By the way, you have a Trackback link, but I don't see any Trackback URL to use for pinging. I just started my blog, using Blogspot. So far the software seems very good, but it didn't come with Trackback. So I added it using Haloscan. The thing is, I pinged Mark Thoma and Dani Rodrik; Haloscan said it was successful, but it never showed up on their sites. Moreover, I've looked through the posts, and after several dozen, with hundreds of comments, I only saw one successful Trackback! Any info on this would be appreciated.

Thanks,
Richard
Blog: http://richardhserlin.blogspot.com/

Steve - re: Krugman's babysitting co-op tale, it doesn't really make any sense (because real balance effects would cancel it out) UNTIL you add in Minsky's elements of financing being a prerequisite to real investment, financing representing contractual temporal cash flow commitments denominated in nominal terms, and fundamental uncertainty around future levels of profit to cover cash flow commitments made today (and the obvious fact that those commitments will still exist in the future even if the profit opportunities do not pan out). Then it all makes perfect sense. Then what Keynes actually wrote (as opposed to the neoclassical synthesis nonsense) all makes sense as well. Finance, in the sense that Minsky described it, is the missing link in macroeconomics, and makes all of the Ptolemaic epicycle analyses around wage rigities and exogenous shocks unnecessary.

IA - While it's great fun to put on the libertarian hat every now and then and rail on about abolishing the Fed, the regulators, the police, the government, etc., the reality is that as long as we are going to have a fractional reserve banking system, we have to have a central bank to act as a lender of last resort and we have to have deposit insurance. WHile the potential for moral hazard is high, experience shows that if there is one market that needs regulation, it's the financial sector, due to a combination of inherent volatility and the potential for extreme negative externalities.

“Moral hazard” seems like a put option or an insurance policy with a socialized premium cost.

In the case of the Federal Reserve's intervention in the credit crisis, the premium will be the eventual cost to the Fed and therefore to the taxpayer. This is a contingent premium cost – it depends on further market developments.

The put option is well out of the money. As an insurance policy it has a very high deductible. The deductible is the cost of the credit crisis to the private sector. At the micro level, the Bear Stearns deductible was most of its shareholder value. Estimates abound for the full financial system damage; $ 1 trillion is representative. And arguably there will be additional knock-on costs for GDP.

So the taxpayer pays the premium.

The private sector pays the deductible.

The taxpayer and the private sector are arguably the joint beneficiaries.

The insured value is the extent of the additional expected costs that would have been incurred without intervention, including the possibility of catastrophic financial implosion. Of course, such value can never be formulated with certainty, because it is a hypothetical cost avoided. But assuming such a formulation of the insured value (and many will not), it seems hard to believe that the eventual premium cost to the taxpayer and the payment of such a sizeable deductible by the private sector won't justify paying for such insurance. When the object of the bet is the collapse of the US financial system, it approximates an economic version of Pascal's wager.

Steve,

Generally what I would say about that graph is that yes volatility in the U.S. economy plummeted just about right at the time of the adoption of (at least largely) Keynesian policies by strong central banks, and it stayed that way for over 50 years, right up to today, but was it causal or coincidental?

I would say it was almost surely highly causal, primarily due to information not in the graph – the very strong logic chains of Keynesian demand-crunch economics. And these are logic chains that rely only on extremely realistic and plausible assumptions. That's the strongest evidence. You saw a nice chunk of it in the Krugman baby-sitting co-op article, and to see a lot more and with great intuition I recommend again Krugman's books, "The Return of Depression Economics" and "Peddling Prosperity".

But other evidence for strong causation in the graph comes from timing, magnitude, and associated logic. The U.S. economy did become more large and diversified after the adoption of Keynesian policies in from about 1935 on, but it had been doing that to a large extent for the period from 1835-1935, and we saw no drop in volatility. The drop only came suddenly just about right at the time of strong use of Keynesian techniques by central banks. As far as political stability, stable periods like 1880-1910 had far greater volatility than during the Keynesian years.

