Prior to the 2008 financial crisis, the Federal Reserve had a long‐standing policy of maintaining a minimal footprint on the credit system. According to Selgin, the Fed use to be a “lean and mean” player in the credit system. However, on the eve of the 2008 financial crisis they made some changes to decades’ old policies that they believed would aid the financial instability of the country at the time. In retrospect, we can now deeply analyze where the Federal Reserve misstepped.
What is the Federal Reserve? What are mandatory reserves? What is the chevron deference? What did emergency lending have to do with the 2008 financial crisis? Is the Fed more constrained than private banks?
00:07 Trevor Burrus: Welcome to Free Thoughts. I’m Trevor Burrus. Joining me today is George Selgin, Senior Fellow and Director of the Center for Monetary and Financial Alternatives at the Cato Institute, and Professor Emeritus of Economics at the University of Georgia. His new book is Floored! How a Misguided Fed Experiment Deepened and Prolonged the Great Recession. Welcome back to Free Thoughts, George.
00:26 George Selgin: Oh, it’s nice to be here again Trevor.
00:27 Trevor Burrus: So I’m a simple constitutional lawyer and you’re a monetary economist, so we’re gonna try and figure out how to meet this in the middle. And this book is very interesting and very complex. In order to understand the story that you tell about how the Fed’s policy and approach has changed, we have to understand what the Fed did before the 2006, I think it was, law that changed things. How they acted, what levers they pulled to adjust the monetary floor of the economy.
00:56 George Selgin: Right. Well, in fact, the Fed’s policies were for regulating interest rates and the stance of monetary policy more generally had remained the same for several decades, not only until 2006, but actually until the financial crisis, until October, 2008 when they changed. They did change because of the 2006 law but only when the implementation of that law was accelerated during the crisis. Anyway to talk about what the Fed used to do. The Fed’s job, of course, is to set the stance of monetary policy, as I said. And what that means is to influence the availability of credit and of money, which are two sides of the balance sheets of deposit banks. Banks make loans but in doing so they create deposits, which are part of the money supply. So regulating the abundance of one is the same as regulating that or the other. And bank reserves are a key instrument that influences the total availability of deposits and bank loans in the long run, certainly. And those reserves have to be obtained from the Fed. The Fed is the unique source of bank reserves in the United States. As well as…
02:26 Trevor Burrus: You mean in terms of like the banks have money on hand, is that the reserves?
02:30 George Selgin: The reserves are… Consist of two types. Indeed, the actual cash notes, Federal Reserve notes, that banks have on hand, but also credit balances that the banks have at their district federal reserve banks, which count as reserves as well and can be converted into cash by the banks at any time. So those two things together constitute the total supply of bank reserves which the Federal Reserve regulates. So in the old days, the Fed would set a target for something called the Federal Funds Rate. Now, this sounds fancy but it refers really to something fairly straight forward. Banks would try to do with as few reserves as possible under the old system because they didn’t earn any interest from the Fed on those balances I mentioned. Therefore, to economize on reserves, banks would hold as few as possible and then if they needed some extra reserves, particularly to meet their minimum legal requirements, but also for other payments needs at the last minute, they could look for banks that had more on hand than they needed.
03:44 Trevor Burrus: Let me stop you just to clarify from this [03:46] ____. So this means, someone comes into a bank and let’s say all legalities are taken care of, and wants to cash a $2 million check, and they don’t have enough reserves on hand to cash that check at the time, is that when they would call upon the Federal Funds Rate to bring that money over?
04:01 George Selgin: Well, conceivably but really in practice what really drove the lending that I’m talking about wasn’t big cash withdrawals.
04:13 Trevor Burrus: Yeah, of course.
04:13 George Selgin: But the fact that at the end of the day, when banks had to settle their accounts with the Fed, they might find themselves, that if they settled those accounts, even if they had enough cash on hand to do so or enough reserve balances, that they might find that they’ve fallen below their minimum legal requirements. So they would borrow from other banks to top off their reserves so that they would meet those requirements and not be subject to penalties. That would be… That was the main thing that drove last minute bank borrowing of reserves, and the borrowing was done, as I said, on the Federal Funds market. Which is to say, they were borrowing from other banks that had surplus reserves in the market where that took place for these, mostly overnight loans is the federal funds market.
05:03 George Selgin: Okay. So the rate at which this last minute borrowing took place was called the Fed Funds Rate, and the way the Fed would gauge the stance of monetary policy, and would set its monetary policy goals, would be to figure out what Federal Funds Rate value was appropriate according to its estimates with achieving its long run goals for inflation and unemployment. Then, of course, if the actual rate at which banks were lending and borrowing on the Fed Funds market conform to that desired rate, the Fed didn’t have to do anything. But if it thought that the actual rate was going to fall below the Fed Funds Rate, the Fed funds were more available, more readily available, the reserves were too abundant relative to its goals, it would take some reserves out of the system.
05:53 Trevor Burrus: Is this a daily?
05:54 George Selgin: Yes, daily. It would take some reserves out of the system in the case where the Federal Funds Rate needed to be propped up a little bit more to hit the target. It would take reserves out through something called open market sales of securities. It would have some securities on its balance sheet, treasury securities, treasury bills, typically short‐term. It would just sell them to dealers and the dealers would pay the Fed and the amount the Fed received would be ultimately deducted from the reserve balances of the banks that dealt with the security dealers. If the Federal Funds Rate looked like it was in danger of becoming too high that would suggest to the Fed that reserves were scarcer than was consistent with its long run objectives, it would engage in open market purchases, which is to say, it would buy reserves from security dealers using what were effectively new credits against itself, creating that many more reserves it would end up in the banking system, and in this way through changing the abundance of the reserves, it would keep the Federal Funds Rate…
07:03 Trevor Burrus: Where it wants it.
