Trevor Burrus: Welcome to Free Thoughts, I'm Trevor Burrus.
Tom Clougherty: And I'm Tom Clougherty.
Trevor Burrus: Joining us today is George Selgin, a Senior Fellow and Director of the
Center for Monetary and Financial Alternatives at the Cato Institute and professor of emeritus
of economics at the University of Georgia.
Welcome back to Free Thoughts, George.
George Selgin: Thanks Trevor, it's nice to be here.
Trevor Burrus: What is the Federal Reserve?
George Selgin: The Federal Reserve is the United States' central bank, and what that
means [00:00:30] is it's the bank responsible for determining what other banks do and the
resources they have available for their activities; the Fed creates the ultimate dollars in the
US monetary system.
Those dollars consist of the Federal Reserve notes everybody sees, and they also consist
of credits that banks can keep at the Fed, can have at the Fed—which is for that reason
called [00:01:00] the banker's bank—and those reserve credits—so called—can be
converted by the banks into paper dollars any time the banks request it.
So using these Federal Reserve dollars as an essential input as it were, the banks go
about their business of creating their own claims to dollars, making loans in dollars,
and creating deposits that are denominated in dollars that people can also spend.
Trevor Burrus: So does the Fed do this ... Does it have the authority over printing [00:01:30]
money and stuff, and does it decide how much money is printed, or does it do it through
some other mechanism?
George Selgin: Essentially the Federal Reserve decides the overall amount of Federal Reserve
dollars, including paper currency, and those credits I mentioned that banks hold at the
Fed.
The Fed determines the sum of those two values, and by doing that determines the scale in
directly of all dollar creation of private dollars like bank [00:02:00] deposit dollars
because of the amount of those ultimately depends on some extent on the availability
of the dollars that the Fed creates.
I should mention because it's common source of confusion that the Fed doesn't actually
print Federal Reserve notes, that's done by the Bureau of Engraving and Printing, but
the Bureau of Engraving and Printing just acts as a service or supplier for the Fed,
but it's the Fed's policies that ultimately that determine [00:02:30] how many of these
notes get put into circulation.
Tom Clougherty: Now, George, you haven't mentioned interest rates yet.
I think if you asked most people what does the Fed do?
What is monetary policy?
Well they'd say the central bank sets interest rates.
I don't think that's quite right, but if it's not, where the interests rates come into this
story?
Trevor Burrus: That's the one thing people know.
Tom Clougherty: Interest rates, yes.
George Selgin: Yes, well it's the one thing people know, but it is really starting as
it were in the middle instead of the basics.
The basics [00:03:00] really do have to do with the Fed's creation of dollars.
The reason interest rates come into the story is because the way the Fed regulates the extent
to which is creates the basic dollars, or the available supply of basic dollars, or
regulates the purchasing power of those dollars, one or the other depending on the regime is
through interest rates that it manipulates or controls.
[00:03:30] So for example, the Federal Reserve before the crisis would have set a policy
rate, and it would ... That would be the rate in which banks could borrow Federal Reserve
credits from one another overnight.
So as I mentioned before, some of the basic Fed dollars that are created consist of credits
that banks have deposits at banks, keep at the Fed dollar [00:04:00] denominated, of
course.
In the old system, things have changed in a way I hope we'll get around to talking about.
In the old system, if banks were short of these deposit credits for their reserve requirements
or other reasons, they could borrow.
One of their choices was to borrow from other banks that had more than they needed, and
that rate of interest at which that overnight interbank borrowing of Federal Reserve credits
took place of Federal Reserve [00:04:30] dollars was called ... Is called the Federal Funds
Rate.
That rate for years was the policy target rate, and the Fed would say well, we think
a good place for the Federal Funds Rate to be is, let's say three percent.
If it crept up above that level, that would indicate that reserves were a little bit in
short supply and it would create some more dollars, put some more dollars into the economy,
make reserves, [00:05:00] Fed dollars more abundant to bring it, the rate, back down
to the target of three percent.
So superficially, monetary policy was about setting the Federal Funds Rate target.
It was about in ... Not just interest rates but specifically this one interest rate.
But underlying this process or goal of keeping this interest rate on target was the basics
of [00:05:30] supply and demand for Federal Reserve dollars for the dollars that the Federal
Reserve alone was capable of actually creating or removing from the system if necessary.
Trevor Burrus: Are you ... You mentioned it's the bank of the United States, now if you
study American History and you learn about the battles over the first bank of the United
States, and the second bank of the United States, is the Fed the third bank of the United
States?
Is it in the same vein as that, or I guess I'm also asking where ... [00:06:00] When
did they come about, where did it come from in that kind of line of progression?
George Selgin: Well yes, according to most authorities, the Federal Reserve was ... Is
in effect the third bank of the United States, in that the first two federally chartered
banks, the first bank of the United States and it's successor, the second bank ... They
were at least proto-central banks.
They had lot ... Some things in common with a modern central bank like the Fed.
They weren't quite [00:06:30] full fledge central banks in many respects, but they certainly
were ... Had some features of modern central banks.
That's why there was a great to-do about the establishment of the Fed because the previous
federal banks had been quite controversial, and the second federal bank's charter had
been famously not renewed by Andrew Jackson who employed his veto power to [00:07:00]
veto to the bill to recharter the second bank, and it looked like at that point we were ... The
United States was done with this idea of a federally chartered bank, or proto-central
bank, or whatever you want to call it.
