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Central Banks Should Stop Paying Interest on Reserves – Article by Brendan Brown

Central Banks Should Stop Paying Interest on Reserves – Article by Brendan Brown

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The New Renaissance Hat
Brendan Brown
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In 2008, the Federal Reserve began paying interest on reserve balances held on deposit at the Fed. It took more than seven decades from the US leaving the gold standard — in 1933 — for the fiat regime to do this and thus revoke a cardinal element of the old gold-based monetary system: the non-payment of any interest on base money.

The academic catalyst to this change came from Milton Friedman’s essay “The Optimum Quantity of Money” where he argued that the opportunity cost of paper money (any foregoing of interest compared to on alternative money-like instruments such as savings deposits) should be equal to its virtually-zero marginal cost of production. Opportunity cost could indeed be brought down to zero if base money (bank reserves, currency) in large part paid interest at the market rate. Under the gold standard, the opportunity cost of holding base money largely in metallic form (gold coin) was indeed typically significant. All forms of base money paid no interest. And the stream of interest income foregone in terms of present value was equal in principle to the marginal cost of gold production (this was equal to the gold price).

Interest on Reserves are Important to Controlling Markets and Imposing Negative Rates
Friedman, however, did not identify the catch-22 of his proposal. If the officials of the fiat money regime indeed take steps to close the gap between the marginal production cost and opportunity cost of base money, with both at zero, then there can be no market mechanism free of official intervention and manipulation for determining interest rates.

That is what we are now finding out in the few years since central banks in the US, Europe, and Japan started paying interest on reserves. (The ECB was authorized to do this since its launch in 1999, while the Fed and BoJ began following the 2008 financial crisis.) Central banks can now bind the invisible hand operating in the interest rate market to an extent almost unprecedented in peacetime. In some cases, central banks have even deployed a negative interest rate “tool” which would have been impossible under the prior status quo where base money paid no interest.

How We Got Here
The signing into law of the Financial Services Regulatory Relief Act in 2006 authorized the Federal Reserve to begin paying interest on reserves held by depository institutions beginning October 1, 2011. On the insistence of then Fed Chief Bernanke, that date was brought forward to October 1, 2008 by the Emergency Economic Stabilization Act. He was in the process of dispensing huge loans to troubled financial institutions but wanted nonetheless to keep interest rates at a positive level (one purpose here was to protect the money market fund industry).

Accordingly, the Federal Reserve Board amended its regulation D so that the interest rate paid on required reserves and on excess reserves would be at levels tied (according to distinct formulas at the start) to market rates. An official communiqué explained that the new procedure would eliminate the opportunity cost of holding required reserves (and thereby “deregulate”) and help to establish a lower limit for the Federal Funds rate, becoming thereby a useful tool of monetary policy.

This was useful indeed from the viewpoint of rate manipulators: by setting the rate on excess reserves the Fed could now determine the path of short-term interest rates and strongly influence longer term rates regardless of how the supply of monetary base was growing relative to trend demand. By contrast, under the gold standard and the subsequent first seven decades of the fiat money regime, interest rates in the money market were determined by forces which brought demand for base money into balance with the path of supply as set by gold mining conditions or by central bank policy decision respectively. A rise in rates meant that the public and the banks would economize on their direct or indirect holdings of base money and conversely.