07:04 George Selgin: In line with its target, which target it would of course, occasionally change according to new expectations about what the target needed to be. So that’s how the old system worked. To emphasize a few of its key features that mattered because of how these changed, it depended on controlling, regulating the scarcity of reserves, where banks were expected to not hold very many reserves, where it was a scarce reserve set up and where the rate being regulated was a market interbank rate that the Fed would influence through its influence on supply, but didn’t actually control.
07:45 Trevor Burrus: But not control through. Yeah.
07:46 George Selgin: Didn’t actually administer it, it didn’t set, in that sense, it didn’t set the Federal Funds Rate. It just set a target for it and then tried to achieve that target by changing how many reserves were in the system.
08:00 Trevor Burrus: So when you have reserves, you talk about mandatory reserves which are legal requirements, legal minimums. And then excess reserves, and with the changes that they start allowing banks to take interest on just holding excess reserves.
08:15 George Selgin: Well, in fact, the change which happened in October, 2008, involved the Fed paying interest on both excess and required reserves ultimately at the same rate for both, though at first there was a difference. And so, but for the overall way the system operated the fact that excess reserves were bearing interest was what really mattered because… And the simple reason for that is that banks are gonna hold required reserves, whether you pay interest on them or not, and no matter what rate you pay. So the new arrangement of paying interest on reserves didn’t have any bearing on banks’ demand for excess reserves… I mean, for required reserves, or had only a slight bearing on that. What it really altered was banks’ willingness to hold excess reserves and ultimately that is going to mark a dramatic change in the overall way in which monetary policy has been implemented since October, 2008.
09:18 Trevor Burrus: And they’ve wanted to do this… They wanted to do this for a while. You kinda talk about this idea, that using the Federal Funds Rate was their main tool but at different times in the past the Fed officials had said, putting interest on excess reserves is something we would like to do at some point, or had asked for it, except for different times they’d been deprived even at the original, I think you say, early on in the ‘30s perhaps or at some point they had been deprived that power.
09:43 George Selgin: Well, we should be careful here. There had been discussions of paying interest on reserves for a long time at the Fed, and it was never, it essentially was never granted that power until the law of 2006 was passed. But up to that time, the expectation was that yes, the Fed wanted to pay interest on reserves, but it would pay a very modest rate of interest. As the statute itself still says it would pay interest rates on reserves, “Not to exceed the general level of short‐term interest rates.” So it was supposed to be a slightly, if anything, a slightly below market interest rate on reserves, and that language was important, because it reflected the fact that it was never intended to… Yes, it was intended to make reserve holding less onerous for banks, so they would hold some more excess reserves than they would have under the old system, but it wasn’t intended to make reserve holding so attractive that they would hold vast amounts of reserves. In 2008, when they in turn finally got to implement the system, they had a much different purpose in mind than the original purpose, which was just to relieve banks of the burden of holding mostly excess reserve… Mostly required reserves.
10:58 George Selgin: Now, they really wanted to get them to stock up on excess reserves, and as they discovered fairly quickly, to do that they actually had to pay a rate of interest on those excess reserves that was higher than prevailing short‐term interest rates, and they managed to wiggle around the law, ultimately several years after the fact, by writing the regulation in a manner [chuckle] that defined…
11:26 Trevor Burrus: Deference.
11:27 George Selgin: General short‐term interest rates, to include rates that were much higher than general short‐term interest rates.
11:34 Trevor Burrus: And then they got chevron deference for that. Correct.
11:36 George Selgin: And then they get… The chevron deference applies to the Fed as it does to government agencies, so the Fed essentially redefined what short‐term interest rates were, and said, “See, we’re abiding by the law, ’cause we’re keeping our interest on reserves lower than some of what we’re calling short‐term market interest rates.” Though nobody else calls them that.
11:55 Trevor Burrus: Did the Fed want to have the banks… This is like 2008, the crisis area.
12:00 George Selgin: This is 2008, when it was starting. Yeah.
12:00 Trevor Burrus: Did they want them to hold on to this money…
12:02 George Selgin: Yes.
12:02 Trevor Burrus: Because they were trying to tighten up money? Is this part of this…
12:05 George Selgin: Yes.
12:05 Trevor Burrus: Tight or loose money that…
12:06 George Selgin: It was actually…
12:06 Trevor Burrus: ‘Cause they’re not on lending it out to commercial loans or bank loans, right?
12:10 George Selgin: That’s right. What people don’t remember, and what Fed officials sometimes seem to choose to forget when they’re talking about this episode, and this change in how it was implemented is that, it was originally implemented as a means for monetary tightening. And the reason they don’t wanna say that, and don’t wanna harp on it certainly, is because everyone now knows in retrospect, almost everyone, that in October 2008, monetary tightening was the last thing the US economy needed. We now know that at that time, a recession had been taking place for quite a few months; officially it started in December 2007, but that wasn’t yet known. We also know from the statistics that total spending in the economy, which is as good a measure as any of what the state of monetary policy really is, was collapsing, and it was collapsing as a negative growth rate. And that’s surely a sign that money was too tight, if anything is. And yet, the Fed officials at the time, that is this is in October 2008, were concerned still, as they had been since the Spring, with headline inflation and core inflation for that matter, of course, CPI inflation, both of which showed rising prices, the inflation rates above what was then an unofficial informal 2% target.
