If a commodity is in "backwardization", that is, if futures prices are lower than current prices, does that imply that futures markets are discouraging storage (encouraging disgorgement)? Paul Krugman makes the case, here and here.

I'm going to challenge him with a low-down, dastardly kind of argument. The gentleman keeps asking for evidence, evidence, and in response I'm going to offer an unfalsifiable hypothesis. Krugman says that futures prices are too low to cause people to withhold physical oil and sell forward, as required to affect spot prices. But whatever forward price curve he shows me, I can posit an invisible "convenience yield" large enough to make hoarding oil worthwhile. I don't even have to be unreasonable about it. Extrapolating from historical data, we see that gently "backwardized" futures prices might be quite sufficient to encourage storage when convenience yields are taken into account.

Despite all of this, I agree with Krugman that futures markets can't explain the recent skyrocketing oil prices. Not unusually, he's been a voice of sanity and reason. But just as speculation in futures need not affect spot prices (if it is balanced long and short), speculative withdrawal of physical supply need not affect the shape of the future price curve. Futures market "signatures" can't be relied upon to distinguish speculative from fundamental demand, and inventory may be unmeasurable, especially if it is offshore or takes the form of withheld production. Further, both futures in contango and measured inventory build can signify known fundamental demand as well as speculation. (Suppose entrepreneurs are planning to fire up many new factories over the next few months. If they buy forward to hedge their exposure to energy prices, that would push futures into contango and promote storage with no one speculating on anything.)

But this isn't about that. This is a disquisition, and ode, a homage and a tribute to the marvelous, mysterious, misunderstood and maligned convenience yield:

The bedrock principle of futures markets is "no arbitrage", that is prices should be set such that there is no investment strategy that yields a risk-free profit higher than the risk-free rate of interest. For a physical commodity, this seems to imply that the forward price should equal the present price plus the risk-free rate of interest and any storage costs. Interest rates are never negative, and storing stuff always costs something, so you'd expect future prices of storable commodities to always be higher than current ("spot") prices. But check out the following graph of the four month "forward yield" of crude oil. (Data courtesy of the EIA, hat tip Krugman, calculations and errors are mine, click for a bigger version).

The "forward yield" is just the percentage by which the future price is higher than the spot price. I'm using four month futures, but I've converted the yield an annual rate. If the forward yield is 10% and the interest rate is 4%, an oil man would profit from buying oil now and selling it forward, as long as his storage costs are less than 6% per year. Tycoons would start buying spot and selling forward until yield dropped to interest + storage.

But didn't we say future prices should be higher than spot prices? Look at the average (the yellow line in the graph). It at -3.4%, well below zero! The yield is negative more often than it is positive. Whenever the yield is anything less than interest + storage, you'd expect oilmen to sell crude from storage and buy it back forward. He earns interest on his cash and saves the storage costs that way, which is better than the profit he'd make storing and selling forward. When the forward yield is negative, Texans should be selling physical and buying forward like mad. By doing so, they earn interest on cash, save storage costs, and lock-in an easy profit buying back their oil for less than than what they sold it for. Very quickly, all the selling should create a glut of physical oil, driving down spot prices, while the buying forward drives up future prices, until the yield is positive and sanity is restored. But negative forward yields for oil have persisted, sometimes for years at a time! We must be missing something. Hmmm...

Suppose someone offered to buy your vacuum cleaner today for $100, and sell it back to you next week for $80, with no risk of wear or breakage. Would you? It would depend how much you value the use of your snorter. If you refuse, we might infer that a week's access to the pleasures of vacuuming is worth 20 bucks to you. We call that value of temporary use a "convenience yield". It's as if having the vacuum cleaner around pays you $20, even if no cash changes hands. Maybe we observe negative forward yields on oil because the smell of oil in the morning is priceless to guys in cowboy hats. (Or not... see below for a more plausible account of oil's "convenience yield".)

Let's eliminate wandering interest rates, and take a look at the storage cost / convenience yield of oil historically. Below is a graph of a three-month forward yield (calculated from the first to the fourth month forward, because futures prices are more trustworthy than spot) with the concurrent 3-month T-bill rate backed out of it, leaving only storage costs. When storage costs are negative, that reflects, by definition, a convenience yield. (Again EIA monthly data, T-bill rates courtesy of FRED, my calculations)

From Jan 1986 through May 2008, oil futures have reflected a convenience yield of 8% per year on average. (This is in rough agreement with the overall mean of 0.021% per day calculated here by Milonas and Henker, see Table 3.)

Suppose that the current convenience yield is about 8% and three month interest rates are about 2%. Then a one-year futures contract should be about 6% cheaper than spot, and a four-month-out contract should be about 1.4% cheaper than a one-month-out contract (reflecting 3 months of storage). At the end of May, the 4-month-out contract was in "backwardation", but was only 0.5% cheaper than the 1-month, still too expensive given the convenience yield. Oil dudes could have earned (on an annualized basis) about 3.6% more than the risk free rate (about 5.6% overall) buying high and selling low, but enjoying the privilege of storage. Now that oil is in gentle contango (as of June 17, the 4 month contract costs about 1% more than the 1 month), buying forward and storing looks like a really fantastic deal.

What is this "convenience yield"? Is it real? It seems like it must be, the economics of an 8% return aren't subtle in the data. But when I first encountered this idea, it baffled me. So instead of talking oil, let's talk hotels.

Suppose you have a hotel, it's morning, and you've got a room that isn't yet booked for tonight. Empty rooms end up costing you about $10 a night, considering your rent, maintenance, utilities, etc. But, you estimate there's about a 50% chance that a weary last-minute traveler will come by and pay your walk-in rate of $150 for the room. So, the risk-neutral expected value of your empty room is $65 [(150 ÷ 2) - 10]. You're risk-averse, not risk neutral, though. You'd accept a certain $60 rather than a 50-50 chance of losing $10 or earning $140. That $60 is the "convenience yield" on your empty room, it's what having a room empty, in case opportunity strikes, is worth to you.

Oil is a "spiky" commodity. Every once in a while, someone really needs it, now, and will pay a premium for immediacy. The market for oil in Cushing, Oklahoma might be reasonably efficient, but what happens when someone in Peoria needs oil today? Opportunity! Instead of running a hotel, you build an oil tank in Peoria. Suppose that every month, there's a 10% chance a desperate client will offer a 5% premium for immediate delivery of all your oil, and that interest and storage cost you 0.2% per month. Then on average, you'd earn 0.5% (10% x 5%) each month from desperate clients, and pay 0.2% in expenses. You don't want to bear the risk of fluctuating oil prices, so you sell your oil forward. If you were risk neutral, you'd be willing to sell it for a discount of up to 0.3% less than you bought it for at the beginning of the month, at which price you'd just break even. But you're not risk-neutral: You attach a "certainty-equivalent" value of only 0.4% to the unpredictable income from needy customers, and would offer no more than a 0.2% discount on month-forward oil sales. In the end, you earn a risk-adjusted 0.4% per month "convenience yield" from desperate polluters, and pay 0.2% in interest and expenses, and 0.2% in hedging costs. If one-month oil futures pay more than 0.2%-less-than-spot, or (golden days!) if they are in contango, you'd buy as much oil as you could and sell it all forward, because every new barrel that you promise to buy high and sell not-so-low represents certain (well, "certainty equivalent") profit.

Putting aside Peoria and our artificial needy customer, sometimes oil spikes even on the wider market, so that anybody with physical oil can sell at a high price and while locking in low-priced near future purchases to replenish their stock quickly enough to meet any other contractual obligation to sell. If you estimate the profit you'd to earn from these occasional opportunities, and subtract a bit to come up with a "certainty-equivalent" value for this uncertain income stream, you'll have determined a convenience yield. It shouldn't be surprising that convenience yields are especially high for volatile commodities subject to frequent shortages and price spikes.

When futures markets are well-arbitraged (which might not always be the case!), the future price of a storable commodity is determined by the spot price plus the total cost of storage, defined as foregone interest, plus storage costs, minus any benefit of temporary ownership &mdash the convenience yield! When a storable commodity like oil is in backwardation, that doesn't mean that the markets are predicting that its price will fall. It means there is a convenience yield. And in order to decide whether futures markets are creating incentives to store or to sell physical stuff, you have to estimate the convenience yield.

Postscript: While I was writing...

Mark Thoma offers a nice extension of Krugman's model, showing how monetary policy, by affecting interest rates, would be expected to affect storage.

Yves Smith offers very pointed commentary on futures markets, speculation, and inventory (here and here).

If policymakers want to "do something" about commodity speculation, they should really start investigating passivity on the short side of the market rather than enthusiasm on the long. Given what's before them, I hope they ignore Michael Masters (ugh!) and Thomas Palley (whom I often like, but yuk), and go with Dean Baker's suggestion of a Tobin Tax (ht Mark Thoma).

In response to a (somewhat ridiculous) proposal that we "sue OPEC" over high oil prices, Mark Thoma writes:

[I]t's unlikely that [monopoly power] is the factor behind the run-up in prices. Monopoly power explains the level of prices, i.e. why price is $8 rather than $5, but it doesn't explain the change in prices, i.e. why the price would change from $8 to $12. There are ways to tell this story, e.g. a war or some other event giving a cartel the cover it needs to raise prices and blame it on external factors, but I don't think that's what's going on in oil markets today, at least I don't think this is a significant factor behind the oil price increases.

