to the Financial Services Regulatory Relief Act of 2006 (the Emergency Economic Stabilization Act of 2008 accelerated these provisions).

    It is the NB’s outflow of funds, or negative cash flow, which forced the Fed to intervene (via $700b TARP, a tsunami of stock purchases despite the 1929 precedent, the multiple expansion of the FRB’s balance sheet, zero maturity money, the Faustian put’s squared of interest rate transmission targets, the $6t conservatureship of Freddie Mac & Fannie Mae, ZIRP,& food stamps, disability claims, & indeed the welfare state, along with enabling the “faux prosperity” of FIRE, investment bank casinos, AIG’s zero sum game, etc.), & thus counteract the recessionary current in the economy. I.e., the welfare of the CBs is dependent upon the welfare of the NBs (where S=I).

    Whereas dis-intermediation (not de-leveraging per se), for the CBs has not been predicated on interest rates ever since 1933, dis-intermediation for the NBs is almost exclusively dependent on the flow of voluntary savings placed at their disposal. The 1990 S&L crisis was precipitated largely because deposit ceilings were deregulated before the NBs longer term assets (read mortgages), could be restructured (i.e., on top of the foray of excessive housing speculation). See also: Barron’s May 22, 1978 “One Crunch Too Many”.

    And any time the Fed follows a contractionary monetary policy [where the rate-of-change (roc), in money flows (MVt), is less than 2-3 percent relative to the roc in real-output], output can’t be sold, hiring is curtailed, & jobs will be lost (i.e., there is not sufficient upward & downward price flexibility within our domestic economy).
    E.g., (2) both Vasco Curdia & Michael Woodford claim the CBs are intermediaries between savers & borrowers (our impacted indoctrination). From a system’s viewpoint, when the commercial banks (DFIs), as contrasted to financial intermediaries (NBs), grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets by initially the creation of an equal volume of new money- demand deposits – somewhere in the banking system. I.e., commercial bank deposits are the result of lending, – & not the other way around.

    I.e., the Friedman rule (, & Keynes’s liquidity preference curve (demand for money) are both false doctrines.

    Bankrupt you Bernanke has done exactly the opposite of what William McChensey Martin Jr. did to correct the housing market in the 1966 S&L crisis.

    See: Dr. Leland James Pritchard (MS, statistics – Syracuse, Ph.D, Economics – Chicago, 1933) described stagflation 1958 Money & Banking Houghton Mifflin,

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

  8. Gravatar of Kevin Dick Kevin Dick
    28. October 2013 at 09:50

    Don’t feel like a plagiarist. The causal mixup between umbrellas and rain is really old. I encountered it in my intro to decision theory class in 1988. Even then, it was presented as if it were old hat.

  9. Gravatar of benjamin cole benjamin cole
    28. October 2013 at 16:26

    Raise interest to spur the economy…well, doctors used to apply leeches to patients with anemia…

  10. Gravatar of ssumner ssumner
    28. October 2013 at 16:58

    Nick, I’d like to see them get rid of the securities first. I never much liked the IOR/QE approach.

    Thanks Kevin.

    Ben, Good analogy.

  11. Gravatar of TallDave TallDave
    29. October 2013 at 10:33

    Interesting piece, thanks for sharing.

    I’m struck by how often that Milton Friedman piece about tight money eventually creating low nominal rates is relevant.

  12. Gravatar of Geoff Geoff
    29. October 2013 at 17:04

    Benjamin Cole:

    “Raise interest to spur the economy…well, doctors used to apply leeches to patients with anemia…”

    That’s what your advocacy of more inflation will result in, according to you!

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