One of the nice things about the Kauffman Foundation’s Blogger Conference is the time to let the mind wander and look at data after having your brain scoured.
One of the worst things is realizing too late that you’ve got a Really Ugly Graphic, and most of the people who could help with it are gone.
Four hours ago at dinner, I was sitting between Brad DeLong and Tim Duy (who pointed out some good contemporary performers of Real Country Music), but I didn’t have this graphic with me. Now Tim is on a plane and Brad is teaching students, and my best option is to ask the AB commentariat if the following graphic scares them as much as it does me.
Even given my hobby-horse attitude toward Excess Reserve (i.e., the Sheer Unmitigated Contempt with which I treat the idea that reserves in general—let alone Excess Reserves—should “earn” interest), the dropping-off-a-cliff impression (and the overall downward trend, even keeping in mind that we do not Seasonally Adjust Excess Reserves, and therefore Seasonal Effects are clear) almost seems to explain why the 32nd month of the “recovery” feels as if it’s just possibly starting something.
To be fair—and a hearty “thank you” to Jeff Miller of A Dash of Insight for reminding me that most people believe the Fed concentrates on M2, not M1—the broader index shows an upward trend (again, discounting the recent decline as a Seasonal Effect):
Otoh, an overall ca. 5% increase in “Net M2,” as it were, over a year in which the dollar has increasingly appeared to be the only reasonable “Safe Haven” doesn’t seem all that large either.
I’ve yet to play with the data beyond this, so I leave it to the AB comentariat:
Do you believe there is something here?
If so, any guesses what it is? Or anything you want to know about it?
If not, what else should we be looking at where Excess Reserves may/should/will (depending upon your degree of certainty) affect the value of the data and/or Real Economic Growth?
The IS-LM model led economic historians to argue money was easy in 1929-30, because rates fell sharply. It led modern Keynesians to assume that money was easy in 2008, because rates fell sharply…
Well, I would say that not just “modern Keynesians” but a lot of people believed that monetary policy was expansionary in 2008.
They believed so not just because (safe) nominal (and real) interest rates were falling, but because the money supply was expanding. Indeed, since 2007 the Federal Reserve has tripled the monetary base
But there remains a reason I suggest that cutting off Tim Geithner’s (and/or Ben Bernanke’s) private parts, stuffing them into his mouth, and perp-walking him publicly down Dewy Square* would be a good re-election move for the Obama Administration, and it comes back to basic economics. Specifically, Brad DeLong’s favorite monetary equation
MV = PY
Now, most of the time, we derive V—Velocity. We kinda sorta hafta. The velocity of money is not something that you really observe directly; to solve the equation for V(i), we have to know Y, P, and M.
But then we’re making assumptions about them. Two of them are probably reasonable:
Y = GDP (or GNP if you add in XM, but let’s not). We shorthand this as “aggregate output.” Even if we weren’t pretending it’s constant in the short-term, we can fairly well define this and hold to the definition. GDP=GDP, as it were.
P = Price Level. This is slightly more difficult conceptually, because we aren’t going to include everything. But if we assume (short-term) that the “market basket” is constant (or at least fungible**), we can come up with a representative index level and just treat this as “inflation.”
The third, however, is more problematic:
M is the Base Money Supply, which is circulating.
Recall that V = Velocity, or, the number of times in a year that a dollar is spent, a definition that led to Keynes’s observation that V isn’t so much a constant (pace Fisher) as dependent on interest rates—V(i). This doesn’t (or, more accurately, shouldn’t) change much in the short-term, even at the zero-bound.
But “velocity” assumes money is circulating, which why it is multiplied by the Monetary Base from the start. If the monetary base has all the mobility of an overBotoxed actor’s face, we’re going to have a problem. I would call the following graphic “Where’s the Real Increase in the Monetary Base?”
The above graphic is Ben Bernanke’s fault. And even Brad DeLong knows this. The proof below the fold.