I think there may have been a change over the last few years in the market power of oil producers, for structural reasons. Traditionally, OPEC has suffered from the usual problem that makes large cartels unwieldy: Under agreements to restrain production, members individually have an incentive to cheat and sell larger-than-agreed upon quantities at still artificially high prices. But that assumes that the production quotas are significantly beneath the capacity of most members to produce. More subtly, it also assumes that each country gains by producing more rather than less oil, if cartel prices are maintained. Both of those assumptions may no longer hold.

As the global oil market has grown, demand may have outpaced individual countries' capacity to supply, either because investment in new projects has not kept pace, or because nations have hit domestic "peak oil". (See Indonesia for an extreme example.) Other countries may desperately need money in order to fund current spending, so it is widely known they will produce as much as they can, regardless of quotas. Ironically, as long as the total capacity of sure-fire cheaters and constrained suppliers is well below global demand at the cartel's target price, the certainty of their output may enhance the ability of discretionary producers to control the quantity produced.

It'd always be easier for a cartel of five or six producers to exercise market power than a cartel of, say, thirteen. But that's especially true when cartel members have little incentive to cheat. Normally, we think of governments as spendthrifts, always eager to spend an extra dime unless constrained by tax revenues or debt markets. That's obviously a mischaracterization of today's most important oil producers, whose governments spend far less than the oil revenue they receive. For Saudi Arabia, selling a barrel more of oil is a portfolio choice: revenue from the marginal barrel will be saved, not spent, so the question becomes whether it is wise to shift some of the Kingdom's current allocation out of oil and into some asset that can be purchased with currency. For countries that have very little non-oil savings, mere diversification would encourage oil sales. It is unwise to have all ones eggs in one basket, and oil producers remember all too well that world prices can go down as well as up. They'd want to store their national wealth in an "efficient portfolio", one that maximizes their return on risk by including a variety of investments.

But as oil producing nations have accumulated vast reserves of financial assets, switching from oil-in-the ground to stocks, bonds, or bank accounts is no longer so sure a bet. Real interest rates on "safe" dollar assets are currently negative, both in US and home country terms, and the outlook for safe euro assets is uncertain at best. Central banks and sovereign wealth funds of oil-producing nations already hold hundreds of billions of dollars worth of Western financial assets. They might already have reached or exceeded what they view as an optimal allocation of their national wealth into these securities. Of course, producers are still not well diversified, and it's pretty clear that sovereign wealth funds are looking for alternative assets that might hedge their exposure both to oil and Western paper. But allocating into less liquid, unfamiliar categories of assets is slow work if you want to do it well. Perhaps current oil revenues outstrip oil producers' capacity to find good investment opportunities, and they view oil-in-the-ground as a better second-best asset than dollars in the bank.

Ten years ago, oil producers did not have vast hoards of dollars and euros, and required oil revenue to meet budgetary needs. World demand was low enough that cheating by OPEC members could corrode producer pricing. It was hard to exercise market power. Now, cheaters don't matter, and discretionary producers may be indifferent or worse to the prospect of selling a barrel more of oil at current prices.

(In a sense you might not call this market power at all, as price equals marginal cost, that is to oil producers, the assets they can buy for the dollar price of a barrel of oil are worth no more to them than a barrel of oil left in the ground.)

Brad Setser recently noted that...

[T]here are two clear paths that could end the current “oil up, dollar down” pattern.

Weakness in the US economy could drag down global oil demand, pulling both the dollar and oil down. Asia’s 1997-98 crisis led both Asian currencies and the price of oil.

Or a rebound in the US economy could push up the dollar while adding to oil demand. In 2000, a booming US pushed up oil prices and the dollar.

Ironically, a strong, healthy US economy might also push oil prices down, even while increasing US and world demand for oil! The price of oil to discretionary producers is not measured in dollars, but in the future purchasing power of the assets dollars can buy. If oil producers expected US financial assets to appreciate in value more quickly than oil (in terms of what they want to buy), President Bush wouldn't have to look anyone in they eye to get the producers to invest in new wells. However, if that's not the case, then the rate of production might be determined more by the political costs of failing to produce than by world demand or current-dollar prices.

But... for US dollar assets to appreciate faster in oil-producer purchasing power than oil itself, those assets would have to represent claims (direct or indirect) on future goods that producers want to buy, that is investment in tradable goods and services. Unfortunately, Brad is probably right to suggest that a "rebound" in the US economy would drive oil prices up, since we've come to believe that more GDP is always better, sectoral composition doesn't matter, and producing tradables is for the little people. Federal stimulus checks might give a zetz to GDP, but in and of themselves they do nothing to make claims on American assets worth buying.

What distinguishes a speculator from a hedger? Here's the New York Times:

Unlike hedgers — the farmers, miners, refineries and other commercial interests that actually make or use the commodities themselves — the speculators, like day traders in the stock market, are simply trying to profit from changing prices.

But that's not really right. Conceptually, a hedger is a party trying to shed risk, usually accepting some cost to do so, while a speculator willingly takes on risk, hoping to profit.

If we take nominal dollars as investors' unit-of-account, then all noncommercial interest in commodities is "speculation", as the Times implies. People are pouring money into commodities because they believe commodity prices will rise in US dollar terms. Since holding cash is risk-free (in nominal dollar terms), all investment is speculation unless it's offsetting some commercial risk.

But if we more realistically view investors' planned consumption bundles as their unit-of-account, the recent interest in commodities is better characterized as hedging than speculation. Investors perceive the value of currency to be more volatile than stored commodities, relative to the goods and services they hope to consume. It would be inefficient for investors to store commodities directly, so they hire professionals to store on their behalf by purchasing financial futures. (In properly functioning futures markets, when more money wants to go long than short, an invisible hand seeks out those capable of efficient storage, and compels them to fill warehouses in order to meet the excess demand.)

What Joe Lieberman proposes to do, then, is best understood not as barring speculation by institutional investors, but as barring hedging, as forcing investors to accept risks that they would prefer to shed.

Yves Smith writes that Senator Lieberman's proposal is "a Nixon-goes-to-China moment". I am wrong far more often than Yves Smith is, but I'm gonna go out on a limb here and say she's mistaken. The Senator fron Hedgefundistan is acting very much on behalf of his constituents. Smith writes:

Opponents may argue that this will simply drive investing in commodities overseas. Perhaps, but funds regulated under the Investment Company Act of 1940 (most US fund managers) don't have that sort of latitude, and ERISA investments could similarly be reined in quite easily. And it's US investors, plagued by (until recently) an ever falling dollar who have had particularly strong reasons to look to a hedge like commodities.

As a move to drive any speculative froth out of commodities, this one isn't bad (but one wonders how all those commodities index funds get unwound). Although some have called for increases on margins at commodities exchanges, that hurts commercial actors as well as speculators. A move like this focuses on the underlying issue more directly.

Goldman in particular would suffer, since as the biggest manager of commodities funds based on its index, GSCI, it not only earns fees, but as we have discussed elsewhere, earns even more from an unsavory but hugely profitable practice called "date rape" around the monthly futures contract roll.

Now before the wealth-holding class howls that they've just been done a dirty by being deprived of inflation protection, there is an asset class that, unlike commodities, supports productive investment. and provides inflation protection, namely, infrastructure investments. The cash flow from infrastructure projects (toll roads, airports) goes up over time, as do the payouts, so they have fairly secure cash flow that increases over time. Although there is some debate about how to view them, they seem closest to an inflation-indexed bond (although any investor would need to study the ability of the enterprise to increase charges versus the drivers of operating expenses).

Many investment funds may be prohibited by charter or regulation from participating in overseas commodity markets, but Senator Lieberman's hedge fund constituents and their wealthy accredited investors are not. The "wealth-holding class" would evade these restrictions quite easily, by funneling money through Connecticut businesses. This would be a growth-enhancing regulation for Stamford.

Meanwhile, retirement funds and retail ETF investors would be stuck with currency-denominated securities, and forced to bear any loss of purchasing power. Infrastructure as an asset class might or might not be a reasonable inflation hedge, as might stock (in the long run, equities are said to pass through inflation), TIPS, or any number of other assets. But that's fundamentally a decision for individuals to make. If infrastructure is a good choice, let the hedge funds buy it. But so long accredited investors (and savvy individuals with direct futures market accounts) have access to commodity exposure, it is inequitable to prevent the beneficiaries of ordinary investment funds from enjoying the same.

The United States economy is suffering the aftermath of poor aggregate investment decisions over a period of many years. Losses will have to be taken on those investments. The "wealth-holding class" responsible for the misdirection of capital will do what it can to shift losses to dispersed and relatively powerless little guys. I'd be glad to see the government take a more active role in addressing America's economic crisis. But most of the proposals out of Washington so far, including this idea from Senator Lieberman, give options to banks and wealthy investors while shoving costs and constraints onto everyone else. Trying to address the "commodity bubble" by restricting so-called speculation is a fool's game. If it's a bubble pop it, if it's a response to real risks, address those. Blaming speculators is like combating global warming by banning thermometers.

FD: I'm an evil speculator, but as an individual who trades futures directly, Senator Lieberman's proposal wouldn't prevent me from escaping the little people's inflation. That said, the only commodities I'm long are precious metals. I'm short Ag comodities via a retail ETF. I lose money all the time, so taking anything I say as investment advice is just dumb.

If you think $135 oil is a speculative bubble, that the only basis for current prices is want of a pin, here's a plan. If you're right, there's a market failure. Those with access to physical oil are accommodating the bubble for some reason, when they could, should in theory, sell forward in quantity and insist upon delivery, forcing speculators who cannot accept physical oil to close their positions at desperation prices. Note you don't have to overwhelm all the specs. Prices are set at the margin. You just have to sell with intent to deliver contracts representing somewhat more than demand for actual delivery to force oil off a cliff and crush the specs like bugs. If private arbitrageurs won't do this — perhaps those who can, don't, because they benefit more from high headline oil prices than they lose from foregoing a one-time arb &mdash then perhaps government should step in.