It took some pretty clever political maneuvering and several financial crises to get central
... To get us back to having a central bank to having the Fed, which was established in
1914.
It's [00:07:30] a long story about the politics, and the instability that informed our taking
up again this idea of having a central bank, and it's a story I've written about.
But in any event, it took a lot of people by surprise to find back in 1914 that we had
not after all settled the question of whether we should have a central bank or not, for
once in for all.
We thought [00:08:00] we had, everybody thought so, particularly the Democrats who were the
party who got rid the second bank of the United States, but low and behold they were also
the party that decided to pass the Federal Reserve Act.
Trevor Burrus: That period of time, roughly 80 years of no central bank, was that ... Was
there some huge gap, or was there some institution that did the job, or was that job not really
needed to be done?
George Selgin: [00:08:30] Well first of all, in principle the job doesn't need to be done.
Particularly if you have a specie or gold or silver standard, which was the case back
in the 19th century and early 20th century.
When you have such a standard, first of all you have a basic money that doesn't inherently
have to be supplied by a public authority today.
Where our standard is paper money itself, [00:09:00] of course it's not something that's
naturally scarce, so only a public utility as it where could be relied upon to supply
the stuff and with luck supply so little of it that it doesn't become worthless.
But when you have a specie standard, in principle, you have a monetary standard that doesn't
absolutely require a central bank.
Now the question is can you have also a stable safe monetary and banking system without a
central bank and the answer [00:09:30] is yes, you can.
Canada here, offers a particularly good illustration because until 1935, Canada didn't have a central
bank, but it had the same basic gold unit, gold dollar that the United States had.
Had a decentralized system, multiple banks, commercial banks issued the paper money of
Canada that was convertible into a dollar ... A fixed amounts of gold, and it was a
very stable well working system.
So Canada's case [00:10:00] is certainly suggests that you didn't need to have a central bank.
'Course the United States didn't have that same system.
When we got rid of the second bank of the United States, what emerged from that step
was not a Canadian type system, but a system that was a real motley arrangement with numerous
states, first of all, [00:10:30] that had their own banking and currency systems all
of which were quite different, and involving different degrees of government intervention
and regulation.
That was the situation until the outbreak of the Civil War.
In those systems, some of them performed relatively well, particularly the ones in the Northeast,
and some of the Southern systems, but others were quite ... Performed quite poorly.
One [00:11:00] of the things though that was common generally with the exception of a few
southern states was that banks could have no branch offices.
That meant that there were no ... There was no paper money that was nationally recognized
or uniform in value.
A bank's notes could be well received and accepted at their face value locally, and
maybe for some distance from their source, but if they traveled far away enough to other
states, [00:11:30] then at some point they would not be trusted or known enough to command
their full value.
So we didn't have a uniform paper currency.
The only thing that was uniform was the gold coin itself, if you took it ... Or silver
if you took it to other parts of the country was still worth what it said it was worth.
So Canada's system was quite different in that regard.
They allowed their note issuing banks to branch nationwide and most of them took advantage
of that, and by the 1880s, '90s, you had [00:12:00] a system of bank notes with different brands
of notes, but they ... You could take a note from Halifax to Vancouver, still would be
worth it's face value.
So the Canadian system achieved a uniform paper currency, a uniform in a sense of uniform
value by allowing banks to be more free, whereas in the U.S. our motley system of state bank
regulations prevented any such result from happening, [00:12:30] that's before the Civil
War.
Trevor Burrus: Do you need a ... Am I hearing correctly that it's better argued that you
would need one of these if you have a fiat currency of some sort, but when we started
it, we were still on the gold standard from what I understand.
George Selgin: Yes, my point is that if you have a fiat currency, since the fiat money
only ... Doesn't have a natural scarcity, so if it's gonna command value, it's quantity
has to be artificially restricted, [00:13:00] and that has to be a matter of policy.
It isn't obviously something that you can rely on profit maximizing issuers to do because
they might just want to issue a whole bunch at once, and get what they can.
So in practice, if you have an irredeemable money, you need some kind of public authority
that you hope, you entrust the responsibility of limiting the quantity of the stuff of supplying
it, but supplying it only in sufficiently limited extent.
[00:13:30] That's why fiat money systems require some kind of central authority, usually a
central bank.
It doesn't follow though that central banks have only been created in ... For the purpose
of controlling fiat money.
Central banking predates fiat money as you noticed with the case of the Fed.
'Course the earliest central banks go much further back, the motivation for creating
central banks in fiat, [00:14:00] in ... Sorry, in metallic money systems are quite different.
The further back you go, the more obvious it is that the motivations were fiscal.
Basically these public authorities could ... Had a flexibility that allowed them to contribute
to the financing of their sponsoring government and make life easy for them, especially during
wars through generous accommodation, in return for the monopoly privileges that they enjoy.
This was the story with the Bank [00:14:30] of England, Bank of France.
Then later on, you had the development of the view that central banks could contribute
to the stability of gold standards by serving as lenders of last resorts, to the commercial
banks and by being a source of emergency loans to them.
This view particularly solidified after the famous ... After the publication of Walter
Bagehot's famous book, Lombard Street, [00:15:00] which is the bible of last resort lending-
Trevor Burrus: When was that?