Back Before the Fed Paid Interest on Reserves
Yes, under the fiat money system the central bank could effectively peg a short-term rate and supply whatever amount of base money was needed to underwrite that — but the consequential growth of supply in base money was a variable which got wide attention and remained an ostensible policy concern. Right up until the Greenspan era, the FOMC implemented policy decisions by directing the New York Fed money desk to increase or reduce the pace of reserve growth and changes in the Fed funds rate occurred ostensibly to accomplish that purpose. This old method of determining money market interest rates under a fiat regime — in which banks’ need for reserves was minute given deposit insurance, a generous lender of last resort, and too-big-to-fail — depended on the banking industry enduring what was essentially a tax on its deposit business, which was then magnified by fairly high legal reserve requirements. Thus, it is not surprising that the original impetus to paying interest on reserves, whether in the US or Europe, came from the banking lobby. There was no such burden under the gold standard even though the yellow metal earned no interest. Banks in honoring their pledge to deposit clients that their funds were convertible into gold had to visibly hold large amounts of the metal in their vaults or at hand in a reserve center. Actual and potential demand for monetary base by the public is more limited under a fiat money regime than under the gold standard as bank notes are hardly such a distinct asset as gold coin from other financial instruments.

More Problems with Friedmanite “Solutions”
Friedman, when he advocated eliminating the opportunity cost of base money under a fiat regime, hypothesized that this could occur under a long-run declining trend of prices rather than by the payment of interest. The real rate of return on base money could then be in line with the equilibrium real interest rate. This proposal for perpetually declining prices would also have been problematic, though. The interest rate would fluctuate, and in boom times be well above the rate of price decline. In any case, the rate of price decline would surely vary (sometimes into positive territory) in a well-functioning economy even when the long-run trend was constant (downward). The equilibrium real interest rate would be below the rate of price decline sometimes (for example, during business downturns), meaning that market rates even at zero would be too high. That situation did not occur often under the gold standard where prices were expected to be on a flat trend from a very long-run perspective and move pro-cyclically (falling to a low-point in the recession from which they were expected to rise in the subsequent business expansion, meaning that real interest rates would then be negative).

What Can Be Done?
So what is to be done to escape the curse? A starting point in the US would be for Congress to ban the payment of interest on bank reserves. And the US should use its financial power with respect to the IMF to argue that Japan and Europe act similarly within a spirit of G-7 coordination such as to combat monetary instability. We have seen in recent years how rate manipulation and negative rates are made possible by the payment of interest on reserves, and are potent weapons of currency warfare. Yes, the ban in the immediate would force the Federal Reserve to slim down its balance sheet so that supply and demand for base money would balance at a low positive level of interest rates. The Fed might have to swap its holdings of long-maturity debt for T-bills at the Treasury window so as to avoid any dislocation of the long-term interest rate market in consequence. That, not the Yellen-Fischer “rate lift off day and beyond,” is the road back to monetary normalcy.

Brendan Brown is an associated scholar of the Mises Institute and is author of Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve: Manifesto for a Second Monetarist Revolution. See Brendan Brown’s article archives.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Asset-Price Inflation Enters Its Dangerous Late Phase – Article by Brendan Brown

Asset-Price Inflation Enters Its Dangerous Late Phase – Article by Brendan Brown

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The New Renaissance HatBrendan Brown
August 12, 2015
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Asset price inflation, a disease whose source always lies in monetary disorder, is not a new affliction. It was virtually inevitable that the present wild experimentation by the Federal Reserve — joined by the Bank of Japan and ECB — would produce a severe outbreak. And indications from the markets are that the disease is in a late phase, though still short of the final deadly stage characterized by pervasive falls in asset markets, sometimes financial panic, and the onset of recession.

Global Signs of Danger

A key sign of danger, recognizable from historical patterns of how the disease progresses, is the combination of steep speculative temperature falls in some markets, with still-high — and in some cases, soaring — temperatures in other markets. Another sign is some pull-back in the carry trade, featuring, in particular, the uncovered arbitrage between a low (or zero) interest rate, and higher rate currencies. For now, however, this is still booming in some areas of the global market-place. Specifically, we now observe steep falls in commodity markets (also in commodity currencies and mining equities) which were the original area of the global market-place where the QE-asset price inflation disease attacked (back in 2009–11). Previously hot real estate markets in emerging market economies (especially China and Brazil) have cooled at least to a moderate extent. Most emerging market currencies — with the key exception of the Chinese yuan — once the darling of the carry traders, are in ugly bear markets. The Shanghai equity market bubble has burst.Yet in large areas of the high-yield credit markets (including in particular the so-called covenant-lite paper issued by highly leveraged corporations) speculative temperatures remain at scorching levels. Meanwhile, Silicon Valley equities (both in the public and private markets), and private equity funds enjoy fantasy valuations. Ten-year Spanish and Italian government bond yields are hovering below 2 percent, and hot spots in global advanced-economy real estate — whether San Francisco, Sydney, or Vancouver — just seem to get hotter, even though we should qualify these last two observations by noting the slump in the Canadian and Australian dollars. Also, there is tentative evidence that London high-end real estate is weakening somewhat.