The US Strategic Petroleum Reserve could sell $135 oil forward in very large quantities, and refuse to close its contracts prior to delivery.

If you are right, and oil is an ordinary speculative bubble, then prices will fall sharply, and the petroleum reserve will be able to recover all the oil it sold cheaply, turning a profit for taxpayers.

But, if you are wrong, and oil prices are due to either current fundamentals or informed speculation on future supply and demand, then players interested in consuming or storing the product will step in as prices begin to fall and start buying. Prices would fall a little, but the drop would be transient, and the petroleum reserve would take a loss when it eventually repurchases to replenish.

It'd be a gamble. But if you think this is a bubble, a quick Federal pricking would be far less damaging public policy than curtailing unleveraged speculation. If you're not so sure it's a bubble, if you think it's possible that current or future supply and demand justify current prices, then you should definitely not be banning speculators, who are doing the good work dissuading us from squandering what is precious. If you think current prices are a monetary phenomenon, that selling oil forward trades a valuable commodity for depreciating paper, then you don't think this is a bubble at all, and limiting speculation is just a way of preventing would-be speculators from evading an inflation tax and spreading disquieting news.

I don't know whether current oil prices a speculative bubble or not. Maybe, maybe not. Maybe the best way to find out is with the help of a nice long pin.

While chatting with a commenter on the previous post, I went back to the Mathematica notebook where I had played with the numbers, and found an error in my arithmetic that is, as they say, "material". I erroneously used 68%, rather than 67%, as the late 90s participation rate, when I asserted that unemployment would be 8% today if participation returned to previous levels. The correct value is 6.6%.

That is, if an additional 0.8% of the "civilian noninstutional population" became active job seekers, but no net new jobs were created, the reported unemployment rate would be 6.6%. (The numbers, which hopefully I've correctly transcribed for a change, are May 2008 data from the June 6 release of BLS employment situation, Table A-1.) That's still a big jump from 5.5%, but it's a far cry from 8%, which sounds like a nasty recession.

To say I regret the error would understate the red-faced heart-thumpingness of the thing. Sorry!

Much of the chatter surrounding the latest BLS release has focused on a spike in the denominator of the unemployment statistic, the fraction of the population either working or actively looking for work. Courtesy of the indispensible FRED...

About a year ago, David Altig (whose macroblogging I miss very much) wrote the following:

[Since 2000] you would be justified in claiming a broad-based decline in the number of people choosing to participate in U.S. labor markets. But I use the word "choosing" intentionally, as I'm convinced that the post-2000 changes in labor force participation rates (or employment-to-population ratios, if you like) reflect trends that are largely independent of the business cycle.

Much turns on the question of why people chose not to participate in the labor force this decade. A "business cycle" explanation, as I read Altig, would mean that people left the labor force because there weren't employment opportunities. They couldn't find a job, and became "discouraged workers", in the lingo. I agree with Altig that this is unlikely. However, unemployment statistics (very uneconomically) ignore price, and stagnant real wages over the period undoubtedly had something to do with the decline in participation. People chose not to work because they decided the money wasn't worth their time.

But it's also important to consider a credit cycle explanation for why people left the workforce. One has the luxury of choice when one can afford to do without employment. During a credit expansion, many people have that luxury, because one can live off of borrowing and asset appreciation. You can quit your shitty job and withdraw some home equity while you write the great American novel, focus on your music, or raise your children. You can go to school, even though you lack savings, because student loans are plentiful.

But when credit conditions tighten and asset prices fall, work becomes less optional. Quitting the rat race and pursuing your passion starts to recall the phrase "starving artist", and not in a charming way. Dad might decide he needs a job to make ends meet, even if that means putting the kids in day care.

Some argue that the US economy is structurally immune from the wrenching spikes in unemployment that used to accompany recessions, because employment has transitioned from volatile manufacturing to more mellow services. See, for example, this excellent analysis from Calculated Risk. CR chooses 8% unemployment as his threshold for a "severe" recession. But the US economy need not lose a single job more to bring unemployment to that level. If participation rose back to the levels of the late 90s without a commensurate increase in new jobs, we'd be there already we'd be at 6.6% unemployment right now. [Note: In my original calculations, I mistakenly entered 68%, rather than 67%, as the late 90s participation rate, significantly exaggerating the effect. My apologies for the error!]

When we ended welfare as we know it, back in the nineties, the slogan "Choose to work" might have captured the spirit of the times. It's ironic that more than a decade later, the apparent health of the American economy depends largely on how many people continue to choose not to work, now that the credit spigot has dried up.

Greg Mankiw offers a strong endorsement of a proposal to cut the corporate income tax from 35 to 25 percent, claiming "It is perhaps the best simple recipe for promoting long-run growth in American living standards." (Hat tip Mark Thoma.) A good case can be made for cutting or even eliminating the corporate income tax. But Mankiw's argument does not cohere.

Let's start positive. Mankiw is right to point out that the "incidence" of the corporate income tax might not in fact be as progressive as its proponents would wish. He quotes studies suggesting that workers end up paying 70% to 92% of the taxes in the form of lower wages. I'm skeptical of those numbers, but it is surely true that some fraction, perhaps even a large fraction, of the corporate tax burden falls on workers and customers rather than presumptively wealthier investors. Mankiw does us all a service by reminding us of this.

Then he tells us a fairy tale:

A cut in the corporate tax... would initially give a boost to after-tax profits and stock prices, but the results would not end there. A stronger stock market would lead to more capital investment. More investment would lead to greater productivity. Greater productivity would lead to higher wages for workers and lower prices for customers.

First, if as Mankiw has argued, the lion's share of tax burden falls on workers, the "boost to after-tax profits and stock prices" would have to be correspondingly small. You can't have it both ways — either investors pay the tax, and stocks would be more valuable without them, or workers pay the tax, and stockholders are mostly indifferent. Perhaps Mankiw doesn't think that workers pay the tax after all.

Suppose there would be a surge in profits and stock prices, either because the corporate tax does burden stockholders, or out of irrational exuberance by cigar-smoking plutocrats. What then? Would "a stronger stock market... lead to more capital investment"? The tax change can't affect the economic opportunities available to firms. It can only affect investment decisions by reducing firms' cost of capital. As long as firms are correctly valued, the cost of equity depends on investor expectations going forward, not the level of the stock market today. Counterintuitively, if investors expect high future stock returns, that implies an increase in the cost of equity, and less corporate investment as existing opportunities face a higher "hurdle rate". Steepening return expectations only lead to more capital investment if they reflect an improvement in the opportunities available to firms. That is beyond the power of a tax cut.

Unreasonably high stock prices can, of course, encourage capital investment, as managers try to exchange overpriced paper for valuable projects, but the quality of investments under those circumstances is questionable at best. Surely, Mankiw does not think we should jolt stock markets into a bubble, because then firms will invest willy-nilly to preserve value before investors come to their senses?

A more charitable interpretation would be that Mankiw meant that investors' required return for stock investments wouldn't increase as much as the after-tax value of investment opportunities would, effectively reducing the equity cost of existing opportunities. But if the after-tax opportunity values would improve (they wouldn't, if workers bore the tax), there's no reason to think investor return requirements wouldn't increase as well. Just as it's hard to say who a tax will ultimately fall on, it's hard to know a priori how the proceeds of an investment tax break will be split between reinvestment, consumption, and safety. Some of the tax windfall would (thank goodness!) go towards delevering to reduce risk, and some would be withdrawn and spent by investors. How much actually goes to new capital investment would depend upon investor preferences, credit markets (which set the cost of safety), and the quality of potential new projects.

In theory, when firms do not have productivity-enhancing new projects at the ready, they return funds to investors. But, in the aftermath of first the dot-com bubble, and then a massive credit & housing bubble, it's worth asking what actually happens when the economy experiences positive shocks to the supply of capital. Perhaps, in a world where agents are informationally limited and distinct from the owners of capital they deploy, it is not always optimal to increase the rate at which capital is made available to firms and investment professionals, when the same wealth might otherwise be consumed or held for future use. We might illustrate this to supply-siders as a "Laffer Curve", with an optimal cost of capital above which productivity-enhancing investments are foregone, but below which wealth-destroying projects are funded. I think we've been on the wrong side of that curve for much of the past decade, so before I get excited about policies that purport to deliver growth by increasing incentives to save and invest, I'd like to see evidence that if we had more capital at hand, we'd use it well rather than employing well-paid intermediaries to destroy stuff in crazy schemes.

Supply side economics is a nice story, a hopeful story. It offers a clean, plausible policy framework: encourage investment, always and everywhere, and prosperity is sure to follow. But this decade has been about a pure a test of that idea as we could hope for. Capital in the United States was incredibly cheap, and what did we do? We destroyed a lot of wealth. We don't need more capital (although we might soon, if our foreign backers get skittish). We need more discriminating capital. In the meantime, the only thing I'm sure "works" about the supply side story is that it shifts the tax burden from richer to poorer. I'd rather that stop working so well.