One big thing, though, which did occur just about simultaneously with strong Keynesian central banking, was simply strong bank regulation, FDIC insurance, etc. This, you could argue, deserves the credit for the decreased volatility. A quote from the text, "Money, Banking, and Financial Markets", 3rd Edition, by Miller and VanHoose: "In the United States between the 1830s and 1930s, national banking panics seemed to occur in regular cycles of fifteen to twenty years." (pages 35-36). But nonetheless, again, the strongest evidence is the very strong logic chains of Keynesian demand-crunch economics.

I do think, like in any part of government, transparency is crucial (with, of course, a few exceptions, like some ongoing military operations), as are checks and balances. This can greatly increase performance. On that subject, another book I recommend is University of Texas Economist and Public Affairs Professor Robert Auerbach's new book, "Deception and Abuse at the Fed". I just got it and have only perused it, but it looks good. I think you'll really like it.

Richard
Blog: http://richardhserlin.blogspot.com/

Frank — Funny you should ask. I have that book on order. I think it quite possible that ideas that presently seem unthinkably radical will within the next few years become topics of serious debate. I think technological changes might render practical some monetary ideas that previously would have been nice in theory but too cumbersome to implement. I've not read the Hayek book, but I do think it's worth considering this sort of idea.

Frank — Commenter "Independent Accountant" has occasionally touched upon the Denationalization of Money on his blog.

JKH,

I have been following this and the previous discussion with interest and lagged understanding.

I presume that you are the JKH I had a discussion about how far the Fed controls interest rates on Brad Setser's blog about a year ago?

I have a clarifying question about recent Fed operations that I would grateful if you or any other reader could answer: what term lending is the Fed doing? The press release of March 7th gave me the impression that the Fed are lending $100bn of 28 day money to primary dealers as well as the TAF (and the primary dealer credit facility announced on March 16th which lends overnight only).

Steve,

Thanks for the pointer. I'm interested to learn your thoughts on Hayek's book. I'll report back when I've finished it. (Could be 2-4 weeks, as I have work deadlines ahead).

Best,

Who says the reduction in volatility is a good thing? There's plenty of evidence for a preference for an "optimal" amount of risk hard-wired into folks. The evolutionary biologists tell us it's to keep our adaptive mechanisms tuned up--not the natural selection type, but day-to-day adaptability. We need to let more volatility happen, so that we don't get fat and stupid, as we have recently. Mainstream economists completely miss the boat on this one. Government's job is to help reduce the adverse impacts on folks during adjustments, not to postpone necessary adjustments and sweep problems under the carpet, as is being now.

Does anybody know of a respectable attempt to calculate the benefits of increased risk-taking on the part of the financial system?

It seems obvious to me that over the last 25 years we've suffered several severe mis-allocations of capital to unbridled animal spirits. However, I'm not aware of the benefits; perhaps someone has taken a stab at articulating them. If I'm going to insure (as a taxpayer) the financial system, I want to know what I'm getting for my money.

RTD:

It is not uncommon for isolated Fed Funds transactions to register well above the discount rate. This can happen very late in the business day. Short banks that have done a particularly poor job in managing their cash positions (e.g. unanticipated outflows) must scramble to cover their positions, and long banks will charge an exorbitant rate to lend to them, knowing that the shorts fear the stigma of going to the discount window. The shorts will usually pay whatever is charged to avoid that. It's all part of the game. It's peer punishment for bad cash management. And it happens when there are thousands of banks moving cash around the system.

This type of isolated rate dispersion is not particularly important. What's important to the Fed is that the average daily trading level for the funds rate, applying to the vast number of system transactions over the course of the day, should not deviate far from the target Fed funds level. Otherwise the Fed will adjust supplied reserves to get it back in line. The average level is known as the “Fed effective” rate, and it is calculated for each day of trading. That's the rate for which the discount rate is a natural ceiling. This will be the case in either the current system or the corridor system. (It's also the case that the credit crisis has increased the normal volatility of the Fed effective rate relative to the target rate.)

Steve,

You write, "By the way, it is true that banking panics were a regular feature of the American economy up through the Great Depression and New Deal reforms. But is there any evidence that harmed real economic growth? Financial losses, insolvencies, etc. are wrenching, but they are part of the feedback mechanism that ought to guide capital allocation.".