The Fed is not out of ammo, the economists at the Bank Credit Analyst insist…
Target a higher inflation rate or pre-specified level for the consumer price index or nominal gross domestic product. Problem: “could undermine the Fed’s long-standing commitment to price stability.”
Stimulate bank lending by putting a tax on excess reserves, hoping that banks will the lend out the money if the have to pay borrowers to take the loans. Problem: “could lead to the collapse of money market funds and the disintermediation of the financial system.”
Buy corporate debt, equities, real estate or foreign currency. Problem: Could require an act of Congress. “Given that the U.S. economy remains stuck in a liquidity trap,” Berezin concludes, “fiscal policy would be the most straightforward way to stimulate….However, the likelihood that the U.S. will receive major fiscal stimulus anytime soon is close to zero.”
I’m not sanguine about the latter. Even absent economic issues (which are minimal in the current environment), the political ones are problematic.*** That it makes more sense than telling people to put their money into a 401(k) that consists 90% of company stock is a low bar to jump. On the other hand, buying Yuan until it has to appreciate is worth exploring.
The first has been getting traction for years. And I admit I can’t decide who was stupider: the people who set a 2% target on no evidence (sorry, David, I held to this even after reading yourcites) or the people who decided a “2% target” meant “<=." It now has enough traction that it will get out of the avalanche about the time the snow melts. So that leaves the second one. Which brings us back to the Monetary Equation problem. Recall that the definition of Velocity is "the number of times in a year that a dollar is spent." I buy something at the Dollar Store, they use that dollar to buy more products and pay employees, the suppliers and employees buy more supplies and other products, respectively, etc.**** So Brad DeLong ("I see no risks in attempting any of these three--and great risks in continuing to dither") agrees with Peter Berezin of Bank Credit Analyst (and me) that we don't want banks holding Excess Reserves as a matter of monetary policy at the zero bound. Fundamental principle of economics: you want to tax things you wish to discourage. You want to subsidize things you wish to encourage. As the Rabbi once said, "All else is commentary." So what did the Federal Reserve do in the face of a desperate attempt from the Fed to stimulate the Base Money Supply?
The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.
Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository institutions’ reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances).
this lead to something that will surprise no economist of any caliber, let alone a Professor at Princeton:
By the time of the stimulus, roughly that amount had been taken out of circulation as the change in Excess Reserves. Even if every cent had been well-allocated, it was already out of circulation.
Ben Bernanke giveth, but Ben Bernanke taketh away even more, in spades.
What Monetary Stimulus?
*Again, I don’t encourage this action. But if you think I can’t create or find a suggestion for each of the Occupy locations, you haven’t read and seen enough Jacobean drama.
**Whether we replace my wife’s three-year old mobile with either a “free” Droid or a “free” iPhone 3GS probably doesn’t have a significant effect. Economists pretend that the “steak-chicken” model is similar.
***Short version: You think the tempest-in-a-teapot that is Solyndra is getting discussion? Try that times ten when three or four REITs and a few companies go under. (Amazingly, those who complain about the “low” return on Government securities also loudly complain when the Government invests in non-risk-free securities.)
****It is left as a side-note that increasing the Velocity of Money is yet another way to reduce tax rates, all else equal. It is also left as a side-note that people who talk about “double taxation” of (voluntarily disbursed) dividends are economic ignoramuses, and that there are many economists who talk in that manner in no way invalidates the first half of this sentence.
The sarcasm of the title of my recent post notwithstanding, there are some things economists understand to be true that are. Among those:
People respond to incentives
As with the Supreme Court, economists extend this principle to organizations, on the (generally correct) idea that organizations are made up of people who act in their own best interest. (It isn’t, pace the old joke, that they wouldn’t pick up a $100 bill lying on the sidewalk; it’s that they would never believe someone would drop one there in the first place.) This is how you get to teach courses in “Organizational Behavior” and the like—it’s not the madness of crowds if they all act “rationally” on an individual basis. (More Skinner than Ballard, but I sidebar.)