Postscript: It is always deflating to see good ideas supported by poor arguments. I'd enthusiastically support eliminating the corporate income tax entirely, if the change were paid for by new taxes at least as progressive as the corporate income tax was intended to be. But my reasons are different from Mankiw's. Currently, the portion of corporate earnings payable to shareholders is taxed as corporate income, while the portion of earnings payable to debt holders is not taxed at all at the corporate level. (The accountants don't call the latter earnings at all, but that is semantics.) This differential tax treatment effectively pays firms to borrow funds rather than raise new equity when they need cash, which is bad public policy. Corporate leverage has social costs, "negative externalities", in terms of financial stability. To the degree government interferes in the capital structure decision at all (and I'm not arguing that it should), policy should favor equity financing since equity-funded firms are better able to internalize the costs of their misfortunes than are highly leveraged firms. So, three cheers for a progressively funded abolishment of the corporate income tax!

Alas, Mankiw proposes increasing gasoline taxes to replace the lost revenue. While there is much to be said for a higher gas tax, it fails the progressivity test. (Poorer people spend a much larger share of their income on fuel than do the affluent. Surely a Pigouvian would delight in redistributing the proceeds of a carbon tax as a flat transfer back to citizens to offset that unfair burden. A rebated carbon tax could be wildly popular, and help save the planet too.)

If, instead, we funded the change by increasing the highest marginal tax rate, or better yet, by creating a new top tax bracket, eliminating the corporate income tax would be a grand idea.

Poor, abused readers — I am making a recycling bin of your eyes!

The following is modified from a monstrosity I began and abandoned over a month ago, thinking about futures markets. Michael Masters' allegations regarding "index speculators" and the CFTC's investigation of price manipulation in the oil market only make sense if the arbitrage between future claims and physical stuff fails to work as advertised. The most clear example arbitrage failures have been with agricultural products, where cash market prices and prices of supposedly equivalent expiring futures contracts have simply not converged. It is to that (now ancient in blog-years) controversy that this suggestion was originally addressed, but I think it applies to the more recent hullabaloo as well. I'm sorry that the links and context are somewhat dated.

For those of you who have been in the financial equivalent of outer space (that is, for those of you with a life), commodity futures markets have been misbehaving recently. I don't want to get into it, but see here and here and here and here and here and here. The problem is that textbook arbitrage constraints are coming loose, the prices of things are wriggling free from one another in incoherent ways, and smashing up farmers in their confusion. Arbitrage is to finance what gravity is to physics. The movement of the spheres makes no sense, has no meaning, if rational relationships between prices aren't maintained.

The universe is blessed with diligent quantum smurfs who ensure the constancy of gravity for us. But arbitrage is left in the frail hands of humans, and frequently our institutions are not up to the task. Fortunately, institutions are fixable. The trouble with commodity futures is that, although all the world can see that, say, spot and future corn seem inconsistently priced, relatively few actors — those with ready access to good, wholesale corn and the means and expertise to store and deliver it — can actually make the trade that would force prices and cosmic spheres to realign themselves. There are limits to arbitrage.

So, a suggestion: As an alternative to delivering actual corn to one of various warehouses in Illinois, permit those short a futures contract deliver a note issued by a kind of "corn bank", entitling the bearer to a quantity of that very same corn on demand from the bank's warehouses. Futures exchanges would regulate and certify competitive commodity banks, delivery of whose notes would constitute contract fulfilment [1]. At the same time, exchanges would host accessible cash markets in these zero-maturity notes (against which there would be negative accruals to cover storage costs, but lets put this technical detail aside for now).

At first glance, this proposal is a kind of nonsolution: Sure, convergence failures in futures markets would trivially disappear, as financial investors would purchase and hold underpriced spot claims and short overpriced futures (or vice versa) if the futures and spot prices were misaligned. But today's convergence failures would just reappear in the form of overpriced deliverable notes relative to the cash price of the commodities they represent. Why would that help?

Financial markets are fundamentally information processing devices. Their purpose is to help investors place capital (or risk) where it can do the most good (or least harm). Thus, it matters very much whether the structure of a market reveals or obscures relevant details about an economic problem. This was a fatal flaw of the late securitization boom — there's nothing wrong with securitization per se, it's a great idea actually, to get previously obscure investments priced by broad and deep capital markets. But capital markets aren't magic. If the securities hawked are complicated bundles of mathematical formulas of incompletely described uncertain securities, "market prices", while they last, may not prove reliable. (OT: See this great post by Going Private about the CDO securitization process).

Trading claims on deliverables rather than direct obligations to deliver would open the arbitrage process to all financial investors, rather than relying on small groups of potentially collusive firms. Mysterious convergence failures would disappear. Rather than going "WTF?" and convening at the CFTC, we'd observe commodity banks eager but unable to sell simple IOUs for commodities at prices well above their cost because they lack storage or shipping capacity. A phenomenon of high finance would unmask itself as an easy to remedy operational problem, with a clear business case attached. Of course, people in commodity industries already understand the bottlenecks they face, and eventually they'll find the financing to do whatever needs to be done. But clarity matters. A couple of months ago, farmers and grain elevators faced a "liquidity crisis" — their traditional funding sources, banks, were skittish due to the credit crunch, and other capital sources don't understand their business well enough to jump in with quick money. With a more transparent informational architecture, capital would cure bottlenecks faster. Time is always of the essence, both from a broad economic perspective, and to farmers who are struggling to meet margin calls on volatile futures contracts when all they want to do is lock-in a price for corn.

This scheme would also render market manipulation more visible, by eliminating complexity at the interface between opaque, dispersed cash markets and liquid, transparent futures markets. If futures prices spike somehow, spot note price would rise, which ought to cause banks to compete for cheap access to the physical commodity. If prices seem "too high", regulators could focus on spot market conditions (are commodity banks competitive? are producers withholding output? are precautionary inventories rising at banks? is there unusual non-bank-intermediated demand, either by current users or speculators?). Arbitrage relationships hold quite well among predictable, liquid paper assets. With a simple market for spot claims, regulators could focus on the present, and let the future take care of itself.

[1] Exchanges would insist upon these notes being non-fractional claims against actual inventory, as the exchange's clearinghouse would ultimately guarantee the notes. These would be depreciating, negative carry notes (due to storage costs), so investors without use of the commodity would shed notes quickly, keeping inventories minimal, unless they wish to finance storage for precautionary or speculative purposes (which inventories would be transparent and measurable). Banks would compete both on the price (reflecting their quality of access to the dispersed cash market) and storage fees (reflecting operational efficiencies).

Michael Masters' testimony regarding the role of speculation in commodity prices has drawn a lot of comment since last week. [See, for example, Cassandra, James Hamilton, Tim Iacono, John Mauldin, Michael Shedlock, Yves Smith.] According to Masters', portfolio investors' increasing participation in commodities via futures markets has been driving a speculative price boom, over a period of years.

I have to say, I am very skeptical of Masters' view. Perhaps I have drunk too deep of the Kool-Aid of orthodox finance, but, as the saying goes, "for every long there's a short", and Masters does very little to explain who is taking the other side of what he presents as a one-way bet, a virtual cornering of the commodity markets. We'll come back to this, because the shorts are the most interesting characters in our story. But before we go much further, we might as well opine a bit on the debate du jour, is "speculation" driving commodity (and especially oil) prices?

This question annoys me, because people rarely define what they mean by "speculation". Are you concerned about...

1. Traditional speculators, making active predictions about future supply and demand, and determining that commodity are underpriced relative to other goods and services.

2. Nervous hedgers, who respond to recent price volatility by taking larger-than-usual precautionary positions in order to manage operational risk.

3. Portfolio diversifiers, who allocate some fraction of their portfolios to commodities in a price-insensitive way, as it becomes ever more convenient to do so, and the investment profession comes to view commodities as an attractively uncorrelated "asset class".

4. Momentum investors, chasing recent price rises into a classic speculative bubble.

5. Inflation hedgers and monetary skeptics, who view the purchasing power of financial assets as increasingly volatile, or who expect a decline in the purchasing power of financial assets, but who do not view commodities as undervalued relative to other goods and services.

6. Corporatist governments, who seek to shed market risk by obtaining non-market access to commodities (vertical integration), or whose policies amount to speculation on future market conditions. Examples include countries that restrict food or commodity exports in response to high prices; China, whose state-affiliated firms purchase stakes in suppliers of essential commodities; Saudi Arabia whose purchase of GE Plastics looks to capitalize on preferred access to petrochemicals; oil producers generally, when they produce below capacity; and the United States with its strategic petroleum reserve. All of these practices have the potential to reduce supply to unaffiliated commodity users who rely on public markets.

It takes all kinds to make a market, and I think that we've got the whole menagerie. Also, we shouldn't forget this story, from Jeff Matthews (ht WSJ):

...the fact that a) world oil demand is up 12 million barrels a day since 2000, and non-OPEC oil supply is up only 4 million barrels a day since 2000, and b) America decided to convert food into ethanol at the very moment that c) China's demand exploded.

See James Hamilton for a fuller exposition of the case that oil price fundamentals are driving prices.

Masters fingers as the villain "index speculators", a Frankenstein combination of Types 3 and 4 above. There outta be a law agin' them, he suggests to Congress. Pension funds should be barred from commodity investing, loopholes that have undermined speculator position limits should be closed, and the increasingly meaningless distinction between commercial and noncommercial traders should be resurrected in CFTC reports. Okay.

But what if the price-setting speculators are not momentum-driven index funds, but "traditional speculators", correctly predicting that prices are below long-term fundamentals? Then limiting commodity speculation would prolong the mispricing, and cause us to waste resources that are kept artificially cheap. Alternatively, what if (as I suggested in the previous post) commodity prices are being driven by monetary fears? Then banning pension funds from commodities would amount to barring the exits, forcing workers to watch helplessly as their retirements are devalued away. If "fundamentals" are driving prices, or a flight by official actors from market to non-market means of resource allocation, limiting speculation would do no good, but would obscure the news by interfering with price transparency. The only circumstance under which limiting "speculation" might be a good idea is if the dominant tale is a momentum-driven speculative bubble. Which could, of course, be the case. Or not.