But with banking panics we're not talking about mistakes and ineficiencies made by logical, sophisticated managers with high levels of information, and then the system just purges and penalizes those mistakes. We're talking about illogical and unneccessary panics that occur largley as a result of a massive asymetric information and externality problem, and then they become a self fulfulling prophesy. They often happen even when there's little or no fundamental reason for them, due to the huge lack of information and expertise on these things by regular people, which is pretty much everyone except the tiny sliver of the population who have studied, and trained, in depth in these areas of the economy.

So many of the mistakes made by people regarding economics (including lots of trained economists) come from acting as though their models are exactly reality. When a model assumes, as most of the basic ones do, that everyone in the economy has perfect information about everything, perfect expertise and education about everything, and perfect rationality, this is fine, as a way of isolating some of the important factors in an economic situation, to see better how they work by looking at what they do in isolation from other factors.

But then after you have isolated all of the important factors and studied them in various models, you have to ask what happens in reality where they are all combined together. What will be the agregate of all of the forces pushing in their different directions with different amounts of strength. How will the results be altered by the inclusion of the real phenomena that all people don't have Ph.D.s in every subject, and don't have 100% of every single sliver of information in the economy stored and constantly updated in their brains.

And now a big tangent into academia (but I think it's worth the diversion):

The above questions are obviosly what a good economist should ask and really think about, but a lot of economists don't. Moreover, sadly, there's a penalty to most economists for spending much time thinking about this kind of thing, because most are evaluated almost completely on publication production, and they will usually produce a lot more if they just save time and act as though the models are given, then micro-specialize in an area, and just do lots of little probes based on taking the models as given.

For most economists it's dangerous to their career advancement to spend much time thinking about the intuition, and how the models apply to the real economy, and how relaxing the assumptions changes the results, and how things outside of their micro-specialized area relate and interact. This kind of overall intuitive thinking and analysis, reading intuition books like "Peddling Prosperity", etc., can take a lot of time away from what is for most economists their fast bread and butter – assuming the models are reality, taking them as givens, and doing some little probes or emperical tests. There's a lot of pressure not to take too much time away from that, at least for the 99% of economists not at top universities, because it's publish or perish.

I myself spend huge time on intuition, the bigger picture, and interelations, as well as important subjects that the insular gatekeepers of the top academic journals turn their noses up at, like much of behavioural and especially personal finance, and normative and practicioner corporate finance. Society would really benefit if academics would bring their advanced statisitcal and theoritical skills to the effort to advance these areas, but because those who pay for most academic work – politicians and voters – can understand very little of the jargon and math in the papers, they can't distinguish research which is highly socially benificial way from research with much less social benefit.

This big asymetric information problem fosters a lot of ineficiency. It allows journal editors and department heads to get away with a great deal of insularity. As for myself, luckily, our business and investment activities have done very well, and we have enough money saved that we don't really need university income, so this obviously makes it a lot easier for me to just go off and work on what I want to work on.

Economists at the top universities, however, do, in fact, have more leeway to think about intuition, and how the many aspects of the economy as a whole intererelate, rather than just focusing on a micro-specialization. And tenure certainly decreases the penalties for not cranking out a lot of publications, but there's still a lot of pressure to publish even at the top universities and among those with tenure, so there's still very strong pressure to crank out pubs and not spend too much time thinking about intuition, and what happens in the real and broad economy where the neat assumptions don't hold.

I am being very critical of economics and finance academia, but as I said in my second May 11 post: Academia may have serious flaws and waste, but it's essentially the only game in town for so much of the important things it does, and the good that does come out is so valuable it's immensely worth having to pay for the waste that's hard to fight in academia's insular world of massively asymmetric information.

End of tangent, now back to banking panics, recessions and depressions:

These just aren't efficient market feedbacks, like companies overinvest in high speed internet cable, and so capacity gets too big for consumer demand and they start losing money and go out of business, sending the message to not move more money into internet cable. And even in that case, externalities could make the market message an ineficient one, where a strong govenrment role can increase efficiency and welfare.

