Sunday, August 5, 2012

Interest on reserves? Is that a joke?

I have recently given a little thought to the fact that the Federal Reserve Banks pay interest on excess reserves, which seems a peculiar thing to do when the Fed should be encouraging lending to credit-worthy borrowers.

To my mind, the United States is in a serious depression, which could possibly last to the end of this decade, if serious action is not taken to shorten it by expansionary monetary and/or fiscal policy.

The Fed currently pays 0.25% interest on reserves, which doesn't seem like much, but keep in mind that reserves are those portions of a bank's money that is not lent out. Interest on reserves is essentially a way of paying banks for not lending money to consumers or businesses. I suppose more reserves mean that less of the financial system's money is at risk, but the bigger issue at this time is surely the instability and risks that come from an economy operating well under its capacity, in terms of labor and capital utilization.

I suggest the Federal Reserve put America's money to work and, as Paul Krugman said, End This Depression Now!


  1. The monetary authorities introduced 4 contractionary policies during the Great-Recession:

    (1) the payment of interest on excess reserve balances
    (2) the expansion of FDIC insurance coverage
    (3) increased bank capital adequacy ratios
    (4) operation twist

    These policies militated against a continuous & orderly flow of voluntary savings into real-investment. Besides acting to stop the flow of funds into new & existing investments, these policies induced dis-intermediation within the non-banks (where the size of the non-nonbanks & shadow banks shrink in size), but the size of the commercial banking remains the same.

    These policies not only STOP the flow of funds (transactions velocity) into investment, they act to REVERSE prior investment levels (force an absolute reduction in the transactions velocity of money).

    By setting up policies that encourage the flow of voluntary savings into the commercial banking system (dis-intermediation), more & more lending & investing has to be promoted by introducing large doses of new money (to offset the depressing economic effects of these perverse & contractionary policies).

    It bears reiteration that the commercial banks (CBs) do not loan out existing deposits (saved or otherwise). The CBs always create new money somewhere in the banking system (every time they make loans to or buy securities from the non-bank public).

    The voluntary savings impounded within the CB system are lost to investment, indeed to any type of expenditure. Savings held within the commercial banking system have a velocity of zero. The upshot is a cessation in the circuit income of money.

    Indeed another proxy for money velocity would be given by the proportion of CB liabilities to non-bank liabilities.

    It is not gDp divided by the volume of money that is relevant, it is the use or non-use of voluntary savings (how big the leakage in national income accounting is). In national income accounting concept, not all savings correspond to investment.

  2. IOeRs (remunerated excess reserve balances) alter the construction of a normal yield curve, they INVERT the short-end segment of the YIELD CURVE – known as the money market.

    The 5 1/2 percent increase in REG Q ceilings on December 6, 1965 (applicable only to the commercial banking system), is analogous to the .25% remuneration rate on excess reserves introduced on Oct 9, 2008 (i.e., the remuneration rate @ .25% is higher than the daily Treasury yield curve almost 2 years out – .27% on 4/18/12).

    In 1966, it was the lack of mortgage funds, rather than their cost (like ZIRP today), that spawned the credit crisis & collapsed the housing industry. I.e., it was dis-intermediation (an outflow of funds from the non-banks).

    Just as in 1966, during the Great Recession, the Shadow Banking System has experienced dis-intermediation (where the non-banks shrink in size, but the size of the commercial banking system stays the same)

    The fifth (in a series of rate increases), promulgated by the Board and the FDIC beginning in January 1957, was unique in that it was the first increase that permitted the commercial banks to pay higher rates on savings, than savings & loans & the mutual savings banks could competitively meet (like the CB’s IOeRs now compete with other financial assets [held by the non-banks], on the short-end of the INVERTED yield curve).

    Bankers, confronted with a remuneration rate that is higher (vis a’ vis), other competitive financial instruments, will hold a higher level of un-used excess reserves (i.e., will both 1. absorb existing bank deposits within the CB system, as well as 2. attract monetary savings from the Shadow Banks).

    SEE: The inverted Eurepo curve spells trouble

    So IOeRs are not just a credit control device (offsetting the expansion of the FED’s liquidity funding facilities on the asset side of its balance sheet). But in the process ,they induce dis-intermediation (an economist’s word for going broke/bankrupt), in the Shadow Banks.
    The effect of allowing IOeRs to “compete” with the returns generated from the financial assets held by the Shadow Banks, has been, and will be, to shrink the size of the Shadow Banks (as deregulation has in the last 50 years – with the exception of the GSEs).

    "Securities purchased (and sold) by the Fed, for example, could be absorbing assets that were held by the non-bank private sector or by the banking system itself."

    But the Fed's research staff missed the corollary - IOeR's "could be absorbing assets that were held by the non-bank private sector or by the banking system itself."

    However, disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of its depositor’s withdrawals.

    The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its “open market power”, to prevent any outflow of currency from the banking system.

    Whereas disintermediation for the Shadow Banks (e.g., MMMFs), is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); i.e., the CBs earning assets, or IOeRs.