Which brings us back to the shorts. "Irrational exuberance" isn't enough to cause a speculative bubble. There needs to be something else that discourages rational traders from taking irrational traders' money when they buy overpriced assets, "limits to arbitrage" in the lingo.

Now, this is an old conversation in academic finance, especially with respect to the stock market. Heck, go chat with Brad DeLong and Robert Waldmann about noise traders, they're right here in the blogosphere. We'll dispense with the details here, and recite the pithy Keynes quote...

The market can stay irrational longer than you can stay solvent.

If a stock is overvalued, to correct the mispricing, you must sell it short. Even if you are right that it is overpriced, if the speculative mania continues, red ink on your short position might drive you out of the market and into poverty long before your foresight is vindicated. On the stock market, unleveraged "longs" can safely buy and hold, but "shorts" are forever at the mercy of the lunatics, hoping and praying that starry-eyed optimists don't go even more batshit insane. Sane people sit on the sidelines, allowing enthusiasm to run unchecked, for a while.

But there's a problem with applying this story to commodities. At least in theory, shorts in commodity futures needn't face the same risks as stock short-sellers. Commodity futures are time-bound and perfectly hedgeable. If you are a commodity producer, and know that futures prices are way too high, you can sell your own product forward into the market. If prices move irrationally against you, your only cost is the foregone opportunity of a speculative gain. If cash prices are out of sync with inflated futures markets, then anyone (in theory) should be able to get into the act, purchasing physical commodities and storing them for future delivery, thereby locking in a certain gain, a perfect arbitrage. If you think that the commodity boom is a speculative bubble, then you have to explain not only who is buying, but why all that speculative interest doesn't attract knowledgeable sellers who hold the price to "fundamentals".

A while back, Yves Smith pointed out the possibility that...

the volume of futures contracts is so large relative to the actual deliverable commodity that arbitrage (via taking physical delivery) won't force convergence of futures prices to cash prices at contract maturity.

In other words, in this messy real world, speculative interest could overwhelm the arbitrage mechanism designed to tether futures prices to fundamentals, for a while. But that begs another question. If you buy Masters' story, then we are in the midst of a speculative bubble that has been building over a period of years, not a sudden spike. So why haven't arbitrageurs increased their capacity to store and deliver goods, as speculative demand has slowly ramped up? The opportunity to profit is tremendous, especially if there are hordes of paper speculators who have no choice but to liquidate or roll their positions every few months. People with access to the physical commodity could profit from more than the ordinary arbitrage. At every roll, they have the entire community of "index speculators" over a barrel. Shorts are under no obligation to let speculators close out their positions at inflated "market prices", or even estimated "fundamental values". They can force longs to accept prices that overshoot downward, exacting a price for release from obligations that paper speculators are incapable of fulfilling, the obligation to accept delivery. If you think Masters is right, you have to explain why, year after year, those taking the short side have been willing close their positions at a loss rather than forcing more deliveries. Why haven't shorts entered the market who are capable of calling index speculators' bluff?

Hmm. Let's turn once again to Smith:

Remember, you can arbitrage futures to physical only if you are permitted to do so (only certain traders, known to have access to the storage and transport, are allowed to take or make physical delivery) and can actually obtain the relevant commodity.

So, there are potentially barriers to entry for bluff-callers. Who are these "certain traders" permitted to make delivery? I don't know, but one would imagine that commodity producers would be prominent among them. So, for the conspiracy-minded among you, here's a theory: Producers' core asset is not the stock of goods they have for sale today, but their potential to produce and sell a stream of commodity out into the indefinite future. It might be worth it for producers to bear an opportunity cost by not exploiting futures trades aggressively — that is by letting specs close positions at artificially bid-up prices — in order to inflate the apparent value of their enterprises, especially when producers intend to borrow funds, sell equity, or make stock-based acquisitions. Managers whose compensation is equity-linked might be particularly enthusiastic. Depending on how numerous and competitive the community of enterprises capable of physical delivery on prominent contracts, there might be a tacit cartel on the producer side, accommodating speculative futures prices, while managing spot supply so that cash market prices (which are less consistent and transparent than futures prices) are not outrageously out of line with futures market benchmarks.

Is this really going on? I have no idea. As I said initially, I can see all kinds of reasons why commodity prices might be rising, besides "irrational speculative bubble". But I do know this. If it is the "index speculators", if it is a speculative bubble, then those who blame workaday money managers asset-allocating into commodities are buying the con and blaming the patsies. If there's a speculative bubble, the mystery — and the target of any reasonable policy interventions — lies on the short side. Sooner or later, the lemmings going long will take care of themselves.

When I see what commodity prices are doing, I don't think "low interest rates" or "skyrocketing demand". I think about a loss of confidence.

There is that old saw about gold, that it is the only money that is no one's liability. Wheat is no one's liability, and neither is corn. Oil is no one's liability.

It is common to invest in commodities as an "inflation hedge". If the central bank prints too much money, you need wheelbarrows to buy bread. If you have a sack of wheat, you will have your bread whatever the central bank does. But if everyone buys wheat, the price of grains will rise, even if the central bank does nothing at all.

Just as the fear of a bank's insolvency can precipitate a run that drives a bank to ruin, loss of confidence in a central bank can provoke a great inflation. The Federal Reserve, much I might criticize it, has not gone on a printing spree. It has lowered interest rates, and altered the composition of bank assets by replacing less liquid with more liquid securities. But the most these measures should do is bring us back, monetarily speaking, to the status quo ante, back to a year ago when asset-backed securities were liquid. The Fed's actions are best described as antideflationary, not inflationary.

But confidence is a funny thing. Central bankers are supposed to be dour and dependable. The current crop is not. Rather than "taking away the punchbowl", central bankers have become the life of the party. Japan's central bankers hand out Yen like free acid. China's guy will give you a microwave oven and a DVD player if you draw him a picture (and sign Henry Paulson's name to it). Our man Ben is an Amadeus-cum-Macguyver, he's brilliant, unpredictable, he'll improvise a Delaware company from paper clips and vacuum up your derivative book with a toenail clipper. Even the ECB's Trichet, who at first comes off like a sourpuss, turns out to be alright, when you've got some Spanish mortgages to pawn.

Some of us think that something's wrong, and these guys we're drinking with aren't serious enough to fix it. We know that trillions of dollars in presumed housing wealth have disappeared, but we don't know who's ultimately going to bear the loss. Americans know that as a nation, we cannot afford our clothes, furniture, or gas, unless the people who are selling it to us lend us our money back. Economists fret about "imbalance" and "adjustment", but we've yet to see a serious plan, other than let's-keep-this-party-going.

So, we lose faith. When we lost faith in Northern Rock, Bear Stearns, Citigroup, or Lehman, the central bankers stepped into the fray, and stood behind them. So, we ask, who stands behind the central bankers? We take a peek, and all we see is our own money. Which we quickly start exchanging for something else.

Although commodity prices have been increasing for years, you'll notice that the very sharp run-up began last summer, at roughly the same time as the credit crisis. Commodities soared when interest rates were still high, but predicted to fall. Commodities are soaring today, even though US interest rates are now predicted to rise. Commodities have soared in euro terms, despite the ECB's refusal to drop interest rates.

I can't tell you where the inventories are, except to wonder why anyone would put them where they would be counted. Hoarders tend to get nervous, and not advertise their hoards. (But this is pretty obvious.) Perhaps producers of storable commodities who lose faith in paper quietly hold back production. Interestingly, people who no longer trust the very core of the financial system remain comfortable with collateralized, centrally-cleared futures exchanges. These are well designed to manage credit risk, but they can default, have defaulted, and will default in extremis. I heartily endorse Cassandra's suggestion that they step up their margin requirements, ASAP.

None of this is any good at all. Capital devoted to precautionary storage would be better employed building new enterprises, laying a foundation for tomorrow's prosperity. But claims on future money are only promises, easily broken or devalued. A run on central banks, a flight from financial assets to stored goods, sacrifices the hope of future abundance for certain present scarcity. Governments can shut futures exchanges, confiscate gold, ban "hoarding, profiteering, and price-gouging". People will hoard anyway if they don't believe in the paper. People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan. Earnest promises to do better soon won't suffice. Nor will yet another drink from the punch bowl.

Mark Thoma offers a very thoughtful rejoinder to my post on whether the Fed should be given authority to pay interest on deposits. Mark's comments range from specific, technical points to broad questions about governance. What follows is a quick response to some of the issues he raises. Do read his piece, The Fed Already Has a Blank Check.

My bottom line remains the same. Although the central bank does have the capability to unilaterally expand its balance sheet, it is subject to a variety of constraints that restrain it in practice. I am opposed to relieving the Fed of those constraints unless hard limits are placed upon the scale of its direct investment in the financial system, both to protect taxpayers from absorbing losses, and to support the long-term ability of financial markets to allocate real economic capital well.

I address some of Mark's points specifically below.

• Mark suggests that "the Fed already has a blank check", because it could increase reserve requirements, rather than borrow funds, to sterilize the inflationary effect of printing cash. This is true in theory, but I think it would be very difficult in practice for the US central bank. The Fed has not used reserve requirements as an active instrument of monetary policy for a long time, and has allowed (encouraged) them to atrophy, with an eye towards eliminating them entirely. (See here and here.) Reserve requirements could be reinvigorated, of course, but not easily or quickly. They would have to be restored over time and in careful consultation with banks, whose enthusiasm for the project would be less than overwhelming.