In economic models, as I obliquely ,mentioned last post, there is no risk-free arbitrage: if there were, “the market” would eliminate it, because it would mean someone was dropping $100 bills on the sidewalk, and the “the market” would make certain that person (or organization) was bankrupted, or at least suffered enough of a loss to change its behavior.
If you need proof of that:
Note that there were a nominal amount of excess reserves being held by some institutions even before interest was paid. We can treat them basically as rounding errors and systemic inefficiencies; given the skewness of the risk-reward, it has always been safer to put an extra $20,000 or so “in reserve” for late transactions, counterparty failures to deliver, or just plain calculation errors. Think of it as the equivalent of taking $60 out of the ATM when you only expect to need $40; the ability to pay taxes you forgot to calculate, upgrade a shirt from poly to cotton, or buy a bottle of water “on impulse” is more valuable (utile) than the day’s interest on that $20 (currently, just over 1/100,000th of a cent from one of my TBTF financial institutions; half that from the other). And so it goes for reserves.
But in September of 2008, the Fed decides to pay interest on reserves—including Excess Reserves. The banks can now make 25 times what they pay in interest, risk-free, just by holding onto money. The Fed is, essentially, leaving $100 bills on the sidewalk.
Hasty disclaimer: it’s doing so for all the right reasons: the banks need to rebuild strengthen their balance sheets, and nationalization is off the table. Every little bit helps. Conceptually, economic theory indicates that one should pay “interest,” in some form, for the right to use another’s capital. (That this breaks down in the details is subject for a discussion over tonics.)
I’m using monthly, blended data—nothing so clear as the BarCap analyst examined in the last post—but it’s fairly easy to see what happens even on that trend. Excess Reserves in October are two orders of magnitude higher than they were a few months. They more than double for November, and then stay in a fairly narrow band until around the time the “recovery” began. From August of 2009 until the end of the year, they rise again, just missing the magic $1 Trillion mark in October, breaking it in November and not dropping below again.
It’s free money; why wouldn’t the people who run the banks take it?
And they do. So the number of $100 bills being dropped on the sidewalk would be expected to decline—save that the Fed has no liquidity constraint, even if we’re ignoring a right of seignorage. And the participants come by each night, picking up more.
The externalities of such a situation are obvious. The most direct solutions are two: either (1) stop dropping the bills or (2) show the banks that there are better investment opportunities on a risk-adjusted basis.
The other option is rather more problematic, not so much because the pump hasn’t been primed as that the water used was rather dirty, with a significant underestimation of the amount of rust that needed to be addressed only compounding the issue.
The result is approximately what one might have reasonably predicted in the goods and non-financial services economy: the Federal G(f) barely compensated for the State –G(s), and only the multiplier effect of that spending actually happening “expanded” anything. (Or, more accurately, some businesses did not fail so rapidly and the cost of some services did not rise so quickly as they would have ex-“stimulus.”) The good news is that there was a barrel of water between the diving board and the ground; the bad news is that the barrel wasn’t full, so the dives had to be better than excellent, with minor injury virtually a best-case scenario.
The non-financial private-sector, in short, has not been able to recover, while the financial sector—propped up by those $100 bills—shows evermore “strength” on the back of dicey assets being held by the Fed, higher fees and lower interest rates for their “customers,” and—of course, $2.5 Billion a year in from the taxpayer.
Sooner or later, we’ll be talking about real money. For now, though, we’re just talking about the real economy. What we have here isn’t (quite) a dead shark—as I said earlier, the private sector has performed amazingly well in the face of opposition to it from the Fed and the banks—but it has a diving tank in its mouth and Tim Geithner et al. taking shots at it will a high-powered rifle. We can only hope that former NYC “financial cop” Geithner isn’t as good a shot as another former NYC cop transplanted to a land he doesn’t like or understand.
As Brad DeLong has noted, Tim Geithner believes it is time for “the economy has now recovered sufficiently for government to begin to make way for private business investment.” In short, he expects “the private sector” to do the heavy lifting in these joyous times of economic recovery.
