Tuesday, September 29, 2009

Selgin on Sumner's Penalty Rate on Excess Reserves

The discussion on Cato Unbound continues.

Selgin endorsed Hummel's criticism of Sumner's proposal to impose a penalty on excess reserves.

I think that the interest rate that the Fed pays on reserve balances should be less than zero--right now.

Consider the following:

  • Private issue of currency.
  • No reserve requirements.
  • Frozen monetary base.

But, the base is a money market mutual fund. The shares are kept at one dollar and invested in Treasury bills. The interest return on the portfolio it transferred to the banks holding the reserves, but the banks pay a 25 basis point management free.

The cost of holding reserves is the management fee. The benefit is reduced transactions costs of more active asset and liability management to continue to meet net clearing obligations. Presumably, the equilibrium demand for reserves is larger than would be the case with zero interest reserves. Less asset and liability management is necessary for the banks. Generally, the cost of financial intermediation is a bit less, the margin between the interest rates banks charge and pay is smaller, and the total size of bank balance sheets are larger.

However, the demand for reserves should still be positively related to the variance of net clearings, the amount of gross clearings, and so nominal income. The market process by which free banking stabilizes nominal income should still apply.

Further, changes in the interest rate will not change the opportunity cost of holding reserves. It will change the interest rate earned on clearing balances in proportion to changes in other interest rates.

If T-bill rates fall, then the interest rate that banks earn on their reserve balances fall too. If T-bill rates fall to something very near zero, the interest rates that banks earn on reserve balances will fall to something a bit less than zero.

It is a feature, not a bug. If interest rates on Treasury bills fall to zero, and there remains an excess demand at zero, and reserve balances have a zero interest rate, it is certainly possible, if not likely, that banks would seek to increase reserve holdings, and disrupt the market process that stabilizes nominal income. If, on the other hand, the interest rate on reserves moves with other interest rates, this will not be a problem.

Some scenarios where a free banking system would need to use the option clause would be unnecessary with interest bearing clearing balances--and those are scenarios where it is the ability of interest rates to fall, even less than zero, that avoids the disruption of using the option clause.


  1. You make some good points here, Bill. Certainly the situation at the moment is exceptional, and there is much to be said for the idea of charging banks an implicit fee for the service of maintaining their reserve balances.

    That leaves me with the following residual complaints about the idea of negative interest payments "right now." (1) Having all but monopolized check clearing, the Fed would be able to charge fees well above the competitive rate, and cannot be trusted to mimic competition if given the freedom to charge any rate it likes. (A fee of zero might in fact be closer than what greater Fed discretion would give us.) (2) It especially doesn't seem right to charge banks a service fee proportional to their reserve holdings while also subjecting them to reserve requirements.

    By the way: I'm pleased by your having noticed David Beckworth's blog. He was one of my (all too rare) Ph.D. advisees at UGA, and I'm also impressed by the work he's been doing, both with his blog and elsewhere.

  2. This comment is slightly off-topic, because it doesn't just concern this post, but also previous entries covering the same discussion at Cato Unbound.

    If inflation is defined as an increase in money supply relative to demand, and deflation is defined as a decrease in money supply relative to demand, then it seems to me that changes in both the money supply and the price level can occur independent of inflation and deflation.

    The price level can fall because of a decrease in the supply of money relative to demand, but it can also fall because of a decrease in the money supply relative to the supply of other goods -- usually an increase in productivity. The latter, in my opinion, is not deflation.

    It strikes me that central bankers treat any fall in the price level as though it were caused by decrease in the money supply relative to demand (i.e. deflation), but such a policy would have distortionary -- and potentially bubblicious -- consequences in the case of a decrease in the money supply relative to the supply of other goods.

    To put it another way, productivity gains do not necessary reduce velocity, and if central bankers do not correctly identify what part of a price level change is caused by deflation, their money supply increases are likely to cause trouble.

  3. Lee:

    I think your analysis is mistaken. I don't think that improved productivity results in deflation independent of the quantity of money and the demand to hold money. Despite that, I think that monetary institutions that stablize the growth path of nominal expenditure are best, and unexpected shifts in productivity should be allowed to change the price level. On the other hand, I think a stable trend for the prices of goods and services is best, with the result that nominal incomes grow with the trend growth real incomes.

    I will prepare a post on this later.

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