How to Identify Late Stages of Asset Inflation

We can identify similar late phases of asset price inflation characterized by highly divergent speculative temperatures across markets in past episodes of the disease. In 1927–28, steep drops of speculative temperature in Florida real estate, the Berlin stock market, and then more generally in US real estate, occurred at the same time as speculative temperatures continued to soar in the US equity market. In the late 1980s, a crash in Wall Street equities (October 1987) did not mark the end-stage of asset price inflation but a late phase of the disease which featured still-rising speculation in real estate and high-yield credits.In the next episode of asset price inflation (the mid-late 1990s), the Asian currency and debt crisis in 1997, and the bursting of the Russian debt bubble the following year, accompanied still rising speculation in equities culminating in the Nasdaq bubble. In the episode of the mid-2000s, the first quakes in the credit markets during summer 2007 did not prevent a further build-up of speculation in equity markets and a soaring of speculative temperatures in winter 2007–08 and spring 2008 in commodity markets, especially oil.What insights can we gain from the identification of the QE-asset price inflation disease as being in a late phase?The skeptics would say not much. Each episode is highly distinct and the disease can “progress” in very different ways. Any prediction as to the next stage and its severity has much more to do with intuition than scientific observation. Indeed some critics go as far as to suggest that diagnosis and prognosis of this disease is so difficult that we should not even list it as such. Historically, such critics have ranged from Milton Friedman and Anna Schwartz (who do not even mention the disease in their epic monetary history of the US), to Alan Greenspan and Ben Bernanke who claimed throughout their years in power — and these included three virulent attacks of asset price inflation originating in the Federal Reserve — that it was futile to try to diagnose bubbles.

We Can’t Ignore the Problem Just Because It’s Hard to Measure

Difficulties in diagnosis though do not mean that the disease is phantom or safely ignored as just a minor nuisance. That observation holds as much in the field of economics as medicine. And indeed there may be a reliable way in which to prevent the disease from emerging in the first place. The critics do not engage with those who argue that the free society’s best defense against the asset price inflation disease is to follow John Stuart Mill’s prescription of making sure that “the monkey wrench does not get into the machinery of money.”Instead, the practitioners of “positive economics” demonstrate an aversion to analyzing a disease which cannot be readily identified by scientific measurement. Yes, the disease corrupts market signals, but by how much, where, and in what time sequence? Some empiricists might acknowledge the defining characteristic of the disease as “where monetary disequilibrium empowers forces of irrationality in global markets.” They might agree that flawed mental processes as described by the behavioral finance theorists become apparent at such times. But they despair at the lack of testable propositions.

Mis-Measuring Increases in Asset Prices

The critics who reject the usefulness of studying asset price inflation have no such qualms with respect to its twin disease — goods and services inflation. After all, we can depend on the official statisticians! In the present monetary inflation, a cumulative large decline in equilibrium real wages across much of the labor market, together with state of the art “hedonic accounting” (adjusting prices downward to take account of quality improvements) has meant that the official CPI has climbed by “only” 11 percent since the peak of the last business cycle (December 2007). The severity of the asset price inflation disease makes it implausible that the official statisticians are measuring correctly the force of monetary inflation in goods and services markets.

What Is the Final Stage?