With panics, the market messages become extremely ineficient and detached from fundamentals. You get self fulfilling prophesies that don't just lead to purging of ineficiency, they lead to severe demand crunches that result in enormous amounts of unneccesarily idle human and material capital for long periods of time, and this certainly lowers wealth creation. Without Keynsian measures, in the long run prices would come down, and that would releive the demand crunch, but as we saw with the great depression, the long run can be very long, and great human suffering and trillions of dollars in lost production can be the cost of waiting when you didn't have to. This is why Keynes said, "In the long run we're all dead."

Moreover, any market message regarding bad capital allocation is still there whether the central bank increases the money supply or not. If there is overbuilding of fiber optic cable, prices and profits for fiber optic cable relative to prices and profits for other activities don't change when the money supply is increased. Smart businessmen still won't put their new money into relatively low profit, overbuilt fiber optics. They will put it into more promissing industries.

A quote from Krugman to sum it up: From "The Return of Depression Economics", page xv:

Most economists, to the extent that they think about the subject at all, regard the Great Depresion of the 1930s as a gratuitous, unneccesary tragedy. If only Herbert Hoover hadn't tried to balance the budget in the face of an economic slump; if only the Federal Reserve hadn't defended the gold standard at the expense of the domestic economy; if only officials had rushed cash to threatened banks, and thus calmed the banking panic that developed in 1930-31; then the stock market crash of 1929 would have lead only to a garden-variety recession, soon forgotten. And since economists and policy makers learned their lesson – no modern treasury secretary would echo Andrew Mellon's famous advice to "liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate...purge the rotteness out of the system" – nothing like the Great Depression can ever happen again.

Then Krugman goes on to say that many have not learned these lessons, and we are not doing enough.

I also strongly recommend you read Krugman's 1998 Slate article, "The Hangover Theory". This really gets to the heart of things and teaches a lot in just a couple of pages. A quote to whet your apetite, "A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle—a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire.", and one more quote, because I'd really like to motivate you and the other readers to read this article:

Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it's not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?

Finally, I'd like to give an analagy to help show the ineficiency of banking panics. At a football game if others start standing up for a better view, then it's best that you stand up too, and eventually everyone may stand up. But almost all would be better off if everyone had stayed seated. As Cornell economist Robert Frank would say, standing up is "smart for one, dumb for all", and this is the title of chapter 10, of a book of his I highly recommend, "Luxury Fever". An important quote from that book: Despite the mythology actively propagated by Republicans, Adam Smith, "although he is widely remembered for his account of why the indivigual pursuit of self-interest often promotes social ends, he was under no illusions that this was always the case." (page 171)

Richard
Blog: http://richardhserlin.blogspot.com/

“That was exactly (one of) my points.”

I'm sorry, but it wasn't your point at all.

Your point, by construction, related to the intra-day volatility of the fed funds trading rate relative to the discount rate, as exemplified by the isolated trade outliers referenced in the Bloomberg article. I made my comment on the relative unimportance of that measure.

My point, which you quote, was on the inter-day volatility of the fed effective rate relative to the target rate. This is a completely different measure and reference point. It's a smoother series because it's a series of daily averages. It measures how closely the Fed is keeping the average fed level around target over time. My comment was only that this series had naturally become more volatile with the challenges of the credit crisis; not that the average daily fed level was spiking through the discount rate level.

As an example of the difference, the Bloomberg article mentioned the date of May 14, when a single funds trade registered at 7 per cent.

Here is the Fed effective rate from May 12 to May 15 (from the Fed's web site):

May 12 13 14 15
Fed effective 1.88 1.93 2.03 2.03

So the fed effective on May 14 was nowhere near the single trade outlier of 7 per cent. It was close to the current target level of 2 per cent, and well below the discount rate of 2.25 per cent. My point was that the volatility of the Fed effective numbers around the target of 2 per cent is probably more than what it would be without the credit crisis, because the Fed's job is more difficult in this environment. But the Fed effective series is still very contained relative to single trade spikes.

On your other point, by no means is the Fed “essentially giving the reserves to a bank and then paying interest to that bank on the reserves the Fed just created.” The Fed makes discount loans to banks that are short fed funds. It would pay interest to banks that are long fed funds. They're different banks. The result is an effective redistribution of reserves where needed. That's the point.

RueTheDay

Point 1

Absolutely Agree.