13:38 George Selgin: We know now that this was unconnected with easy money, that particularly it was reflected commodity shortages in certain parts of the world and not in excess growth in the money supply. In any event, because they were concerned about inflation instead of the fact that spending was going, was circling the bowl, so to speak, as was the US economy more generally, Fed officials were seeking some way to avoid easing money even though… And this is the other important in fact, during these… The months… During this period, the Fed is already engaging in substantial emergency lending because there are financial system problems. There are…
14:26 Trevor Burrus: Is that TARP?
14:28 George Selgin: TARP, there’s TARP. There’s the TAF. There’s about a dozen other relevant acronym programs for emergency lending, many of which involve the Fed, most of which involve the Fed. So its emergency lending is up, but it doesn’t want too easy money, that’s important. It thinks the problem…
14:48 Trevor Burrus: It was doing both at the same time?
14:50 George Selgin: It thinks the problem is illiquidity in certain financial firms, not in the economy in general. So normally, making emergency loans would add to reserves, that is it would do that other things equal. But the Fed didn’t want to add to reserves, because as I’ve explained under the traditional system that’s easing monetary policy, and they’re worried that there’s already too much inflation. So, what did they do? They didn’t wanna stop the emergency lending. Instead they had been selling off securities to an amount exactly equal to the emergency lending, so that they didn’t create reserves on net. But now in October, come October, after the failure of Lehman Brothers, the scale of emergency lending really shoots up.
15:40 George Selgin: At the same time that Fed’s treasury portfolio is now very low; it’s sold as many treasuries as it feels it can get away with. So it has to come up with something new. That’s when they request the early implementation of interest on reserves, the idea being, “Well, if we pay interest on reserves, we can get banks to just hold onto the new reserves we’re creating. As long as they hold on to them and don’t use them as a basis for new lending, new deposit creation, then it won’t contribute to the inflation we’re concerned about.”
16:12 Trevor Burrus: So would that…
16:12 George Selgin: That’s why they implemented interest in reserves, ’cause they wanted to tighten monetary policy, but they were engaged in heavy emergency lending, so they needed a means to sequester those bank reserves, to lock them up, instead of having them contribute to more growth of spending.
16:28 Trevor Burrus: So is that offsetting? Do they see it as offsetting the money that they were giving the banks under the asset relief programs and stuff?
16:33 George Selgin: Yes.
16:34 Trevor Burrus: Tighten up your reserves and here’s $700 Billion.
16:37 George Selgin: Basically, “We’ll give you a bunch… We’re gonna create a bunch of reserves and that’s gonna shore up the balance sheets of the institutions we’re directing these reserves to. But we don’t want ‘em to spill into the general economy, we don’t want them to contribute to any general growth and lending.” In other words, we want banks to have more reserves but we don’t want them to grow their balance sheets anymore than they already have. They’ll be more liquid, they’ll be less likely to fail, but we don’t want them to be doing anything for the rest of the economy because as far as we’re concerned the problem is just to keep… Make these banks liquid and keep them alive.
17:12 George Selgin: There is no general economic problem that we, the Feds, should be addressing right now. That is essentially what they were thinking. And it’s actually, it’s even worse than it sounds because remember that while they were sterilizing, certainly, what they were doing was taking liquidity away from the rest of the economy as if it wasn’t in any need of liquidity, and could even spare some in order to help the beneficiaries of the emergency lending program. Of course, now we know in retrospect the economy as a whole, the sound part of the economy, the un‐troubled part of the economy was starving for liquidity as well. And could not… Could ill afford to be forced to do with less of it in order to sustain these emergency lending programs.
17:56 Trevor Burrus: So if we take a step back and we’ve sort of established this tale where the Fed is paying interest rates, that is, banks to hold excess reserves and they’re just holding ‘em, they’re not making commercial… They start making fewer loans and putting less money into the economy ’cause they can make more money, or they’ve… And with less risk possibly too, by holding on to these reserves. Is this… Would this be analogous to getting such a high rate of return on interest in your savings account, that you simply don’t invest in the stock market and therefore not helping create better consumer credit and other things to grow the economy?
18:31 George Selgin: Well, yes and no. It’s actually… The analogy with the stock market is not quite right because whether people put money in a savings account or put it in the stock market, they are funding private market investment.
18:45 Trevor Burrus: Sure, yeah. But to that person then?
18:48 George Selgin: That’s not true if what’s competing with the private market and lending is the Fed itself. Particularly is the Fed itself, in this case. Then what’s happening is not… People are still saving, the banks… They’re still putting money in their banks, the backing… Many of the sound banks are receiving lots of deposits at this time, it’s not that the banking system was collapsing. But some banks were in trouble. But now, with the new program, the banks are lending to the Fed a lot of what they would have lent elsewhere, that is the… You have a shift in the composition of bank lending from buying other interest earning assets, acquiring other interest earning assets, including loans to businesses, consumers, what have you.