George Selgin: It was 1873, however it should be said, and many people don't realize this,
that when Bagehot wrote Lombard Street, he was referring of course to the Bank of England,
and the role it should play in reverting or limiting crises.
He was very explicit in that book.
He said that the ultimate course of instability in the English banking system was the Bank
of England's monopoly [00:15:30] privileges in the way they resulted in a concentration
of reserves in that bank, such that it became the only agency capable ... It was both the
instrument by which instability was generated, and the one institution that could act to
contain the damage from that instability if it would only act in a public spirited way
by lending generous once a crisis broke out.
But Bagehot was quite emphatic that if you hadn't had this monopoly ... [00:16:00] This
heaping up of monopoly privileges in the Bank of England, if you had what he called a natural
banking system with reserves and privileges spread out among competing banks.
An example, contemporary example would've been the Scottish system, then you won't need
a lender of last resort because you won't have the underlying cause of instability in
the first place.
Unfortunately most people have read ... Most economists have read Bagehot [00:16:30] as
making a positive case for central banks as lenders of last resort in a gold standard
context.
But of course, in the fiat money context, therefore you have two rationales for having
a central bank.
One is to control the ultimate quantity of money, which it otherwise is not self controlling
and the other is to have a source of emergency funds when the ... When things go array in
the banking system, and that's what we ... That's the conventional wisdom today.
Tom Clougherty: [00:17:00] Yeah, so we had the Fed now for 100 years or more, and it's
clearly changed an awful lot over that period of time.
What monetary policy means in practice has really developed beyond all recognition.
I think we should probably bring this conversation a little bit more up to the present day, in
particular the financial crisis of 2008.
I know for me, and I think for a lot of people, that was when we really got interested in
monetary policy.
When people thought maybe there's something weird going on here, and we should learn more
about it.
[00:17:30] So maybe before we just jump into that though, let's talk about what was the
status quo before the financial crisis in terms of monetary policy.
Now you've already said the Fed would manipulate the Federal Funds Rate, they'd affect the
cost of banks lending or borrowing from one another.
Why were they doing that?
If they raised interest ... That interest rate or lowered it, what were they trying
to do and what was its knock on effect in the economy?
George Selgin: As you said Tom, the Fed's [00:18:00] responsibilities and power changed
dramatically since 1914, and to by the period before the crisis for some decades ... Of
course, the gold standard was no longer part of the story, so the Fed had absolute responsibility
for the overall amount of money created in the economy, and therefore for controlling
the rate of inflation and deflation.
The Fed's mandate [00:18:30] required it to ... Both to avoid dramatic instability of
the value of money ... And substantial changes in that value, and also to limit unemployment,
so the Fed had it as it were secular mandate, longer run mandate to make sure that the dollar
didn't depreciate too rapidly relative to goods and in a more cyclical mandate to make
sure that we didn't have cycles of unemployment-
Trevor Burrus: How did-
George Selgin: Which could partly be a reflection [00:19:00] of a short run shortage of money.
Trevor Burrus: Okay, that was my question ... 'Cause I, yeah, it seemed like something
that's not related to monetary policy.
George Selgin: No it is.
Too much money, you get inflation, too little money, you get deflation.
Too little money in the short run, you can get a downturn, a business downturn with unemployment
until either the central bank makes up for the monetary shortage or prices adjust downward
and end up on the newer equilibrium, but that's a process fraught with difficulties.
Tom Clougherty: Actually George, when we say there isn't [00:19:30] enough money, then
in the short run that could cause a downturn, what does that practically mean, not enough
money in the system?
It's not like people can't find the bank notes.
George Selgin: What it means is that people ... In practice, what it means is that there
may be plenty of money out there, but the money isn't being spent.
So people hold on to money balances to a certain degree, but ultimately the main reason people
hold [00:20:00] on to money, which consists of a Federal Reserve cash or certain kinds
of bank deposits is to have a ready access to purchasing power for spending.
Things go sour in monetarily speaking, either when the rate of spending is excessive, so
there's too much money chasing after too few goods in the famous formulation of Milton
Freedman, or when the opposite happens when spending declines rapidly.
The reason these are both [00:20:30] problems is because you want ... Businesses have to
re-coop their expenses on average, some businesses may not, and others may profit, but on average
we don't want them all losing money because that just means ... That doesn't prove that
the businesses are bad, or that we should be putting resources elsewhere.
It just proves that spending is not keeping up with underlying cost.
Spending is shrinking, so avoiding a shrinkage [00:21:00] in the flow of spending is important
as a way of limiting business cycles, and unemployment, and deflation.
On the other hand, if everybody is ... If people are spending more than ever, profits
are swollen, that doesn't give you a useful signal about which businesses ... You can't
have more of everything.
You can't have more investment in everything.
So what ends up happening, of course, is costs start rising, the profits disappear, costs
can't [00:21:30] keep up with prices.
In equilibrium, there's an equilibrium that's the same as where you started, but the process
of adjustment can involve some ways.
So this is where we get this idea that a good central bank will manage things so that prices
neither rise rapidly, nor fall rapidly, and cycles are avoided.
But at bottom, it's really about stabilizing, not prices per se, but spending.
Keeping 'em spending on a nice even [00:22:00] schedule.
Trevor Burrus: This is what ... This is like before, so ... 'Cause from what I understand-
George Selgin: This is still true.
