Tuesday 18 March 2014

Paying interest on reserves is a nonsense.


Frances Coppola (if I’ve got her right) argues here that where commercial banks have unprecedented amounts of reserves, the central bank can still control lending by uping the interest paid on those reserves. But that throws up an absurdity, as follows.
If I decided to keep thousands under my matress in the form of physical cash, and someone suggested that government / central bank / taxpayers should pay me interest for that useless activity, that would be regarded as a joke. But physical cash is base money: just like reserves. I.e. paying interest on reserves is as absurd as paying people to keep cash under their matress.
I suggest the solution to that absurdity is that the currency issuer, ideally, should never pay anyone simply to hold currency. Instead, demand should be controlled by controlling the AMOUNT of currency issued. And indeed the latter policy has been or is advocated by others: e.g. Prof. Richard Werner, Positive Money, Warren Mosler and (as far as I can see) Milton Friedman at one point in his career. Thus if and when central banks start dishing out large amounts of taxpayers’ money to banks (and hence bank customers) for effectively keeping cash under their matresses, the latter individuals and groups will have a good chortle.
Moreover, two recent studies have shown that interest rate adjustments are pretty ineffective in regulating demand. See here and here.

3 comments:

  1. Frances gets the wrong end of the stick IMO.

    Just think of a bank that always lends and never bothers with deposits. It just goes to the discount window all the time and gets the Central bank to lend to it directly.

    That's the outer limit. A bank will always lend to a creditworthy borrower prepared to pay a price above that charged at the discount window.

    Which is why Warren says that we should just cut out all the inter bank crap and effectively make all regulated banks go straight to the discount window - by providing a central bank overdraft.

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    Replies
    1. Yes but in Warren’s zero interest rate world, what rate would banks pay at the discount window? I don’t like the idea of the rate being 0%, if that’s what you’re suggesting.

      As to regulating demand, and as a leading MMTer Warren would presumably go along with having govt / central bank just create new money and spend it (and/or cut taxes) so as to control demand. As to banks, looking for funds, I suspect he’d favor leaving them to borrow from whoever they can at whatever rate of interest they can. It could be in that scenario that bank share and bondholders and depositors would want and average of 5% or even 10% for funding banks.

      If banks in that scenario were suddenly allowed to go running to the discount window and borrow at 0%, that might at a stretch be excusable in an emergency, but I don’t approve that “free money” as a permanent source of funds for banks.

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  2. The confusion between currency, reserves, and XXXX continues!

    If money was simply a physical object like gold or currency, the confusion would be considerably less. Gold would be the easiest because it is difficult to increase in quantity. Currency introduces a degree of complexity because anyone can print currency.

    A third degree of complexity comes when central depositories are used. Known as 'banks', central depositories dispense with physical holding of either gold or currency and instead use strict accounting.

    The strict accounting fails as a physical record when deposits are loaned and dispersed to third parties. After dispersal with subsequent redeposit into the banking system, (two or even) more claims can come to exist on each physical dollar originally deposited. The possible existence of dual (or even more than two) claims on each original physical dollar is the cause of bank runs.

    Now I agree with you that it is nonsense to pay interest on reserves UNLESS the goal of the Central Bank is simply to transfer funds to the operating interface banks. The Central Bank might do this if they wanted to keep the interface banks solvent in a time of weak demand for additional money. Apparently something is causing more money to flow into the economy than the economy can use.

    A future discussion might explore if too much money is REALLY being supplied. "Too much" would probably be coming from government expenditures but most economist will not agree that government expenditures actually increase the money supply. Plenty to discuss here.

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