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George Selgin


Subtitle: How a Misguided Fed Experiment Deepened and Prolonged the Great Recession, CATO Institute, Wash. DC., 2018, 205 pgs., index, references, Appendix, Paperback


Reviewer comments:
The title is as play on words - The author's thesis is that the FED changed from its former policy of not paying banks interest on their deposits with the FED to a new concept of establishing a 'floor' for interest rates - and his conclusion is that this policy 'floored' the banking system and economy in another sense. Congress passed a law that allows the FED to pay interest on the balance in legal required bank reserve accounts at the FED. But the FED has interpreted this to include paying interest also on bank excess reserve accounts. And it has been setting the interest rates above the market interest rate. The result is that banks choose to keep their funds in the safe reserve accounts at the FED rather than creating loans to the public. This defeats the hope that the banks will issue more loans to producers that enable the economy to expand.
The book appears to be aimed at fellow economists and government policy makers. It is full of economic jargon and typical econometric methods. The same basic conclusion - that the Fed and the Treasury made mistakes (or didn't know what they were doing) has been the conclusion and subject of other books, but this one comes at the issue from a different point of view. Despite the inclusion of 'inside baseball terminology' the author's prose is clear and concise enabling the lay reader to understand both what is going on and why the author believes a different policy is necessary. He has organized the chapters well, to begin with the former FED treatment of required bank reserves and then to progress chronologically and by subject to more and more complex issues. Finally, he proposes changes.

In this summary and review I can only describe the 'high points'. I hope to urge the readers to study the book itself. And readers are urged to study the two other books by George Selgin that I list below, which provide a full understanding of his libertarian economic philosophy.


Chapter 1- Introduction: An Experiment Gone Awry
The author recounts the actions of the FED in response to the financial crisis in 2007-8. He notes that the response was 'a sequence of controversial monetary policy experiments aimed at containing the crisis and, later on, at promoting recovery." And, "One of those experiments consisted of the Fed's decision to start, paying interest on depository institutions' balances with it, including both their legally required balances and any balances they held in excess of legal requirements." And further, "Because the interest rate on excess reserves was high relative to the short-term market rates, the new policy led to the establishment of a 'floor' type operating system, meaning one in which changes in the rate of interest paid on excess reserves, rather than open market operations, became the Fed's chief instrument of monetary control'.

This book is the only one I have found among so many that discuss the 'great recession' in which the author describes this process and its results in these terms. The whole book is a description and analysis of the policy, which he describes as 'misguided'. We might use more negative terms. He lists his main conclusions.
it 'intensified the severe economic downturn'
'led to a sustained collapse in the interbank market'
'dramatically reduced the effectiveness of open market operations'
'undermined productive investment by substantially increasing the Fed's role in allocating scarce credit'
' increased the risk of the Fed's being called upon to undertake and finance strictly fiscal policy undertakings'

The author concludes his introduction by stating his purpose which is to encourage the Fed to change back from this 'floor' system to the more conventional 'corridor' type system.


Chapter 2 -Prelude: Monetary Control Before the Crisis
In this chapter the author provides a summary of the Fed operating system prior to the financial crisis of 2008. Its policy following the Great Inflation era was to set an explicit target for the federal funds rate, the overnight interest rate at which institutions that kept deposit balances at the Fed lend those balances to, or borrow them from, other such institutions.' And these balances did not generate interest from the Fed. But the borrowed (lent) nightly exchange did generate interest for the lender. The role of the Fed was to attempt to manage the supply of bank reserves to keep the actual federal funds rate at its desired level. They relied on data and statistics, but even so it was a guess - trial and error. The Fed would raise or lower that interest rate with the objective of creating 'tight' or 'loose' monetary policy (tight or loose loan environment in the banking system) in hopes of increasing employment without increasing inflation. But the federal funds rate is the private rate of the banks. The Fed influences it indirectly by setting the size of the required bank reserve itself. Note, that funds deposited by a private bank with the Fed are a cost since they are not available for making a loan.
The author explains the mechanics of all this in the Open Market operations of the New York Fed including such arcane terms as the 'reprorate'. So the 'immediate goal' for the Fed 'was to keep the federal funs rate on target'. But the real, ultimate goal was 'to achieve a monetary policy stance that accomplished the Fed dual mandate - low inflation and high employment.


Chapter 3 - Interest on Bank Reserves
Dr. Selgin points out that non-interest receiving bank reserves required by law at the Fed create a tax on the deposits which results in a tax on the private sector depositors. The Fed earns interest on its portfolio but pays most of that to the Treasury, thus reducing the government net interest on its debt. The idea that the Fed might pay interest to the banks for their deposits was discussed from the beginning but was opposed by the Wall Street banks. During the "New Deal' Congress passed a law that prevented commercial banks from paying higher interest rates on their deposits, so they were happy with the situation. When, in the 1960 's the creation of the "Reserve fund' and other money market funds and increased competition compelled the request for a change to enable the Fed to pay interest to the banks. Naturally the Treasury was opposed because that would reduce its seigniorage profits. The banks acted to side step the Treasury by creating 'sweep accounts' to cover over night exchanges of balances. All these competitive changes resulted in the change on interest payments for bank reserves at the Fed. But, initially, the interest was to be payable only on the legally required reserve balances, not excess reserves. This was enabled by the Financial Services Regulatory Relief Act of 2006.


