Matthew Klein has a good post taking down Robert E. Hall’s claim that reserves are lend out. It’s annoying that supposedly intelligent professors and central bank advisors don’t understand how the monetary system works.
He quotes from Hall’s Jackson Hole paper:
Paying an above-market rate on reserves changes the sign of the effect of a portfolio expansion. Under the traditional policy of paying well below market rates on reserves, banks treated excess reserves as hot potatoes. Every economic principles book describes how, when banks collectively hold excess reserves, the banks expand the economy by lending them out. The process stops only when the demand for deposits rises to the point that the excess reserves become required reserves and banks are in equilibrium. That process remains at the heart of our explanation of the primary channel of expansionary monetary policy. With an interest rate on reserves above the market rate, the process operates in the opposite direction: Banks prefer to hold reserves over other assets, risk adjusted. They protect their reserve holdings rather than trying to foist them on other banks. An expansion of reserves contracts the economy.
My emphasis. I don’t know what textbook Hall is reading, but that is so not true. A simple exercise will explain why. Say Bank X think it has too many reserves, and wants to reduce them by buying longer dated US Treasuries. Bank X finds a seller and transfers the money, receiving a bond in return. The seller of the bonds give up the bonds, but receive money in return, which will be deposited somewhere, thus leaving the total amount of reserves unchanged. The only way that the total amount of reserves change is if it is the Federal Reserve selling the bond! If only Hall had read Barnejek’s post from May, we would not have this paragraph.
This shouldn’t be hard. However, Klein is nice to Hall, because he could have kept going. Here’s the next paragraph from Hall’s paper:
The only excuse for not cutting the reserve rate is the belief that short rates would fall and money-market funds would go out of business. This amounts to an accusation that the funds are not smart enough to figure out how to charge their customers for their services. Traditionally, funds imposed charges ranging from 4 to 50 basis points, in the form of deductions from interest paid. A money-market fund using a floating net asset value can simply impose a modest fee, as do conventional stock and bond funds. The SEC may accelerate this move by requiring all money funds to use floating NAVs.
No it is not. Let me give you some reasons and a reading list:
- It is not just money market funds that invest short term money. E.g. GSEs don’t have access to place money at the IOER rate. They would pay too.
- It could have seriously deflationary consequences.
- Disruptions in the markets might not be negligible, as shown in e.g. failure to deliver.
- The 0.25% on IOER is not the reason banks aren’t lending — even if what he said about reserves is true.
- This is going to be tough on banks with little-or-no effect on interest rate on loans. Just look at Denmark.
This is just a very quick post. But, errr, tenured professors should now better.