Trevor Burrus: This is still true, but from what I understand with the ... So this is
what they were doing before the Great Depression, in the '50s, it was ... They were all ... They
were still just mostly focusing on the ... What you said, the inflation rate and the unemployment?
George Selgin: What I've just described it what they ought to do, and it still what they
ought to do.
It is never been exactly what they have done because they screw up all the time.
You've had episodes of sever deflation [00:22:30] like the '30s, you've had long periods of
mounting inflation like the '70s and early '80s, '60s, late '60s, and of course, we had
the recent crisis, so what I was describing was an ideal, what they ought to try to do,
rather than what the Fed or any other central bank has actually been doing.
The ideal hasn't changed, the ideal was before 2008, it's still the ideal today.
Now, the question then is [00:23:00] how did they try to do the right thing?
Whether they did it or not, and before 2008, to go back to that discussion of interest
rates and all that, they used ... What they would do is they would set up policy rate
target.
Now basically what this means is that they would say to themselves, "Well we believe
that if banks are borrowing from each other at a three percent rate, that's going to be
consistent [00:23:30] with an overall level of money creation, loan lending, etc., that
we'll achieve our spending, stable spending target."
Okay?
Implicitly, that won't ... Or that won't cost too much inflation or deflation, it won't
cost too much on unemployment.
So the target rate is a rate that is ... There ... It's what they believe is the rate that's
consistent with achieving [00:24:00] their overarching objectives.
They might be wrong in their choice of this target rate, but let's assume that they actually
are correct.
That they know where that rate should be to keep things going smoothly.
Then of course, they ... Their objective, their immediate challenge is to see to it
that the actual rate at which banks are borrowing from each other doesn't deviate from that
target.
The way they would do that in the old pre-2008 days, was if the [00:24:30] rate ... If the
actual Federal Funds Rate tended to be rising above the target, let's say above three percent,
they would go out and purchase assets in marketplace, usually government securities, and they would
pay for them with newly created deposit credits, Federal Reserve credits, and that would mean
the bank reserve become more plentiful, and that would mean the supply of Federal Funds,
right?
Which is the reserves available for overnight lending would go up, and that should [00:25:00]
lower the actual equilibrium funds, right?
And help get the target-
Trevor Burrus: Lower the interest rate on borrowing and so-
George Selgin: That's right.
Trevor Burrus: But theoretically encourage more house, buying of houses, and car loans-
George Selgin: The idea is if the Federal Funds Rate is getting too high, that will
also will tend to mean tightness and other lending markets, so in keeping it from rising,
you're also keeping those other rates from rising.
Conversely, if the Fed [00:25:30] Funds Rate is sagging, that suggests that there's not
much demand for Federal Funds.
You want to keep it at target, you're gonna withdraw some reserves 'cause evidently there's
more out there than banks need to sustain the target interbank rate.
That's how the system works, so it's a combination of setting a target interest rate that you
hoped was the right target, and then engaging in what are called open market operations,
which is either buying government securities [00:26:00] in the open market and having the
Fed buy these securities, or selling them, depending on whether they wanted to make reserves
more available or less to achieve the target.
If doing all this, they then found that ops, the inflation rate is higher than we thought
it would be, or lower, or unemployment is not where we think it should be, that would
of course be caused for rethinking the target they've been setting, adjusting it upward
or downward, and then [00:26:30] undertaking corresponding open market operations to achieve
the new and hopefully correct rate target.
Tom Clougherty: So hopefully correct.
George Selgin: Yeah.
Tom Clougherty: But did this process go completely haywire in the run up to the financial crisis?
If so, what kind of role did it play?
George Selgin: I wouldn't say that the process when haywire in the run up to the financial
crisis.
The financial crisis of course is a situation where you can have [00:27:00] an often typically
do have an extraordinary demand for reserves, right?
Because of panic, because of uncertainty, because of perceived risks of lending, so
suddenly other things equal the tendency is for banks to clamp down on lending, including
interbank lending, and for the demand to hold reserves to become extraordinarily high under
those circumstances.
For a given Federal Funds Rate target, the challenge [00:27:30] of monetary policy becomes
to supply that many more reserves to keep the target at the rate, at that target because
otherwise it's certainly gonna tend to rise above.
So in a way, there's nothing different from a crisis situation, it's business as usual,
except that it's a situation where in order to keep its target, a central bank has to
create a lot more reserves than it normally would ever have to do, that is then [00:28:00]
it would have to do on crisis time.
Until 2008, sometime in the middle of 2008, the Fed was, I think, more or less doing that.
For example, the first big shock of the crisis, big financial shock that mattered from a monetary
policy point of view was when the Bank Paribas in France [00:28:30] looked like it was about
to go under, and in response to this big liquidity shock, sure enough-
Trevor Burrus: With that ... I want look at that term, liquidity shock.
They just can't enough money right at that moment?
George Selgin: There's an exceptional demand to pile up a bank reserves finance ... By
different financial institutions, banks and other financial institutions want to stock
up on cash.
That is precisely the circumstance [00:29:00] that means that they're ... That they were
less willing to lend cash, which means interbank rates are gonna go up unless somebody else
makes more cash available, which is where the central banks went in.