• You'll hear no argument from me when Mark suggests that the Fed already has the power to do great harm. Poor monetary policy can lead to unnecessary recessions, or to credit and mis-investment booms that leave the economy structurally crippled. That an institution already has great and terrible power is no argument for handing it yet another means of mischief-making.

• While central banking has always entailed risk, customary and statutory constraints usually reduce the likelihood of harm. Any asset can lose value, but restricting Fed purchases to short maturity Treasury securities limits the risk of capital losses, and importantly, distributes gains from seignorage to all taxpayers. Purchasing or lending against more speculative assets provides a subsidy to particular sectors and institutions (undermining legitimacy), puts taxpayer funds at risk, and privatizes the gains of seignorage in the event of nonperformance. (Central bank cash that otherwise would have retired public debt are instead distributed to private parties and never returned.) Fair allocation of seignorage gains is one of the prime virtues of fiat money central banking. Lending against questionable collateral imperils that advance.

• Mark correctly points out that the potential upside of the Fed's bank investments is not merely, as I suggested, "about what [taxpayers] would have earned investing in safe government bonds". The purpose of the central bank's activism is to prevent harms to the public that might result from turmoil in the financial sector, and these foregone harms should be included in our calculus. But if we include nonfinancial benefits, we must also consider nonfinacial costs, such as the long-term effects of the "moral hazard", a loss of information in asset prices (assets must be valued as complex bundles of economic claims and options on potential government support), and impaired political legitimacy of the central bank and the financial system as a whole. We must weigh these costs and benefits against alternative policies, not only a straw-man scenario under which all government agencies stand completely aside and watch helplessly as the world falls apart. Of course, in "real time", the Fed did not have the luxury of reflection. But we do have it now. Mark and I would come to very different judgments about the nonfinancial costs and benefits of Fed policies. I assure you that, in general, Mark's judgment is much better than mine. Nevertheless, cranks like me will aver that the long-term costs due to moral-hazard and information loss are inestimably large, that questions of legitimacy and favoritism will haunt financial capitalism for a generation, and that it would be possible (even now!) to adopt uniform procedures for managing the collapse and reorganization of institutions that could not survive without life support from the Fed. Who should be empowered to decide these issues? Ben Bernanke? Hank Paulson? I vote for the people that I voted for, warts and all.

I want to make clear that I don't actually disagree with Mark on the technical question of whether an interest rate corridor is a good idea. So long as the Fed restricts itself to traditional monetary policy — that is, so long as it buys only Treasury debt with borrowed funds — I would support this change (mostly because an interest rate corridor is easier for non-experts to understand than open market operations).

Unfortunately, not only has the Fed resorted to unorthodox tools during an acute emergency, but all indications are that the central bank plans to expand its innovative practices and continue them indefinitely. The "unusual and exigent circumstances" under which the Fed's extraordinary actions have been justified specifies duration about as precisely as the "global war on terror". Mark has great confidence in the Federal Reserve, and sees little hazard in granting it more freedom to maneuver. I view the central bank as prone to catastrophic error, and wish to see its capabilities clipped, not enlarged. I think the consequences of centralizing private sector risk on public sector balance sheets will turn out be grave, and must oppose any tool that would make it easier for the Fed to continue to do so.

Finally, Mark writes regarding the occasional need for fast action in a crisis:

This is an old problem — how much authority should be centralized thereby allowing quick and immediate response during a crisis, and how much should be retained in slower, deliberative bodies like the House and Senate? The War Powers Act reflects this compromise — we want the ability to respond quickly to an attack or other military developments, but we worry about the concentration of power in the hands of a single individual. Centralization has the benefit of allowing a quick response to a crisis, but it risks being out of step with the democratic process. In the case of financial market emergencies, however, I have more faith in the Fed than in congress to act quickly and correctly. That's partly because I have little faith in the ability of congress to quickly comprehend what the problem is and attack it directly and effectively — many of them admit to not having a clue about economics, and more worrisome are the ones who think they have a clue but don't — but congress should not give up its oversight role.

I have little faith in Congress, and even less faith in the Fed. (That's not, by the way, a reflection of the individuals running the place. Ben Bernanke is quite brilliant. But culture and ideology saddle the Fed with both blind spots and hubris.) I like Mark's idea, though. I'd support a financial "War Powers Act" that would authorize emergency extensions of secured credit by the Fed to private actors deemed systemically important. But here's my deal-breaker: That support would have to be withdrawn within 180 days, and would not be renewable. Six months is long enough for solvent institutions to counter a "liquidity panic" with full disclosure, for modestly troubled institutions to secure new capital, and for regulators to arrange an orderly unwinding of firms that cannot be made solvent and liquid within the statutory timeframe. Whaddaya say?

By the way, we'll have our six-month anniversary of the first $40B in TAF financing in June.

Last week, the Fed decided to ask Congress for the right to pay interest on bank reserves. (Hat tip Barry Ritholtz, see also William Polley, Mark Thoma, Brad DeLong) This is a very big deal.

Don't be misled into thinking that the Fed's proposal is just some arcane, technocratic change. The Federal Reserve is asking taxpayers for a big pile of signed, blank checks. That's far too much power to put in the hands of a quasipublic organization with little democratic accountability. This authority should not be granted without some strong strings attached.

First, some background. There is a trend among central banks to move from old-fashioned, fractional-reserve banking to a system whereby interest rates are managed via a "channel" or "corridor", and under which fixed reserve requirements might be dispensed with entirely. The basic idea is simple. The Fed currently manages interest rates indirectly, by manipulating the supply and demand for cash in the banking system. But the Fed could adopt a more direct approach. It could choose two interest rates, a "floor rate" at which the Fed would stand ready to borrow funds, and a "ceiling rate" at which the Fed would stand ready to lend. As long as there is no stigma attached to transacting with the Fed, banks would never lend for less than the floor rate or borrow for more than the ceiling rate. The interbank interest rate would necessarily lie within a "corridor" defined by these two interest rates. The Fed would continue to adjust the money supply to keep interest rates somewhere inside the desired range. But the corridor would serve as a fail-safe. When banks have more cash than would be consistent with the policy interest rate, they would lend the excess money back to the Fed, causing it to disappear in a poof of green smoke. When banks have too little cash, they would borrow more into existence, until the quantity on hand becomes consistent with the Fed's desired interest rate. The level of borrowing from or lending to the Fed would provide feedback, telling central bankers whether they need to add or remove cash from the banking system to achieve their targetted interest rate, usually at the center of corridor.

A corridor system would represent a meaty change to how central banking is done in the US, but the approach seems to work okay in other countries. Advantages for central banks include more robust control of short-term rates, and the ability to fine-tune monetary policy by altering the "spread" between the central bank borrowing and lending rates without changing the core interest rate. A disadvantage, from taxpayers' perspective, is that the loss of zero-interest reserves amounts to a stealth tax cut for banks. On the back of my napkin, the cost to taxpayers would be between $190M to $530M per year if the level of reserves is unchanged. (I'm assuming "floor rates" between 1.75% and 4.75% against reserves of $11B). The Wall Street Journal reports estimates of $150M and $280M per year. If one assumes that corridor interest rates will roughly match the Treasury's average cost of financing over time, and that the Fed invests reserves in Treasuries, then the total cost of the program in NPV terms would be the value of the current (interest-free) reserves. This amounts to a one time cost of about $11 billion. A more serious drawback is that a channel system paves the way for the getting rid of reserve requirements entirely, which seems a perverse thing to do in a credit crisis caused by too much leverage. But reserve requirements have already been eviscerated, and nothing prevents regulators from maintaining or strengthening reserve requirements in a channel system.

So far, so good, then. As long as the Fed is conducting ordinary monetary policy, switching to a channel system offers modest benefits at a modest cost to taxpayers. But the Fed's monetary policy has not been ordinary at all lately. In fact, it's been quite extraordinary. It is in the context of this extraordinary policy that the Fed has asked Congress to accelerate its authority to implement a channel system, and it is in the context of this extraordinary policy that we must consider the change.

The core of the Fed's new exuberance is a willingness to enter into asset swaps with banks. The Fed lends safe Treasury securities to banks, and accepts as collateral assets that private markets consider dodgy or difficult to value. (This is the direct effect of the Fed's TSLF program, and the net effect of TAF and other lending arrangements that the Fed sterilizes in order to hold its interest rate target.) In doing so, the Fed puts taxpayer funds at risk. If a bank that has borrowed from the Fed runs into trouble, the Fed would face an unappetizing choice: Orchestrate a bail-out, or permit a failure and accept collateral of questionable value instead of repayment. Either way, taxpayers are left holding the bag.

In December, the Fed had $775 worth of Treasury securities. That stock will soon have dwindled to $300B, give or take. The difference, about $475B, represents an investment by the central bank in risky assets of the US financial sector.

$475B is an extraordinary sum of money. It is as if the Fed borrowed more than $1500 from every man, woman, and child in the United States, and invested that money on our behalf in Wall Street banks that private financiers were afraid to touch. For bearing all this risk, if things work out well, taxpayers will earn about what they would have earned investing in safe government bonds. If things don't work out well, the scale of the losses is hard to predict. The Fed will claim to have done "due diligence" on its loans, to have valued collateral conservatively, and will point to strength of bank guarantees and the enormous diversity of collateral assets to convince us that its actions are safe and prudent. But rating agencies made the same claims about AAA CDO tranches, and turned out to have been mistaken. Correlations often tend towards one when asset values fall sharply. Central bankers struggling to manage day-to-day crises in financial markets might cut corners when trying to value complex securities. They might find it convenient to err on the side of optimism, as the ratings agencies did, albeit for very different reasons. And even if the Fed is cautious and sober-minded, are we sure that central bankers can value these assets more accurately than private investors?