A progression of the asset price inflation disease into its final stage (general speculative bust and recession) would mean the end of monetary inflation and also inflation in goods and services markets. What could bring about this transition? Most plausibly it will be a splintering of rose-colored spectacles worn by investors in the still hot speculative markets rather than Janet Yellen’s much heralded “lift-off” (raising official short-term rates from zero). What could cause the splinter? Perhaps it will be a sudden rush for the exit in the high-yield credit markets, provoked by alarm at losses on energy-related and emerging market paper. Or financial system stress could jump in consequence of the steep falls of speculative temperature already occurring (including China and commodities). Perhaps there will be a run from those European banks and credit funds which are up to their neck in Spanish and Italian government bonds. Or the Chinese currency could tumble as Beijing pulls back its support and the one trillion US dollar carry trade into the People’s Republic implodes. Perhaps scandal and shock, accompanied by economic disappointment will break the fantasy spell regarding US corporate earnings, especially in Silicon Valley. As the late French President Mitterrand used to say, “give time to Time!”

Brendan Brown is an associated scholar of the Mises Institute and is author of Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve: Manifesto for a Second Monetarist Revolution. See Brendan Brown’s article archives.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

How Wilson and the Fed Extended the Great War – Article by Brendan Brown

How Wilson and the Fed Extended the Great War – Article by Brendan Brown

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The New Renaissance Hat
Brendan Brown
November 9, 2014
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As the world reflects on the incomprehensible horror of the Great War which erupted 100 years ago there is a question which goes unasked in the media coverage. How was there no peace deal between the belligerents in 1915 or at latest 1916 once it became clear to all — especially after the Battle of the Somme — that the conflict had developed into a stalemate and holocaust of youth?

While there had been some early hopes for peace in 1916, they quickly evaporated as it became clear that the British government would not agree to a compromise deal. The political success of those who opposed compromise was based to a considerable degree on the argument that soon the US would enter the conflict on the Entente’s (Britain and France) side.

Although the US had allowed the Entente (but not the Central Powers) to access Wall Street without restriction during the first two years of the war, the historical evidence shows that President Wilson had been inclined to threaten Britain with the ending of its access to vital US market financing for its war effort if it failed to negotiate seriously for peace. But Wilson was dissuaded from urging peace on the negotiators by his political adviser Colonel House.

A less well-known story is the role of the then-newly created Fed (which opened its doors in 1914) and its allies within the Wilson administration in facilitating Entente finance. Two prominent Fed members — Paul Warburg and Adolph Miller — had fought a rear-guard campaign seeking to restrict their new institution from discounting trade bills or buying acceptances (largely financing munitions) issued by the belligerents (in practice, the Entente Powers). But, they had been thwarted by the persistence of the New York Fed chief Benjamin Strong (closely allied to J.P. Morgan and others who were gaining tremendously from arranging loans to France and Britain) and the Treasury Secretary McAdoo, the son-in-law of President Wilson. (McAdoo, whose railroad company had been bailed out personally by J.P. Morgan, was also a voting member of the Federal Reserve Board).

Milton Friedman has argued that the creation of the Federal Reserve made no difference to the US monetary and economic outcomes during the period of neutrality (up until March 1917) or during the US participation in the war (to November 1918). The difference, Friedman contended, came afterward when the Fed allowed rapid monetary growth to continue for a further year. Under the pre-Fed regime, Friedman argues, the US would also have experienced huge inflows of gold during the period of neutrality and under existing procedures (for official US gold purchases), and these would have fueled rapid growth of high-powered money and hence inflation. In the period of war participation, the Treasury would have printed money with or without the Fed (as indeed had occurred during the Civil War).