That's just what the Fed did in that episode, you could look at the statistics and see the
amount of Federal Reserve dollars spikes 'cause they're pouring more in to make up for the
reality that there's an exceptional demand, and that is still ultimately aimed at keeping
[00:29:30] the target rate where it's supposed to be.
Now of course, in the background you have the ongoing consideration of whether the target
rate itself needs to be adjusted in light of these developments because it may also
turn out that you need to set that rate lower in order to accommodate the changing reality
that involves a greater ... Once again a much greater demand for Federal Reserves and liquidity,
so [00:30:00] the two things are happening.
One, it takes more reserves in a crisis to keep the target where it is, and also a crisis
is a time when your target rate might need to be lower ... Lowered as in recognition
of the exceptional persistent demand for liquidity.
As I said, until 2008 at least, I think the Fed's conduct was about right in light of
these basic principles, [00:30:30] but then in 2008, things started to go quite haywire,
and did so I think not just because the crisis becoming that much more sever, which it did,
but because I think the Fed made some very serious miscalculations that actually in turn
contributed to the severity of the crisis.
Trevor Burrus: Well some of those, I heard some people argue that some of those included
low interest rates after 9-11, like too low of interest rates [00:31:00] helped move us
towards the crisis because people were borrowing too much.
George Selgin: Well now you're stepping back-
Trevor Burrus: Yeah, a little bit, but-
George Selgin: There is a question whether the Fed set its targets too low, not so much
after 9-11, but after the dotcom crash, whether it kept rates too low for too long, set its
target too low, and then of course, acted to achieve that target.
No, I think there's a lot of truth to that.
That is setting too low a target [00:31:30] in turn contributed to do an excess creation
of reserves, excess credit, excess lending, which contributed to the sub prime, what we
know in retrospect was a sub prime bubble.
I think that's all true.
The mistakes I'm talking about are ones the Fed committed after the bubble breaks, which
I believe it started to make some real mistakes in that case, some time in mid 2008.
Trevor Burrus: So [00:32:00] what are those?
Are they related to just bad interest rate setting, or is it-
George Selgin: Ultimately-
Trevor Burrus: A new thing entirely?
George Selgin: Ultimately they are ... Ultimately they are to put it as tersely as possible.
Starting in around mid-2008, the Fed became determined to stick to what in retrospect
was too tight of monetary policy stance to maintain a target interest rate [00:32:30]
that was too high relative to what was really required to help the economy stay on its feet,
or avoid a collapse.
For some time, they set the target rate at two percent, which sounds very low and was
low by historical standards and more typical norm would be four percent, twice that.
However, in crisis situation, it can take a much lower target interest rate to avoid
a downward spiral, and I think [00:33:00] in retrospect, it's pretty clear that the
two percent rate that the Fed was striving to maintain was too high.
It only very reluctantly lowered that rate, first to 1.5% after the Lehman disaster and
then eventually as low as two point ... .25% or a range from zero to 2.5, but by that time
it was too late, and indeed, even 2.5 was too high.
But [00:33:30] it's interesting to look back at why the Fed was obstinate or ... Again,
this is all hindsight, right?
So we mustn't be too ungenerous when all this is going on, it's very hard to tell exactly
what the situation is.
But what seems to be the case was at the time, the inflation numbers did not seem to suggest
that the monetary policy was too tight and there were [00:34:00] genuine fears that it
might in fact be too loose, so you had people pressing for the maintenance of two percent,
arguing against lowering it, the so called inflation hawks were doing their thing, and
it was to satisfy that ... Those concerns that the consensus ended up favoring, trying
to maintain first two, and then 1.5%.
Even though if you look at what was happening [00:34:30] at the time, whatever regardless
of the inflation numbers, actual spending was collapsing, and inflation numbers can
be very misleading because they indicate a number of things, most obviously they don't
just depend on how much people are spending.
They depend on this state of availability of various goods, and services, and commodities.
So spending is really what you want to look at, and if you looked at spending, it was
going down the ... Going down [00:35:00] very rapidly, but it's how the Fed strove to maintain
two percent despite what was going on that I think was particularly tragic because in
fact, the Fed was creating reserves or would have creating reserves during this period.
These are the months leading up to Lehman Brothers, including the time of its collapse.
The Fed was engaged in substantial emergency lending to various banks through various lending
[00:35:30] programs, banks and some other financial institutions and markets.
If the Fed had simply done that, it would have ... And not tried to compensate by other
means, we would've had a substantial increase in reserves, analogous to the increase from
the Bank Paribas crisis hit, that should have helped to maintain liquidity, keep lending
and spending [00:36:00] from collapsing.
However, because it was determined to maintain at two percent rate target, the Fed feared
that these lending programs would create too many reserves, and it offset them until Lehman's
failure, or after offset them 100% with open market sales, which of course, are normally
a tightening measure.
So it took back with one hand what it put in with the other.
Total liquidity didn't increase at all, therefore for these crucial months when spending was
[00:36:30] actually collapsing, you could see that the Fed's balance sheet doesn't grow
at all.
It's flat because there's more lending, but there's open market operations that's the
Feds selling treasuries from its portfolio to offset the loans that are otherwise increasing
the total assets.
There's no net liquidity creation in this crisis.
It's much worse than Bank Paribas, you would think.
Let's put a lot of liquidity [00:37:00] out there 'cause things are really gettin' scary,
and that's not what the Feds doing.