19:38 George Selgin: To holding reserves, which is lending to the Fed. And what does the Fed do? What does it finance with this lending? The Fed finances its holdings of treasury and agency securities, and ultimately after QE long‐term treasury and agency securities. But the point is what the Fed does not do, that ordinary banks normally do, is to provide credit in the form of loans to businesses and consumers, etcetera. So if you think that shifting funding from ordinary bank borrowers to the treasury and government agencies is efficient, well, then I guess you wouldn’t have any problem with this. Even if it goes on for, well, until now.
20:24 George Selgin: But if you think that in fact there is a sacrifice of more productive lending opportunities for less productive diversion of savings to the government and its agencies, then you can only hold this to be regrettable. And by the way, the Fed for… Until the crisis, the Fed had a long standing policy of favoring having a minimal footprint on the credit system. Being, if you can believe it or not, a lean and mean Fed, which it was, relatively speaking. Not only compared to today but compared to most other central banks in the world, it has to be said, the Fed operated with a very slim balance sheet.
21:05 George Selgin: And the Fed officials themselves lauded this, because they said, “Look. See, we have a… We’re lean, we’re mean but credit in the economy goes mainly to the private sector with only a minimum amount going to us.” Well, minimum given that they had monopolized all the currency holdings of the system which is already grabbing a fair amount of savings. But the point is, it was a relatively lean system that had a low opportunity cost in terms of the diversion of savings away from the private sector and towards the government sector. That all changes with the reform of 2008 and it’s a change that remains in effect to this day.
21:47 Trevor Burrus: If I was to translate what you said previously to make sure I understand it. If you have the banks lending to the Fed and having the Fed do what it wants with it, it’s not very market friendly in the sense of where resources should go. That’s what you were saying before, right? Market based resource allocation is that when the banks are lending to people who want to start businesses or they see opportunities in the marketplace, that’s a better position for a more efficient allocation of resources than having the Fed be the one making those decisions?
22:17 George Selgin: Yes. I think most economists would agree. If for no other reason because banks are less constrained. We think of the banks being… Private banks… Commercial banks being more constrained to the Fed. In many respects they are, but not when it comes to the kinds, the variety of assets they can have. As the Fed like many central banks, for very good reasons, is restricted in the assets it ordinarily acquires, and in our case, it’s mainly Treasury securities or some agencies, mostly Treasury securities before the crisis. And then agencies, of course, became more… And issue securities became more important later.
22:56 George Selgin: So no… Everyone understands that because the Fed is constrained in the quantity of assets it’s not in a position even if it could to choose the best return investments to make with people’s money allowing for the risk. So that fact alone makes it highly unlikely that by putting savings in the Fed instead of in the banks, we’re going to get as efficient and productive in allocation of those savings. So that’s the most basic argument. A more subtle argument is simply that the forces of competition, the fact that banks have to have skin… Commercial bankers have skin in the game, means they have to be more alert to productive investment opportunities, and also more careful about how they choose them.
23:49 George Selgin: Now we know, of course, the crisis itself teaches us, that [chuckle] under modern conditions whatever the reasons banks don’t always do a good job of this. When that happens, they can fail, and fail sometimes spectacularly. But that’s actually part of the mechanism that assures that for the most part you have resources being used effectively by banks, because there are severe consequences when commercial bankers screw up, or there should be. They sometimes get rescued.
24:23 Trevor Burrus: Yes.
24:23 George Selgin: Here at Cato we feel strongly that they shouldn’t be, in that case, that would make banks even more capable of doing a better job than the Fed possibly can of investing resources efficiently. But despite “too big to fail”, and other interventions that undermine productive bank lending, I think most people, most economists would still agree that if we want savings to be used effectively, we want a small Fed footprint, not a large or gigantic Fed footprint, which is what we have now.
24:56 Trevor Burrus: And you argue that the effect of this was profound, and it seems with the literature that you cite where there’s a back and forth where some people say it’s not a big deal of giving interest on excess reserves, other people said it was. You say it was so profound that it almost, I think “the Fed funds market cease to function”, that almost essentially cease to function, that the mini banks just were looking at the interest on excess reserves, and no longer doing the interbank lending, which also cut down interestingly on interbank monitoring, which I found to be very interesting.
25:31 George Selgin: Right. So there are several reasons why I consider the changes implemented in 2008 to be extremely important. One which we were talking about before is that the Fed’s credit footprint has gotten so much bigger. And that means, in my opinion, a less productive allocation of scarce savings. Now, that is a controversial claim not because the Fed isn’t bigger, everyone knows it is, and not even because the Fed is bigger relative to commercial banks is just what matters here. It’s now 30‐something percent of total banking system assets or Federal Reserve assets up from something like seven or 8% before the crisis, so that it’s the ratios that matter here. Nobody denies those things are true.
26:23 George Selgin: What many do deny is that there’s any real cost here. There are various arguments I go into in the book to the effect that all of this is a free good. We’ve really… We haven’t reduced bank lending, we’ve just increased reserves, is essentially the argument. That the Reserves have been created costlessly. So it’s as if banks were doing all the lending that they would have been doing anyway, and they have all these reserves through the banks. So those arguments all essentially amount to the assertion as I put it in the book, that while there may not generally be such a thing as a free lunch there apparently is according to these people, and…
27:03 Trevor Burrus: Free reserves.
27:03 George Selgin: Actually I think it’s a free liquid lunch.
27:05 Trevor Burrus: Liquid lunch, yes.