There are two big caveats to consider about Friedman’s “the Fed made no difference” case. The first is that the administration and Wall Street’s ability to facilitate the flow of finance to the Entente would have been constricted in the absence of backdoor support (via trade acceptances and bills) by the new “creature of Jekyll Island” (the Fed). The second is that both camps within the Fed (Benjamin Strong on the one hand, and Paul Warburg and Adolph Miller on the other) were united in welcoming the accumulation of gold on their new institutions’ balance sheet. They saw this as strengthening the metallic base of the currency (both were concerned that the Fed’s creation should not be the start of a journey toward fiat money) and also as a key factor in their aims to make New York the number-one financial center in the world, displacing London in that role.

Without those hang-ups it is plausible that the US would have trodden the same path as Switzerland in dealing with the flood of gold from the belligerents and its inflationary potential. That path was the suspension of official gold purchases and effective temporary floating of the gold price. The latter might have slumped to say $10–14 per ounce from the then official level of $21 and correspondingly the dollar (like the Swiss franc) would have surged, while Sterling and the French franc come under intense downward pressure. In effect the Entente Powers would not have been able to finance their war expenditures by dumping gold in the US and having this monetized by the Fed and Treasury — a process which effectively levied an inflation tax on US citizens.

This suspension of gold purchases would have meant a better prospect of there being a gold-standard world being recreated in the ensuing peace. The exhaustion of British gold holdings during the war ruled out the resurrection of Sterling as gold money. Its so-called return to gold in 1925 was in fact a fixed exchange rate link to the US dollar. The US would have been spared much of the cumulative wartime inflation. The Fed would not have been so flush with gold that it could have tolerated the big monetary binge through 1919 before ultimately being forced by a decline in its free gold position to suddenly tighten policy sharply and induce the Great Recession of 1920–21. That episode led on to the Fed focusing during the 1920s on modern monetary management (counter-cyclical policy changes and price stabilization). The consequences of that focus, ultimately fatal to the gold order, were the Great Boom and the Great Depression.

Brendan Brown is an associated scholar of the Mises Institute and is author of Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve: Manifesto for a Second Monetarist Revolution. See Brendan Brown’s article archives.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

The Japanese Deflation Myth and the Yen’s Slump – Article by Brendan Brown

The Japanese Deflation Myth and the Yen’s Slump – Article by Brendan Brown

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The New Renaissance Hat
Brendan Brown
October 4, 2014
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The slide of the yen since late summer has brought it to a level some 40 percent lower against the euro and US dollar than just two years go. Yet still Japan’s Prime Minister Shinzo Abe and his central bank chief Haruhiko Kuroda warn that they have not won the battle against deflation. That caution is absurd — all the more so in view of the fact that there was no deflation in the first place.

Some cynics suggest that Abe’s and Haruhiko’s battle cry against this phoney phantom is simply a ruse to gain Washington’s acquiescence in a big devaluation. But whatever the truth about their real intent, Japan’s monetary chaos is deepening.

Japanese Prices Have Been Stable

The CPI in Japan at the peak of the last cycle in 2007 was virtually at the same level as at the trough of the post-bubble recession in 1992, and up a few percentage points from the 1989 cycle peak. Hence, Japan alone has enjoyed the sort of price stability as might be enjoyed in a gold-standard world. Prices have fallen during recessions or during periods of especially-rapid terms-of-trade improvement or productivity growth. They have risen during cyclical booms or at times of big increases in the price of oil.

If price-indices in Japan were adjusted fully to take account of quality improvements they would have been falling slightly throughout, but that would also have been the case under the gold standard and was fully consistent with economic prosperity.

yenslumpSuch swings in prices are wholly benign. For example, lower prices during recession coupled with expectation of higher prices in expansion induce businesses and households to spend more. A valid criticism of the Japanese price experience of the past two decades has been that these swings have lacked vigour due to various rigidities. Particularly valid is the claim that price falls should have been larger during the post-bubble recession of 1990-93 and subsequent potential for recovery would have been correspondingly larger.