It is actually depriving the more solvent financial institutions in the marketplace
of funds in order to move a greater supply of funds to troubled institutions that are
taking part of ... In its emergency lending programs.
Trevor Burrus: That's interesting 'cause it makes me wonder about why it makes these choices.
Is it politically influenced?
[00:37:30] Is there something going on ... It's supposed to not be, even though the president
chooses the Fed Chairman, does it seem like their playing politics to some degree?
George Selgin: Well it's ... There's no question that there's a lot of pressure on the Fed
to aid particular financial institutions, especially the large ones, the too big to
fail ones, that it's gonna give them credit no matter what because it's ... It fears that
if they fail, the dominoes will start falling.
[00:38:00] The problem is that ... Be that as it may, whether those decisions are sound
or not, it doesn't make any sense if you're concerned about other dominoes falling, so
you wanna prop up the one domino in front of the line that you're most concerned about.
You can't do that by taking credit away from all of the other dominoes in order to prop
up the first domino because then you're causing them to suffer liquidity [00:38:30] shortage,
so they may not be in trouble because the big domino falls on them, they're in trouble
because you're taking liquidity away from [crosstalk 00:38:40]-
Trevor Burrus: All the back dominoes are falling, even though the front ones are standing up.
George Selgin: And if we go back to Bagehot, of course, if we go back to Bagehot, this
is entirely contrary to the spirit of Bagehot.
For Bagehot, the reason you need a lender of last resort is not to prop up the trouble
institutions, it's to see to it that the sound institutions stay sound.
They don't [00:39:00] suffer collateral damage from other failures, and it's perfectly possible
in principle for the Federal Reserve to lend generous in a crisis to sound institutions
without deprive ... Instead of lending to the unsound by depriving the sound of liquidity.
A second best solution would be create a lot of net liquidity, bailout some big firms,
but make sure you keep the other firms that are sound [00:39:30] from suffering as a result
of your policies.
The Fed chose to do the worst possible thing.
It propped up the insolvent or presumably insolvent institutions by lending generously
to them, but it was also sucking back liquidity from the rest of the marketplace, which causes
the crisis to spread that way.
If your goal is to keep the crisis from spreading, you're not gonna do it by punishing the solvent
firms [00:40:00] to prop up the insolvent ones.
Tom Clougherty: So that ... The Fed's started to go wrong in the middle of 2008.
George Selgin: That's right.
Tom Clougherty: They weren't increasing general liquidity.
They were bailing out some organizations, they were offsetting that by clamping down
elsewhere.
George Selgin: That's correct.
Tom Clougherty: So spending and the wider economy kept tumbling.
George Selgin: Kept tumbling.
Precisely-
Tom Clougherty: Did the Fed eventually catch up with the vents, did they realize they'd
gone wrong and tried to fix it?
George Selgin: Unfortunately, they really didn't.
They did in the sense that they relented ultimately in trying to maintain [00:40:30] what was
first two percent, and then at 1.5% ... They stopped trying to do that.
But they stopped only when they had ... They were failing utterly that the actual Federal
Funds Rate was just falling below their target, and the target became meaningless.
So finally they said, okay, we're gonna move our target to get it closer to where we can
... Where the rates actually are, and in that sense, they relented and they loosened.
But in fact though, [00:41:00] they never actually provided the liquidity that by then
the economy desperately needed.
This is when things really get weird because after the failure of Lehman's and also the
bailout of AIG, they took another step.
You see, by then the amount of emergency credits that the Fed was creating were such that it
could no longer offset the credits with open market sales.
The Fed needed to keep a certain amount [00:41:30] of treasury securities on its books for income
purposes.
It needs to be generating income, which you don't do by buying doubtful assets, you have
to have assets that are paying some interest.
So at a certain point, the Fed asset ran out of treasuries with which to sterilize or offset
the emergency lending, this happened after the Lehman disaster.
But now at that point, of course, it might of just said, "Okay, well we're gonna have
[00:42:00] to let our balance sheet grow and let that contribute to liquidity."
But they were still determined to not let that happen, to not let emergency follow policies
translate into easy monetary policy.
So they had to come up with a scheme other than sterilization to achieve that result.
That's what interest payments on reserves originally served, the purpose that it originally
served.
Now on the right for the Fed to pay interest on reserves was already on [00:42:30] the
statute books as a result of a 2006 law.
But it wouldn't of taken affect until 2011, if I remember correctly.
So they passed an emergency measure that essentially allowed them to begin paying interest on reserves
two years earlier than the original law would have.
That meant they could begin paying in October 2008.
Now what was the point of this?
The point was now that the balance sheets gonna grow, how can we keep that from [00:43:00]
actually contributing to general liquidity in the marketplace and to an overall easing
of policy.
If we pay interest on reserves, make it adequately remunerative for banks to pile up reserves,
then the reserves we're creating through our emergency programs will go into the banks,
they will add to net total reserves, but the demand to hold reserves will go up as well.
The banks would just sit on them, just sit on them.
That will mean that it doesn't [00:43:30] spill over into the Fed Funds market and of
course, behind implication was spill over into other markets, other bank lending markets
'cause the banks are gonna hoard the reserves.
This was deliberate, this was a deliberate move once again aimed at maintaining what
in retrospect was an overly tight monetary policy stance whether it is 1.5% or whatever
the number was, because we still have a spending collapse and interest on reserves there, that
became [00:44:00] the new way of not easing monetary policy at a time when it desperately
needed to be eased.
