Tom Palley has an interesting paper out on the Fed’s attempt to taper its QE program. I have written about the tapering program before here and here and I have written about how QE works here.
Anyway, I will deal with the main policy proposal that Palley lays out in a moment but first I want to address a passage that I think slightly misleading. Palley thinks that the Fed’s tapering program gives an effective “tax cut for banks”. His reasoning runs as such,
Third, the payment of higher interest rates on excess reserves promises to be very expensive. It is also expansionary, which runs counter to the purpose of raising interest rates. The expense is very clear. Given banks hold $2.6 trillion in total reserves, every one hundred basis point increase in interest rates costs the Federal Reserve $26 billion. If the Fed’s policy interest rate returns to 3 percent, that would cost $78 billion. That is an effective tax cut for banks because the Fed would pay banks interest, which would reduce the profits it pays to the Treasury. The banks, which were so responsible for the financial crisis, would therefore emerge winners yet again. Taxpayers, who bailed out the banks, would once again bear the cost. Paying interest to banks would also run counter to macroeconomic policy purpose since it would be pumping liquidity into the banks when policy is explicitly trying to deactivate liquidity. That smacks of policy contradiction. (p4)
Frankly, I think this is nonsense. It’s not just the banks that would benefit from higher interest rates on reserve holdings at the Fed. It is basically any saver in the economy — pension funds and so on included. The Fed would effectively be offering a perfectly safe asset — that is, a deposit at the institution that creates the money — upon which savers can get an interest rate. Will the banks benefit from this? Yes. But so will other savers.
I also don’t think that this “smacks of policy contradiction”. By this criteria all changes in interest rates would “smack of policy contradiction”. Whenever the Fed moved to raise interest rates to quell aggregate demand they would simultaneously be increasing aggregate demand among savers. In this sense all monetary policy is “contradictory”. I suppose this is true in some sense but the question is one of net effects: does raising interest rates increase or decrease aggregate demand generally? The answer, I think, is that generally speaking raising interest rates works to decrease aggregate demand.
These points tie into Palley’s proposal to have what he calls Asset Based Reserve Requirements (ABRR). Basically, the idea is that banks should have to hold reserves against assets. This would effectively function as a tax on banks. Holding assets would become more expensive in the sense that the banks would have to hold reserves in order to keep the asset on their books. But Pally forgets to mention that this tax would affect anyone who holds assets — again, that is basically all savers in the economy.
Palley’s proposal would also have enormous effects on exchange rates. As Post-Keynesian economists stress time and again, a key determinate of exchange-rates are capital flows. Given that Palley’s proposal would impose a cost on holding assets in, say, the US this would affect capital flows into the US and could lead to a depreciation of the dollar. Palley actually recognises this when he writes,
…imposing ABRR might even cause some US outflows by financial capital seeking to avoid reserve requirements. (p7)
All that said, I actually like Palley’s idea because it allows central banks to steer asset markets in a far more direct manner than they currently do. Palley highlights this when he writes,
The specific effects on bond and stock markets would depend on the particulars of how reserve requirements were assessed. The stock market would likely strengthen if stocks were assessed with a zero reserve requirement while bonds had a positive requirement. This is because stocks would become relatively more attractive compared to bonds. Conversely, stock prices would likely drop if stocks were subjected to a positive reserve requirement and bonds were zero-rated. (p7)
I really like this aspect of Palley’s proposal. At the moment central banks use a very unfocused sort of monetary policy. This can lead to enormous contradictions.
Take the Greenspan years as an example. In the 1990s and 2000s the US economy was extremely weak and required low interest rates to get investment rolling. But this led to low mortgage rates and an explosion of mortgage lending. The Fed was thus caught between a rock and a hard place. On the one hand, if they wanted to quell mortgage lending they had to raise interest rates across the economy. On the other, this would dampen real investment and risked leading to a slump.
What’s more the Fed actually lost control of mortgage rates in this period. Take a look at the graph below which shows how mortgage interest rates didn’t respond to increases in the Fed’s overnight rate.