If the Fed were to blow through the rest of its current stock of Treasuries, it would have invested more than $2500 for every man, woman, and child in America. Public investment in the financial sector would have exceeded the direct costs to date of the Iraq War by a wide margin. Would that that be enough? If not, how much more? Just how large a risk should taxpayers endure on behalf of companies that arguably deserve to fail, to prevent "collateral damage"? Have we considered other approaches to containing damage, approaches that shift costs and risks towards those who benefited from bad practices, rather onto the shoulders of taxpayers and nominal-dollar wage earners? Does this sort of policy choice belong within the purview of an independent central bank?

Now I don't actually mean to be too harsh. Putting aside the years of preventable foolishness that got us here, in the new day that began last summer, a crisis emerged that had to be managed and the Fed was the only organization capable of stepping up to the plate. I don't love the decisions that were made, but decisions did have to be made, and there weren't very good options. But now we have a moment to reflect. If the credit crisis flares hot and bright again, how much more citizen wealth should be put at risk before other policy options are considered? That's not a rhetorical question: We need to choose a number, a figure in dollars. My answer would be something north of zero, but not more than the roughly $300B stock of Treasuries that remains on the Fed's balance sheet. But this is a decision that Congress needs to make.

And what does all this have to do with the question that will soon be put before the Congress, whether the Fed should be permitted to pay interest on deposits? Everything, as it turns out. Suppose the Fed decides it wants to swap more than the $300B in Treasury securities it currently has available in order to support the financial system. Given its current tools and practices, the Fed would have to print money in order to buy more Treasuries to swap. But if it did that, the extra cash would drive interest rates below the Fed's target level, quite likely provoking inflation. The Fed cannot simultaneously swap away more than its existing stock of Treasuries and satisfy its legal mandate to promote price stability, unless it resorts to something weird.

But suppose Congress gives the Fed the authority to pay interest on reserves. Suddenly the Fed can print cash to buy all the Treasuries it wants to swap for troubled assets. When banks find they have more cash than they need, they lend the money back to the Fed, collecting the "floor" interest rate and removing the currency from circulation. Since interest rates can be held to any level by adjusting the "corridor", the Fed would retain the flexibility to respond to inflation. At the same time, it would be able print cash in any amount that it pleases — "to infinity and beyond!" — in order to fund asset swaps (or outright purchases) at taxpayers' risk. This strikes me as a delegation of Congressional authority that would not only be undesirable, but arguably unconstitutional.

So, should we simply refuse the Fed's request? Probably not. Brad DeLong makes an excellent point:

The Fed may also want to raise the general level of interest rates in order to fight inflation--which requires that it sell its Treasuries for safe bank reserves rather than temporarily swap them for risky MBSs.

The Fed is already rubbing pretty close to its "balance sheet constraint". If, after exposure to gamma radiation from televised images of food riots, Ben Bernanke were suddenly transformed into The Incredible Volcker, he might lack the tools he'd need to jack rates up into the muscular high teens, unless he's given this new authority. So what should we do? James Hamilton has an answer:

Congress has a quite proper role in determining the magnitude of the fiscal risk that the Fed opts to assume... [A] statutory limit on the non-Treasury assets that the Fed is allowed to hold might make sense. Perhaps the outcome of a public debate on this issue would be a decision that the Fed needs the power to lend to private borrowers even more than the $800 billion or so limit that it would run into from completely swapping out its entire portfolio... Or perhaps after deliberations, Congress would decide that the business of swapping Treasury debt for private sector loans is one that is better run by the Treasury rather than the Federal Reserve.

I agree. I think that Congress should grant the Fed's request, but it should simultaneously impose constraints on the composition of the Fed's balance sheet that cannot be violated without express legislative consent. This will be a complicated exercise, unfortunately. Besides government debt, central banks quite ordinarily hold precious metals and foreign exchange, and limitations on non-Treasury assets will have to take this into account. Plus, restrictions would have to be written carefully to apply to off-balance sheet arrangements such as TSLF, and contingent liabilities like the insidious reverse MBS swap proposal. Finally, Congress must consider restrictions on the Fed's ability to enter into derivative positions, whether directly or indirectly via special purpose entities, including how the bank's existing derivative book should be managed and whether the bank should or should not guarantee the liabilities of current Fed-affiliated SPEs.

Congress might also limit the quantity of reserves on which the Fed will be permitted to pay interest.

The Fed can retain full independence for the purpose of conducting ordinary monetary policy, exchanging government debt for cash and vice-versa. But if the central bank wants to put ever greater quantities of public money at risk, it will have to accept a lot more public supervision. If the prospect of intrusive oversight is too much for the Fed, then, as James Hamilton hints, perhaps the roles of central bank and macroeconomic superhero should be moved to separate boxes on the organizational chart. If we are not careful, the next bank requiring a taxpayer bailout may be the Federal Reserve system itself.

The graph below plots the US Federal Reserve's stock of "uncommitted Treasury securities", defined as Treasury securities held outright less securities lent to dealers. The graph starts in December 2007, just prior to the announcement of the TAF program.

As of April 30, the Fed's uncommitted stock of Treasuries was $382B, just under half of its December 5 stock. The Fed recently announced a $50B expansion of the TAF program, and a widening of acceptable collateral for its TSLF program. Assuming the Fed sterilizes the extra TAF funding (very likely) and that the $200B pledged to TSLF is now fully exploited (likely), the Fed's stock of uncommitted Treasuries will soon be $275.5B. Just over 64% of the Fed's stock of Treasury's will have been exhausted since the Fed began its unconventional lending programs in December.

Data are taken from H.41 Factors Affecting Reserve Balances. I've assumed that all securities lent to dealers are Treasuries.

See also FED: Running Out of T-Bills at Alea.

In my previous post, I suggested that "depth-weighted spreads" ought to serve as a measure of the uncertainty surrounding a asset's future cash-flows. Felix Salmon quite correctly points out that quoted bid-ask spreads don't in fact correlate very well at all with cash-flow uncertainty. Felix notes that the popular stocks often trade with one-penny bid/ask spreads, while you'd see much wider quotations on the more predictable bonds of the very same enterprises. So, what's going on?

I'll tell the story in pictures. Don't be fooled though. Despite the presence of graphs, there is nothing scientific about this exercise. I'm trying to illustrate stylized facts as I understand them, not provide new evidence in support. If you think I'm wrong, let me know.

At about noon today, I took a snapshot of the limit order book for Coca-Cola stock (as presented via my brokers' trading tool). The "quoted spread" was one penny, bid price $58.10, ask price $58.11. At the same time, I found a Coca Cola corporate bond for which a spread was quoted. The quoted spread on the bond was much larger by any measure: You could sell a bond for $1043.34, or buy one for $1058.85, for a quoted bid-ask spread of $15.42. One penny for uncertain equity vs $15 bucks for a bond whose cash flows are virtually guaranteed!

Obviously, this is not an apples to apples comparison, just given the face values of the bonds. It's not surprising that you have to pay a market-maker more to take on $1000 of inventory risk rather than $60. (Remember, market-makers are "in the moving, not the storage business". Their nightmare is that they buy something whose price moves against them before they can sell. You gotta pay them more to take a big risk than a small risk.) But, in per-dollar terms, the spread on one bond is still much higher than that one share of stock. You'd have to pay roughly two basis points (0.02%) in spread on every dollar invested in order to buy and resell a share of stock. To take a round trip on a bond, you'd pay almost 147 basis points! 2 basis points vs 147! So, stocks spreads are much smaller than bond spreads any way you cut it, right?

Wrong. The graphs below shows "half spreads", the difference you'd pay from the current midpoint price to buy or sell the security according published price quotes. Here's our view of the world so far:

But let's broaden our horizons, shall we? What if we want to invest, say, $15,000 in Coca-Cola? Is the spread still cheaper on stock?

Probably not. Note how even very large, popular stocks are not quoted very deeply, even though the apparent spreads are very small. And note the shape of the cost curve: The cost on a per-dollar transacted basis always increases, and at an increasing rate. (Spread is a convex function of volume.) It's obvious that if you were to extrapolate on the buy-side, you'd end up paying more for the stock than the near constant, 73 basis point bond spread that would lock in $15K worth of the bond. The quoted spreads on the stock are very narrow. But the price action is a bitch, if you want to transact quickly and in quantity. (Note the asymmetry of the curve. The obvious conjecture is that market-makers are net short, and would prefer to hedge by purchasing than to go shorter by selling. But at some point not very distant from the midpoint, the spread would take off on the bid side as well.)

Here's an entirely fabricated, but probably more informative picture:

Which security has tighter spreads, the stock or the bond? For small volumes, the stock wins. But as volume increases, the stock's spread increases much faster than the bond's, reflecting the bond's greater certainty of valuation.

Now, again, this is all terribly stylized. Limit order books are notoriously incomplete, and give little hint as to either market supply and demand or market-maker willingness to transact. Actual transactions often occur inside of spreads. Quoted spreads do correlate with various "liquidity measures", but they are terribly noisy because they ignore depth, and the informativeness of a spread increases with depth. Also, lots of trading happens inside quoted spreads. Volume-weighted "effective" or "realized" spreads, that compare actual transaction costs to spread midpoints would be more informative.

But still. A market-maker in Coca-Cola bonds this morning had written the entire world a free option to buy $74,000 or to sell $18,000 worth of a bond at will. Stock dealers, on the other hand, put less than $5K on the line in either direction. The bond dealer's spread reflected a less precise but far more confident estimate of the bond's value.