Chapter 4 -The Floor System's Beginnings
The above act was amended in 2008 (due to the crisis) by the Emergfency Economic Stabilization Act to enable the change to take place sooner. The author describes all this and quotes Fed officials about the policy motivations. He includes graphs to illustrate the results resulting from the difference between a 'corridor' policy system and a "Floor" system. He notes that the actual interest rate seemed 'paltry' at 25 basis points, but its impact on bank behavior was substantial. He quotes various other analysts who report on this significance. This includes much detail and graphs.


Chapter 5 - Is the Floor System Legal?
In this chapter the author considers the title situation. He compares the intent of the Law enabling interest payments on only legally required reserves with the results of what actually happened, payment on all reserves. More detail and more graphs illustrate the significance. He questions the legality of the Fed unilaterally making the change to give interest on excess bank reserves.


Chapter 6 - The Floor System and Interbank Lending
The author stresses his points with the first subsection title -"Good-by Fed Funds Market" He demonstrates that the resulting bank behavior on stashing more than expected ( required) reserves with the Fed. The original interest payment system 'served not only to keep fresh reserves from lowering the Fed funds rate, but to dramatically reduce the total volume of lending on the Fed funds market." His argument is supported by pages of discussion and more graphs.

Another section subtitle emphases the results: "From Lender of Last Result to Borrower of First Resort"
The proof of this requires an extensive discussion focused on behavior of individuals (bank officials) seeking to maximize profits. He writes: "In the United States, as in the Eurozone, the collapse of interbank lending created a further motive, beyond the return on reserves itself, for banks to accumulate excess reserves. That's because with the collapse in the volume of federal funds lending, banks that once routinely relied on overnight unsecured loans to meet their liquidity needs discovered that doing so was no longer prudent.


Chapter 7 - The Floor System and Reserve Hoarding
The author begins with this: "Apart from its effect on interbank lending, the most notorious consequence of the Fed's interest payments on excess reserves has been unprecedented growth in banks' excess reserves balances, meaning Fed balances held by banks beyond the requirement to meet their minimum legal reserve requirements, together with banks' holdings of vault cash.' Again, his proof is contained in pages of description and graphs. He notes that 'most of the new reserves ended up at the very largest U.S. banks or at U.S. branches of foreign banks." He cites the numbers. He also notes that the favoritism of the big banks is due to their being the primary dealers that are the Fed counterparties that have 'first dibs' on the new reserves that the Fed creates when the Treasury auctions its bonds each week. The original function of the primary dealers was to redistribute the reserves (Treasury bonds) throughout the banking system.
Selgin turns next to the "Quicksand Effect'. By this he means that the larger the huge excess reserves held by the banks - "the more liquidity the central bank supplies to an economy in an IOER based liquidity trap, the deeper it becomes mired in that trap,"
There is much more in this chapter.


Chapter 8 - The Floor System and Retail Lending
In this chapter the author demonstrates that the quantity (and ratio) of bank commercial lending to the size of its reserves has greatly declined since 2009, meaning that the banks are NOT lending as much in relation to their available reserves as they did prior to the financial crisis. He devotes considerable attention to the example of Japanese banks.


Chapter 9 - The Floor System and Monetary Policy
In this long chapter the author expands his discussion and analysis to the wider subject of what the Fed interest rate policy has done to its national money policy. This requires even more application of economic theory to the role of money in the market.
He summarizes his objective for the chapter: "Having addressed the bearing of the Fed's switch to a floor system on various sorts of bank lending, we're now equipped to consider how it influenced the course of the Great Recession and subsequent recovery."
He divides his subject matter into topic sections: IOER and Tight Money in 2008-2009; The Floor System and "Quantitative Easing"; Stimulus without IOER?' Stimulus at the Zero Bound; Positive, Zero, or Negative?; Canada's Counterexample' An Overtightening Bias?'
IOER stands for 'interest on excess reserves' His thesis is that the Fed payment of interest to banks on their excess deposits at the Fed works to counter their efforts with low market short-term interest rates to encourage lending and expansion of the economy. To support his thesis the author provides even more charts and graphs with complex explanations.


Chapter 10 - The Floor System and Credit Allocation
In this chapter the author progresses to examine the critical real world effects. Credit allocation is the fundamental financial - economic issue. By whom, to whom, and for what purposes is credit, the life blood of investment and economic expansion, actually allocated. His discussion categories are:
"Central Banking versus Commercial Banking;
"As we've seen, although the total quantity of Fed reserve balances is mainly a function of the size of the Fed's balance sheet, the quantity of excess reserves banks hold ultimately depends on banks' demand for such reserves, as influenced by their yield relative to other assets".
IOER and Financial Repression;
"Because the Fed's own portfolio choices are limited, and especially because those limits generally exclude lending to nonfinancial firms or individuals, it can't be expected to employ savings as efficiently or productively as commercial banks." (Note - This is why Goldman reorganized itself as a bank during the recession, so it could receive Fed support). Dr. Selgin describes why the IOER is a type of 'financial repression';

Reserve Hoarding and the Productivity Slowdown;
The author considers that the commercial banks stashing excess reserves with the Fed is a form of hoarding rather then deploying its reserves to finance loans to the productive sectors of the economy. "One of the most disconcerting features of the post crisis recovery has been the 'great productivity slow down' that accompanied it." The Fed policy and practice resulted in greater seigniorage for itself, which it largely remitted to the Treasury, reducing its net deficits, but encouraged banks to deposit funds with it rather than create productive loans.