With Palley’s proposal, however, if the central bank ever found itself in this position again it could raise reserve requirements on mortgage-based asset classes. This would have the effect of raising the mortgage interest rate without raising other interest rates.
The problem with implementing Palley’s policy now is that the US economy, as I have written elsewhere, is highly dependent on savers and investors spending money. You can see this clearly in the following graph that I’ve taken from Steven Fazzari and Barry Cynamon’s excellent paper Inequality, the Great Recession, and Slow Recovery. The chart graphs consumption-to-income rates in the US based on income — specifically the bottom 95% of the population versus the top 5%.
As we can see it was a rise in consumption-to-income of the top 5% of the population at a time when the consumption-to-income ratio fell off for the bottom 95% and failed to recover.
My interpretation of this is that the top 5% have buttressed their spending with income made from capital gains. By this logic, any policy that hurts savers and asset investors could have enormously damaging effects on consumption. This could then lead to a fall-off of domestic investment as corporations and businesses saw a fall in demand for their goods and services.
I’m not saying that Palley’s proposal shouldn’t be enacted. But the current recovery is likely tied very immediately to the financial sector. And if the fall-off in demand that Palley’s proposal would cause is not replaced by some other source it could lead the US economy back into recession. Given the political situation in the US right now around the government budget it seems highly unlikely that policymakers could step in to fill this gap.
So, if we’re going to talk about Palley’s proposal we should do so with our eyes wide open. The fact that these are the conditions under which we have to make policy decisions is tragic and attests to decades of poor economic management (some of which reeks of class war). But the situation is as it is. And we have to ask ourselves the question: is it worth risking another recession to beat up on the banks? Because surely it will not be the banks that are hurt most if a recession occurs.
“Will the banks benefit from this? Yes. But so will other savers.”
You have to have a reserve account to get the money from the Fed or any other central bank.
There’s no guarantee of any pass through.
The banks will pass it through to their customers. If they do not another bank will. There is a substantial degree of functioning competition in this market.
“Paying interest to banks would also run counter to macroeconomic policy purpose since it would be pumping liquidity into the banks”
As far as I can see, paying interest on reserves doesn’t actually increase the quantity of reserves, unless the central bank has negative capital. So Palley seems to be a bit wrong here about IOR and liquidity.
Great piece as always Phil.
I would just like to comment on this part of your post:
“Whenever the Fed moved to raise interest rates to quell aggregate demand they would simultaneously be increasing aggregate demand among savers. In this sense all monetary policy is “contradictory”. I suppose this is true in some sense but the question is one of net effects: does raising interest rates increase or decrease aggregate demand generally? The answer, I think, is that generally speaking raising interest rates works to decrease aggregate demand.”
I don’t think that the statement “…generally speaking raising interest rates works to decrease aggregate demand.” is complete enough in its conception.
If we were to try and work out just how much benefit the savers get vs the debtors, we would have to know the levels of debt. Interest rate increases have drastically different net impacts when Govt securities are running at 50% of GDP compared to 200% of GDP. Imagine the different fiscal impacts higher interest rates would have between Australia and Japan.
And of course we could go much deeper and start to talk about the levels of private debts, maturity structures, flexible vs fixed rates, indebted sectors compared to incomes and on and on.
In conclusion, any statement or prediction made about the net impacts of interest rates on aggregate demand must contain a qualifier about debt levels in order to at least be logically consistent.
This is true. But you also have to take in the non-monetary effects. You have to take into the effects interest rates have on investment. If the central bank raises the short-term rate above the long-term rate investment will generally contract sufficiently to cause a recession. The channel through which this works is typically residential investment. There is also a major affect on inventory demand and on auto loans.
Check it out. Every time the short-term rate goes above the long-term rate you get a recession.
Right, but inverted yield curves are unique phenomenon. They do not represent a means of explaining why debt levels do not matter to predicting the net impacts of a particular interest rate move. Neo-liberals believe in the archimedean lever of interest rates, I’m not so convinced.
Besides, thanks to you among many fine writers and teachers, I’ve come to believe in a fairly simple world paradigm…..’if mainstream economists believe something, its probably a good idea to expect the opposite to be true”. Its served me pretty well so far 🙂