The shallow, tight spreads on uncertain stock valuations are what I think of as "paradoxical liquidity". Why do market-makers guesstimate very precise values for (some) stocks, while signaling "no confidence" by putting little money behind their guesses? Why do bond dealers offer looser estimates, but back them with a willingness to trade at high volume? Perhaps bond market-makers face higher fixed costs, limiting how tight they can pull spreads and still be profitable. Perhaps it is because stocks trade in less fragmented, more competitive markets. Competition forces market-makers to converge upon a single midpoint price (however arbitrary), and drives spreads towards zero. But as spreads approach zero, so does profit. Some stocks have penny spreads and other stocks don't. How come market-makers stick around to drive spreads down to nothing for some equities, but not for others? Is it because low spread stocks can be more precisely valued than other stocks? Absolutely not. As Felix mentioned, even glamour tech stocks, whose prices rise and fall like soap opera divas, sometimes have one penny spreads.

Instead, it is active randomness rather than staid certainty that drives some stock spreads to be much tighter than bonds or shares of less popular firms. Market-makers derive profit from "noise traders", from people buying or selling at market prices for their own reasons, but who have no better insight into the future value of the stock than the market-makers themselves. When dealers trade with investors who are better informed than they are, they lose money on average. To make up for this, market-makers seek out the business of "fools" (as Tyler Cowen put it, reminding us of the seminal paper by Glosten and Milgrom and inspiring Felix to coin a memorable phrase). Stocks popular with noise-traders attract multiple dealers, who compete spreads down to minimal levels, and then share slivers of profitable foolishness. In the academic model, fools and informed traders are indistinguishable to market-makers, so market-makers must keep spreads wide enough to offset their losses to insiders. But that needn't be the case. Those making markets in stocks popular with noise-traders could instead try to separate clienteles based on order size, flow, and type. During "lulls", dealer competition forces prices to converge to arbitrary values at minimal spreads. Dealers collect pennies on small trades as "fools" trade back and forth at market. But as soon as they catch the slightest whiff of informed trading — large order sizes, inventory build-up, rumor, whatever — market-makers ramp up spreads and shift prices until they find a new price point that is somewhere inside of more informed traders lack-of-confidence interval. They then compete spreads back down to an arbitrary price point, and return to happily collecting pennies. The particular price at which a stock trades, despite microscopic spreads, contains little information about the "true value" of the security, other than that the price is "close enough" so as not to draw the attention of informed predators.

"Paradoxical liquidity" is why I suggested in the previous post that "depth-weighted spreads", rather than simple bid-ask quotes, ought correlate with valuation uncertainty. As quantities in a limit order book go towards zero, Newtonian finance gives way to the quantum spookiness and game theory. In general, we should treat spreads with more money behind them as more informative than those with less, and compare the relative valuation uncertainty of different instruments using high dollar spreads, rather than best-bid-and-ask. But even scale is arbitrary, and noise trading isn't just about little tech-stock speculators. Another word for noise trader is "liquidity trader". People who sell at market prices because they want cash, or buy at market because they want a place to park cash for yield, but who don't analyze the hold-to-maturity value of the assets they swap are, from market-makers' perspective, no different than sweaty day traders. When, for whatever reason, liquidity traders go away, market-makers find they have no pennies to compete for, and spreads revert to bounds that reflecting valuation uncertainty of people actually willing to bear the risk of ownership. Paradoxical liquidity is fun while it lasts, and consoles naive traders by offering visibly tight spreads in exchange for hidden price volatility. But in the end it serves no one but the middleman. When it "dries up", withdrawal can be a bitch.

Update: I've struck the last couple of sentences. It's always fun to end stuff with a punch, but I'm not sure it's right that paradoxical liquidity "serves no one but the middleman". The shape of the spread curve is probably not something to get too moralistic about. There are positives and negatives associated with what I've called paradoxical liquidity. As always, trader beware.

Yves Smith packs a powerful insight into an unassuming sentence:

Liquidity is not a virtue in and of itself unless it produces a benefit to the real economy.

Liquidity is often said to be the great lubricant of financial markets. Let's go with that metaphor for a moment. Yeah, baby, liquidity. It's high performance motor oil that turns hard metal to smooth silk and keeps the engine of capitalism firing on all cylinders! Pop the hood and pour that stuff in. Rub it onto the gears and axles, so nothing ever squeals, pops, or (God forbid) grinds to a halt. Slather it all over the tires, so that no friction comes between our purring metal machine and the sweet American road.

Ummm, wait a minute... Putting lubricant on the tires might not be such a great idea after all. Friction is precisely what tires need to do their jobs. Throw a lot of oil on the tires and, well, something bad might happen.

Similarly, in financial markets, we want liquidity at some times and in some places. But there are times and places where we want, even need (gasp!) illiquidity!

Illiquidity. That word is so ugly. What might be another word for the same phenomenon? How about "commitment"? When a person invests in something that is not very liquid, they are committed. They are necessarily betting on its fundamental value. Liquid securities can be bought or sold as a trend or a trade or a play for a greater fool. But if the thing you are buying can only be sold with a big haircut, you'd better hope for a really gigantic fool if you have no confidence in its underlying value. (Clever managers did find ways around this problem, but let's put principal/agent issues aside for the moment.) When financial markets are too liquid, everything looks like cash. Superfluous distinctions — like the economic meaning of the assets bought or sold — fall by the wayside. Sure, investors always prefer liquidity to illiquidity. An option to buy or sell quickly and cheaply is preferable to an option to buy or sell slowly and with large transaction costs. But just because investors like something doesn't mean that it's good. Investors like rainbows and ice cream and free money from taxpayers. But the rest of us prefer that investors make serious, informed decisions about what is and isn't of value, and that they be paid for evaluating and actually bearing risk, rather than artfully shifting it (or whining when it cannot be shifted, because omigawd-there-is-no-liquidity!). Of course there is a balance here, commitment is one thing but a ball and chain is another, if assets become too hard to buy or sell, the costs of financing genuinely useful enterprises would increase until even good risks are not borne at all. It's not that liquidity is a bad thing. It's a good thing of which there can too much.

But how much? Another word that should be attached to any conversation about liquidity is "accuracy". There is, in some sense, a "right" level of liquidity, defined by the uncertainty surrounding the present value of an assets future payoffs. We laud markets for "price discovery", their ability to distill complex economic facts into simple prices that put a value to unknowable future events. But we need markets to communicate the uncertainty surrounding those valuations as well. The depth-weighted spreads of assets whose values are nearly certain should be much narrower than those of assets whose payoffs cannot be accurately predicted. When that is not the case, it represents a market failure. The recently wide spreads on complex structured credits are not the crisis — those spreads accurately reflect the uncertainty surrounding what the instruments are actually worth. Nobody knows, so spreads should be wide. The real crisis was two years ago, when "oceans of liquidity" meant that whatever the underlying value of a thing, you could sell it quickly for near what you bought it, so spreads grew artificially narrow. Confidence is good only when confidence is merited. We need not only accurate prices, but accurate confidence intervals, accurate spreads, accurate levels of liquidity rather than simply more, more, more.

Yves Smith points us to a couple of pieces discussing the Fed's "balance sheet constraint", the notion that the central bank may run out of treasury securities to exchange, whether temporarily or permanently, for the questionable securities held by private banks. This asset swap has emerged as the Fed's core response to the current crisis, and is the essence of what James Hamilton referred to as monetary policy on the asset side of the balance sheet. In an excellent summary, Greg Ip describes the various options the Fed would have if it were to run low on Treasuries.

Fundamentally, the Fed would have two options: It could increase the size of its balance sheet by issuing cash, which would require sacrificing its target Federal Funds rate target and letting that rate drop to zero. This option is referred to in the trade as "quantitative easing", but that's just a fancy term for printing money and tolerating any inflation that results. Alternatively, the Fed could expand its balance sheet by borrowing from someone else — from the US Treasury, from banks with excess cash, or from the public directly. This would permit the Fed to increase the scale of its asset swaps without sacrificing its ability to conduct ordinary monetary policy.

If you want to understand the details, do read Ip's piece. The Fed's "balance sheet constraint" is not a hard limit. The Fed can circumvent it. But that doesn't mean that the size of the Fed's balance sheet is not important. Consider this, from Ip (emphasis mine):

The easiest would be to ask Treasury to issue more debt than it needs to fund government operations. As investors pay for the bonds, their cash moves from bank reserve accounts at the Fed to Treasury accounts at the Fed. The Treasury would allow the money to remain there, rather than disbursing it or shifting it to commercial banks who, unlike the Fed, pay interest. Because the shift of cash out of reserve accounts leads to a shortage of reserves, it puts upward pressure on the federal funds rate. To offset that, the Fed would enter the open market and purchase Treasurys (or some other asset), replenishing banks’ reserve accounts. The net result is that the Fed’s assets and liabilities have both grown but reserves and the federal funds rate are unaffected. This wouldn’t cost Treasury anything so long as it doesn’t bump up against the statutory debt limit. The loss of interest on its cash deposits at the Fed would be roughly offset by the additional income the Fed pays Treasury each year from the interest on its bond holdings.

It's only true that this operation doesn't cost the Treasury anything if what the Fed buys with the excess cash pays as much as the Treasury's cost of borrowing, and there is no loss of principal. But if the Fed uses the cash (directly or indirectly) to buy or lend against market-shunned securities, then the Treasury is only made whole if those securities perform, or the loans against them are repaid. If the market is irrationally shunning these securities, then the Treasury will eventually break even. But if