Chapter 11 - Fiscal Consequences of the Floor System
The author here moves on to discuss the impact of the Fed interest rate policy also on government finances. "A floor system differs from any sort of corridor system, including the Fed's precrisis system, not only in its effects on the workings of monetary policy in the strict sense, or on credit allocation, but also in its broader fiscal implications."
There are two topics:
Treasury Remittances;
"The Federal Reserve's capacity to generate interest revenues in excess of its interest expense, and to do so even despite holding safe, short-term Treasury securities, rests upon its ability to pay below-market interest rates on its liabilities". Prior to the crisis the Fed's liabilities were non-interest bearing securities, therefor the interest it received from its portfolio was pure profit. It earns tens of billions of dollars in interest, but has only a billion or so of expenses from its own overhead. It remits most (95%) of the interest back to the Treasury. This is why we note that in recent years the government reports its annual interest expense on its debt as less despite the debt being larger. However, with the 'floor' system it pays more interest due to the 'excess' bank reserves it holds. But, despite this (as the author shows in figure 11.1) the Fed remittances to the Treasury have doubled and doubled again since 2007. The reason is that the Fed makes a large profit from other sources. Readers might be interested to learn that the Fed has also expanded the quantity of currency in the money supply AND it does not pay interest on that. Currency is a loan to the Fed (government) that does not pay interest.

Other Fiscal Consequences; The author summarizes by commenting that despite its increased interest expense it is unlikely that the Fed could become bankrupt. A 'good' result is that the reduction in the Fed's profit does increase a surplus in the private economy that can benefit consumers. Nevertheless, the author maintains that a 'corridor' monetary system is better than a 'floor' system.


Chapter 12- The Floor System and Policy Normalization
Fed officials claim that they want to 'normalize' monetary policy and interest rates. But the author believes other wise - that they intend to retain the 'floor' interest rate system. He believes this not only from the speeches delivered by Fed officials but also from the actual events, which show that the Fed has not reduced the size of its portfolio in relation to GDP. He believes the Fed wants to maintain its expanded power over credit allocation and the economy.


Appendix 1- Bank Lending and the Interest Rate on Excess Reserves
Some math to support the author's thesis.


Appendix 2 - Proposed Amendment to the 2006 Financial Services Regulatory Relief Act
The wording of the author's proposed legislation to shift the Fed policy



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George Selgin - Money Free and Unfree

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George Selgin - Fractional Reserve Banking

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Peter Schweizer -Extortion

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Danielle Dimartino Booth - FEDUP

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David Wessel - In FED We Trust

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Lawrence White - The Theory of Monetary Institutions

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Lawrence White - The Clash of Economic Ideas

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Peter Conti-Brown - The Power and Independence of the Federal Reserve - Princeton Univ. Press

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Peter Wallison - Hidden in Plain Sight: What Really Caused the World's Worst Financial Crisis and Why it Could Happen Again - Ecounter Books

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Anat Admati & Martin Hellwig - The Bankers' New Clothes - Princeton Univ. Press

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Charles W. Calomiris - Stephen H. Haber - Fragile by Design: The Political Origins of Banking Crises and Scarce Credit - Princeton Univ. Press

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Jeffrey Friedman - Engineering the Financial Crisis

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Philip Coggan - Paper Promises: Debt, Money and the New World Order

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David Graeber - Debt: The First 5.000 Years

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Peter Bernholz - Monetary Regimes and Inflation -Dr. Bernholz has published a second edition of this important book in 2015, in which he left the original chapters alone and added two new chapters.

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Patrick Newman - "Review of Monetary Regimes and Inflation" by Peter Bernholz - 2015 edition
This edition was reviewed by Patrick Newman in the Quarterly Journal of Austrian Economics, Vol., 19, No2, pgs.`87-191, Summer, 2016. The reviewer then focused his comments on chapters 2 and 9. He begins by discussing the financial crisis of 2007-8 and the reactions to it by academic economists. One issue was the huge monetary expansion the major central banks created and their increase in the reserves of the major member banks. The purpose was to provide liquidity and stimulate economic activity. The expectation was fear that this would generate also massive inflation (in accordance with standard economic theory) - and debase (depreciate) national currencies. Newman provides this data - The Fed increased MO by 334.99% but M2 increased by 47.42%.
Newman notes "Bernholz should have also mentioned at least for the United States, the use of the contemporry new policy took by the Federal Reserve to pay interest on member bank deposit with this new proviso, banks no longer have as much of an incentive to engage in credit expansion in order to earn interest and cover the cost of inflation eroding away idle balances."


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