Cynics among us—why, yes, that might well include me—would note that the private sector has had to do much of the heavy lifting for the past several quarters, in the face of what is varyingly described as “a precipitous decline in Aggregate Demand” or “a rise in unemployment.” (You say overextended credit, I say bankrupt.) And that its performance has been, not to put too fine a point on it, exemplary in the face of the constraints presented.
Yes, I’m praising the efforts of the private sector. Not just because small businesses especially are trying to sustain current levels of production and services in the face of tightened credit and the aforementioned AD decline, but also because they, as LBJ once observed in another context, have been put into the position of trying to run a race when the shackles are just being removed from their ankles.
I blame the banks.
Now you know it’s me. The problem is, the evidence is on my side. Recall that the alleged reason we needed to “save” the banks is that they are Financial Intermediaries, taking a slice out of the matching between Investors (Savers, in most economics models) and Capitalists, who borrow to recombine Capital (K) and Labor (L) into a new product that presents a better return than the old one.
Call it “creative destruction.” Call it “capitalism.” Call it “economic growth.”
Let us ignore—though it Abides, like Earth or a steaming pile of elephant dung—that the “intermediaries” were making somewhere between 30 and 40% of the total profits in the U.S. for the past decade. We can (1) pretend that those were all payday lenders, (2) be a “first-best economist” and claim that is the way things should be, or (3) realize it’s a problem and leave addressing it for another time.*
But let us not ignore that capital supply is essential to growth possibilities. With labor abundantly available, the limitation on creating new product is essentially The Big K, and it’s “Main Street” proxy, money.
As noted above, in most models of economic growth, we treat Savings as being equal to Investment. This makes sense: even when the Financial Intermediaries were making $3 or $4 of every $10, they were reinvesting in better systems, better technology, better analysis, and better methods. Low Latency leads to High-Frequency Trading (HFT) which leads to…well, let’s be nice and just say “greater firm profits.” Even if only 50% of those profits are being directly reinvested, they are being reinvested, while the rest produces at worst greater paper investments and at best a higher velocity of money and/or a multiplier (“trickle-down”) effect from increased spending.**
Put your money in a Mutual Fund, it’s Invested. Buy a stock, it’s invested. Put it in a Demand Deposit Account (what used to be a “Savings” or “Checking” account), and it’s invested (“swept”) by the Financial Intermediary, who gives you a share of the profits in the form of interest.
Not to sound like a broken record, but Excess Reserves put a spanner in that last one. Don’t believe me, ask economists Bruce Bartlett or Joe Gagnon. Or just look at a graphic of M2 and what I’m calling “Intermediary Private Investment” (M2 minus the Excess Reserves maintained by Financial Intermediaries).
As Excess Reserves are not Seasonally Adjusted, I used the NSA version of M2. As noted in my previous post, up until September of 2008, the Fed did not pay interest on Excess Reserves (or Reserves, for that matter), so that excess reserves were essentially a rounding error—funds kept because of the asymmetric risk-reward of a miscalculation, or “precautionary savings.” They tended to total about $1-2 Billion on average, rather minor in the context of $7-8 Trillion.***
But once you hit September of 2008, the growth in M2 is more than negated by the growth in Excess Reserves. Indeed, the horizontal line on the graphic above is the level of Intermediary Private Investment in August of 2008—nine months into the “Great Recession.”—isn’t exactly reaching for the skies. But it’s also significantly higher than the current I, as opposed to S.
(Note that the NSA trend is also downward since the alleged beginning-of-recovery months of June-July, 2009. That the performance has been as good as it has been in such a context is amazing.)
When Savings=Investment, there is potential for growth. When savings go into mattresses—for good reason, especially in the pre-FDIC days—intermediaries cannot do their job so efficiently as the models presume.
What are we to call it when Intermediary Private Investment is significantly less than Savings—when not the people, but the intermediaries themselves, are stuffing money into their own, interest-bearing mattress?
I would suggest “bad economics,” but that term seems too applicable to more general conceits.