From a practical perspective, I doubt that the effective fed rate breaches the discount rate very often. That would require a longer statistical study to verify. I'm guessing it's happened from time to time when the Fed is in the midst of an aggressive tightening cycle, and has followed up with a Fed funds target increase fairly quickly – i.e. it has let the funds rate drift up in anticipation of taking imminent action to hike the target rate.

You've raised an interesting technical point, though. The idea that the discount rate is etched in stone as an absolute ceiling even for the fed effective rate probably isn't absolutely necessary in an operational sense. It's probably no more necessary in the corridor than it is in the current system. But given the stigma relationship of the discount rate to the funds rate, it seems like a natural upper bound. I do think that sustained levels of the fed effective rate exceeding the discount rate would be dysfunctional relative to the normal spread relationships and incentives – except on a very temporary basis as I noted above.

Point 2

Agree Again

Remember that paying interest presumably replaces the need to drain excess reserves from the system through open market operations. This is a mechanical reserve/rate management facility. Unlike our comments on the discount rate as a slightly ambiguous ceiling rate, it should put an unambiguous floor rate on the effect of excess system reserves on the fed funds rate trading level (although maybe there's some exceptional wrinkle here that I can't think of right now).

Furthermore, and more to the point of the credit crisis and your point I think, the Fed will be able to increase aggregate system reserves well above required levels, thereby opening up the possibility of increasing the size of its balance sheet, and its asset intervention activities, without wrecking its control of the funds rate. (Given the nature of our discussion, we can see that “control” is very much a relative term, but “enough control” is the operative idea.) The facility to increase total reserves and balance sheet size in a functional way makes this approach (paying interest on reserves) quite different than the open market approach.

In this type of analysis in general, it's always useful to remember that the behaviour of individual banks in the system is often different than the behaviour of the system as a whole (i.e. the behaviour of the “average bank”). The Fed controls the system setting, which is a constraint in total, while individual banks sort out their cash positions in different directions within that constraint. I think your last point was on aggregate system behaviour rather than individual bank behaviour, which is why I mention this.

Rebel Economist,

I basically agree with what you're saying in your comment which begins with "Richard Serlin", on 5.18.2008 1:26pm. I do think important new ideas can be presented from economists not at top universities and others, but it's time consuming; you can often get them published in top journals, but only if you spend a lot of time first learning all of the related literature, and then show how it relates and doesn't, and use similar theoretical form. You also have to learn a great deal of mathematics and statistics to model and present it technically and formally -- so this largely precludes those without Ph.D. knowlege people, who have great ideas, but don't have the technical skills to do the above.

I'm sure that many people have thought of lots of ideas that later won Nobel prizes, but they didn't have the technical skills to write them up formally to get them published. Later someone from Harvard does write it up formally, and with the formality and the pedigree it gets published.

Even if you do have the Ph.D., it can be hard to take the time to go into a long term project to produce something really new, when there's constant pressure to crank out safe,sure out fast publications.

So it can be tough, but if you can spend the time, and have or acquire the technical skills, it can be done.

Ignore any and all interest rates, as “triggers” to guide open market operations. The money supply can never be managed by any attempt to control the cost of credit.. In other words, it is impossible to use interest rates as a vehicle to effect monetary policy – unless the objective is to feed a rampant inflation.

The decline in the asset types that require legal reserves, and the decline in reserve ratios on these assets, has effectively eliminated all constraints on the creation of new money &credit, i.e., the elimination in reserves against large CDs in 1980, repurchase agreements against Government &agency securities in 1980, against E-Dollar funding in 1990, against non-transaction accounts in1991, &the reduction in reserve ratios on transaction deposits from 10% to 8% in 1992, etc.

A parallel situation existed prior to the DIDMCA in 1980. The number of member banks that dropped their membership to the system, continued to grow, until the non-member banks owned c. 37% + of the banking system's assets. .Years have passed, and these precedents were forgotten – i.e., why membership for the non-member banks was compulsory.

According to the bankers, the system's stringent and exigent rules (reporting, reserves tax, maintenance req., etc.), were deterrents, and made membership less profitable. So when the bankers complained, Congress capitulated, and sought under the guise of deregulation, to accommodate their constituent's interests (which became the harbinger of all future legislation (that being deregulation has been political, not economic).

