Topic: Finance, Banking & Monetary Policy

Interest On Reserves, Part III

Why do I keep harping on interest on reserves? Because, IMHO, the Fed’s decision to start paying interest on reserves contributed at least as much as the failure of Lehman Brothers or any previous event did to the liquidity crunch of 2008:Q4, which led to a deepening of the recession that had begun in December 2007.

That the liquidity crunch marked a turning point in the crisis is itself generally accepted. Bernanke himself (The Courage to Act, pp. 399ff.) thinks so, comparing the crunch to the monetary collapse of the early 1930s, while stating that the chief difference between them is that the more recent one involved, not a withdrawal of retail funding by panicking depositors, but the “freezing up” of short-term, wholesale bank funding. Between late 2006 and late 2008, Bernanke observes, such funding fell from $5.6 trillion to $4.5 trillion (p. 403). That banks altogether ceased lending to one another was, he notes, especially significant (p. 405). The decline in lending on the federal funds market alone accounted for about one-eighth of the overall decline in wholesale funding.

For Bernanke, the collapse of interbank lending was proof of a general loss of confidence in the banking system following Lehman Bothers’ failure. That same loss of confidence was still more apparent in the pronounced post-Lehman increase in the TED spread:

The skyrocketing cost of unsecured bank-to-bank loans mirrored the course of the crisis. Usually, a bank borrowing from another bank will pay only a little more (between a fifth and a half of a percentage point) than the U.S. government, the safest of all borrowers, has to pay on short-term Treasury securities. The spread between the interest rate on short-term bank-to-bank lending and the interest rate on comparable Treasury securities (known as the TED spread) remained in the normal range until the summer of 2007, showing that general confidence in banks remained strong despite the bad news about subprime mortgages. However, the spread jumped to nearly 2-1/2 percentage points in mid-August 2007 as the first signs of panic roiled financial markets. It soared again in March (corresponding to the Bear Stearns rescue), declined modestly over the summer, then showed up when Lehman failed, topping out at more than 4-1/2 percentage points in mid-October 2008 (pp. 404-5).

These developments, Bernanke continues, “had direct consequences for Main Street America. … During the last four months of 2008, 2.4 million jobs disappeared, and, during the first half of 2009, an additional 3.8 million were lost.” (406-7)

There you have it, straight from the horse’s mouth: the fourth-quarter, 2008 contraction in wholesale funding, as reflected in the collapse of interbank lending, led to the loss of at least 6.2 million jobs.

The Importance of Sound Money and Banking: Lessons from China, 1905–1950

The history of China’s banking system in the first half of the 20th century offers powerful insights into the conduct of monetary policy and the consequences of government intrusion into banking and monetary institutions that are well worth considering today. Monetary economists and monetary historians would do well to study China’s example, and, in particular, Chang Kia Ngau’s 1958 book, The Inflationary Spiral: The Experience in China, 1939-1950. As you’ll see, sound money and sound banking matter a great deal in creating a harmonious and prosperous society.

In 1905, during the final years of the Qing Dynasty, the first government bank, the Hupu Bank, opened in Peking. It was established by the Imperial Ministry of Revenues when China was still on the silver standard to help finance government deficits by issuing paper currency (see specimen above). In 1908, the bank was renamed the Ta Ching Government Bank (Great Qing Bank), and in 1912, under a new charter, the bank became known as the Bank of China. Another government bank of issue, the Bank of Communications, was established in 1908.

The constant pressure for central and provincial governments to increase spending beyond revenues led to attempts to suspend convertibility. For example, in 1916, President Yuan Shih-kai of the Republic of China ordered the Bank of China and the Bank of Communications to halt convertibility of their bank notes, and the public was instructed to accept those irredeemable notes at par. The largest note-issuing bank, the Shanghai Branch of the Bank of China, refused to comply with the president’s order and was able to defend its notes against a bank run. The Peking Branch of the Bank of China, however, complied with the order, as did the Bank of Communications (Chang: p. 5).

In Manchuria, officials imposed the death sentence on individuals who exchanged irredeemable bank notes at less than par. Despite this severity, there were heavy discounts on provincial government bank notes “which placed a very real limit on the extent to which these issues could be increased.” By 1922 all irredeemable notes from the Bank of China and the Bank of Communications were withdrawn (Chang: p. 5). The public then slowly regained confidence in paper currency as banks recommitted to redeem their notes in silver.

China Has Chosen Instability

The plunging Shanghai Stock Exchange and the sudden reversal in the yuan’s appreciation have caused fears to spread beyond China’s borders. Is something wrong with the world’s growth locomotive? In a word, yes.

Indeed, China’s leadership has chosen instability. They have forgotten my golden rule: stability might not be everything, but everything is nothing without stability.

How did China arrive at this point — a point of high uncertainty and potential economic instability? A look at China’s exchange-rate regimes provides a window into these troubled waters. Since China embraced Deng Xiaoping’s reforms on 22 December 1978, China has experimented with different exchange-rate regimes. Until 1994, the yuan was in an ever-depreciating phase against the U.S. dollar. Relative volatile readings for China’s GDP growth and inflation rate were encountered during this phase.

After the maxi yuan depreciation of 1994 and until 2005, exchange-rate fixity was the order of the day, with little movement in the CNY/USD rate. In consequence, the volatility of China’s GDP and inflation rate declined, and with the yuan firmly anchored to the U.S. dollar, China’s inflation rates began to shadow those in America (see the accompanying exchange-rate table). Then, China entered a gradual yuan appreciation phase (when the CNY/ USD rate declined in the 2005-14 period). In 2015, the yuan began to experience weakness. In terms of volatility, economic growth and inflation rates, China’s performance has deteriorated ever since it dropped exchange-rate fixity.