The irony of this, if I may, I know I'm going on for long, but this was October 2008, and
remember at this time, the concern is that policy is ... Must not get any looser, it's
where we need it to be 'cause there's some potential for inflation, a very wrong perspective.
Again in retrospect, [00:44:30] by November, by mid November, late November it's now abundantly
clear to everybody that policy is not too tight and what the economy could desperately
use is some monetary stimulus.
So now, you would think at that point that the Fed officials would say, "Okay, fine.
Now we want monetary stimulus.
We had better stop paying banks to pile up reserves because that's something that we've
been [00:45:00] doing to prevent monetary stimulus from happening even as we create
more reserve."
So logically let's get rid of the interest on reserves.
That's what you might think they would've done, but they didn't.
They didn't, instead they decided that they were gonna keep this interest on reserves
in place, and the only new policy they pursue is that they would now more aggressively create
reserves, not just create them incidentally to emergency lending, but to create them on
purpose and [00:45:30] in vast amounts, quantitative easing, large scale asset purchases.
But wait a minute, hold on, if interest on reserves served before then to make sure that
however many reserves the Fed created, they didn't serve to stimulate bank lending and
spending.
Why should it be any different that now that you're deliberately creating reserves, won't
that just mean that banks have that many more reserves that they sit on, and we know that
in fact that is exactly [00:46:00] what it meant.
As I put it in testifying to Congress in July, I said, "You know, this ... If insanity is
thinking that doing the same thing over again will result in a different outcome than before,
then the people at the Fed have seem to be a little bit off their rockers."
Because you have the same policy of credit expansion or reserved expansion that they
have set things up so that it won't matter that they do this, it [00:46:30] won't ease
things.
Now you're just gonna say, "Well if we ... We're gonna leave that setup in place, and we're
gonna create that many more reserves, but this time it will ease things."
Of course, something did change, something did change, right?
No, they weren't completely insane, so something had to change in their minds between October
2008 and late November 2008, but that allows them [00:47:00] coherently to ... somewhat
coherently to believe that a balance sheet expansion that their ... That the system that
prevented balance sheet expansion from providing stimulus until November 2008 is starting in
December 2008 is going to allow balance sheet expansion to be stimulating.
Did I lose you on that?
Trevor Burrus: No, I'm just ... 'Cause there's also an election in there.
George Selgin: Yeah, I don't think that had anything to do with it.
Trevor Burrus: 'Cause in October to November 2008-
George Selgin: Yeah, I don't think that had anything to [00:47:30] do with it, but the
point is ... Certainly what's true is now they want to stimulate.
They've got the same system in place that makes reserves pile up no matter how many
you create, or why.
But now they're gonna say that creating the reserves, even though they still pile up,
is going to stimulate.
How do they convince themselves that things have changed?
What's changed?
What's changed is between October 2008 and December 2008 is they've got a new theory.
They have a new theory.
The new theory is theory of portfolio [00:48:00] adjustment, etc., that's a theory of how large
scale asset purchases can stimulate the economy even if the purchases ... The reserves that
the purchases create sit in bank's vaults, as it were, without moving.
So a theory has changed, and because the theory has changed, reality should change with it.
This is a little less than completely insane, but it is not completely [00:48:30] sane either.
Tom Clougherty: So we shifted from a system where if the Fed wants to stimulate the economy
somehow, they'll create bank reserves, the banks will be flushed with cash, so they'll
lend more, that will encourage spending.
It's a fairly straight forward transmission.
George Selgin: That's right.
Tom Clougherty: Now we're in a situation where we're going to give the banks lots of reserves,
but we explicitly don't want the banks to lend them out.
George Selgin: That's right.
Tom Clougherty: We want a portfolio balance effect to take place.
What does that really mean?
George Selgin: It means that as [00:49:00] the Fed buys assets in large quantities, of
course the prices of the assets that it's purchasing is going to be bid up, and the
yields of those assets will come down, and the idea is if any interest rates change on
any assets, that should have trickled down effects through arbitrage, right?
That's gonna affect other interest rates including short term rates, so that you are after all
putting downward pressure on short [00:49:30] term rates, but you're not doing it by actually
increasing the scale of lending, and money creation that goes on.
You're just, as it were, achieving a new equilibrium in set of interest rates without any change
in the nominal scale of activity, the total dollars moving around in the economy.
Well this is where thinking of monetary policy solely in terms of interest rates becomes
dangerous because [00:50:00] the right way to think about it is yes, interest rates are
instruments, they're means.
We can think of policy setting as setting interest rates, but what we're really doing
is changing the amount of money creation that's going on, that the banking system is engaged
in, and that means more or less lending and so on.
But if you start to think that monetary policy is only about moving interest rates where
that's the ultimate objective, now you can embrace a [00:50:30] portfolio balance theory
where anything that gets interest rates, say short term rates, to go down is great.
Even if it doesn't translate into an increase in bank lending, money creation, deposit growth,
and so on.
This is a big mistake.
I'm not ... It's true that these portfolio affects are not irrelevant when interest rates
change, prices are changing, those are relative prices.
So some economic activities gonna be changing, [00:51:00] but gosh, if what you want is to
get people to spend again, it's ... This is a much more loose connection.
