Friday, April 24, 2009

On Reserve

Why is Ben Bernanke paying banks to push money under mattresses (i.e. keep it on reserve at the Federal Reserve)? That is the question that Hall and Woodward ask. By paying interest on the reserves on deposit at the Federal Reserve at the same time that the economy enters what appears to be a deflationary cycle, Bernanke is encouraging banks to essentially remove money from the working money supply and place it under a (virtual) mattress where it is absolutely of no use insofar as fostering economic activity.

Let us not forget that the only purpose of money is to foster economic transactions. Money in and of itself has no intrinsic value -- it's just funny-shaped pieces of toilet paper with pictures of dead people on it. It's what you can buy with money that has value, not the money itself. Money on reserve in a bank vault effectively does not exist as far as the economy is concerned. So why is Bernanke encouraging banks to essentially remove money from the money supply?

My theory: Bernanke is a follower of Milton Friedman monetarism. Friedman focused upon money volume, not money velocity, and believed that simply increasing the base money supply was sufficient to prevent deflation (his famous "helicopter drop" speech). Bernanke believes that he is increasing the money supply by printing money to pay this interest on the Fed deposits, and thus performing his duty as a central banker. The problem is that it simply is not working. Instead it is encouraging banks to take money out of the money supply and stuff it under a (virtual) mattress at the Federal Reserve -- exactly the opposite of what should be done during a deflationary cycle.

What's the first thing to be done? First of all, the Fed needs to quit paying interest on reserves. Paying interest on reserves creates a perverse incentive to put money on deposit at the Fed rather than put it into the economy. This would at least unlock lending for consumers and businesses who are solvent, though the core solvency issue underlying our economy -- the sheer numbers of consumers and businesses that are effectively insolvent -- still remains, meaning that it's unlikely that this would reduce bank reserves more than a few percent.

So how to encourage more movement of bank reserves out of the Fed vaults? Hall and Woodward suggest negative interest rates to actually discourage banks from holding money on reserve at the Federal Reserve and encourage them to instead put their money either into loans or into something a little less risky than loans such as Treasuries, where at least it makes it into the economy rather than sitting under a mattress. Greg Manikiw, on the other hand, is skeptical. Manikiw believes that banks, lacking any safe alternative to keeping their excess reserves on deposit at the Federal Reserve, will simply start offering negative interest rates on deposits (i.e., charge you to keep money in their vaults), at which point all that happens is that instead of the money being under a (virtual) mattress at the Federal Reserve, it instead gets withdrawn from banks and shoved under real mattresses. And frankly, given the core solvency problem, I'm not so sure Manikiw is wrong about the effects of charging negative interest rates on bank deposits at the Federal Reserve.

So to reiterate: Bernanke needs to at least quit with this nonsense of paying banks to withdraw money from the money supply. That's the last thing you want in a deflationary cycle. Return the Fed interest rate on reserves back to zero, and get as much of that money as is possible back into the economy (which, as I've previously pointed out, needs roughly a 2% rate of inflation to encourage money to circulate rather than sit under mattresses). Beyond that there is no magic bullet, but at least Bernanke can quit throwing gasoline on the deflationary fire...

-- Badtux the Monetary Penguin


  1. You still haven't read "The Shock Doctrine" or you might be more alarmed at what the Milton Friedmanites actually pulled off in other countries with the neoliberal economic policies they shoved down government's throats in order to borrow money.

    The Bush administration was alarmed when Latin America told the IMF and the World Bank to go fuck itself.


  2. sorry, I meant

    neoliberal economic policies they shoved down government's throats in order allow them to borrow money.

  3. Nunya, Tux isn't as conspiracy-minded as those of us on the Left. But I'm with you on this one -- everything that's happened in the Bush Reign of Error makes sense if you look at it through a "Shock octrine" lens. (And Clinton helped the corporate agenda along too, in a back-slapping, good ol' boy way.)

    I recall that one of the ostensible reasons for paying interest of FedRes reserves is because banks were whingeing "Oh, it's so unfair that you make us keep money in our vaults and don't pay us anything for doing that." I also think that paying interest on reserves is one of the ways Bernanke thinks he will soak up the excess money he's created by trying to reflate the bubble, once the economy has recovered. As if he could get that right, after getting so much else wrong.

    But ultimately, it's a mystery. There is so much to learn about these subjects -- like the quantum physics of money. That's why I read your Econ posts and the links (plus lots of other stuff -- I'm getting into a site called "The Automatic Earth" lately that would interest you, Nunz.) I want to know what's at the core of what's happening.

    And unlike you, Tux, who sees benign management at work, I see evil. Evil that's far evilly-er than Microsoft's brand...

  4. The problem, Bukko, is that deflation hurts the financial industry a whole lot more than it hurts anybody else because it renders the financial industry insolvent. Bankers fear deflation even more than they fear hyperinflation -- both end up driving money out of banks and thus collapsing them. So I cannot see the notion of "evil bankers deliberately deflating the currency" as being credible. On the other hand, "idiot ideologues acting based on ideology rather than on reality" is a different tale...

    - Badtux the Reality-based Penguin

  5. "evil bankers deliberately deflating the currency"I don't know where that phrase came from, Tux. While I subscribe to the premise that bankers are eeeeevil -- at least the ones at the tippy top like Paulson -- I don't think they would deliberately deflate. While that DOES put them in a stronger position, via the increased power they have over debtors, ultimately those debtors will default, and both sides are screwed.

    So my conspiracy mindset does not subscribe to intentional deflation. I think banksters prefer blowing bubbles, because they supply the raw material that makes a bubble -- creditcash. There's more profit to be made in an expansion than in a contraction.

    Here's where my tinfoil hat might differ from yours, though. I reckon that the financial power structure -- the banksters, hedgies, politicians who favour them and others in the money-spinning complex -- is nimble and reactive. They've got schemes to make money on the way up, and on the way down too. Devices like options to short your own company's stock, or the investment vehicles you sell.

    I'm not so far gone as to think that there are Illuminati, Bilderbergers or Davosians meeting in a room somewhere to map this all out. Managing grand conspiracies is like getting cats to cooperate. I DO think that there's a shifting cast of characters who can operate with inside knowledge, because they control the political and financial decisions, and they know how to make money with that.

    Little by little, as Klein points out in her book, these elites gain more control over society. Especially the financial elites, because money is the lubricant that keeps the gears of the economy from seizing up. And they control the money.

    Every so often, there is a disruption in the elites' mechanics -- a French Revolution, or Bolshevik takeover, or Mao in 1949. The system gets scrambled, and rebooted. It's a bad thing for all concerned, because blood is shed and peasants starve. The primitive populist in me says "Good-o, because the rich people get knocked back too!" But at the worldwide level things are unfolding now, with the enormous power of destruction at mankind's fingertips, a massive economic reboot might be the end of organised civilisation. That would be a bad thing. It would be nice if we could work things out for the benefit of all people, not just the elites.

    However, if a lot of rich peoples' heads wind up on pikes too, it won't be all bad. So I figure it's a win either way.


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