 

So, why did China drop exchange-rate fixity in 2005? After all, China’s fixed-rate regime had performed very well. Pressure from the U.S. and many nonsensical mercantilist’s arguments, emanating from Washington, D.C., caused China to abandon fixity. Little did Beijing realize that it had chosen instability.

Interest On Reserves, Part II

Of the many bemusing chapters of the whole interest-on-reserves tragicomedy, none is more jaw-droppingly so than that in which the strategies’ apologists endeavored to show that paying interest on reserves did not, after all, discourage banks from lending, or contribute to the vast accumulation of excess reserves.

Apart from resting on logic that’s bound to bring a smile to the face of anyone reasonably conversant with the rudiments of Money and Banking 101, these demonstrations fly in the face, both of the original justification for IOR, as offered by Federal Reserve officials themselves, and of the Fed’s recent decision to double IOR (and, with it, the upper-bound of the Fed’s federal funds rate target range) so as to prevent inflation from rising above the Fed’s 2 percent target.

Now, unless general understanding of basic monetary economics has deteriorated even more than I suspect it has over the course of the crisis and recovery, that understanding still sees inflation as a consequence of “too much money chasing too few goods.” But money can either chase after goods, or rest in bank vaults (or in the virtual vaults consisting of deposits at the Fed). It can’t do both. Thus the logic (and for once it is logical logic) behind the Fed’s decision, both in October 2008 and last month, to check inflation by raising the interest return on bank reserves.

Alexander Hamilton, Banking Mercantilist

In this past summer’s controversy over whether Alexander Hamilton’s image should be replaced on the $10 bill, outraged commentators made many extravagant claims on behalf of Hamilton’s wisdom in matters of money and banking policy. For example, Ben Bernanke blogged that “Hamilton was without doubt the best and most foresighted economic policymaker in U.S. history,” citing among other evidence that “over the objections of Thomas Jefferson and James Madison, Hamilton also oversaw the chartering in 1791 of the First Bank of the United States, which was to serve as a central bank and would be a precursor of the Federal Reserve System.”

Now that the controversy has cooled we can take a more informed perspective. There is no denying Hamilton’s importance and influence, or that his life story is compelling, as evidenced by the sold-out hip-hop musical Hamilton currently running on Broadway. But the wisdom of his policy advice, and the merits of the First Bank of the United States (BUS), are another matter.

The War against Cash, Part II

I wrote yesterday that governments want to eliminate cash in order to make it easier to squeeze more money from taxpayers.

But that’s not the only reason why politicians are interested in banning paper money and coins.

They also are worried that paper money inhibits the government’s ability to “stimulate” the economy with artificially low interest rates. Simply stated, they’ve already pushed interest rates close to zero and haven’t gotten the desired effect of more growth, so the thinking in official circles is that if you could implement negative interest rates, people could be pushed to be good little Keynesians because any money they have in their accounts would be losing value.

I’m not joking.

Here’s some of what Kenneth Rogoff, a professor at Harvard and a former economist at the International Monetary Fund, wrote for the U.K.-based Financial Times.

Getting rid of physical currency and replacing it with electronic money would…eliminate the zero bound on policy interest rates that has handcuffed central banks since the financial crisis. At present, if central banks try setting rates too far below zero, people will start bailing out into cash.

And here are some passages from an editorial that also was published in the FT.

…authorities would do well to consider the arguments for phasing out their use as another “barbarous relic”…even a little physical currency can cause a lot of distortion to the economic system. The existence of cash — a bearer instrument with a zero interest rate — limits central banks’ ability to stimulate a depressed economy.

Meanwhile, Bloomberg reports that the Willem Buiter of Citi (the same guy who endorsed military attacks on low-tax jurisdictions) supports the elimination of cash.

Citi’s Willem Buiter looks at this problem, which is known as the effective lower bound (ELB) on nominal interest rates. …the ELB only exists at all due to the existence of cash, which is a bearer instrument that pays zero nominal rates. Why have your money on deposit at a negative rate that reduces your wealth when you can have it in cash and suffer no reduction? Cash therefore gives people an easy and effective way of avoiding negative nominal rates. …Buiter’s solution to cash’s ability to allow people to avoid negative deposit rates is to abolish cash altogether.

So are they right? Should cash be abolished so central bankers and governments have more power to manipulate the economy?

There’s a lot of opposition from very sensible people, particularly in the United Kingdom where the idea of banning cash is viewed as a more serious threat.

Theoretical Fedcoin, Meet Operational NuBits

In a recent blog post, St. Louis Fed Vice President David Andolfatto suggests that central banks “consider offering digital money services (possibly even a cryptocurrency) at the retail and wholesale level.” His reasoning is straightforward. Bitcoin, he observes, offers a host of benefits, most of which relate to its role as a payment device. It enables individuals to transfer funds more cheaply than traditional payment mechanisms. But it also has shortcomings, the chief of which, Andolfatto claims, is its short-run price volatility.

As an alternative, Andolfatto points to “Fedcoin” — a central bank-issued cryptocurrency proposed earlier by J.P. Koning. In theory, Fedcoin would employ the same blockchain ledger technology as bitcoin to transfer funds between accounts. However, as Koning explains, “One user — the Fed — would get special authority to create and destroy ledger entries, or Fedcoin.” To what end? According to Koning, “The Fed would use its special powers of creation and destruction to provide two-way physical convertibility between both of its existing liability types — paper money and electronic reserves — and Fedcoin at a rate of 1:1.” Hence, Fedcoin would offer the payment system advantages of bitcoin — the ability to transfer funds cheaply — without its excessive purchasing power instability.