27:06 George Selgin: Or free liquidity lunch. And without going into it here in any detail, I take on those arguments and show that in fact they’re quite false. In real equilibrium, it is not true that reserves are costless, there really is a real reallocation, it’s more obviously true now that the crisis is over and we’re no longer in a state of under high unemployment. That after all if the real resources are being shunted to the Federal Reserve system and to the markets it supports when it buys assets away from private sector lending, there’s just no getting around this, it’s essentially a mathematical truth.
27:57 George Selgin: And so the people at the Fed love to harp on how wonderful it is to have all this liquidity in the banking system, which makes it safer in certain respects, and nobody can deny that the greater liquidity does reduce certain risks. The point is for goodness sake, it doesn’t do so for free. And there’s a reason why we didn’t want banks to be holding vast amounts of excess reserves before the crisis, even though it would have made things safer then too, and that’s because there’s a real cost involved, and at 2.5 trillion or so, still in excess reserves in the system, that cost is substantial.
28:45 Trevor Burrus: I found this quote really shocking, and here’s one line that you wrote. So, in making the case for sticking with a floor system which is the interest on excess reserve system, we haven’t mentioned that term yet.
29:00 George Selgin: That’s right, yeah. We haven’t explained why it’s called the floor system, which is of course, what one of several things my book title alludes to, but maybe we’ll get around.
29:08 Trevor Burrus: Yeah. So the floor, and then the other one is the corridor system, we can explain that, but this quote is shocking for the reasons you just said. “In making the case for sticking with the floor system, Fed officials and economists observe that it is, “It is operationally much less complex than a corridor system, in that it reduces the need for routine open market operations to limit departures of the effective Federal Funds Rate from its assigned target. The argument is valid as far as it goes, but it fails to go far enough because it overlooks the costs that go hand in hand with the gains that Fed officials like to harp upon.” ” That line when you say, “The gains that Fed officials like to harp upon.”
29:43 Trevor Burrus: “As Oreck Linsdale and Jablecki have compellingly argued to arrive at a sound decision regarding a Central Bank’s optimal operating framework, want us to take all relevant trade‐offs, that is all the costs and benefits of alternative arrangements, into account.” And the reason I wanted to read that, and I apologize if I butchered the name of one of those economists I said. The reason I wanted to read that is it struck me as amazing when you said Fed officials like to harp on the gains. So you have Fed economists, who don’t seem to be taking all the costs and trade‐offs into account of the Fed doing something this big, which seems like just forgetting Economics 101, that they view this as costless, and they just look at efficiency on the Fed side and not look at how it restructures the economy. Is that a common thing that Fed officials or Economists tend to do?
30:32 George Selgin: Well, I don’t know if common is quite fair but they sure do this sort of thing a lot. I have two articles that are relevant to the point, one on this specific issue is something I wrote for Alt‐M called The Strange Official Economics of Interest on Reserves, which explains the one‐sidedness of the arguments that are being made by Fed officials for the system. One‐sidedness partly because they’re ignoring the costs of the system, the costs of having so much liquidity and having banks therefore lend more to the Fed than they used to. And other costs as well that I go into in the book.
31:18 George Selgin: But I also have an earlier piece I wrote for the Cato journal called, “Operation Twist the Truth”, and I’m afraid I can’t remember the subtitle, but it is something like how the Federal Reserve officials distort the Fed’s record and history. And that talks about how, yes, they have done this sort of thing before. This is what institutions do, of course, in justifying themselves. There’s a thin line between providing information and providing propaganda. But I’m afraid that some otherwise, very good Fed economists sometimes cross that line when they tilt the scales in favor of the benefits of whatever Fed programs and actions, or in favor of some claims about the Feds record by ignoring relevant facts, they do do this, and this is a case in point.
32:17 Trevor Burrus: Well, it seems like the wholesale restructuring, not… That’s maybe an over‐statement, but a large restructuring of how lending is done, and of banking practices is a big deal. I mean no matter what.
32:28 George Selgin: Yes, it is a big deal. And the other point is that some of the changes that have taken place, some of the consequences of the reform that has taken place, are ones that in other central banking systems have had much more serious discussion. You were talking earlier, Trevor, about the Fed funds market and what the implication of interest on reserves and the floor system have been for that, and that’s the second important consequence, as there are a couple of others we’ll perhaps get to. But it did indeed shut down interbank federal funds lending. This is, again, not controversial, that is the statistics are very clear. Banks for reasons that should be obvious in light of what we’ve been saying, have no incentive to take part or have very, very rare incentive to take part in interbank federal funds lending, because most of them have more than ample reserves to begin with, so they don’t find themselves ever short at the end of the day. And besides that, the banks that have excess reserves would not be inclined to lend them for a Fed funds rate that’s…
33:42 Trevor Burrus: Just a little bit more maybe, with more or less.
33:43 George Selgin: Well, actually, in practice it’s less…
33:45 Trevor Burrus: But even the lending…
33:46 George Selgin: Effective Federal Funds Rate, so you wouldn’t… The whole point of this system remember was to make banks hold down to reserves instead of parting with them, and that included particularly parting with them by lending to other banks in the overnight market.
34:00 Trevor Burrus: But lending is also, has cost that holding on to reserves doesn’t, like oversight cost monitoring, and things like these, yeah.