There's a much more doubtful connection between portfolio affect changes and short term interest
rates, and just how much spending and lending are going on, versus the old fashioned adjustment
in short term rates that is caused by creating more Federal Reserve dollars, getting them
into the loan markets, getting more bank deposits created, that [00:51:30] is a much more certain
connection.
Interest rates can fall in different ways, and in some ways the declines don't have much
to do with overall spending activity than in other ways, in other cases they do.
We've moved from a transmission mechanism that ... Where the connection between lowering
interest rates and increasing spending is pretty certain to one where the connection
between lowering interest rates and increasing spending is quite uncertain.
The defenders [00:52:00] of QE or long ... Large scale asset purchases at the Fed and elsewhere,
what they'll do is say, "We know this policy worked."
Oh, how do you know that?
"Well look, the interest rates changed."
That's what they're studies show, but if you ask them, and I have asked them.
I said, "Well okay, but that ... Did that come along with more spending?
Did it reduce unemployment?
Did it actually ultimately achieve the macro economic changes that we really care about?
'Cause we don't care about the interest rate per se."
They would say, "Well the studies on that are [00:52:30] a little less clear."
In other words, no, we have no evidence that that happened, and I don't think it happened
very much.
It's no secret that the recovery was sluggish, but it is perhaps a somewhat well kept secret
that quantitative easing just didn't work very well when it comes to the things that
really matter.
Trevor Burrus: So is the whole thing kind of quixotic, and the endeavor of the Fed,
it doesn't seem to be ... It's made a lot of mistakes, arguably [00:53:00] the Great
Depression, and 2008.
It's trying to figure out the right number in a very complex economy so you could criticize
it on sort of Hayekian or Austrian grounds, no one can really figure out what the right
rate is and things like this, and it makes a lot of mistakes, and some of those mistakes
are cataclysmic.
So is this the kind of thing that is too error prone to continue to exist in the way at least
it does, or there are in the Fed people that is just ... It's not undertaking worth doing
or doing well.
George Selgin: [00:53:30] Well it's easy enough to point to the mistakes the Fed has made,
and to argue as you say along hierarchy and lines that it's unlikely we could have a Federal
Reserve that doesn't make mistakes like this because the ... Both the information required
and the necessary incentives are lacking for it to always be expected to do the right thing.
[00:54:00] But to get from there to saying "Therefore we shouldn't have a Fed," it ... You
can't just jump to that conclusion from those observations.
You have to have an idea in mind of some alternative arrangement that is going to be capable of
addressing these problems, that is gonna do a better job of stabilizing the economy.
Now I did say earlier that in the past we had systems like the Canadian system, Scottish
system that [00:54:30] worked pretty darn well, but they also depended on the existence
of reasonably stable external monetary standard, a precious metal standard that was the foundation
for the whole thing.
I also explained that if you don't have precious metal, if you don't have a commodity standard
of some kind, you've got to have a public authority that's ultimately controlling the
supply of your fiat monetary standard.
So we either have to go to some commodity, [00:55:00] doesn't have to be gold or silver,
could be bitcoin-
Trevor Burrus: Then could be bitcoin.
George Selgin: Some call it a synthetic commodity.
But let's not get into a bitcoin discussion for once.
But if you're not gonna do that, and they're all kinds of reasons why trying to get back
to a metallic standard is very difficult proposition.
Trevor Burrus: See our last episode with you?
[crosstalk 00:55:23] We'll link it in the show notes.
George Selgin: That's right.
Then of course you have to have at least [00:55:30] a skeletal central bank that's responsible
for the total quantity of fiat money, then the question is can we organize things so
that it arranges that quantity, or manage that quantity in a way that's more satisfactory
than what we've seen over the course of the Fed's existence?
I think the answer is yes, we could.
We could do a lot better.
I joined forces with a so called market monetarists and believing [00:56:00] that first of all,
our monetary policy should be oriented towards stabilizing total spending or statistically
it's counterpart of nominal GDP or something like that.
That that alone would be a vast improvement 'cause at least we're trying to do what we
should be trying to do.
Then it becomes a question of what are the right mechanisms for seeing to it that nominal
G&P is stable and a favor there, a more automatic approach so that we don't have to worry about
the [00:56:30] Fed officials being distracted by other concerns, goals, interest pressures.
So these are some of my thoughts, it would help to have a financial system that is itself
less vulnerable to crises, and there's a lot that can be done in that direction.
But it doesn't consist of heaping more regulations on to what we already have.
That's how we've gotten to the place we're at and it has not worked.
It rather consists of appreciating what kinds of deregulation [00:57:00] can help to lead
us to a self regulating arrangement.
That certainly includes getting rid of the promise of bailouts that is such a source
of corrupting factor in our system.
So there's a lot to be said about how we could do better than the present Federal Reserve
arrangement, but saying why don't we just rid of the Fed is not saying very much because
it really just leaves [00:57:30] you with begging all kinds of questions about what
sort of arrangement is supposed to fill that vacuum.
So I think we have to think hard about how we can get from where we are to a better system
and not just think about what we'd like to get rid of 'cause that's only half the story.
Trevor Burrus: Thanks for listening.
This episode of Free Thoughts was produced by Tess Terrible and Evan Banks.
To learn more, visit us on the web [00:58:00] at www.libertarianism.org.
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