Just as the percentage of member banks continued to erode prior to the DIDMCA, today the percentage of zero-bound banks continues to rise. Data as of May 2002 estimated the number of zero-bound banks at approximately 70%. What volume of assets is held by this 70%, or that held by the remaining 30% of accounting-bound banks, is indeterminate.

Nevertheless, there is broad agreement among professional economists, that legal reserves or statutory reserve requirements have reached the threshold where they are no longer binding/constraining [their indirect evidence]

(1) operate with lower volume of non-interest-bearing reserve assets (2) increase in ATM networks
(3) tightened cash inventory
(4) excess clearing balances/reserves
(5) deposit sweeps
(6) decline in applied vault cash
(7) decline in required reserve balances - IBDDs
(8) clearing balances exceed required reserves
(9) increase in surplus vault cash.
It was true that the legislation in 1980 was driven by the need to incorporate all money creating institutions under the aegis of the Reserve Authorities, in order to regulate some combination of total, excess, net-borrowed, free, and required reserves, (the rate and direction of movement of these components) and thereby administer proper control over the money supply.
Since 1942 money creation has become a system process (excess reserves disappeared, and thus money creation was no longer likened to “pushing on a string”). I.e., no bank, or minority group of banks (from an asset-holding standpoint), can expand credit (create money), significantly faster than the majority banks expand.

So if the accounting-bound banks hold 80 percent of all bank assets, an expansion of credit by the zero-bound banks, and no expansion by accounting-bound banks, will result, on the average, of a loss in clearing balances equal to 80 percent of the amount being checked out of the zero-bound banks.

I.e., if the accounting-bound banks hold a substantial majority (70-80%) of the assets of the entire system, the Fed could (through the accounting-bound banks) attain an acceptable degree of control over the money supply. Unfortunately, this economic restraint is becoming less and less effective as the proportion of total bank assets held by accounting-bound banks continues to decline.

The technical staff's studies have centered on the number of banks, rather than the growth in the volume of the zero-bound bank's earning assets - a blunder – because as the system expands, so does the rate-of-change in member commercial bank credit. This is evidenced by the “money multiplier” (MM) or the system's “expansion coefficient” (fractional legal reserves).

From 1996 until 2006, “MM” rose at the fastest pace in the Fed's history - 48% increase in 10 years (the period corresponding to Greenspan's conundrum). During roughly this same time frame, housing prices climbed 83% in 5 years (Case-Schiller).

Before the latest breakdown, it took 35 years for the “MM” to double (1977-2005), the same rate as in the previous 30 years (1947-1977), - a predictable path. Consequently, “MM” (an important measuring instrument), has been undermined (defined by commercial bank credit divided by legal reserves).

This in and of itself, is prima facie evidence that the Fed has lost any current way of monitoring, or controlling, the legal reserves, of any of our money creating, or potentially money creating, depository institutions.

It is an a priori conclusion that by the time the volume of assets held by the zero-bound bank earning assets reaches 50%, it will be impossible for the Federal Reserve to control the growth of money supply. I.e., all prudential reserve banking systems have heretofore “come-a-cropper”.

Money creation by private profit institutions is not self-regulatory – the “unseen hand” simply does not function in this area. Invariably the systems created too much money, speculation became rampant, inflation distorted and destroyed economic relationships, confidence that the banks could meet their convertibility obligations eroded, “runs” on the banks caused mass banking failures, and entire economies were left in ruin.

With this historical record to draw from the pertinent question is: Why is Congress and our Monetary Authorities allowing zero-reserve or zero-bound banking to grow on an unregulated, prudential reserve basis? I.e., New Zealand pioneered this approach and subsequently lost control of its money supply sending interest rates soaring to 8% + and their currency to 25 year highs. The answer is indeed why?

And when the ”Financial Services Regulatory Relief Act of 2006 goes into effect, and the provisions thus granted are concluded, the money creating depository institutions will be uncontrollable on two devastating fronts: (1) pegging interest rates & (2) zero reserve requirements.