34:04 George Selgin: Yes, yes. But, so they shut down the interbank… There’s still Fed funds market activity, but it’s not interbank lending, it’s various government‐sponsored enterprises like Fannie and Freddie, that keep accounts, keep balances at the Fed, but are not eligible for interest on reserves under the 2006 laws. So they get nothing for their reserve balances still. So what do they do when they have reserve balances to spare? They lend to the banks that are willing to share some of their interest in return for a 6 basis point differential profit or something like that. It’s easy money for the banks that do it. So it’s [34:47] ____.
34:47 Trevor Burrus: To these other banks reserves?
34:50 George Selgin: Yes.
34:50 Trevor Burrus: Yeah, and then the banks send some of the interest back.
34:50 George Selgin: So the other banks get more reserves and send some of the interest back to the GSEs. And so that’s the only activity on the Fed funds market, it’s not interbank for them… It’s with rare exceptions. So why does this matter? It matters because as you mentioned, before the crisis the presence of an active interbank federal funds market, provided an important venue for banks to monitor each other. Because those are unsecured loans, those interbank loans. And therefore any bank that took part in that market would have a strong incentive to do its homework to figure out which banks were sound and which ones weren’t. And as a result of all this homework, the interbank federal funds market, was a sort of canary in the coal mine of bank credit. If there were any problems with any bank in that system you could bet that the bank, the other banks would be the first to know, and at the first sign of any serious problems that bank would be essentially kicked out of the Fed funds market. And then you knew there was a problem with that bank, and that in turn became…
36:04 Trevor Burrus: Big signal.
36:05 George Selgin: The source signal for all other banks and anyone else who cared to cut back their involvement with that bank. And because you had such a signaling mechanism in place, two things were true. First, the monitoring helped to keep banks sound in the first place, and second, it meant that so‐called contagion effects would be contained, because any rational person would have no reason to run on a bank that was still being treated as a sound counter‐party in that Fed funds market, by other banks that had reason to keep abreast of everything happening withdf their counter parties. So they’ve killed that.
36:58 George Selgin: By the way, this is not… This point is not mine. It is one that has been made by prominent economists including at least one Nobel Laureate. It’s a point that has been debated extensively in Europe, and elsewhere in the world, where it is one of the reasons why many other banks, central banks, that flirted with floor systems or used them in the past, have tried to move away from those systems. The only central bank whose experts have not deemed it worthwhile to even consider this as an important point, and who, I hear get pissed off, and other people point out that it should be considered important, are the US central bankers. And I think that’s highly irresponsible.
37:50 Trevor Burrus: You also say that this could’ve… We have a productivity decline that has been written about for total factor productivity for workers or at least, it doesn’t go up at the same rate it has been. Could this… This is… You say this could be a contributing factor to that, correct?
38:06 George Selgin: Not the Fed funds market factor, that’s all about rates.
38:07 Trevor Burrus: No, the interest rates.
38:09 George Selgin: The growth in the Federal Reserves credit footprint…
38:14 Trevor Burrus: Okay.
38:15 George Selgin: I point out in the book, could be a factor. Logically you would think it’s certainly detracting from productivity to some extent. We don’t know how much.
38:27 Trevor Burrus: And this is…
38:28 George Selgin: There’s no way that shunting so much credit to the Fed, savings to the Fed, makes the economy more productive, it presumably makes it less productive. How much? I don’t know.
38:39 Trevor Burrus: Let me just clarify my microeconomic brain. One of the reasons, for example, not the only one, is because let’s say is a businessman wants to get a loan to buy machinery that makes his workers more productive, but is unable to get it. That’s the kind of decision that would lead to having less productivity growth, correct?
38:58 George Selgin: That’s right, you would have more lending, other things equal, to businessmen and consumers as well, by commercial banks, if their balance sheets were not skewed to include substantial quantities of excess reserves, which take up room on those balance sheets that other buys might be taken up by those other kinds of bank investments. And that’s the opportunity cost of interest on reserves, the presumption ought to be that those other kinds of lending would be more productive.
39:40 Trevor Burrus: And also the one thing that struck me as very interesting is that the size of the Fed balance sheet and the way it’s made up with the interest on excess reserves rather than focusing on the Federal Funds Rate, means that there’s possibilities for political manipulation?
39:54 George Selgin: Yes. Oh, yes. Absolutely, right. So let me just step back a minute Trevor and mention a point that your listeners are going to wonder about if I don’t mention it certainly.
40:07 Trevor Burrus: Please. Please.
40:10 George Selgin: Two things are responsible for the size of the Fed both absolutely and relative to the rest of the economy and to the commercial banking system. For the growth in that size. I mean, since the crisis. We’ve talked about interest and reserves, but the other thing, of course, is expansion, absolute expansion of the Feds balance sheet. Which is partly a result of the emergency lending we’ve been talking about, but also more importantly, a result of deliberate balance sheet growth through three rounds, massive rounds of quantitative easing since October, 2008. So those things go hand in hand, in the one hand you have an interest rate that encourages banks to hold on to excess reserves that come their way, instead of doing what banks normally would do with those unwanted reserves. And then you have the actual creation of more nominal excess reserves to the tune of $2.7 trillion almost at one point. And so both of those things are responsible for the size of the Fed.
41:18 George Selgin: I should add to this that your listeners may well wonder. Well, if the Fed created interest on reserves or implemented it to keep reserve creation from stimulating the economy, why should they have expected more deliberate reserve creation, starting with QE1 to stimulate the economy. And that’s a good question.
