In Which I Try and Fail to Understand the Current State of Right-Wing Monetary Economics: Wednesday Focus: March 19, 2014

Josh Bivens sends us a link to a House of Representatives hearing he participated in, with a striking discussion that takes place at the 45:00 mark…

On the panel, in addition to Josh, were Larry White,[1] Marvin Goodfriend, and Paul Kupiec. Congressman Bill Foster asked why predictions five years ago that the Federal Reserve’s expansion of its balance sheet would produce runaway inflation had been wrong:

Marvin Goodfriend said he would: “forgive people who… did not catch what what the Fed was doing” and so forecast inflation. In his view, the Fed’s “dumping so many reserves into the system created a zero opportunity cost environment and the banks just held the reserves”, and that was not something that we had seen since the 1930s–hence not something people should have been expected to forecast.

Paul Kupiec added: “It was worse than that: [the Fed] pay[s] [banks] 25 basis points on holding reserves…”

And Larry White chimed in: “the Fed has sterilized those injections” that had taken “the monetary base and see[n] it double and triple…” by paying interest on reserves.

On the videotape, Josh Bivens looks visibly flummoxed. I can see him thinking: “All of these guys are relatively orthodox quantity theory guys–they all expect a tripling of the monetary base to cause 200% inflation. And here they are, all saying that what you need to halt that 200% inflation is for the Fed to offer to pay 0.25%/year on reserves. Paying the banks $5 billion a year on their $2 trillion of reserves is enough to stop a 200% inflation in its tracks, and do so indefinitely. Do they really believe this?”

Apparently they do…

House Committee on Financial Services hearing: Federal Reserve Oversight: Examining the Central Bank’s Role in Credit Allocation:

Congressman Bill Foster: During the financial collapse and the extraordinary accommodation that came in response to it many of my colleagues on the right routinely predicted runaway inflation. You saw talk about “debasing our currency” and so on. In terms of the runaway inflation, which I think that we have not seen in the five or so years since then, how could they have been that wrong? If we could just go down the line and hear why the predictions of runaway inflation that we heard were so wrong.

Marvin Goodfriend: We had the typical model of the money supply in the textbooks uses a money multiplier that says that for every dollar of [outside] reserves that banks have they create ten dollars of [inside] money. What happened–and that is the way the world worked as long as–and here is a little technical detail–as long as the interbank interest rate was above zero and the interest rate on reserves was zero. So there was an opportunity cost of holding reserves so that banks had a fraction of reserves that they would hold against their [inside] money [deposit obligations]. And what happened when the Fed dumped reserves into the system was that the interbank interest rate went to zero–which was the interest on reserves–in the jargon of academics there was a zero opportunity cost of holding reserves. We had never seen that before. And so people who aren’t taking money and banking in my class, they are not going to notice that, but that is what happened. The Fed by dumping so many reserves into the system created a zero opportunity cost environment and the banks just held the reserves. The last time we saw anything like that was in the 1930s. So I forgive people who kind of did not catch what the Fed was doing and what would happen.

Paul Kupiec: It was worse than that: they pay them 25 basis points on holding reserves.

Lawrence White: Yes, I think that is right. If you look at the monetary base and see it double and triple–the Fed’s balance sheet, that is, you think that: “high inflation is coming”. But you have to recognize that the Fed has sterilized those injections.

Congressman Foster: So you would attribute the failure of those on the right to correctly anticipate that there was not going to be runaway inflation to a lack of economic sophistication, roughly speaking?

Lawrence White: On the right and on the left.

Congressman Bill Foster: Those on the left did not share this mania about runaway inflation. Dr. Bivens, do you have a diagnosis of this failure to understand the problem?

Josh Bivens: Yes. I think inflation remained so low in spite of those predictions because people totally underestimated how long it would take the economy to recover. We still have deeply depressed aggregate demand in the economy. That is what is keeping prices low. I just do not buy that a quarter of a percent [per year] interest rate on reserves is what is keeping all those reserves from flying out into the economy. What is keeping prices low is the enormous gap between potential supply and aggregate demand in the economy, even today.


[1] Do recall that Larry White is really, really, really, really not a fan of Ben Bernanke’s monetary policy at all:

Inflation is inadvertently fostered by the discretionary policies of central banks…. Inflating central bankers like to pose as inflation fighters… [and] stabilizers of financial markets…. The Bernanke Fed—and normally one shouldn’t personalize the Fed, but here the topic is actions that exemplify the rule of men in authority rather than the rule of law—has by its arbitrariness violated the rule of law in at least the following… creat[ing] new ‘facilities’ for lending to nonbanks and for buying their illiquid or toxic assets, even dedicating the majority of the Fed’s asset portfolio to these facilities… set[ting] up a special subsidiary… to sweeten an acquisition deal to protect the bondholders of the investment house Bear Stearns… buy[ing] and hold[ing] bad assets from a single failed insurance company… jamm[ing] the failed investment house Merrill Lynch down the throat of Bank of America… the Fed violates the rule of law by its repeated use of §13(3)….

There is much to be said for… free banking on a gold or silver standard… set[ting] a strict limit on the volume of money and credit created…. [Friedrich] Hayek… said… ‘that the monetary system must be under central control has never, to my mind, been denied by any sensible person’…. The sequence of Federal Reserve actions… should give us pause…. Perhaps the Federal Reserve System… is now moving us away from freedom and along the road to serfdom.