Why? Because the Fed cannot control interest rates, even in the short-end of the market, except temporarily. The effect of a series of temporary pegging operations (the one-day cost-of-carry on Government bonds), as guide posts, is indirect, and varies widely over time, and in magnitude. And cost, obviously, is not a significant factor determining the volume of borrowing (see Jan 82 – Jan 83).

Why inflationary? The effect of tying open market policy to a FFR target is to supply additional (and excessive) legal reserves to the banking system when loan demand increases. Since the member depository institutions have no excess reserves of significance, the banks have to acquire additional reserves, to support the expansion of deposits, resulting from their loan expansion.

If the aggregate of their bids for Federal Funds pushed the rate above the bracket set by the “trading desk” this would automatically trigger buy orders, which then ultimately led to an excessive volume of (1) Open Market Purchases, (2) Reserve Bank Credit, and (3) Legal Reserves. Soon a multiple volume of money is created on the basis of any given increase in legal reserves.

Since “MM” has been emasculated, what the net expansion of the money supply will be, won't be known until long after the fact. This is the process by which the Fed has financed the rampant real estate speculation which has characterized the 3d millennium.

From the monetarist's perspective, the only tool at the disposal of the monetary authorities in a free capitalistic system through which the volume of money can be controlled is legal reserves and reserve ratios.

I.e., monetarism involves controlling the volume of total reserves, not the volume of non-borrowed reserves as administered by Paul Volcker. This mis-guided procedure lead to the ill-advised “abandonment of a reserves-based targeting procedure”.

It is no happenstance that the FFR went to 22.4% under Volcker's purview (the 79-83 non-borrowed reserves-based targeting procedure). During this period, at times 10% of all reserves were borrowed. Under this operating procedure, legal reserves grew at an astronomical 15% annual rate in the last 6 months of 1980. And today, in contradiction to Volcker's experiment, the Central Bank under Bernanke, utilizes borrowed reserves exclusively.

To expand the money supply there must first be a net expansion of Federal Reserve Bank Credit. When this is the objective of monetary policy, buy orders for governments (usually Treasury bills) are executed through the “trading desk” in the Federal Reserve Bank of New York for the accounts of the 12 Federal Reserve Banks. Thus the volume of IBDDs is almost exclusively related to the volume of Reserve Bank Credit.

The Fed finances these purchases through the creation of new inter-bank demand deposits (IBDDs). These are the initial legal reserves of the member commercial banks. These are member bank legal reserves and they can be converted dollar-for-dollar into Federal Reserve Notes.

There are two immediate effects of these operations: (1) Treasury bill quotes rise, rates go down, and (2) excess legal reserves are injected into the banks, thereby putting downward pressure on the FFR. This is the short-run.

The reserve assets (legal reserves) that all money creating institutions are required to hold should be of a type the monetary authorities can quickly ascertain and absolutely control. The only type of bank asset that fulfills this requirement is inter-bank demand deposits in the 12 Federal Reserve District Banks, owned by the member banks (IBDDs).

This was the original definition of the legal reserves of member banks in the Federal Reserve Act of Dec 23, 1913 (Owen-Glass Act) and it is still the only viable definition (June 21st, 1917- November 30th,1959 requirements pertaining to assets – Reg. D).

The time is long past for the Congress to require that balances (IBDDs) in the Federal Reserve Banks be the sole legal reserves of all banks. If this reform is not made, all other reforms will be of little consequence.

The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves. Under the monetarist's doctrine, the first rule of reserves and reserve ratios should be to require that all money creating institutions have the same legal reserve requirements, both as to types of assets eligible for reserves, as well as the level of reserve ratios. The DIDMCA went only this far. Now Congress has given the Board of Governors permission to pursue a zero-reserve req. policy.

Then, to be successful, (to use legal reserves as both a credit-control device, and as a forecasting tool), member commercial banks must have uniform reserve ratios, for all deposits, in all banks, irrespective of their size (10% at a minimum - across all deposit liabilities – or equal to the existing reserve ratio on all transaction deposits).

This is corroborated by 7 years of deliberation in which the 1931 Fed. Res. Committee's recommendation to change the method of computing reserve requirements was: (1) uniform percentage requirements against the volume of deposits of all classes at all banks, (2) requirements against debits to deposits. This significant and yet confidential document wasn't de-classified (released to the public) until Mar 23, 1983.