41:44 Trevor Burrus: This is good, you can ask the questions that I don’t know to ask. I do have a question about quantitative easing right here, but…
41:48 George Selgin: Okay. But the answer is that, well, between October, 2008 and December, when they decided on starting quantitative easing, Fed officials of course, finally came to understand that the economy needed stimulating. So that changed.
42:10 Trevor Burrus: So they use a different method though.
42:12 George Selgin: That’s right. Well, that changed but what didn’t change was interest on reserve. Now, they did lower the interest rate on reserves ultimately to just 25 basis points. It doesn’t sound like much, but by that time other interest rates were so low that it was still an attractive rate for banks relative to other short‐term interest rates. So now you had the problem. Well, if we wanna stimulate the economy, what can we do?
42:36 George Selgin: You might have expected the officials at that point to say, “Well okay, now we need to go back to a zero interest rate on reserves”. Or even consider a negative rate which as we know other… Some other central banks did in fact resort to. But they didn’t, they insisted that on keeping a positive interest rate on reserves throughout the crisis. Only now they were going to engage in deliberate reserve creation. Not for emergency lending but for stimulus purposes. And so, how is this going to work? Well, they had a new theory, and the theory… They had several new theories, but all of them boiled down to, “We’re going to create a lot more reserves.” So we’re gonna up the scale of this, and if we do that, and particularly if we create the reserves by buying long‐term assets there can be a stimulus effect from that even if it doesn’t encourage more bank lending. And that stimulus effect is going to work through portfolio mechanisms and blah, blah, blah. They had a bunch of controversial theories. And so you might say. I think it’s fair to say, that the only thing that changed between October and December 2008 is they came up with new theories.
43:50 S3: Okay.
43:50 George Selgin: Right. [chuckle] So the theory’s gonna change in that with a new theory the world will work differently. That’s the cynical way to view it. But these theories were all quite controversial. Ben Bernanke himself quipped, famously, “QE works in practice but not in theory”. We could talk more about how it worked in practice later. Suffice for now to say that actually it’s not so clear how well it worked in practice either. So that was all a long digression…
44:17 Trevor Burrus: Of how we got the balance sheet of the Fed.
44:19 George Selgin: Yeah.
44:19 Trevor Burrus: Yes.
44:19 George Selgin: So I’m now, finally, gonna get around to the point you were just raising before I digressed which was the question of the politics of having a large balance sheet. And here the new thing that really matters most in my opinion is that whereas under the old system there was an intimate connection between how big the Fed made its balance sheet and the stance of monetary policy. Where buying assets loosened the stance of policy and selling them tightened. Under this new system, once banks were swamped with excess reserves, further changes in the quantity of reserves make no difference to the stance of policy. The policy stance has changed by changing the interest rate paid on reserves, not by changing the size of the balance sheet.
45:07 George Selgin: Okay, so what? What’s the political problem? The political problem is that the size of the balance sheet has become a free parameter. That is, there’s no obvious reason why it should be a four trillion or three trillion or ten trillion or any trillions that you want, so long as it’s big enough. Some economists put big enough at less than one trillion, perhaps a few hundred billion, to maintain the new system. When by making the balance sheet into, as it were, a free parameter not intimately determined by the monetary policy needs, that raises the problem that all kinds of people would love to see the Fed grow its balance sheet more by buying this asset or those assets, including the US Treasury.
46:03 George Selgin: And this creates a real problem of possible abuse of the balance sheet for fiscal purposes, a far greater problem than existed in the past. In the past, just to give you the most obvious kind of example. In the past, if some administration went to the Fed and said, “By God, we want you to ease monetary policy by buying more treasury securities and make life simpler for us.” And in case nobody’s noticed, administrations do this sort of thing now and then. In the old system, the Federal Reserve authorities could legitimately say, “Well, we have a mandate to achieve a certain inflation target, and also, we have an unemployment mandate. But for the present purposes, the inflation target is what really matters here. And we will violate our mandate if we buy too many of your securities. So we can’t help you. We can’t help you consistent with our mandate… ” That was a pretty empowerful argument, right? “We can’t accommodate the administration because it’ll cause inflation. And that’s against our responsibilities.” They can’t say that anymore.
47:12 George Selgin: And we’re already hearing from all kinds of advocates of various kinds of government programs and policies, whether macro or micro. “Why not have the Fed just buy up all kinds of stuff?” And we cannot say, no one can say, the Fed cannot say, to those people. “Oh, we can’t do that consistently with our mandate.” In fact, they don’t have an argument. And the Fed is not, as it is we know from history, the Fed is not always able to resist pressure to monetize this and that. That’s how it… That was a problem already. Fed independence was already not what one would ideally like it to be.
48:02 Trevor Burrus: But they had a good argument.
48:03 George Selgin: But they had a good argument that helped shore up what level of independence it had. That’s now no longer an argument. This is a very serious problem. It’s been pointed out by the way, not just by me but by Charles Plosser. But not by enough other people. I think it’s extremely dangerous. Of the three major adverse consequences of the switch to the floor system that we’ve talked about, the destruction of the interbank monitoring, the expansion of the Fed’s credit footprint and the unanchored size of the Fed’s balance sheet, I think the last may in the long‐term pose the gravest dangers.
48:43 Trevor Burrus: So is this… Is this… The balance sheet, is it money such that via manipulation of some sort, if say, Donald Trump doesn’t get Congress to fund his will, he could try to pressure the Fed to use some of that money in the balance sheet to pay for it off the books, so to speak?
