What role do we want the monetary base to serve?17th March 2019
Over at Econlog, I have a new post discussing the Fed’s opposition to narrow banking, and specifically John Cochrane’s excellent post criticizing the Fed’s position. I’ll eventually get to narrow banking in this post, but first I’d like to consider some basic questions about the monetary base, which are rarely asked.
Before 1913, the US had no Fed and the monetary base was 100% composed of currency (and coins.) There were no bank deposits at the Fed. It’s perfectly possible to run the world’s largest economy on that basis. Yes, there were occasional financial crises, but the 1931-33 banking crisis was far worse, so creating the Fed didn’t solve the problem. When I was in school, I was taught that it was FDIC that actually ended banking crises, but then we had 2008. Crisis-free Canada didn’t have a central bank until the 1930s and had no deposit insurance until the 1960s, so whatever causes financial crises it’s certainly not a lack of government intervention.
When the Fed was created in 1913, base money was expanded to include deposits at the Fed, not just currency. But why? Why add these reserve deposits, and if it’s a good idea, why not let anyone have a deposit at the Fed? I’ve never seen a good explanation.
I once wrote a post suggesting that we go back to the pre-1913 currency-only monetary base, half jokingly and half seriously. I’m sure John Cochrane would have been horrified, as he has quite rightly noted that the government can produce safe liquid assets quite cheaply, and hence on efficiency grounds there’s something to be said for saturating the economy with the stuff (say via the “Friedman rule”.)
But I wonder if that isn’t penny wise and pound foolish. Or as Tobin once said, “it takes a heap of Harberger triangles to fill an Okun Gap”. (Which means micro efficiency costs are an order of magnitude smaller than the costs of demand side recessions, i.e. the cost of inadequate monetary policy.)
Suppose we had had a currency-only monetary base in 2008. If the Fed had done $3 trillion in open market purchases, what would the impact of all that extra currency have been, given the currency stock was only $850 billion going into the recession? I’m not sure, but I suspect the Fed would have gotten more bang for the 3 trillion bucks.
Since my currency only idea is a pipe dream, let’s go the other direction. Let’s say deposits at the Fed are a great idea. I still want to know why they are restricted to banks. It’s only a matter of time before we go to all electronic money. Is it feasible to have a monetary regime where it is illegal for anyone but a banker to hold lawful money? I doubt it. In that case, it seems like Morgan Ricks’ proposal for allowing the public to have accounts at the Fed is only a matter of time.
Indeed the logic of this is so powerful that “narrow banks” are already trying to create a backdoor into the Fed, by having bank deposits where 100% of the money is placed in interest-bearing reserves. Basically, you’d have a checking account at the Fed, but there’d be a middleman to preserve a fig leaf for the idea that in the era of FDIC and interest-bearing reserve accounts, the commercial banking system is actually a useful way of providing liquidity to the public. It isn’t. Banks should be taking illiquid funds (CDs, etc.) and creating illiquid assets (loans, etc.).
Somewhere between ultra-safe reserves and risky loans we have bills and bonds. Who should serve as the intermediary in that case? Mutual funds?
If you want to have low inflation and zero interest rates, the central bank balance sheet will get large. Eventually the Fed may go beyond Treasuries and start buying private bonds. But big central bank balance sheets are a choice; it’s not hardwired into the modern world, as so many pundits seem to believe.
If you allow narrow banking, it may have the effect of increasing the demand for base money. John Cochrane suggests that the Fed has the option of not increasing the supply, which is true. But if rates are stuck at zero when demand for reserves increases, then not increasing the supply is highly contractionary.
So now we have another issue to consider, balance sheet size and monetary policy effectiveness. In theory, the government can create reserves costlessly, and meet any market demand. But real world central banks seem reluctant to have excessively large balance sheets, largely for psychological reasons. Unless this mental block can be overcome, perhaps through therapy, a greatly expanded central bank balance sheet might complicate monetary policy.
To me, central banks seem like a spoiled 10-year old boy, who complains about every option you offer him:
1. Do monetary policy “a outrance” to prevent demand shortfalls? They whine that there are “costs and risks” of doing what it takes.
2. But the costs and risks of the Fed buying government bonds are not real, as a central bank is part of the consolidated government balance sheet. Then they whine that it would be embarrassing to ask Congress for a “bailout”.
3. OK, adopt the sort of monetary regime that prevents the zero bound, one of the options now favored by many academic economists (as well as economists like Bernanke before he got to the Fed.) The Australian approach, for instance. Can’t do that, it’s too controversial.
So we’ve got this ever expanding Rube Goldberg device of a financial system, where plugging one leak just causes another to develop. Each step seems logical, but no one is thinking about the ultimate destination. What do we want of our monetary base? What types of base money should exist? Who should get to hold each type of base money? How attractive should it be to hold base money? (I.e. how competitive should the IOR rate be?)
The Fed’s horribly confused defense of its anti-narrow banking policy is an indication that there’s no real long run plan here; they are making it up as they go along. As each step exposes more logical contradictions, more patches are put in place, more plugs placed in leaks at the bottom of the boat. Our political system is not one where you can simply “blow it all up” and start with a more rational system, and maybe that’s for the best (for Hayekian reasons.) So we’ll keep muddling along, and eventually end up in a very different place.
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