By Dan Kervick
In my recent post Escaping from the Friedman Paradigm, I noted the following remark by Paul Krugman on the way monetary policy ordinarily functions when interest rates have not fallen to the zero bound:
… people are making a tradeoff between yield and liquidity – they hold money, which offers no interest, for the liquidity but limit their holdings because they pay a price in lost earnings. So if the central bank puts more money out there, people are holding more than they want, try to offload it, and drive rates down in the process.
And I was very critical of this model of central bank open market operations. As I put it then:
… what in the world can it mean to say the central bank “puts money out there” that people then try to “offload”? How can that happen? The central bank doesn’t stuff money into people’s pockets, and it doesn’t force them to hand over their financial securities in exchange for money. It offers money in the open market in exchange for securities. So if people preferred the securities to the money, they would’t have traded the securities for the money in the first place. It makes little sense to say that financial institutions first seek money for their securities on the open market, and then having too much unwanted money hanging around seek to dump it by obtaining securities for their money.
Interestingly, Krugman offers up the very same flawed model in a piece in yesterday’s New York Times:
Now, think about what happens when the Fed makes an open-market purchase of securities from banks. This unbalances the banks’ portfolio — they’re holding fewer securities and more reserve — and they will proceed to try to rebalance, buying more securities, and in the process will induce the public to hold both more currency and more deposits.
Again, this model of Fed securities purchases makes no sense to me. The central bank doesn’t buy securities by exercising some kind of eminent domain. It doesn’t force banks to sell their securities. Rather, the Fed Open Market Desk announces it’s intention to buy securities and the primary dealers then submit offers. In other words, the Fed offers to pay money for securities in the open market, and banks only sell those securities if they accept the price determined by an offer they themselves have made. So it makes little sense to say that at the end of this process the banks find their portfolios in an undesired condition and therefore need to “rebalance” them.
When Krugman says that the banks then “induce” the public to hold more currency and deposits, I take it he means that the banks then lower their lending rates so that more people are willing to borrow at the new, lowered rate. This they do, according to Krugman, in order to carry out the portfolio rebalancing he has described. But I believe the process here works quite differently. The Fed has no ability to push dollars and deposit balances out into the economy by forcing undesired money on banks which will then force the money onto the public, but achieves its aims by targeting interest rates.
Banks generally make their money on the spread between the rate they must pay for additional funds and the rates they are able to charge for the loans they make to the public, and the key rate in the market for funds is the rate paid in the interbank lending market (the “Fed Funds” rate.) The Fed has shown that it has the ability to target this rate with very little volatility. Thus it simply announces the new rate it wants to set, and participants in the market move automatically to that new rate. If the rate is lower than it was previously, this will increase the banks’ willingness to loan at lower rates than previously and will thus build up aggregate bank deposit balances. This will increase the banks’ aggregate demand for reserve account clearing balances to handle the larger volume of payment obligations that are the natural consequence of the expansion of deposits. The primary dealers, who possess reserve accounts at the Fed and are themselves the key supplying participants in the interbank market, will attempt to satisfy that demand by selling more securities to the Fed in exchange for dollar reserve balances. And the Fed then buys those securities via open market auctions.
So Fed open market purchases are not aimed to force money through the system and out into the hands of the public. They are designed to support and accommodate the higher demand for reserves that the Fed itself has influenced by announcing a new target Fed Funds rate. The Fed influences lending and expands bank balance sheets by targeting prices, not quantity. And of course, none of this works any longer once the Fed Funds rate has fallen close to the zero bound, and the Fed cannot set the rate any lower.
Also, Krugman is still attempting in this new piece to defend the loanable funds model of credit markets. He often seems to suggests that when banks want to increase their loans, they satisfy their increased demand for funds by attracting more deposits from the public, presumably by offering better rates for CDs and term deposits, better services etc. But while that might make sense from the standpoint of some individual banks, it makes little sense from the standpoint of the banking system as whole, and cannot explain the function of bank credit markets in response to an increased demand for consumer loans. For the most part, when a bank customer deposits funds in a bank, those funds come from transfers from another bank account. For example, your employer’s paycheck to you is a payment order issued against your employer’s own deposit account at some bank. if you deposit your employer’s paycheck in your bank account, your bank will ultimately collect the funds by receiving a transfer into its reserve account from the reserve account of your employer’s bank. The same sort of transfer occurs if you move your deposit account from one bank to another to take advantage of better terms. An individual bank can absorb deposits from its competitors and use those funds to expand its lending; but the banking system as a whole cannot in any significant way increase its lending by sucking up deposits. Instead, banks extend their lending and deposit account liabilities first, which increases its subsequent demand for larger clearing balances in its reserve accounts, which the banking system as a whole then meets by absorbing injections of funds from the Fed as part of the open market operations described above.
Paul Krugman seems determined to be the last dinosaur standing in defense of some outdated models of central bank operations.
Cross-posted from Rugged Egalitarianism