Prices in Japan did fall steeply during the Great Recession (2008-10) but the perceived potential for recovery was squeezed by the Obama Monetary Experiment (the Fed’s QE) which meant an immediate slide of the US dollar. It was in response to the related spike of the yen that Prime Minister Abe prepared his counter-stroke. This involved importing the same deflation-phobic inflation-targeting policies that the Obama Federal Reserve was pursuing. Washington could hardly criticize Tokyo for imitating its own monetary experiment.

Deflation and “The Lost Decade”

The architects of the Obama Monetary Experiment have cited as justification Japan’s “lost decade” and the supposed source in deflation. In fact, though, the only period during which the Japanese economy underperformed other advanced economies (as measured by the growth of GDP per capita) was from 1992-97. The underperformance of that period had everything to do with insufficient price and wage flexibility downward, the Clinton currency war, and the vast malinvestment wrought by the prior asset price inflation, coupled with a risk-appetite in Japan shrunken by the recent experience of bust.

Moreover, as time went on, from the early 1990s, huge investment into the Tokyo equity market from abroad compensated for ailing domestic risk appetites. Yes, Japan’s economy could have performed better than the average of its OECD peers if progress had been made in de-regulation, and if Japan had had a better-designed framework of monetary stability to insulate itself from the Greenspan-Bernanke asset price inflation virus of the years 2002-07. (The Greenspan-Bernanke inflation caused speculative temperatures in the yen carry trade to reach crazy heights.) But deflation was never an actual or potential restraint on Japanese prosperity during those years.

True, there was a monetary malaise. Japan’s price stability was based on chance, habit, and economic sclerosis rather than the wisdom of its monetary policy. It had been the huge appreciation of the yen during the Clinton currency war that had snuffed out inflation. Then the surge of cheap imports from China had worked to convince the Japanese public that inflation had indeed come to an end. Lack of economic reform meant that the neutral rates of interest remained at a very low level and so the Bank of Japan’s intermittent zero rate policies did not stimulate monetary growth.

The monetary system in Japan had no secure pivot in the form of high and stable demand for non-interest bearing high-powered money. In Japan the reserve component of the monetary base is virtually indistinguishable from a whole range of close substitutes and banks had no reason to hold large amounts of this (given deposit insurance and the virtual assurance of too-big-to-fail help in need). Monetary policy-making in Japan meant highly discretionary manipulation of short-term interest rates in the pursuance of fine-tuning the business cycle rather than following a set of rules for monetary base expansion.

The Yen After Abenomics

When Prime Minister Abe effected his coup against the old guard at the Bank of Japan there was no monetary constitution to flout. Massive purchases of long-dated Japanese government bonds by the Bank of Japan are lowering the proportion of outstanding government debt held by the public in fixed-rate form. But this is all a slow-developing threat given a gross government debt to GDP ratio of around 230 percent and a current fiscal deficit of 6 percent of GDP. Bank of Japan bond-buying has strengthened irrational forces driving 10-year yields down to almost 0.5 percent despite underlying inflation having risen to 1 percent per annum.

It is doubtless the possibility of an eventual monetization of government debt has been one factor in the slump of the yen. More generally, as the neutral level of interest rates in Japan rises in line with demographic pressures (lower private savings, increased social expenditure) one might fear that BoJ manipulation of rates will eventually set off inflation. Part of the yen’s slump, though, is due to a tendency for that currency to fall when asset price inflation is virulent in the global economy. This stems from the huge carry trade in the yen.

The yen could indeed leap when the global asset price-inflation disease — with its origins in Fed QE — moves to its next phase of steep speculative temperature fall. The yen is now in real effective exchange rate terms at the record low point of the Japan banking crisis in 1997 or the global asset inflation peak of 2007. So, the challenge for investors is to decide when the Abe yen has become so cheap in real terms that its hedge properties make it a worthwhile portfolio component.

Brendan Brown is an associated scholar of the Mises Institute and is author of Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve: Manifesto for a Second Monetarist Revolution. See Brendan Brown’s article archives.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.