Under the current policy, fixing lower reserve requirements for time deposits is just a method, and an illogical method, of reducing the average reserve requirements for the banks. It encourages bank customers to opt for high liquidity, &higher yielding, deposit accounts/new money (whose growth is unrestrained by the standard devices of reserves and reserve ratios).

Despite the study and press to the contrary, the conclusion is unmistakable, monetarism has yet to be tried. Thus do we create for ourselves problems which never should exist.

To Rebel Economist again,

My comment about how you can still publish in good academic journals with really new ideas after applying a lot of time and effort was basically for new ideas not in the areas where there's a lot of snobbery or just exclusion. Such areas include many practitioner things, most of personal finance, normative corporate finance, and more.

There, the gate keepers at the journals often really don't want to publish anything in those areas often due to an unwarranted snobbery, or due to the fact that if such areas became big, it would make it harder to publish in their own areas, and it would make their own expertises less valuable and prestigious.

For example, up until about 30 years ago, it was virtually impossible to get any behavioral finance published at all. Who gets to finally break the doors down to the top journals on these subjects? Usually someone who already is famous in the field, or at least has Ivy league pedigrees.

A good example is Robert Frank of Cornell. For decades he's been saying the very obvious and important thing that someone's utility depends greatly depends on others consumption. In other words, the utility most people will get from a 2008 Honda Accord will depend greatly on what others are driving. If everyone else is driving 10 year old Kias it will be higher than if everyone else is driving Mercedes.

Someday Frank may win a Nobel prize for discovering this "brilliant" idea that only a bizillion other people figured out by the time they were 5 years old. But Frank is perhaps the first one with pedigrees and a big reputation to push for it, put it into formal models, and start getting it published in top journals. And the gate keepers of those journals tried hard to resist in large part because these better and more realistic models made their own models, and the models they were expert in, less valuable.

What do you do if you don't have the big reputation? There's still a lot more you can do than just put it on blogs. You can still often publish in practitioner journals or lower ranked academic journals, and this gives you good proof that you thought of it first when some famous guy later wins a Nobel for it. And it's still valuable to formalize it and link it to the existing literature as much as possible.

I've been following this discussion for a while but I'm not sure what to make of it. It seems to me that the essential question that need to be solved for the monetary system we are currently living under is how to solve the issue of moral hazard. All other discussions seems vacuous. The central bank, in all countries affected, sits on the short term resources by it's unique ability to print cash. The state sits on the long term resources because of it's ability to tax the people. The only right starting point must be to look at these entities as a whole in an intertemporal model. We must thus minimize the hazardous expectations that arises in this world. There is clearly a problematic behaviour that arises with the expectations that the short term capacity of the central bank will be supported by the long term resources of the state That is, the latter will be forced to bail out the first which again will be forced to bail out the "system".

What is the solution? Frankly I don't know. But I believe this is the essential question to be asked. Maybe I will do it in a future academic career. Hoping to be published in a publication that will have the crediblity to make policy of my solutions.

Martin - While moral hazard is certainly a significant issue, it is not the central problem. It is a second order problem - solving it would eliminate some of the negative consequences of the palliative measures taken against the real problem, but would leave the real problem unsolved.

I just picked up this week's copy of The Economist, and it has an 18 page spread entitled, "Barbarians at the Vaul: A special report on the future of banking." Very disappointing. There was considerable hand wringing over moral hazard, the perverse incentives associated with the compensation models prevalent in the industry, and the impact of financial instability on real economies. The articles quickly evolved into typical TINA-spiel. In the end, the recommendations amounted to the need for greater transparency though with the caveat that it should be market-driven rather than government-driven (yeah right), whining about fair market valuation accounting driving instability (I don't see how you can be a free market advocate if you don't believe in the efficiency of the price mechanism at a minimum), and modifying certain regulations to make them more countr-cyclical rather than pro-cyclical (this one has some merit). Very little about fundamental, substantive, structural reform.

RTD: What is the central problem then?

Martin - Not Swedish, American. The central problem is the ability of the financial sector, due to its position as the nexus of the payments system, to transmit instability throughout the rest of the economy.