49:01 George Selgin: Well…
49:02 Trevor Burrus: Is that the kind of way it could be used or?
49:04 George Selgin: That’s a possibility, but he could also just say to the Fed that he wants the Fed to engage in more security purposes… Purchases, right? What Trump has been doing, we know is saying they shouldn’t raise interest rates as much, but if he were more astute, a student of central banking, he wouldn’t do that. He’d say, “Why don’t you go out and buy some more of our treasuries. We’re coming up with new ones all the time that we have to sell.” And so, because remember the system is designed so that the Fed can gobble up treasury securities. It can’t buy them, it’s not supposed to buy them directly from the treasury, but it buys them from the open market. It can gobble up as many as it likes, that’s not gonna affect the stance of monetary policy. If Trump and his administration understood this, and maybe they do, they would be saying, “Why doesn’t the Fed do this?” And I would be curious myself as to what the Fed’s argument would be. What’s the Fed’s counter‐argument?
50:07 Trevor Burrus: So we have a different world as you say…
50:10 George Selgin: We certainly do.
50:10 Trevor Burrus: The number was, the balance sheet of the Fed is 30… What was the number percentage you said compared to the…
50:16 George Selgin: Thirty something percent, about 30% of the total banking system assets, that’s the assets of commercial banks plus those of the Federal reserve banks.
50:26 Trevor Burrus: Compared to like 7% before the…
50:28 George Selgin: That’s correct, yeah. It’s much bigger, much bigger.
50:29 Trevor Burrus: That’s a huge change. So it seems like getting…
50:31 George Selgin: That’s the footprint that I was talking about.
50:33 Trevor Burrus: It seems like getting out of this could be very, very difficult. Also because there’s been a lot of restructuring to some extent, bank behavior and everything.
50:42 George Selgin: Absolutely, and some new regulations that some people think make going back impossible, I don’t.
50:48 Trevor Burrus: So what do we do?
50:50 George Selgin: Well, what we do, first of all, we want to see the Fed continue with the underlying program that it has in place. It is shrinking its balance sheet very slowly. However, if the intent is to maintain the current system, it’s… We shouldn’t expect the balance sheet to shrink much more than… I don’t think they’ll shrink it below three trillion the way things are going. I’d be surprised if it ever got lower than that. And then it’ll start rising again. So any way you slice it will have a much bigger Fed if current arguments prevail. The only way we can get it smaller is to first of all convince people that we need to get it smaller, that we should get it smaller, as we can certainly do, if we go back to a corridor type system. And I should say, in explaining what I mean by that, that we never had a true corridor system, though we had something like it. In a corridor system the interest rate is… The stance policy is controlled the way in fact it was controlled before the Feds.
51:53 George Selgin: So the difference between that system and a orthodox corridor system, is that in an orthodox corridor system, the Feds target rate sits usually half way between an upper bound that’s the Feds emergency lending rate or the discount rate, and a lower bound that’s set by interest on reserves. So you can have interest on reserves in a orthodox corridor system, you usually do. But it’s a modest rate that’s below the targeted policy.
52:25 Trevor Burrus: Doesn’t give too much incentive to hold on.
52:26 George Selgin: Doesn’t give that. In this system you have scarce reserves, you don’t have banks holding on to any reserves that come their way. So, if we go to a corridor system, then we can have a mean lean Fed again. Maybe not quite as mean or quite as, I should say, maybe not quite as lean. [chuckle] Probably as mean…
52:49 Trevor Burrus: As mean.
52:50 George Selgin: As before, ’cause there are new liquidity requirements in place that would encourage banks to hold some more reserves than they have in the past. But it is not true what some people claim, that these new regulations would favor having… Banks having vast amounts of excess reserves if they do now are needing many more than before. Because the liquidity requirements can be met with either Treasury securities or reserves, both of which are so‐called high quality liquid assets. So if reserves were not much more attractive in their yield than treasuries, what we would see is banks holding more excess reserves in the past, but not…
53:34 Trevor Burrus: As many.
53:35 George Selgin: Not, certainly not needing a trillion or more. And then they would also hold more treasury securities. But that’s actually… Even if they do hold more treasury securities than before, that’s better than holding more reserves, even though it sounds like it’s the same because in the other case, the Fed would hold the treasuries instead. But it actually does make a difference, because treasury securities are more useful to banks, because they can be used, hypothecated in various kinds of lending, whereas reserves have a peculiar quality that they’re not useful to any non‐bank institutions.
54:19 George Selgin: And no, non bank institutions cannot have reserves.
54:19 Trevor Burrus: Non bank institutions, yeah.
54:22 George Selgin: Cannot have balances with the Fed that are interest earning or otherwise. So if a bank has reserves on its balance sheet it can’t use them as collateral for borrowing from any other institutions, see. So if in a world where you did nothing else but had the banks hold the reserves instead of the Fed, you’d still be improving things. But what I’d like to see is a world where we have a lot less demand for reserves absolutely than we have now. And fine, if the liquidity coverage ratio means that banks hold more treasuries, that’s fine. But that doesn’t mean the Fed has to be there.
55:10 Trevor Burrus: Thanks for listening, Free Thoughts is produced by Tess Terrible. If you enjoy Free Thoughts, please rate and review us on iTunes. To learn more, visit us on the web at www.libertarianism.org.