Answers: Taking IOR to Zero

I want to thank all the commenters on my last post — at Angry Bear, at Asymptosis, and at Mike Norman’s blog. You’ve provided me with exactly the education I hoped to achieve. Here’s hoping others benefited similarly.

I asked: what would happen if the the Fed cut the interest rate on reserves from its current .25% to zero. I was not suggesting it should be done. I simply wanted to understand what would happen if that one variable changed.

I want to summarize the conclusions I’ve come to based on all the discussion.

This is me speaking, based on sifting and considering all the responses. I won’t link to all the excellent comments that brought me to this. (Though I do want to highlight the Angry Bear comment by Bad Tux beginning “At 0% IOR”. It arguably explains things better than I do here, and at significantly less length.)

First, the market monetarists responses. Scott Sumner said (in comments a while back on his blog, which I linked from my original post):

It could be slightly expansionary, or if accompanied by other moves, wildly expansionary.

I’m presuming he says “slightly expansionary” based on the theory Mark Thoma gives us in a November 17 post that Cameron was nice enough to link to on Angry Bear:

it would slightly lower the incentive for banks to hold cash rather than loaning it out, and more loans would help to spur the economy

So banks could lend a quarter point cheaper, or loosen their lending requirements slightly. Assuming there’s some decent amount of demand at lower rates (elasticity of demand is appreciably > 0), or that good borrowers are asking for loans but being turned down cause they’re too risky, this could have a small effect. Scott’s “other moves” presumably include NGDP level targeting by the Fed, but that’s all beyond the contained question I asked here.

James Oswald — who cites himself as a market monetarist but who seems to understand and adhere to much MMT thinking in his other comments and writings — said at Asymptosis:

There is no reason to think they [reserves] would not decrease back to the pre-IOR levels, at least over time, pushing around around 1.4 trillion dollars of high powered money into the economy and triggering significantly higher inflation.

This doesn’t seem to make any sense at all. (And I rather doubt that the Sumners and Beckworths of this world would agree with it.)

In (simplistic) theory, taking IOR nominally negative (the extreme case) would make banks want to instead hold physical currency, with its higher (zero) nominal return. Continuing the simplistic theory, that more-liquid money would be lent and spent more.


1. There are significant costs and management headaches associated with holding currency — trucks, warehouses, security guards, all that rot.

2. It’s completely unclear why banks holding warehouses full of currency would have any incentive effects on borrowing and lending — hence real-economy purchases/velocity. Lenders and real-economy borrowers do their thing because they see valuable risk/return opportunities in the real economy. Changing the form of banks’ holdings will not affect that real-economy reality. Recent history: the QE trades — giving banks reserves in return for bonds — doesn’t seem to have had such an effect, if the massive runup in excess reserves is any testament.

3. Explaining #2: For banks, currency is (see #1) less liquid than reserves. They’re not carrying it in their pockets so they can buy gum at the corner store. They want to make loans; are they going to make them in cash?

4. Even if they did make the move to currency:

A) They couldn’t all do it; there’s not enough currency around.

B) The effect would be to reduce the amount of currency “in circulation” (it’s stuffed under banks’ mattresses), presumably prompting exactly the opposite of what market monetarists suggest:

a. Less real-economy spending/circulation/velocity and

b. Deflation — dollar bills would be harder to come by, so they’d be more valuable relative to real goods

At least in the discussions I’ve been perusing, this “currency” theory of “pushing” “more-liquid” money into circulation doesn’t make any sense. At all.

Market monetarists do seem to at least loosely and implicitly adhere to the (questionable) theory that people and businesses spend more because they hold money in more-liquid form — and they might even confute bank’s incentives and behavior with people’s incentives and behavior at times — but still this currency thinking is probably not a good or widely held market-monetarist theory. In any case it deserves unequivocal debunking.

So: Numerous cogent and convincing commenters agree that taking IOR to zero would have negligible first-order effects on lending and spending. And (invoking authority here) Mark Thoma agrees, in the post cited above:

It probably wouldn’t do much

But – considering the practical, workaday effects on the financial system such as those depicted in the currency fantasy above — Thoma links to an article by Todd Keister from the NY Fed. In short, IOR of zero would break a whole lot of financial entities’ business models. The gang at Mike Norman’s blog point to the problems already facing primary dealers, which could be (greatly?) exacerbated by a drop to zero. StreetEye on Angry Bear says that it would trash the main-street banking model. And etc. Various institutions would die or just withdraw their services/trades from the financial system.

The second- and third-order effects of such eventualities could have profound negative impacts on the real economy.

Which perhaps explains another thing I’ve been wondering about: why did the Fed institute IOR in the first place, and why did it do so when it did?

We can at least give the Fed credit for understanding the business models of various financial entities. When they saw interest rates heading toward zero, they instituted IOR to prevent the systemic lockup/breakdown described above.

IOW, nothing (much) to see here folks. Move along.

Sorry if I’m so dull that I had to go through all this to figure it out.

Make sense?

Cross-posted at Asymptosis.