*I would rather lose what is left of my eyesight and hearing than take the second position; others, from Scott Sumner explicitly to Brad DeLong implicitly, have significantly variant mileages, which is why there’s a horserace for describing economic policies in the past decade or so. They are winning, while I received several decent paychecks over the time.
**It is left as an exercise whether the “trickle-down” effect is positive or significant.
***Another sign of improved technology is that the growth in reserves decelerates—funds are used more efficiently by the intermediaries—after ca. 1990/1991; the trend moves slightly upward in the Oughts, though that is both relatively minor and possibly due to complications related to the expansion of products offered.
For quite a while, the Fed was quite happy to have that money on its books. Indeed, the power to pay interest on reserves was considered a key tool to keep control over all the liquidity the Fed pumped into the system during the financial crisis. The Fed wanted to see bank lending increase, but in a controlled fashion, so as not to fan the flames of an inflation surge.
But as worries about the outlook have risen, the game has changed. Some see a move to drive all those reserves into the economy as a key way to produce better economic growth. Markets got to thinking Fed Chairman Ben Bernanke would indicate this as a possible path when he testifies before the Senate Wednesday and the House of Representatives Thursday on the economic and monetary policy outlook.
Economists, however, think ending the interest on reserves policy would be a bad idea.
Right, because the $2,534,722.22 a year paid in interest on $1 Billion in excess reserves is a drop in the bucket for the U.S. Federal deficit.
And because the risk-free rate of return that features in so many economic models should be different for intermediaries (financial institutions) than wealth-creators (businesses).
And because “excess reserves” are money issued by the government which is inflationary because of the multiplier effect of money—which, of course, assumes the money is being invested. (As this money is, in taxing our tax dollars and giving them to Vikram Pandit, Ken Lewis, Lloyd Blankfein, and Jamie Dimon [in descending order of theft; YMMV].)
And, of course, because that $1 Billion that is not being used in the economy would only produce about $5-8 Billion in GDP, which is roughly, what, 50,000 to 80,000 new jobs?
But, of course, banks have better use for the money than potential workers.
[Barclays Capital’s Joseph Abate] noted much of the money that constitutes this giant pile of reserves is “precautionary liquidity.” If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum. [emphasis mine]
Oh, well, since they’re not going to lend the money anyway, we should have no trouble paying them interest on it. What is The Fed other than a mattress stuffed by tax dollars?
The key phrase is “precautionary liquidity.” If you assume that the recovery started in June or July of last year,* then you would expect “excess reserves” held for “precautionary liquidity” to have declined over time, as the need for “precautions” is reduced as the economy becomes safer. But that hasn’t been the case.
Choose one (or both) from: (1) the banks don’t believe the economy is recovering or (2) the banks are holding assets on their books at higher levels than they know they are worth, and are therefore using “excess reserves” to cover real losses until they can’t any more.
It is unclear whether Abate sees the banks’s unwillingness to be intermediaries as a feature. But at least he knows not everyone is doing it.
Abate buttressed his argument that banks really just want to stay liquid by noting who is holding reserves at the Fed. He said the 25 largest U.S. banks account for just over half of aggregate reserve levels, with three by themselves making up 21% of the reserves.
So the biggest of the Too Big to Fail banks have decided not to act as financial intermediaries, preferring instead to continue feeding from the taxpayer trough (where the $25MM in interest really is a drop in the bucket) and/or pretend that they are more solvent than they really are.
And, according to the Wall Street Journal, economists believe we should continue to pay those banks for misvaluing their assets and refusing to perform their economic function.
The economic theory I learned is that capital is paid its marginal product. The marginal product of those excess reserves is zero, while the required reserves are intended to explicitly provide “precautionary liquidity.”
Unless the TBTF banks are arguing that the Fed’s current Reserve Requirements are too low—a possibility, perhaps, though the FT cites evidence contrariwise—the basis of all economic and financial theory indicates that they should receive no interest on those reserves.
An “economist” who says otherwise is either lying or selling something.
*I would argue—see yesterday’s post—that June 2009 is rather eliminated by the non-recovery of more than half the states’s job markets a full year later.